The right way to go about it (Roth IRA)?

[LRAO]

For those who need a re-fresher about me...

I'm now 29 y/o.

Self-employed physical therapist who maximizes his solo 401(k) contribution every year.

I have been maximizing my Roth contributions the last 4 years.

So every year, I convert the 401(k) money into a "rollover" IRA. It's stupid, but it's necessary as 401(k) money is very "touchable" in a lawsuit but IRA money is less "touchable."

Anyways, so now I have a nice chunk of change sitting in the rollover IRA, which is eligible to be converted to a Roth. This would cost me quite a bit, but I think it would be worth it, and my rationale is:

a. it's tax-free money at the end, and I have lots of time for compounding to work for me.
b. I do not know what tax-bracket I'll be in, nor do I know what the government will do to tax-brackets.
c. I don't spend a lot of money, so the money I spend on the taxes for now won't be missed terribly (I would probably just find another investment to put that money now anyways).

So, should I convert?

 

[brewer12345]

What bracket would you be converting in? If its above 15%, I would hold off. Its nice to let the gummint's money compound for your benefit...

 

[retire@40]

Convert enough to keep your long-term tax payments at a minimum.

If you convert nothing, you may end up in a high tax bracket in the future.

If you convert everything, you may pay a lot of unnecessary tax now and be in a zero tack bracket in the future.

Spreadsheets are your friend.  And you will need to spend time tweeking them at least once a year to forecast your future taxable and non-taxable income.

 

[Nords]

So, should I convert?

Maybe.  You have to do the math for your situation.

It makes a lot of sense to convert a little every year (or during low-income years) up to the top of the 15% bracket.  It's hard to believe that future taxes will be lower than that amount... although the govt could theoretically scrap the current system in favor of another type of tax. There's a finite amount of risk in paying taxes now while hoping that the rule changes won't screw you later.

Converting now and paying the taxes from taxable funds (and not from the IRA) effectively boosts the size of the IRA.  It's a "freebie" contribution.

Converting before RMDs means that you won't be required to take withdrawals that might push you into a higher income-tax bracket.

Converting before RMDs means that you won't have to raise your earned income and subject your Social Security to taxation.

And finally, judging from the stress levels of my parents-in-law & IRAs, converting to a Roth avoids the complication of having to correctly calculate an RMD and then having to correctly calculate the tax basis of that RMD.

 

[eridanus]

So every year, I convert the 401(k) money into a "rollover" IRA. It's stupid, but it's necessary as 401(k) money is very "touchable" in a lawsuit but IRA money is less "touchable."

I thought it was the other way around?

http://www.latimes.com/business/investing/la-ira-story3,1,6221607.story

 

[uncledrz]

So every year, I convert the 401(k) money into a "rollover" IRA.  It's stupid, but it's necessary as 401(k) money is very "touchable" in a lawsuit but IRA money is less "touchable."

I seem to remember that the last time I looked at this in detail (admittedly several years ago) the 401k was better protected than the IRA because the 401k plan itself had a nonalienation provision in the establishing documentation.

Anyone else have better information on this?

Uncledrz

 

[LRAO]

Thanks for the replies.

What's an RMD?

 

[boutros]

Thanks for the replies.

What's an RMD?

Same as an MRD...

I guess that won't answer your question.  My handy acronym decipher says required minimum distribution. You required distribution when your 70.5 or whatever the age requirement might be 40+ years from now.

 

[Martha]

RMD is required minimum distribution.  There are RMDs for 401ks and traditional IRAs, but not Roths.

On the issue of creditor protection, under changes in the bankruptcy code any 401k is fully protected from creditors, even solo 401ks.   If you don't file bankruptcy then the question is whether ERISA is sufficient to protect the solo 401k. There is a dispute in the applicable professions about whether a 401k, established by an employer which has no employees other than the owner,  is protected from creditors under ERISA.  However, most say at worst the solo 401k will be treated the same as an IRA.  So I have trouble seeing the rationale for the conversion unless your state has some odd ball version of the law.  


EDIT: poked around a little more and it looks like that there are some states that have IRA exemptions without catchall exemptions for other plans like solo401ks. So, if that state finds that the solo 401k isn't exempt under ERISA, you are better off with an IRA. However, your option if you are in those kind of financial straights, may be to file bankruptcy and get the broad protections of the bankruptcy code in retirement plans.

 

[LRAO]

It makes a lot of sense to convert a little every year (or during low-income years) up to the top of the 15% bracket.

How do you figure out how much you can convert "up to the top of the 15% bracket"?

Thanks.

 

[REWahoo]

How do you figure out how much you can convert "up to the top of the 15% bracket"?

I'm using a tax software program (TurboTax, TaxcCut) or an online tax estimator to do some “what if” estimates on how much you can convert from a traditional IRA to a Roth (each dollar converted is taxable as income) and stay within the 15% bracket. The program will tell you both your average rate and your bracket (the rate at which your last dollar of income is taxed).

 

[mathjak107]

just curious,,,how many people are actually in higher tax bracket retired then when they were working and earning a pay check?

not many i bet

 

[mathjak107]

i could never see taxes being higher ,not income tax anyway....with 1/3 of our population a baby boomer headed for retirement or retired i can not imagine a politician or group telling the baby boomers they are raising their tax brackets....i dont see that in the cards..also the brackets themselves are going up by about 3,000 every year..in a few years even a 100,000 a year may end up in the 15% bracket...couple that with moving to a state with either low or no income tax and i dont see taxes being higher for 95% of americans......why anyone would want to pay taxes now for a remote chance they may be higher when they arent working is not great odds in that direction in my opinion.....

 

[Gone4Good]

i could never see taxes being higher ,not income tax anyway....with 1/3 of our population a baby boomer headed for retirement or retired i can not imagine a politician or group telling the baby boomers they are raising their tax brackets....

Hmmm.  Me thinks the baby boomers are going to have a choice to make - they can either vote to increase taxes or they can vote to cut Social Security and Medicare.  Any guess what they'll choose?

 

[Nords]

How do you figure out how much you can convert "up to the top of the 15% bracket"?

Assuming that you meet the initial conditions for a conversion, there are two ways.
1.  The "Easy Button".  Ask a tax preparer or a CPA to figure it out for you.  They'll figure it out from Forms 1040 and 8606.  Or, if you're a do-it-yourselfer,

2.  Admittedly this is a method that only an engineer could enjoy.  If your situation deviates from mine (e.g., collectibles sales or commodities trading or selling real estate or some unusual deduction) then my advice is worth what you paid for it.

Estimate your AGI for the year (including interest & non-qualified dividends) by filling out the front page of Form 1040.  Subtract whatever's taxed separately (like your long-term cap gains, your 28% cap gains, & your qualified dividends).  Subtract your deductions (or the standard deduction) and then subtract your exemption.  Take the resulting number and subtract it from the top of the 15% bracket to see how much of a taxable portion of your IRA you can convert.  We'll call this the "taxable amount", and let's say that it's $30K.  (Hey, you have a big mortgage interest deduction.)

If you've made only deductible IRA contributions and never had to fill out Form 8606 in your entire life, then congratulations-- you're done!  That taxable amount is the same as the conversion amount, so that's how much you can convert to stay within the 15% bracket.

If, like the rest of America's taxpayers, you've made non-deductible IRA contributions and have a basis in your conventional IRA, then you may want to push the limits.  If that's the case then take a clean copy of Form 8606, a pencil, and (unless you do your sudokus in pen) a big eraser.  Fill it out through line 7 using the IRA's basis (from your last Form 8606 plus this year's non-deductible contributions) and the latest value of all your conventional (non-Roth) IRAs.

Line 10, the non-taxable fraction of your IRA, is determined by dividing the Line 5 IRA basis by its Line 9 total current value.  Let's say that fraction is 0.250, indicating that 25% of the amount of your IRA conversion is not subject to tax (and 75% is subject to tax).  The total amount of your conversion becomes the taxable amount divided by the value of (1 - non-taxable fraction) or (1 - 0.250).  For a taxable amount of $30,000 your total amount converted would be $30K/(1 - 0.25) = $40,000.

This calculation assumes that your IRA is going to stay flat during the rest of the year.  If it rises in value, more of your conversion will be subject to taxes and that may push you over the 15% line.

BTW Form 8606 lines 7 & 8 track other distributions or conversions that you've already made that year.  I've assumed those numbers are "zero", but if they're not then you may want to consult a tax pro.

just curious,,,how many people are actually in higher tax bracket retired then when they were working and earning a pay check?
   not many i bet

My tax bracket when I'd have to take RMDs will be about the same tax bracket as my working years, but you're asking the wrong question.

When you're ER'd and not taking RMDs or SS, and maybe not even a pension, your tax bracket is about as low as it's ever going to get during your life.  The time before those income streams start is the time to convert from a conventional IRA to a Roth.  Once the RMDs start, no matter what bracket you're in, it's all too easy to lose SS to taxation.  I'm not aware of any IRA conversion calculators that address this ER situation, and most of them don't even address the SS taxation issue.

i could never see taxes being higher ,not income tax anyway....
why anyone would want to pay taxes now for a remote chance they may be higher when they arent working is not great odds in that direction in my opinion.....

I've been paying taxes since 1977 and I don't think that today's brackets have ever been lower.

But good luck with that, my friend.  Gotta do your own math for your own situation.

 

[REWahoo]

2. Admittedly this is a method that only an engineer could enjoy. If your situation deviates from mine (e.g., collectibles sales or commodities trading or selling real estate or some unusual deduction) then my advice is worth what you paid for it.

Estimate your AGI for the year (including interest & non-qualified dividends) by filling out the front page of Form 1040. Subtract whatever's taxed separately (like your long-term cap gains, your 28% cap gains, & your qualified dividends). Subtract your deductions (or the standard deduction) and then subtract your exemption. Take the resulting number and subtract it from the top of the 15% bracket to see how much of a taxable portion of your IRA you can convert. We'll call this the "taxable amount", and let's say that it's $30K. (Hey, you have a big mortgage interest deduction.)

If you've made only deductible IRA contributions and never had to fill out Form 8606 in your entire life, then congratulations-- you're done! That taxable amount is the same as the conversion amount, so that's how much you can convert to stay within the 15% bracket.

If, like the rest of America's taxpayers, you've made non-deductible IRA contributions and have a basis in your conventional IRA, then you may want to push the limits. If that's the case then take a clean copy of Form 8606, a pencil, and (unless you do your sudokus in pen) a big eraser. Fill it out through line 7 using the IRA's basis (from your last Form 8606 plus this year's non-deductible contributions) and the latest value of all your conventional (non-Roth) IRAs.

Line 10, the non-taxable fraction of your IRA, is determined by dividing the Line 5 IRA basis by its Line 9 total current value. Let's say that fraction is 0.250, indicating that 25% of the amount of your IRA conversion is not subject to tax (and 75% is subject to tax). The total amount of your conversion becomes the taxable amount divided by the value of (1 - non-taxable fraction) or (1 - 0.250). For a taxable amount of $30,000 your total amount converted would be $30K/(1 - 0.25) = $40,000.

This calculation assumes that your IRA is going to stay flat during the rest of the year. If it rises in value, more of your conversion will be subject to taxes and that may push you over the 15% line.

BTW Form 8606 lines 7 & 8 track other distributions or conversions that you've already made that year. I've assumed those numbers are "zero", but if they're not then you may want to consult a tax pro.

Jeeez Louise, Nords. You left out the part about what to do if you approach critical mass and an implosion is imminent.

 

[HFWR]

I think it was something about raising a frosty beverage... 

 

[Nords]

Jeeez Louise, Nords.  You left out the part about what to do if you approach critical mass and an implosion is imminent.

Sorry, I thought everyone knew what to do for that.

I did learn that, no matter how much it lightens the mood, you're not supposed to say "Oh, #$%^!" before you order the Reactor Operator to insert a full manual scram.

 

[mathjak107]

boy can you imagine doing a roth if it existed instead of a deductable ira back in the days when up to 60% of ones income was taxed...what a screwing.................
lets face it if the gov't gives us something, there has to be something in it that  puts the odds of benefiting from it in their favor....the push now to get you to convert to a roth is a scam for most americans...they want the tax money from you that they may never see....as i point out all the time,,, you can withdraw almost 35,000 every year at retirement from a traditional or 401k with about 1500 bucks total tax due on it...almost 20,000 at zero and the next 15,000 at 5%...... thats 35,000 every year almost tax free...why would most people want to throw that away and convert to a roth ? to add insult to injury if you convert you know have almost 1/3 less money working for you to boot

 

[uncledrz]

you can withdraw almost 35,000 every year at retirement from a traditional or 401k with about 1500 bucks total tax due on it...almost 20,000 at zero and the next 15,000 at 5%...... thats 35,000 every year almost tax free...why would most people want to throw that away and convert to a roth ? 

If the IRA withdrawals are the only income, I don't disagree with your assesment. The problem crops up when a couple has other income streams which will take them into a higher tax bracket. A bit of planning and some payment now can avoid what may be higher taxes later. Say you've got a couple with a $12,000 a year pension, social security each of $12,000 a year, non deferred assets which generate $24,000 a year as well. That totals to $60,000 a year. If withdrawals were completely voluntary from the IRA's, then tax would not have to be realized. But at 70 and 1/2 the government requires withdrawals to start. A good portion of that money will be taxed at a rate higher than 15%.

OTOH, if they can manage their income now (delay social security, for example), they can then convert at the 15% rate and the Roth IRA will not be taxed, and is not subject to mandatory withdrawals.

Of course, the government can change the rules. It has done so before, but that's a risk we all take.

Uncledrz

 

[mathjak107]

the slight trade off in tax on the marginal amount is way offset by having the extra dough growing for you all those years that you would have payed up front as tax

 

[REWahoo]

the slight trade off in tax on the marginal amount is way offset by having the extra dough growing for you all those years that you would have payed up front as tax

Is this the same reasoning you used to decide it was way better to lease than buy a car?

 

[mathjak107]

well we dont want to start the lease vs buy thing again,but the fact is yes depending on how long you intend to keep the car the lease is the better deal if you like a new car every 3 or 4 years....especially if you trade the car in back to the dealer at the wholsale price like most people do....

i believe the figures were over 80% of retires are in the 15% or lower bracket...some of us may not be but most of america is

 

[REWahoo]

i believe the figures were over 80% of retires are in the 15% or lower bracket...some of us may not be but most of america is

So, for those of us in the 20% who are/will be above the 15% bracket, this...

the slight trade off in tax on the marginal amount is way offset by having the extra dough growing for you all those years that you would have payed up front as tax

...isn't necessarily true.

 

[Nords]

the slight trade off in tax on the marginal amount is way offset by having the extra dough growing for you all those years that you would have payed up front as tax

In just about every Roth IRA conversion discussion in which I've participated, I've pointed out that the conversion taxes should be paid from funds outside of the IRA.