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Tax Deferred to Roth Strategy
Old 06-03-2004, 08:47 PM   #1
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Tax Deferred to Roth Strategy

Situation:
I am retiring soon, a few months before I turn 59. For the first 3+ years, I plan to use after-tax money to supplement a small pension. By age 62 I will have to start withdrawing from my tax-deferred IRA (because after tax money will be exuasted by then except for an emergency fund) . My marginal federal tax rate in retirement will be 15% and I will be a long ways from hitting the 25% bracket. My state tax rate is approx. 5%

Proposed Strategy:
I do not currently have a Roth IRA. I am thinking that once I start withdrawing from my tax-deferred IRA at 62, I should open a Roth IRA account and withdraw an additional amount beyond what I need to supplement pension and social security for living expenses. The additional amount would be equal to the annual limit for a Roth contribution.

Is this allowed by the tax rules? That is, can I put a partial IRA withdrawal into a Roth, or does a Roth have to be funded from either earned income or a complete IRA conversion? (I couldn't find anything on Roth web sites that says whether this is allowed.) If it is not allowed, then there is no reason to read the rest of this note.

If it is allowed, then here is my rationale for doing it:

I will have to pay 15% + 5% extra tax on the additional withdrawal. (I would pay that tax with existing after-tax money.) But I will have to pay that tax sometime in the future anyway. I realize my total amount invested at any point in time would be less under this strategy (by the amount of the extra taxes paid, and any growth that money would have generated). But I am thinking that maybe the tax-free growth in the Roth would eventually offset that. As an added benefit, it would reduce the impact of RMD at 70 1/2 for the tax-deferred IRA since there would be less in it.

Do you think this is a sensible strategy? If so, I might even open a small Roth account now with after-tax money to get the 5 year clock started. Thanks.

Dale
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Re:  Roths need earned income or conversions
Old 06-03-2004, 09:22 PM   #2
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Re:  Roths need earned income or conversions

Nope, you have to fund a Roth from earned income or via a conversion.

If you need a specific tax-law quote, you could work through IRS Pub 590 (http://www.irs.gov/pub/irs-pdf/p590.pdf, I didn't see a 2004 version yet) or you could post at Ed Slott's IRA discussion board (http://www.irahelp.com/cgi-bin/forum/index.cgi/) where the CPAs seem to live for providing detailed answers to IRA questions.
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Re: Tax Deferred to Roth Strategy
Old 06-04-2004, 04:25 AM   #3
 
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Re: Tax Deferred to Roth Strategy

I offer this only for entertainment value. Doubt it will
help anyone else.

Most of my net worth is tied up in a very small PHC
(personal holding company). It used to be a manufacturing company until I shut it down (to ER)
in 1993. The company had a relatively large net
loss carryforward which could be used to offset
future profits in the corp. (if any). I've worked it way down in 11 years but the corp. still pays no income taxes due to the NOL.
Also, since I get most of my income through the corp.,
I have 100%% control over how much I take out each
year, so that I can cap my income at a level which
allows me to pay no personal income taxes either.

Thus I am currently a 100% non-income tax payer at
both levels. This won't go on forever of course, and
it would be pretty difficult without a working spouse

John Galt
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Re: Tax Deferred to Roth Strategy
Old 06-04-2004, 05:01 AM   #4
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Re: Tax Deferred to Roth Strategy

I too periodically look at conversion but also have been too lazy and too leery of my ability to predict future tax and returns. So my trad. IRA stays unconverted for now. But 'may' 'maybe' a small amount someday?
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Re: Tax Deferred to Roth Strategy
Old 06-04-2004, 08:58 PM   #5
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Re: Tax Deferred to Roth Strategy

mcci,

Vanguard has a nice package explaining the
ins and outs of IRA to Roth conversion. Give
them a call. I looked into conversion but like
GDER and unclemick I am too lazy to follow up.
I do remember that you can convert part of
your IRA. It is not necessary to do a total
conversion.

My question to the great unwashed is this: If
you convert part of an IRA to a ROTH one year
can you add to the same ROTH the next year, etc.,
or do you have to set up a new ROTH each year?

BTW, if you do convert some of your IRA, pay the
tax out of after tax savings. I think Vanguard has
a calculator on their website that will give you a
feel for the tradeoffs.

Cheers,

Charlie
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Re: Tax Deferred to Roth Strategy
Old 06-05-2004, 12:01 PM   #6
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Re: Tax Deferred to Roth Strategy

Thanks to all for the information. *I'll check the you links provided and also Vanguard's calculator.
A partial conversion to top off the tax bracket *each year may be a good stragegy but I'll have to look carefully at the trade-offs. *It looks more beneficial for a younger person who would have more years for the Roth to grow tax-free to make up for paying taxes at conversion time. *

For anyone else who is interested in converting to a Roth, I found this web site last night that has a lot Roth information, including a good explantion of the rules for conversions and the trade-offs to consider.
http://www.fairmark.com/rothira/index.htm
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Re: Tax Deferred to Roth Strategy
Old 06-05-2004, 03:09 PM   #7
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Re: Tax Deferred to Roth Strategy

Charlie,

I believe that annual contribution to a ROTH is not affected by how much, if any, you convert from a traditional IRA. They are mutually excelusive events, if you will.

No new (different) Roth IRA is required. Both annual contributions and conversions can be put in that same account because they are all after-tax money.
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Re: Tax Deferred to Roth Strategy
Old 06-05-2004, 09:07 PM   #8
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Re: Tax Deferred to Roth Strategy

Thanks, mickeyd

The only reason I brought up the question of
separate ROTHs for each conversion was because
of the 5 year holding period before you can withdraw
without paying tax on the gains. How does one
keep things straight?

Cheers,

Charlie
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Re: Tax Deferred to Roth Strategy
Old 06-06-2004, 07:09 AM   #9
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Re: Tax Deferred to Roth Strategy

Vanguard's booklet on IRAs explains all this stuff very well. Vanguard would handle the accounting for withdrawals and in general Roth distributions are: contributions first, conversions second and investment earnings last. The document is in their site's forms section and is downloadable to a PDF format.

Bill
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Re: Tax Deferred to Roth Strategy
Old 06-06-2004, 03:16 PM   #10
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Re: Tax Deferred to Roth Strategy

Thanks, Bill

Cheers,

Charlie
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Re: Tax Deferred to Roth Strategy
Old 06-09-2004, 12:08 PM   #11
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Re: Tax Deferred to Roth Strategy

I'm planning to move shares of two tech stocks that tumbled after the bubble from a Vanguard IRA to a Vanguard Roth IRA while the values are so low, thus minimizing tax liability. Of course, this plan is predicated on the belief, perhaps unjustified, that the stock values will grow substantially in the future. BTW, the stocks are CSCO and NUAN.

db
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