T-IRA -> ROTH conversion best practices?

[walkinwood]

Assuming that it makes tax sense to convert from your traditional-IRA to a ROTH IRA, what are your practices?

Seems to me, that the best thing to do is to move an estimated amount from T-IRA to ROTH (maybe a bit more than you think you'll need) early in the tax year. That way, if the transferred assets increase in value, you're ahead of the game. If the transferred assets decrease in value, you can recharacterize it at the end of the year and make another transfer. (That's what I understand. Is this right?)

Just before you file for taxes (or 4/15), you can trim your transfers to stay within your desired tax bracket by recharacterizing any excess.

I just found out that recharacterizing a contribution is a piece of cake at Vanguard. They walked me through it on the phone. They also did all the calculations & moved the appropriate amount.. Turbo-tax makes it easy to report.

Any other things I should be thinking off or doing?

 

[ronocnikral]

Technically, you have until 10/15 of the following year to recharacterize if you file for an extension.

Which account you convert into and recharacterize back into play a part. And there are time limits to "re-converting".

We discussed a lot of it here. http://www.early-retirement.org/forums/f28/roth-conversion-question-61045.html

 

[walkinwood]

Thanks, I missed that thread. Good stuff there!

All - if you have anything to add, please consider using the thread linked above.

 

[Animorph]

That's pretty much the plan I have for the next few years. It looks easy to recharacterize whole accounts, but not so easy to partially recharacterize. I plan to convert a slightly small amount at the beginning of the year into a new account. If the market declines during the year, I'll recharacterize the older conversion and convert again into a new account. At the end of the year I can fill in with a small conversion if I have too much extra space. I'll know my tax situation better than as well.

I also try to convert investments that seem to be down compared with the rest of my investments. Hopefully that adds a tiny bit of extra value if they pop back up at any time in the future.

Not too much room to convert this year since DW decided to work half time through the end of the year, but we'll still get some in. And then there should be many years of this, right up to and maybe a couple of years into RMD's. I should be an expert in a couple of years.

 

[Free To Canoe]

This is my personal Tira to Roth best practices.
My income in early retirement has been low and I pay 0 federal taxes with some tax deduction room left over.
I have been converting as much as I can and still pay 0 federal tax. I figure that this is a can't go wrong scheme, even if I end up paying 0 federal tax after I start collecting SS and the inevitable RMD catches up with me. The Savers Credit and last minute IRA contributions have been very useful for making income adjustments.
Thanks Ronocnikral for the link.

 

[mickeyd]

I have been piece-mealing my TIRA-Roth conversion over the last 6-8 years. The first (main?) thing that I always take into consideration is how much of my taxable savings stash I want to "spend" on federal taxes. If I have an abundance of cash sitting around earning less than 100bp and I don't have any large costly projects in the near future (new car, home upgrade etc) I generally do a conversion each December and pay the quarterly taxes via EFTPS.

 

[Koolau]

I did a lot of conversions after ER. I had significant already-taxed money to cover the taxes AND to live on (keeping taxes low). Now, I'm nearly out of already-taxed-money. So, rather than converting any more, I'm just using the deferred money to live on. Withdrawals get into the 15% bracket, but that would be true even if I converted. The other thing I did was make a stab at estimating what my initial RMDs would be. Based on my cash burn vs investment growth, I think I have the RMDs about where I need them to be without further withdrawals. So, I guess my suggestion would be to keep potential RMDs in mind and don't go overboard on the conversions (unless, like Free To Canoe you can convert at 0% tax.)

Someone a lot smarter than me (and familiar with TurboTax, etc.) can probably titrate this to the nth degree - never paying too much tax now and also keeping future RMDs in a range that keeps taxes low when reaching 70 1/2. Of course, the big question is whether tax rates and brackets will change significantly, and none of us has that crystal ball.

So, to get conversion "right", it seems to me that one needs a good handle on the future of:

Income totals (by year) and their sources (deferred pensions, etc.) and timing (don't forget when you plan to take SS)

Estimated RMDs when you reach 70 1/2 (investment growth within tIRAs/401(k)s is a key here as well as your current totals)

How long will your already-taxed money last.

What else did I miss??

 

[Animorph]

A few things I do try to keep in mind:

ACA subsidy income limits,
Tuition tax credit income limits,
Roth contribution income limits (with some earned income),
Tax brackets and the new $250k/$400k AGI special tax case income limits.

Given that dividends are a big end of year unknown, it's going to be fun trying to hit a specific target.

 

[Independent]

I've done this in years when we've been in a 15% marginal bracket because I'm estimating that we'll eventually be in the 25% bracket.

I don't feel any need to hit a specific amount of transfers, all I care about is that I fill up the 15% bracket. If I move more than that, I pay 25% now instead of 25% later, that doesn't seem like a big problem to me.

 

[Koolau]

A few things I do try to keep in mind:

ACA subsidy income limits,
Tuition tax credit income limits,
Roth contribution income limits (with some earned income),
Tax brackets and the new $250k/$400k AGI special tax case income limits.

Given that dividends are a big end of year unknown, it's going to be fun trying to hit a specific target.

Specifically, the Medicare monthly premium sliding scale based on MAGI (or is it AGI?). Probably not an issue as you would already be into the 25% or 28% bracket by then. If so, one probably would not do a conversion (of course, YMMV).

 

[FinancialDave]

That's pretty much the plan I have for the next few years. It looks easy to recharacterize whole accounts, but not so easy to partially recharacterize. I plan to convert a slightly small amount at the beginning of the year into a new account. If the market declines during the year, I'll recharacterize the older conversion and convert again into a new account. At the end of the year I can fill in with a small conversion if I have too much extra space. I'll know my tax situation better than as well.

I also try to convert investments that seem to be down compared with the rest of my investments. Hopefully that adds a tiny bit of extra value if they pop back up at any time in the future.

Not too much room to convert this year since DW decided to work half time through the end of the year, but we'll still get some in. And then there should be many years of this, right up to and maybe a couple of years into RMD's. I should be an expert in a couple of years.

I am wondering with all these conversions and recharacterizations do most keep the investments intact, or convert the account to cash first.

Seems like if the account is converted to cash anywhere along the line you could easily lose any benefit of the recharacterization, if the market turned on you.

fd

 

[Animorph]

I am wondering with all these conversions and recharacterizations do most keep the investments intact, or convert the account to cash first.

Seems like if the account is converted to cash anywhere along the line you could easily lose any benefit of the recharacterization, if the market turned on you.

fd

No, all investments are intact and never cash. All through Fidelity online, I just tell them how many shares of each fund to transfer to the new Roth account. The recharacterizations will just change the new Roth account back into a regular tIRA account. The only small glitch is that I can't be sure what the exact value of the Roth conversion will be, since it will be priced at the end of the day. Not an expert yet though, just a couple of Roth conversions to my name, and one of those was cash (and left me with a tIRA with $0.01 in it after Fidelity credited it with an interest payment.)

 

[FinancialDave]

Here is what bothers me about this strategy - it has a flavor of market timing to it, that as we know may or may not work out in your favor. For instance say you convert, your fund goes down, so then you recharacterize hoping to pay less taxes later - however because of the market shortly after the recharacterization and before you can convert back, the market jumps up and never looks back - you just LOST money, and worse yet you have lost "time" if you have a plan to convert a certain dollar amount of your funds over time.

fd

 

[mickeyd]

For instance say you convert, your fund goes down, so then you recharacterize hoping to pay less taxes later - however because of the market shortly after the recharacterization and before you can convert back, the market jumps up and never looks back

To avoid this situation I always convert from my TSM IRA and exchange it into a TSM Roth. No change.

 

[FinancialDave]

To avoid this situation I always convert from my TSM IRA and exchange it into a TSM Roth. No change.

According to WordCrow.com, TSM can have 81 different meanings, however none of them seem to apply here - so may need some help.

The only way to avoid the situation talked about in this thread is to convert a money market account which has no chance of losing money.

fd

 

[Animorph]

Here is what bothers me about this strategy - it has a flavor of market timing to it, that as we know may or may not work out in your favor. For instance say you convert, your fund goes down, so then you recharacterize hoping to pay less taxes later - however because of the market shortly after the recharacterization and before you can convert back, the market jumps up and never looks back - you just LOST money, and worse yet you have lost "time" if you have a plan to convert a certain dollar amount of your funds over time.

fd

Not a problem! If the market goes down, I Roth convert again (using different tIRA shares) into a second new account. I can recharacterize the earlier Roth conversion account anytime (within the year) without consequence. The recharacterization makes it like the original conversion never happened, so no market hit. Especially at the start of my Roth conversion career, I have plenty of tIRA available for multiple stabs at hitting a market low. I do have to wait for greater of year end or 30 days, IIRC, before I can Roth convert the recharacterized account again.

Not market timing at all, since it's pretty much can't lose. Just a minor hassle to keep doing it over and creating new accounts. And don't want to screw up and leave too much or too little converted.

 

[FinancialDave]

Not a problem! If the market goes down, I Roth convert again (using different tIRA shares) into a second new account. I can recharacterize the earlier Roth conversion account anytime (within the year) without consequence. The recharacterization makes it like the original conversion never happened, so no market hit. Especially at the start of my Roth conversion career, I have plenty of tIRA available for multiple stabs at hitting a market low. I do have to wait for greater of year end or 30 days, IIRC, before I can Roth convert the recharacterized account again.

Not market timing at all, since it's pretty much can't lose. Just a minor hassle to keep doing it over and creating new accounts. And don't want to screw up and leave too much or too little converted.

I think you might be a little confused if you think anything to do with the market is a can't lose.

In the first place anytime any investment you own goes down you just lost money at least on paper -- sure recharacterize it and you don't have to pay the taxes, but if it keeps going down you eventually will have to sell it and pay the piper.

Let's take the second scenario. Your investment goes down 5% after converting it, so you recharacterize it back to the TIRA, now the investment goes up by 20%, stuck in the TIRA - wouldn't it have been smarter to have just left it in the Roth?

fd

 

[Felix Mulier]

The only way to avoid the situation talked about in this thread is to convert a money market account which has no chance of losing money.

fd

+1 - this looks like too much w*rk and not enough upside. Also, IMHO, these kinds of back-and-forth transactions are sure to attract someone's attention. I would say, also not worth inviting scrutiny.

Moe: What's a good word for "scrutiny"? Larry: "scrutiny!" Curly: NYUCK, NYUCK, NYUCK!

 

[RunningBum]

I think you might be a little confused if you think anything to do with the market is a can't lose.

In the first place anytime any investment you own goes down you just lost money at least on paper -- sure recharacterize it and you don't have to pay the taxes, but if it keeps going down you eventually will have to sell it and pay the piper.

Let's take the second scenario. Your investment goes down 5% after converting it, so you recharacterize it back to the TIRA, now the investment goes up by 20%, stuck in the TIRA - wouldn't it have been smarter to have just left it in the Roth?

fd

In the 2nd scenario, it sounds like when he recharacterizes back to the tIRA, at the same time he converts the same amount from a different tIRA. I looked and didn't see any rules against it as long as you are using different accounts but I could've missed something. Seems like a bit of work but it may be worth it.

I'd just caution that you should really understand all the rules as it's easy to screw yourself. I recharacterized once because some of the stocks lost money and didn't realize I couldn't just recharacterize the losers since it was all in one account, and I also couldn't convert again that year, again because of the one account. I think I more or less broke even but it was a lot of work and confusion to no advantage.

I recharacterized part of another conversion again last year because I had tried going to the top of the 25% bracket and that threw me into AMT taxes. That time my Roth was all in bonds so it hadn't grown much and recharacterizing the small gains was better than the AMT hit.

Someone mentioned not being worried about going a bit over the 15% bracket. Be aware that once you start pushing your total income above the 15% line such that qualified dividends and LT cap gains start getting taxed, every dollar you convert is not only taxed at 15% (if you are out of the 10% bracket), but a dollar of divs/CGs goes from 0 to 15%, causing an effective 30% tax. This continues until all of your divs and LTCGs are taxed at 15%, at which point the next dollar of conversion is taxed at 25% with no additional tax on divs/CGs. Take a close look at how the Qualified Dividends and Capital Gains worksheet on your taxes work to understand this.

 

[Animorph]

I think you might be a little confused if you think anything to do with the market is a can't lose.

In the first place anytime any investment you own goes down you just lost money at least on paper -- sure recharacterize it and you don't have to pay the taxes, but if it keeps going down you eventually will have to sell it and pay the piper.

fd

Geez, are you all in FDIC insured CD's?

Your original concern was being out of the market for a day or two during the conversion or recharacterization. That doesn't have to happen. No market losses there, and no need to "time" the market.

A loss during the conversion process is a good thing, not bad. If the market drops 50% after a Roth conversion, you recharacterize it back into a tIRA. At that point you're back to where you were with your tIRA at the beginning of the year, except it's now in two accounts. There was no extra loss due to the Roth conversion and recharacterization, just the "normal" loss you would have had in the tIRA. You immedately Roth convert different tIRA shares that are now worth 50% less. If you convert the same dollar amount as before, you now have 100% more shares in the latest Roth IRA. 100% more shares for the same taxable amount. That's a good thing. If you convert the same number of shares as before, then your tax liability for the conversion is now 50% of what it was for the first Roth conversion. Same shares in the Roth for half the tax cost. That's a good thing. You can always minimize the conversion tax hit or maximize the number of shares that are Roth converted. That's the no lose part. You can't make a giant timing mistake due to market changes. You can decide if it is worth $X to recharacterize and Roth convert again, and it's not hard.

Let's take the second scenario. Your investment goes down 5% after converting it, so you recharacterize it back to the TIRA, now the investment goes up by 20%, stuck in the TIRA - wouldn't it have been smarter to have just left it in the Roth?

fd

I think there may be a misunderstanding here that I was talking about converting all IRA assets to a Roth account in one big event. For tax purposes, this is a bad idea. I'm just converting maybe 10% of my IRA assets per year, and none of DW's yet. Some of your questions are very valid in that case.

You can Roth convert as much as you want and as many times as you want during the year, up to the total of your IRA's. However, you can't Roth convert the same shares twice within the same year. So once they're recharacterized back into a tIRA they're kind of out of commission for the year. There is no immediate tax consequences. At the end of the year you can recharacterize whichever accounts you don't actually want to leave as Roth conversions. Again, with no immediate tax consequences. April 15th of the following year you pay the tax for the Roth conversions you let stand.

So, you Roth convert by transferring shares from a tIRA into a new Roth account at the beginning of the year. The market goes down 5% and you decide to recharacterize that Roth account. First you create a second new Roth account and convert the same dollar value into it as you did for the first Roth conversion (transfer more shares than before). That gives you more shares in your second Roth account than the first even though the dollar value (and tax cost) is the same, because the market went down. The same day, or a few days later you can recharacterize the old first Roth conversion account. That old account is now a normal tIRA account. It has the same shares in it that you originally transferred from your old tIRA account, so it is like that first Roth conversion never happened, both in terms of shares in tIRA's and tax costs.

In fact, after all this, you have all the same shares you started the year with, and you haven't had to pay any transaction costs. You have been able to transfer more of those shares into a Roth account than you did at the beginning of the year. And you owe taxes only on the second Roth conversion, the same amount you would have owed for the first conversion if it hadn't been recharacterized. No share changes, other than location. No additional gains/losses and no shares bought/sold due to the conversion/recharacterization.

Now the market goes up 20% after the conversion/recharacterization and your tIRA and new Roth both go up 20% with it.

 

[larrytbm]

My technique is based on an Aug., 2002 article written by James Lange, CPA. Early each year, I set up 5 or more Roths, each a different stock or mutual fund. Total amount is about 2.5X more than what I anticipate keeping. Then 14-20 months later (Apr. 15th - Oct. 15th) I decide which Roths to keep and which to recharacterize. And I do the same thing 12 months later, even before making my decision on the previous years conversions.

I have been doing this for 5 completed tax years, paid a conversion tax of 11% while the assets have grown by 61%. The first year's conversions are now fully tax free and as each conversion hits the 5 tax year milestone, I can begin consolidating them. Even in bad years, I have finalized at least one conversion just to fully utilize all other tax breaks and credits. Gains have always been greater than the tax burden. Almost 50% of my portfolio is now in Roths so I guess it will get harder to make beneficial conversions, so some assets may still be in T-IRAs when I reach 70-1/2.

 

[Animorph]

Dug this thread up to add something, since I'm in the middle of doing some conversions now after waiting for the fourth quarter to avoid tax problems with a larger than expected conversion.

I'm converting each fund into a separate Roth conversion account, maybe twice as much as I want to convert, and will select which ones to recharacterize near tax time in 2014. I'll also convert to three new Roth conversion accounts with $6k, $3k, and $1.5k in cash. Given that most of my individual fund conversions will be about $12k, the cash will allow me to adjust the total amount converted a little closer (should be within $1.5k) to the tax limit I'm targeting. Without them, I could use a few smaller fund conversions, which might not work as nicely if they drop in value in 2014. The cash is a safe neutral investment that I still have laying around. No problem if it gets converted or not.

 

[Sesq]

My technique is based on an Aug., 2002 article written by James Lange, CPA. Early each year, I set up 5 or more Roths, each a different stock or mutual fund. Total amount is about 2.5X more than what I anticipate keeping. Then 14-20 months later (Apr. 15th - Oct. 15th) I decide which Roths to keep and which to recharacterize. And I do the same thing 12 months later, even before making my decision on the previous years conversions..

This is pretty clever. Some of the abusive ideas involve non-correlated assets or hedges or options. This is just picking winners by the nature of what the law permits.

I hope I remember it when I am ready (ha-ha).

 

[FinancialDave]

What I worry about is the fact that the IRS can change how it views what people might consider an entirely legal transaction and all of a sudden you end up owing more taxes and penalties than you expected.

Sometimes a transaction is entirely legal, but it is how the IRS views the intent of the transaction.

 

[sengsational]

One additional "best practice" that came up in another thread today would be to leave your 401(k) account open, rather than roll that into your tIRA. There are some caviats, but given low fees and stability, you won't "dilute" the after tax basis in your tIRA with all of the pre-tax 401(k) money, and your conversions will be a higher percentage tax free in the early years.