Roth IRA Conversion - Logic Analyst

[kannon]

Hello All -

While watching a PBS Infomercial it got me thinking about Roth IRAs - specifically - conversion to a Roth IRA from our 401/403's and Traditional IRAs.

My wife and I will be fully retired the end of this year. With our pension and delay of SS till age 70, I put together a financial plan spreadsheet. One tab focuses on Income Tax. With our planned income, we will have a few years at a 15% marginal tax rate, more at 25%, but eventually in our 70s with the RMD we will be shot into the 33% marginal tax rate.

Here's my thinking. We have a few years of what I call "tax headroom" - amount of money before we move into the next tax bracket. It seems "logical" that during those year's we take advantage of the "head room" to convert or IRAs to Roth IRAs. Thinking is that if we don't do anything and wait for the RMD, we will be in a higher tax bracket.

I know we will lose dollars to the tax pay out and lose those potential growth - my estimate is about 4% growth (we are only about 30% in equities). I ran an IRA conversion calculator on Vanguard and the amount saved was significant.

One other feature I like is that if we move funds to a Roth IRA it will be good for our kids which we hope to leave an inheritance.

Regardless, it appears a complicated analyst. Was hoping to understand all of the factors before I start modifying my spreadsheets.

Thanks

Kannon

 

[samclem]

Yes, what you describe is a very common situation and what you are doing is what many of us are doing/plan to do. Search around here a bit (term "Roth Conversion" etc) and you'll find lots of discussion on this.

The combination of RMDs and receipt of SS benefits can add up to a "tax torpedo" (another term of art you can search for), and lots of us try to reduce the size of our tIRAs to reduce the magnitude of the "torpedo".

In addition to converting your IRAs to Roths, along the same lines you may want to sell/rebuy stocks in your after tax account while you have some "headroom" in the 15% tax bracket (so, zero% cap gains taxes). This will reset the cost basis on those to a higher level, and possibly reduce later taxes if you need to sell after tax investments when you are no longer at the zero CG rate.

My own personal angle on this is to not go crazy with it. I'd take advantage of the 15% bracket, but I don't know if I'd do much at the 25% bracket to prevent paying taxes at 28%. In my own case, the purpose of our portfolio is to provide income throughout our lives, and right now (with a 40+ year horizon, maybe!) I like to reduce taxes, but I also need enough funds to make sure they see us through to the end. The money is a cushion against uncertainty (in returns, spending levels, government/tax policies, etc). If I get to be 85 and I have a lot of it, I really won't feel bad paying higher taxes at that point--the money got me to the finish line. So, while I'll do things to reduce highly-likely future taxes, I won't go too far in that direction--paying lots of taxes up front when I could get bad investment returns and wind up staying in a lower bracket anyway. Well, those thoughts are worth what you paid for them.

Good thinking, and good luck!

 

[jim584672]

Don't forget to factor in the loss of ACA subsidies due to higher income from the conversions.

 

[bamsphd]

If I get to be 85 and I have a lot of it, I really won't feel bad paying higher taxes at that point--the money got me to the finish line.

Bet you curse your younger self and the Government when you are 85.

However, I'll admit I'm doing basically the same thing right now. I looked at going after ACA subsidies and Roth conversions, but for 2014 I ended up harvesting 0% capital gains targeting a very small tax bill. I went that route mainly because I wanted to raise some cash and restore my equity/bond target allocation. I will revisit the question in December 2015, if not before.

 

[Rothman]

As the name suggests I like Roths! We didn't have that option early in our earnings years where they are a great choice for savings while in low tax brackets, but still should play a role for us. I think having a good mixture of taxable, tax deferred, and tax free is the best answer, while your Tv show guy seems to imply move everything to tax free. Tax free growth forever is attractive and small bequests to grandchildren or great grandchildren can extend the value over their life expectancy. The biggest opportunity is for people who have tax deferred accounts with significant after tax basis, moving those to a Roth and paying tax on pre-tax portion now in order to take advantage of the opportunity to capture tax free growth on the after tax money is huge. Lastly as you suggest using the portion of AGI to the next tax bracket has similar benefit to grow some Roth legacy money. I wish you success in your plan.


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[columbus]

I'm 35 and plan to convert a small ira soon at 25% tax for tax free growth.

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[Chuckanut]

I just ran a potential Roth IRA conversion for 2015 through my tax software, and some calculators that compare the after tax value in the future.

I figure my current and future tax rates will be the same 25%. That may be naive, but predicting the future is not one of my skills.

Basically, I end up pretty much with the same amount. I can pay the tax today and roll into the Roth, or pay it later as I withdraw the money in retirement.

However, the calculators omit the possible hit on taxing SS benefits that probably will occur when I withdraw from a traditional IRA after 70 1/2. So.......

It looks like the SS tax rules favor the conversion. But, I really hate to write that check.

 

[ChrisC]

One other feature I like is that if we move funds to a Roth IRA it will be good for our kids which we hope to leave an inheritance.

Regardless, it appears a complicated analyst. Was hoping to understand all of the factors before I start modifying my spreadsheets.

Thanks

Kannon

I started conversions last year, filling space in my bracket to minimize the tax torpedo impacting us in the future with RMDs. One factor I've seen considered, but not mentioned here, is the potential tax bracket of your heirs. It makes better sense to do the conversions as a legacy play to your kids, if you think your kids will be in high tax brackets or higher than the brackets you will be in during RMDs. On the other hand, if your children will likely be in low tax brackets, I'm not sure it makes a lot of sense for one to convert when you're at the 25 or 33 brackets, when the kids will be at the 15 percent bracket: you would be paying more in taxes in that case (and leaving less money in your estate) for kids who really can't take great advantage of the Roth.

 

[2017ish]

We likely will convert up to the top of the 25% or 28% bracket beginning year after we cease wage income; we are extremely lopsided with assets in tax deferred accounts. No way to get all or most of it converted in 12-13 years (unless market really tanks), but will convert so as to give us tax diversification and limit the marginal rate on the RMDs.

Haven't really crunched the numbers yet, as it has no impact on our decisionmaking today. Will do so before starting the process, but would be surprised if we don't follow this plan.

 

[Chuckanut]

The SS tax angle will get bigger and bigger because, IIRC, the amount earned before taxing SS begins is not indexed to inflation.

 

[Rothman]

ChrisC, you forget one unfortunate fact of using a traditional IRA for legacy transfer, it requires you to die early to leave a sum since the traditional IRA mandatory withdraws require you to draw down your balance every year starting at 70 1/2 while with a Roth there are no required minimum withdraws to meet since Uncle Sam already has his tax money. This fact lets a Roth set up for a grandchildren or great grandchildren to grow during your lifetime if you never need the money and continue to grow when young ones start to withdraw based on their life expectancy. Remember we all use these low SWR to be safe, the true expected probability is we will never touch that Roth which is our last fund to deplete only after taxable, and tax deferred have been exhausted.


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[ChrisC]

ChrisC, you forget one unfortunate fact of using a traditional IRA for legacy transfer, it requires you to die early to leave a sum since the traditional IRA mandatory withdraws require you to draw down your balance every year starting at 70 1/2 while with a Roth there are no required minimum withdraws to meet since Uncle Sam already has his tax money. This fact lets a Roth set up for a grandchildren or great grandchildren to grow during your lifetime if you never need the money and continue to grow when young ones start to withdraw based on their life expectancy. Remember we all use these low SWR to be safe, the true expected probability is we will never touch that Roth which is our last fund to deplete only after taxable, and tax deferred have been exhausted.


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Well. I think this is not entirely accurate. Roth 401Ks have RMDs for the owner. And inherited Roth IRAs have RMDs too. Roth IRA Required Minimum Distribution (RMD) | RothIRA.com

 

[Marc]

Don't forget state taxes. I am currently in a 6% state whilst I will be retiring to a state with zero personal income tax rate; so I am deferring making any conversions. When I get to Texas, I think it will probably be better harvesting capital gains at zero percent for a few years so I will again defer Roth conversions. I am hoping for at least five years (age 60-65) at 15% bracket then increase withdrawals from retirement accounts but stay in 25% bracket for next five years and then bite the bullet from 70 on with SS and RMD.

Of course, who knows what tax policy will be over the next dozen years.

Marc