Second thoughts on Roth Conversions

[ESRBob]

Was just talking to someone who has almost all their savings (about 1 million) in a traditional IRA, and is able to live on about 40k per year withdrawals, and is considering using the 72t exception to start those withdrawals now around age 50.

It seems to me that in a case like theirs, a Roth conversion may actually be counterproductive (not just a wash as many have argued here might be the case). Reasoning is that with just 40k or so of income, various deductions and exemptions could serve to get that taxable income down into the $20,000 range, where federal taxes would be substantially if not completely in the 10% bracket. It's unlikely they would be able to convert to a Roth at 10%.

I've been thinking all along of IRAs being kept for decades and even modest ones ballooning into huge numbers which would trigger RMDs at large tax brackets, but if you start draining the IRA through a 72(t) in your 50s, it might turn the math around.

Anybody been down this road before and thought through some of the implications?

[Zoocat]

Bob,
I don't know what a 72t is and it doesn't seem likely that many people are going to be in that situation. I have read your book and found it to be quite informative and valuable, especially for the reader (moi!) with "average" knowledge of investing. I think that your question poses an important issue: who are you writing your book for? Is it for the more sophisticated investor/early retiree or is it for the average person who wants to an overview of all the issues related to early retirement?

The reason I am converting my conventional to a ROTH is because I am assuming I will be in a higher tax bracket at retirement age. Even those older than me at 57 will likely be paying higher taxes in the future as our government comes up against the humongous national debt and obligations to social security and medicare.

Old babe

[gindie]

Quote:

Originally Posted by Oldbabe I don't know what a 72t is and it doesn't seem likely that many people are going to be in that situation.

Oldbabe, A 72t is a way to tap your IRA before 59 1/2 without penalty. You must make RMD's according to the IRS tables for 5 years or until 59 1/2, whichever is longer.

So, in the case that Bob was describing, that person would lock themselves into at least 9 1/2 years of withdrawls.

[Nords]

Quote:

Originally Posted by ESRBob It seems to me that in a case like theirs, a Roth conversion may actually be counterproductive (not just a wash as many have argued here might be the case). Reasoning is that with just 40k or so of income, various deductions and exemptions could serve to get that taxable income down into the $20,000 range, where federal taxes would be substantially if not completely in the 10% bracket. It's unlikely they would be able to convert to a Roth at 10%. Anybody been down this road before and thought through some of the implications?

It's a very good point, and probably why the conversion question is discussed ad nauseum infinitum.

Someone using a SEPP could take it a year at a time and decide whether or not it made sense to convert. By the time they hit 59.5 (end of the SEPP) they'd be very conversant with the legislation, all the factors, and the math...

[ESRBob]

I guess since you only have to take the withdrawals for 5 years or until 59 1/2 it isn't the end of the world if you get it wrong -- it's not like the 70 1/2 year-old's RMD schedule that locks you in for life...

Old Babe -- good point though about who the readers are etc. I think a book that goes through multiple editions is a bit like software that keeps adding features. Readers say they want more about ways to crack their IRA nestegg early, so, voila, a new section appears in this edition. I think the challenge will be making sure the book doesn't lose its simplicity even as it goes into more detail on certain topics. The good news is there aren't too many substantive changes (nobody who has the old one should need to rush out and buy a new one!) More on health insurance, early withdrawals and about a hundred tweaks here and there, mostly from reader input or forum discussions here. For example, I had to include George and Tioga...
http://vagabonders-supreme.net/blog/blog.html

[dgalbraith100]

Quote:

Originally Posted by ESRBob Was just talking to someone who has almost all their savings (about 1 million) in a traditional IRA, and is able to live on about 40k per year withdrawals, and is considering using the 72t exception to start those withdrawals now around age 50. It seems to me that in a case like theirs, a Roth conversion may actually be counterproductive (not just a wash as many have argued here might be the case). Reasoning is that with just 40k or so of income, various deductions and exemptions could serve to get that taxable income down into the $20,000 range, where federal taxes would be substantially if not completely in the 10% bracket. It's unlikely they would be able to convert to a Roth at 10%. I've been thinking all along of IRAs being kept for decades and even modest ones ballooning into huge numbers which would trigger RMDs at large tax brackets, but if you start draining the IRA through a 72(t) in your 50s, it might turn the math around. Anybody been down this road before and thought through some of the implications?

I'm not understanding what the difference in taxes they pay would be in a conversion vs. the 72t. Either way, they should pay the same amount of taxes, one is just 5 years early. (you need a 5 year delay before you touch the money from the conversion). Once the 5 years have expired, the money becomes a contribution which can be withdrawn tax/penalty free. I'm talking about using the conversion as a way to access the TIRA money instead of a 72t, not as a way to "use up your lower tax brackets".

Quote:

Originally Posted by ESRBob I guess since you only have to take the withdrawals for 5 years or until 59 1/2 it isn't the end of the world if you get it wrong -- it's not like the 70 1/2 year-old's RMD schedule that locks you in for life...

A 72t is 5 years or until 59 1/2 which ever is LONGER. So for those Early ER's doing the 72t thing can be a pretty long lock. (20+ years). I would use the Roth conversion as a way to access your TIRA money without the 72t lock. That way you get access to the money, you can increase/decrease/stop the conversions at any time if life changes (as it likely will in 20+ years).

You do need enough in taxable accounts to start the conversions after you retire, and be able to live for 5 years and pay the taxes on the conversions (don't use the conversion money to pay the taxes or you'll pay the penalty to, start early and you will pay for the taxes on your normal income+the conversion).

You are paying taxes 5 years early, but unless things change drastically, my federal taxes will be ~0. (Annual budget is currently ~30K, 2 kids), So the early tax issue is a non issue for me. (today anyway).

I'm using the Roth not as the "No income tax" vehicle, but as a way to get access to a TIRA with a 5 year delay and the freedom to stop which the 72t does not provide

Laters,
-d.

[CyclingInvestor]

I am 48, retired last year, with 87% of my savings in IRAs. I have started taking
72t distributions (easy-to-calculate method) on my big IRA (76% of total investments).
I will be moving from a high income tax state (CA) to a non-income tax state (WA)
in the next few years, where I will start Roth conversions on my small IRA (11% of
investments). Whether I continue them will depend on tax rates after 2010. I wll
then decide whether to stay in WA, or move to OR (another high income tas state).

Even with the 72t withdrawals and some conversions, my withdrawals from age 60
onward will probably be at high tax rates (assuming I draw 4% to age 70.5 and RMDs
thereafter), but if that is my biggest problem I will smile all the way to the tax office.

[teejayevans]

Quote:

Originally Posted by ESRBob Was just talking to someone who has almost all their savings (about 1 million) in a traditional IRA, and is able to live on about 40k per year withdrawals, and is considering using the 72t exception to start those withdrawals now around age 50. It seems to me that in a case like theirs, a Roth conversion may actually be counterproductive (not just a wash as many have argued here might be the case). Reasoning is that with just 40k or so of income, various deductions and exemptions could serve to get that taxable income down into the $20,000 range, where federal taxes would be substantially if not completely in the 10% bracket. It's unlikely they would be able to convert to a Roth at 10%. I've been thinking all along of IRAs being kept for decades and even modest ones ballooning into huge numbers which would trigger RMDs at large tax brackets, but if you start draining the IRA through a 72(t) in your 50s, it might turn the math around. Anybody been down this road before and thought through some of the implications?

But what happens when they start taking SS??
Also, wouldn't it be nice to have money that you are not force to take out starting at
70 1/2?
To me, if you can transfer up to the limit of the 15% tax bracket, and the choice of paying
15% now, or some unknown later, I'd take the 15%.
Tom

[ESRBob]

I'm suddenly feeling very fuzzy between the ears....

dGalbraith, good reminder of the 72(t) being the Longer of 5 years or age until 591/2.

Still what you are talking about amounts to using taxable income to prepay taxes on an TIRA conversion to a Roth with the idea that you'll then spend the money a few years later by taking it out of the Roth. It seems counterintuitive to me -- my thought with the Roths was always to keep the money in there as long as possible, once you'd taken the 'medicine' of prepaying the tax.

If you do have taxable income, then try to live on it, and when it is no longer enough, then go to the 72(t) distributions. They will/might be at low enough levels that your taxes will be zero or quite low -- if you were to withdraw, for instance, 30k a year and had two kids, you should have exemptions, standard deductions, child credit, maybe some deductible health insurance premiums via a self-incorporated business that would bring tax down to nil or near-nil.

If people are going to be converting Roths in any meaningful amounts, then they are going to be pushed up into at least the 15% bracket each year, so it would seem they would end up paying more tax. I've always been a huge fan of Roths, but this scenario made me re-think as it seems it could be a scenario where Roth conversion would lead you to pay more taxes.

TJ -- good point about SS -- that would push taxable income back up again, though of course you could delay it until 67.

Maybe one way out of it is to do both -- take 72(t) distributions if you need them, an then also do Roth conversions (perhaps out of a second IRA if the rules are fussy about this) up to the extent of using up any low tax brackets all through your years prior to taking SS. Then when you are drawing SS, you have the non-taxed Roth money to draw out if you need it, keeping overall taxes down.

Hopefully by the time you are forced to withdraw any remaining TIRA money at 701/2, the balance is low enough that the extra taxes aren't onerous. CyclingInvestor, this might offer you some relief even if you don't think you'll care too much.

This seems to be pushing us out of the realm of early retirement and into the realm of regular retirement. Maybe this is all well-trodden ground on some equivalent board to ours out there that deals with regular retirement issues? Anybody frequenting anything as good as ours out there for regular retirees?

[terminator]

Quote:

Originally Posted by ESRBob Reasoning is that with just 40k or so of income, various deductions and exemptions could serve to get that taxable income down into the $20,000 range, where federal taxes would be substantially if not completely in the 10% bracket. It's unlikely they would be able to convert to a Roth at 10%. Anybody been down this road before and thought through some of the implications?

This is related to a point justin made earlier this week about how low taxes can be for married people with kids. It's quite conceivable (ha ha) that a 50 y/o still has kids under 18 at home and can get a $1,000 per kid tax credit which makes those taxable numbers even lower.

Retirement planning really needs to be a question of individual situation. For instance, running the numbers on a mix of income that is 50% dividends and 50% ordinary income (wages, interest, non-qualified dividends, etc.) I can take $60k in income per year before I'd pay a single dime in federal taxes thanks to my married with kids status. Throw in a couple more kids, higher property taxes or mortgage interest or other itemized deductions and that would be even higher. So the "put a lot in the 401k/IRA" or "convert to Roth IRA up to the 15% bracket" standard advice isn't necessarily a right fit for everyone. Of course, who knows what federal tax laws will be in the future . . . .

[teejayevans]

Also, I think its good to be tax diverse:
1.IRA/401K
2.Roths
3.Taxable accounts
4.Offshore bank account

TJ

[Texas Proud]

Quote:

Originally Posted by ESRBob Maybe one way out of it is to do both -- take 72(t) distributions if you need them, an then also do Roth conversions (perhaps out of a second IRA if the rules are fussy about this) up to the extent of using up any low tax brackets all through your years prior to taking SS. Then when you are drawing SS, you have the non-taxed Roth money to draw out if you need it, keeping overall taxes down.

As someone else does at times.... ding ding ding....

This is what I was going to point out... why 'waste' a low tax bracket? If the person has any possibility of being in a higher tax bracket later in life, convert as much as you can up to the top of your low tax bracket... and pay the tax with non IRA money...

The only 'gotcha' on this is if you would be in a lower tax bracket... if he will 'use up' the $1 million, then it might not be a good idea to conver to ROTH as he will be taking out the money anyhow...

I am putting aside money in a ROTH hoping never to touch it... it is my 'reserve' for large unexpected expenses... I will leave it to some family member so they get to keep it as a ROTH.. but, I don't want to get so much in there that I mess up my taxes in later years..

[ESRBob]

Texas Proud,
I think that's my first 'ding ding ding' in my years of posting here. Feels great! Thx!

Not sure why it is, but finessing the tax system is like a hobby for me, and finessing Roth conversions has always been something like making a nothing-but-net shot from the half-court line 8) Having said that, I'm hit with AMT this year which kind of feels like tripping on the ball and kicking it out of bounds while falling flat on my face with 4 seconds left in the game...

[justin]

ESRBob,

I plan on doing exactly what the person in your OP is doing. I plan on taking $40-50k per year out of traditional IRA's at the most, so my taxable income after deductions and exemptions would be very small. It doesn't make sense for me to pay a lot of taxes to convert to roth's. This is a personal analysis each person must consider though. Not sure how RMD's will affect me, although there will probably be a very different tax scheme in place 35 years after I start ER when RMD's will be a concern.

I might convert a little to roth's to use up all the zero or 10% brackets (if the 10% bracket still exists in 7-8 years...).

[dgalbraith100]

I see two types of Roth accounts, one is where I put money that will be in there "forever" or as long as I can keep it there. That is for the tax free component, and is restricted to 4K a year and the conversion amounts that keep you in a "good" tax bracket.

The other type of Roth is for my income needs. This Roth account isn't for money to sit in, it isn't how you would normally think, or use a Roth. But... it provides a slick way to get access to your T-IRA money before 59 1/2. This Roth "account" is about Transfer.

Why not use a 72t? I am 35, and am just waiting a few more years to cover the health ins. piece (I could cover it with 4% right now, but I have a very long window to cover, so 2.5-3% WR would make me feel better). If I retire as scheduled, and start a 72t, I will be required to do the SEPP's for 20+ years, with dire consequences if I fail to get it perfect. The other big consideration is if I decide to take up a hobby that pays money. Doesn't matter in the 72t situation, you just get stuck with a bigger tax bill and money thats out of a IRA that you really wish you could leave in. In the Roth Conversion method, no big deal, you just have more money in your Roth than you planned on having. Not a bad thing.

I have enough in my taxable account to live for 5 years. During those 5 years, I will start conversions from T-IRA -> R-IRA. Starting on retirement year 1, I will withdraw the needed annual budget from the taxable, and convert the annual needed amount for year 6 into the R-IRA. In Year 6, I withdraw money from the R-IRA, and convert the T-IRA -> R-IRA needed for year 11. Taking money out of the R-IRA in year 6 is a tax/penalty free event because the money I converted is now a contribution.

This means I don't have to use a 72t which seems very restrictive for 25 years. Its all about the freedom, and as far as I can see, I give nothing up using this method to access the money. It just requires 5 years of planning. Its a different way of thinking about a Roth. This Roth is not about savings, its about transfer. Transfer your money from a T-IRA to a R-IRA and five years later transfer it into your savings account, avoiding the 10% penalty.

If a 72t results in zero in taxes, the conversion will also result in zero in taxes. They will be for the same amount, one will just be 5 years in advance. You pay no "extra" taxes going this route. (or fewer either). The only benifit is you don't lock yourself in to a 72t for 25 years.

Plan 1: (72t method)
1-5 live off taxable
5-25 do 72t and pay taxes on income.
Pay "income" taxes year 5-25.

Plan 2: (T-IRA -> R-IRA conversion method)
1-5 Live off taxable, convert t-ira -> r-ira paying taxes.
5-20 do conversion and pay taxes 5 years in advance.
Pay "income" taxes year 1-20.

At year 20, you can stop doing the conversions (or at least only convert enough to eat up the "good" tax bracket.) and live off the conversion without converting anymore because you will be 59.5 at year 25 (where you can just do standard TIRA withdraws)

Since the amount I will be converting will be low enough, I pay zero in taxes either way. So the flexablity of not doing the 72t appears to be the way to go.

Hopefully that gives people something to chew on.

Laters,
-d.

[ESRBob]

D-
I'm chewing!
Definitely never heard of this approach, but I can't find any flaws with it. It does seem to rely on a number of assumptions which might or might not come to pass.

I also wonder -- is the T-IRA really so big that it is such a piggy bank you can be dipping into for life, with you only in your mid-30s? If not, then you'll be earning income for awhile longer, and may be able to get a Roth 401k to be funnelling the money there instead of putting it first into the T-IRA and then going through the conversions.

Even if you leave your career employment, it may be easiest to start a little sideline business instead and set up a Roth 401k there which you could funnel all your earnings into, up to 15k + Cola per year. Continue to save like crazy now, which will generate taxable savings to live off of during semi-retirement.

[dgalbraith100]

Right now a large portion of my net worth (80%) is tied up in T-IRA's. Alot of years maxing out 401K's (and then rolling them to IRA's) and a really good stock bet. But to retire early I need access to the money. I do not want to be locked into something for 25 years. Initially I found the 72t and that was my plan, but the more I look at it, the more I think doing conversions to pull the money out is the safer way to go.

And if I'm wrong, then I can simply start the 72t and nothing lost. If I'm right, then I just saved myself being tied to the required SEPP until I'm 59 1/2. Which could be a long time.

Of course if I can't convince my wife to quit her job then the issue may be moot and so far she hasn't said yes, but she hasn't said no. I need about 4 more years to reach $1M assuming current contributions and standard market returns, better or worse will adjust the date.

No hurry, were both happy with the current status quo, but just want freedom in the options department. Once we have a choice, we'll see what comes.

And for a whole different thread, I find myself saving less the closer we get, it isn't how much we are putting in now thats driving the gains, so we have definatlly relaxed the budget.

Laters,
-d.

[ESRBob]

DG- Yeah, the bigger the portfolio, the harder it is for saving money to influence it. Once you're semi-retired, though, you can think not in terms of your portfolio size, but rather in terms of your annual spending amount -- say 4% of that. Then the savings (or splurges) become a material portion of the budget again. There may be a way to set up a shadow budget even while you're working that can keep the value of your savings still up front and center for you. Congrats on loading up the 401k and having it do well in the markets.

[teejayevans]

Quote:

Originally Posted by dgalbraith100 And for a whole different thread, I find myself saving less the closer we get, it isn't how much we are putting in now thats driving the gains, so we have definatlly relaxed the budget.

I think when time gets close (at least a year before you plan to RE), you should try to
live at the 4% level or less. If you can't do it, then you'll know before you leap that you
need more $.
tj