Thinking about a Roth conversion strategy

[swampwiz]

I was reading an earlier thread, and this got me thinking ...

A few years ago, I had a really bad year income wise, so I simply converted a small IRA I had, and ended up with about $9K in line 43 taxable income, with negligible tax liability. It was like a free conversion.

I am now going to transfer my nice, still fairly fat 401K to a traditional IRA. I plan to spend most of my time in a low cost foreign country, only bleeding a little bit off the 401K (with the 10% penalty ) as I need to. If the bleed would not be too high, then it seems that it would similarly make absolute financial sense to continue and convert any amount of traditional IRA to Roth IRA in which my line 43 taxable income would be below the total of the standard deduction, standard exemption(s), and capital loss (i.e., with my $32K in capital losses over the last 2 years, I will be able to use $3K of the carryover loss for the next 10 years!) And of course, so long as I would spend a lot of time abroad, any income I would receive would be tax-free (under a certain amount.)

So as a single person, taking 2009 as an example, I would essentially have a 0% tax rate up to $5700 (standard deduction) + $3650 (exemption) + $3000 (capital loss carryover) = $12350. And if I were married with a family, it would similarly be $21700 + $3650 for every child. And if the 0% rate were extended via a higher standard deduction or exemption (which I think Obama will push for as a back door way of lowering taxes on middle income taxpayers while raising taxes on the wealthy), then even more could be in this range.

What do you think?

 

[Gotadimple]

Yes.

 

[Animorph]

I'll be doing that when DW finally retires and we have no earned income for a few years until SS and pension kicks in.

 

[jdw_fire]

I plan to spend most of my time in a low cost foreign country, only bleeding a little bit off the 401K (with the 10% penalty ) as I need to.

if your income needs are very small consider withdrawing some of your contributions to your Roth instead of pulling from the 401k/TIRA and paying the penalty. the WD of Roth contributions would be tax and penalty free and i believe you could still make the TIRA to Roth conversions.

 

[Borbastic]

income tax in another country

I was reading an earlier thread, and this got me thinking ...

A few years ago, I had a really bad year income wise, so I simply converted a small IRA I had, and ended up with about $9K in line 43 taxable income, with negligible tax liability. It was like a free conversion.

I am now going to transfer my nice, still fairly fat 401K to a traditional IRA. I plan to spend most of my time in a low cost foreign country, only bleeding a little bit off the 401K (with the 10% penalty ) as I need to. If the bleed would not be too high, then it seems that it would similarly make absolute financial sense to continue and convert any amount of traditional IRA to Roth IRA in which my line 43 taxable income would be below the total of the standard deduction, standard exemption(s), and capital loss (i.e., with my $32K in capital losses over the last 2 years, I will be able to use $3K of the carryover loss for the next 10 years!) And of course, so long as I would spend a lot of time abroad, any income I would receive would be tax-free (under a certain amount.)

So as a single person, taking 2009 as an example, I would essentially have a 0% tax rate up to $5700 (standard deduction) + $3650 (exemption) + $3000 (capital loss carryover) = $12350. And if I were married with a family, it would similarly be $21700 + $3650 for every child. And if the 0% rate were extended via a higher standard deduction or exemption (which I think Obama will push for as a back door way of lowering taxes on middle income taxpayers while raising taxes on the wealthy), then even more could be in this range.

What do you think?

If you are referring to the foreign earned income exemption, that refers to income you "earned" (by working). Getting a work visa in another country could be a problem. If you mean your conversion to Roth, that would not be earned income. So unearned income is US taxable even if you qualify for the foreign earned income exemption.

Foreign Earned Income Exclusion - What is Foreign Earned Income

 

[yakers]

Does one have to declare to the IRA manager like Vanguard specific funds for conversion of a traditional IRA to a Roth IRA? My DW has began monthly withdrawals from her traditional IRA. We do not always need these funds and I tend to reinvest at least part of them in a taxable account. Federal & state taxes are withheld from the withdrawals and that is OK with us. We do not have any earned income. Can an amount equal or less than these withdrawals simply be deposited in her Roth IRA? It would be very convenient if we could occasionally do this after we see the cash flow situation each month. Better to invest tax free than taxable.

 

[lhamo]

I'm actually in the process of figuring out how to do this. We have been living overseas since 2002, and with the exception of one year when I had a taxable fellowship that messed things up, we have generally been under the FEIE limits every year, and have paid no U.S. federal income taxes with the exception of that one year. But I was contributing to a 403(b) account up until 2007 (new employer has a 403(b) Roth option, so I switched to that starting in 2008). I currently have a little over 100k in my old 403(b). So what I am planning to do is roll it over to a regular IRA at Vanguard, and then convert it into new Roth IRA accounts over a 5-6 year period, until everything is converted over.

DH and I generally don't have more than about US$5k in combined US earned income every year, and our taxable investment earnings have gone down considerably since we sunk most of our money into an apartment, so I figure I can convert about $20k/year into the Roth without having to pay any taxes on it (because it will still keep us below the $26k taxable income threshhold -- we have two kids, so U.S. earned + investment income has to exceed $26k annually for us to get into taxable range).

If it turns out that this works, we will probably take the same strategy with DH's 403(b) account after he leaves his current employer or retires. No reason not to switch money from taxable to tax-free accounts as you can, I assume.

Trying to find good resources that discuss this issue -- doesn't seem that there is much out there. Appreciate any tips/links anyone might have.

lhamo

 

[LOL!]

Why pay a 10% penalty? If you only need a little bit, then why not start 72(t) SEPP and withdraw without penalty?

Also when you do conversions, it's nice (and imperative) to pay the tax with money not from your IRA.

 

[smjsl]

If you are referring to the foreign earned income exemption, that refers to income you "earned" (by working). Getting a work visa in another country could be a problem. If you mean your conversion to Roth, that would not be earned income. So unearned income is US taxable even if you qualify for the foreign earned income exemption.

Foreign Earned Income Exclusion - What is Foreign Earned Income

Welcome to the board, Borbastic! Interesting point.. so if a person retires say in Canada, and gets all the income from dividends / interest, they do not qualify for the foreign earned income exclusion... Also, looking over form 1116 (I never used it), it seems like one can only get credit there to the extent of the earned income; i.e. if earned income is 0, line 16 there is 0 and you get no deduction... Does it mean that interest is double-taxed then? (I did not look into Canadian taxes though.)

I also checked out US-Canada treaty in this short pub 597 and not sure what to make of the following text regarding Roth IRAs:

A distribution from a Roth IRA is exempt from Canadian tax to the extent it would be exempt from U.S. tax if paid to a U.S. resident.

It seems to imply that Roth distributions could actually be taxable in US?! (Otherwise why would not they just say it's not taxable if it's never taxable in the US?)

It then goes on to say

In addition, you may elect to defer any tax in Canada on income accrued within the Roth IRA but not distributed by the Roth IRA.

But if you can defer it until distribution and distribution would not be taxable, then you don't have to pay at all... so, again, this seems to suggest that somehow the income accrued within Roth could be taxable in US (otherwise, it would not be taxable in Canada per previous statement)... ?

 

[Gotadimple]

Does one have to declare to the IRA manager like Vanguard specific funds for conversion of a traditional IRA to a Roth IRA? My DW has began monthly withdrawals from her traditional IRA. We do not always need these funds and I tend to reinvest at least part of them in a taxable account. Federal & state taxes are withheld from the withdrawals and that is OK with us. We do not have any earned income. Can an amount equal or less than these withdrawals simply be deposited in her Roth IRA? It would be very convenient if we could occasionally do this after we see the cash flow situation each month. Better to invest tax free than taxable.

Generally, one does identify the fund they want to convert. But it doesn't have to be that way. One can always convert cash instead of investments.

There is nothing to say that you couldn't do a monthly conversion, especially in a month when you don't need the distribution -- as long as you are not taking the distribution to meet a Required Minimum. I think in that case, you can't convert the RMD.

Out of curiosity, does Vanguard have to liquidate one of your investments in order to make the monthly distribution?

-- Rita

 

[Borbastic]

Welcome to the board, Borbastic! Interesting point.. so if a person retires say in Canada, and gets all the income from dividends / interest, they do not qualify for the foreign earned income exclusion... Also, looking over form 1116 (I never used it), it seems like one can only get credit there to the extent of the earned income; i.e. if earned income is 0, line 16 there is 0 and you get no deduction... Does it mean that interest is double-taxed then? (I did not look into Canadian taxes though.)

I also checked out US-Canada treaty in this short pub 597 and not sure what to make of the following text regarding Roth IRAs:
It seems to imply that Roth distributions could actually be taxable in US?! (Otherwise why would not they just say it's not taxable if it's never taxable in the US?)

It then goes on to say

But if you can defer it until distribution and distribution would not be taxable, then you don't have to pay at all... so, again, this seems to suggest that somehow the income accrued within Roth could be taxable in US (otherwise, it would not be taxable in Canada per previous statement)... ?

You can qualify for the FEI exclusion but dividends, interest, pensions etc are not considered earned income, and thus they are taxable to the US. Tips, wages are excludable.
You can claim a tax credit for taxes paid to other countries for unearned income. This is usually the case when you own foreign stock.
It is possible for a Roth to be taxable in the US, with early withdrawals.

 

[swampwiz]

if your income needs are very small consider withdrawing some of your contributions to your Roth instead of pulling from the 401k/TIRA and paying the penalty. the WD of Roth contributions would be tax and penalty free and i believe you could still make the TIRA to Roth conversions.

The Roth IRA was a conversion from a traditional IRA in 2005, so I would be able to withdraw without penalty. I had thought that it was after 2005. This opens up new possibilities.

The conversion amount was about $9K, but it it only has a value of about $5400 now. I suppose that I could take a complete distribution - or perhaps leave in a token amount - and have an extra $3600 in contributions left to take out at no tax. Perhaps I could convert some of the traditional IRA, and immediately take out the $3600 tax free? How should I exactly handle this?