Trad IRA RMD and Roth Conversion Strategies to Minimize Income Taxes

[chinaco]

Sorry... This is a long post because the topic is complicated. But it is worth a read!

I am studying a long-term tax strategy to optimize/minimize our income tax obligation. I am beginning to look into Roth conversions to try to understand how to deal with income taxes. One Issue that I am considering is the eventual RMD implications of a TRAD IRAs, 401ks, etc.

It is my understanding that a Roth IRA does not not require an RMD. Retirement Plans FAQs regarding Required Minimum Distributions

Has anyone considered how they are going to utilize a Roth Rollover to minimize the tax bite that might occur at 70 with TRAD IRAs, 401ks, etc?

The optimized strategy depends on one's situation and of course no one knows how future laws and tax structure may change the possibilities to minimize tax implications... But as they say Failing to Plan is Planning to Fail, so I am looking into strategies. The best I can do at this time is make some assumptions on the size of the account, inflation (increase in income level per tax bracket), and tax brackets.

I could not do this while DW and I were both working because of our earnings... We were constrained when DW was working because of our earning level and the limits on rollover based on income level. Now that DW is ERd and I am still working... I am in a high marginal tax bracket and any rollover would just push me into a higher bracket today.

However, once I ER (at 55), it seems that I have several years that I can use to my advantage to perform a series of yearly Roth Rollovers (while staying under a certain marginal tax bracket) to minimize the income tax that could hit us at 70. Plus get the benefit of future earnings on the Roth since they are completely tax sheltered.

Has anyone found a good source of information on strategies and techniques (legitimate and legal) related to the confluence of income tax, RMDs, etc with the goal of minimizing the tax bill? My goal, of course, is maximum net income and minimum taxes! But I do want to spend the money along the way.

Thoughts... Ideas anyone?

 

[52andout]

Everyone's income and spending is bound to be variable, but by reading the IRS publication and trying not to be confused we have done the following.

Year number one of retirement we had some income so used it to fund two roth IRA's to the max. We lived off the rest of the income and a little after tax savings for the first year. Tax we paid was shockingly minimal.

Year number two is this year. Due to years of tracking we estimate we will need about $55,000 before taxes to live on. I hope someone has a good source on how to figure this out as it would help us as well. I do know you don't pay much tax after deductions on this amount (compared to what we paid as two earners), so we will convert some to Roth.
I need to read Ed Slotts book again. irahelp.com Ed Slott America's IRA Expert

 

[kaneohe]

I've seen this one recommended a few times. Not sure I'd follow this to the letter yet but it gives one perspective......

Optimal Retirement Calculator and Retirement Decision Support System

 

[akck]

My general plan once retired is to take out enough to take full advantage of the lower tax bracket and roll it into a Roth each year before age 70. Of course, it ultimately depends on the then current tax structure.

I've also heard of people taking SS at age 62 and the year they pay it back to get the higher payout. They then convert what they can to take full advantage of the tax credit resulting from adjusting past returns.

 

[Gotadimple]

Has anyone found a good source of information on strategies and techniques (legitimate and legal) related to the confluence of income tax, RMDs, etc with the goal of minimizing the tax bill? My goal, of course, is maximum net income and minimum taxes! But I do want to spend the money along the way.

Thoughts... Ideas anyone?

You know, I don't think there has been anything published that adequately addresses partial Roth conversions to reduce RMD. I have read bits and pieces that hint at doing partial conversions up to a tax bracket, but most of the press is focused on full conversions from traditional to Roth.

So, I've developed my own strategy (and I think several here are doing the same):

Within limits of available cash in a taxable account, convert T-IRA to Roth up to a specified tax bracket limit. Tax bracket limit is defined as Top of the Selected Tax Bracket + Itemized Deductions + Personal Exemption.

The Tax Bracket limit helps to determine how much of the T-IRA can be converted annually to a Roth. ORP can also help in your situation by suggesting a "pattern" of conversion as it does a rough estimate of your tax bracket when compiling tables.

All of that is well and good, but what hasn't been discussed is how one draws from their various sources to get maximum income with minimum taxes. The general theory is draw first from taxable, then Traditional, then Roth. But I think there needs to be some combination to keep one within a specific tax bracket -- and at withdrawal time, keep income lower to avoid giving all the Social Security back in tax payments at IRS filing time.

-- Rita

 

[Nords]

I am studying a long-term tax strategy to optimize/minimize our income tax obligation. I am beginning to look into Roth conversions to try to understand how to deal with income taxes. One Issue that I am considering is the eventual RMD implications of a TRAD IRAs, 401ks, etc.
However, once I ER (at 55), it seems that I have several years that I can use to my advantage to perform a series of yearly Roth Rollovers (while staying under a certain marginal tax bracket) to minimize the income tax that could hit us at 70. Plus get the benefit of future earnings on the Roth since they are completely tax sheltered.
Has anyone found a good source of information on strategies and techniques (legitimate and legal) related to the confluence of income tax, RMDs, etc with the goal of minimizing the tax bill? My goal, of course, is maximum net income and minimum taxes!
Thoughts... Ideas anyone?

This subject seems to come up all the time. You could start with the first two lines of this FAQ Archive:
http://www.early-retirement.org/for...vert-my-ira-401-k-to-a-roth-or-not-30664.html

If you can predict that you'll be in a higher tax bracket someday (especially for RMDs or Social Security taxation) then it makes sense to convert to a Roth IRA to the extent that you stay in a lower bracket. We've been doing a little bit every year for nearly eight years.

One of the keys to conversion is to pay the tax bill using funds outside of the IRA.

 

[TromboneAl]

Are you sure you care about RMDs? The way I figure it, if I don't care about leaving a big inheritance, RMDs are not an issue. That is, if I'm not taking out the required minimum distribution it just means I'm not spending enough, and I should get my ass in gear.

Please tell me if I'm wrong -- no one has ever given me a reason for worrying about RMDs if inheritance isn't in the equation.

 

[Animorph]

Convert to Roth while we're ER's with no income, up to the tax bracket limit, as long as the taxable funds last. Then withdraw from traditional IRA up to the same tax bracket limit and fill in with Roth withdrawals to meet income needs. Long into retirement we still hit a crossover point where RMD's get large enough that we exceed the target tax bracket limit. It doesn't look like converting additional funds into the Roth beyond the tax bracket limit helps us any, so we'll probably have to put up with the higher marginal taxes later on. Better than higher taxes earlier on I guess.

 

[TromboneAl]

From this RMD calculator, if you were 76 today, and had $1 million in your account, your RMD would be $47,000, or 4.7% of your account value.

 

[chinaco]

...
All of that is well and good, but what hasn't been discussed is how one draws from their various sources to get maximum income with minimum taxes. The general theory is draw first from taxable, then Traditional, then Roth. But I think there needs to be some combination to keep one within a specific tax bracket -- and at withdrawal time, keep income lower to avoid giving all the Social Security back in tax payments at IRS filing time.

-- Rita

My thoughts exactly. That rule of thumb "Draw taxable first, etc) is like the general rule of planning your retirement income needs using 80% of working income. Works fine as a rule of thumb... but is not very accurate for detailed planning purposes.


Based on this IRS link, it appears that a beneficiary (e.g., spouse) of the TRAD IRA will still owe the income taxes on the IRA (as distributions occur). There doesn't seem to be any benefit in terms of step up on basis (if one dies unexpectedly).

http://www.irs.ustreas.gov/publications/p590/ch01.html#en_US_publink1000230538

Plus this IRS link indicates that an RMD cannot be rolled over into a Roth.

Retirement Plans FAQs regarding Required Minimum Distributions

Not sure if one can roll non RMD funds from the Trad IRA into a Roth in the same year RMD is taken (in addition to taking the RMD).

However, depending on how much money is in the Trad IRA or 401k... taking an RMD + SS + Other Sources and also doing a Roth Rollover might push one into a high tax bracket at 70. Possibly higher than the tax bracket one may have before RMD begins.

There are a number of factors to consider so some projections might help to understand it better. Perhaps doing projections for a best case and worst case scenario... but there a some unpredictable timing factors (such as market conditions at the time of RMD or other rollovers) that may cause affect the outcome.

It seems that doing a rollover at the end of a business cycle when the market has tanked might be used to one's advantage. For example, if the stock market drops by 35% at the end of the next business cycle... it would seem to be a good idea to begin rolling and reinvesting in stock (or stock mutual funds) in the Roth IRA.

 

[ejman]

I just simply use Turbotax as a forecasting tool for 2010. I input my expected income for 2010 and then I just play with various conversion amounts to see what the resulting additional tax would be. I realize there will probably be some tax changes but as far as I know the 2010 rates are not all that different from 2009. I'm also aware of the possibility of splitting the income to two years but at the conversion levels I look thats a nonevent. Using that approach I see that I can convert $10K this year at a cost of $800, while $20K would cost me $2,400 and so on. I then can decide how much tax I want to pay for this year. Based on that, my converting $500K this year - not going to happen...

 

[haha]

Are you sure you care about RMDs? The way I figure it, if I don't care about leaving a big inheritance, RMDs are not an issue. That is, if I'm not taking out the required minimum distribution it just means I'm not spending enough, and I should get my ass in gear.

Please tell me if I'm wrong -- no one has ever given me a reason for worrying about RMDs if inheritance isn't in the equation.

In my case, I have children but inheritance is not a huge consideration, though it is something that I hope to do. Still, I see good reason to avoid RMDs when possible. The 4% SWR is not written in stone. The RMD will necessarily cause me to pay more income tax, including more tax on social security. This is money that may come in very handy down the road. I find it hard to imagine a situation in which I would feel that I should get busy and spend more money.

Ha

 

[chinaco]

...
Please tell me if I'm wrong -- no one has ever given me a reason for worrying about RMDs if inheritance isn't in the equation.

Not completely sure Al.... that is what I am trying to figure out.

My basic question in the beginning was: can I smooth my tax events out and get a lower average tax bracket over a series of years instead of waiting till RMD begins.

The it occurred to me that the RMD is a taxable event. A Trad IRA to Roth IRA is a taxable event. If I experience a taxable event anyway... am I better off rolling the money into a Roth IRA and not having to pay any future taxes on growth after the rollover.

It seems to me that in certain situations one may be able to optimize/minimize their tax obligation.

But I do agree with you about the spending part

 

[Koolau]

Guess I'll weigh in here since I've always been a proponent of Roth conversions.

As mentioned before (alluded to by Nords in this thread) by paying the taxes with outside funds (money you have just laying around) you can actually increase the amount of money that will be tax exempt in the future. I've discussed this elsewhere and I'm guessing the Fairmark site does a better job. In essence, you end up with a "bigger" Roth IRA than you had when it was a T-IRA.

Roths DO have a lot of advantages for inheritance.

One big reason - and I know everyone says "don't base your decision on 'possible' future tax policy" - anyone here really think taxes will be lower in your lifetime than they are now? If you do, conversion probably doesn't make much sense. If, like me, you see only one way for taxes to go - i.e., UP - that's one more reason not to be "forced" to withdraw money through RMDs.

RMDs take away your flexibility for tax planning - no matter how tax policy morphs over the next few years. Flexibility is almost as important to me as marginal tax rates. That's why, for instance, I'm so glad I got a stack of I-bonds when I did. I can cash those in as needed and "titrate" my taxes to a given marginal rate. Some of the money has already been taxed and some of it is taxable (my gain). With RMDs, you take what they tell you to take - and most likely, every nickel of it is taxable that year. If that pushes you into a higher marginal tax rate or makes more SS taxable, tough!

So, I'm a proponent of Roth conversion - I just wish I were more skilled at determining the exact amounts to convert in which years, based on all the factors (that we know now) and maybe even with the guesses I'm willing to make about the future. My tax guy isn't much help. He's old school. He doesn't believe in tax "planning". So, if I give him a scenario, he'll calculate it for me, but he won't sit down and try to figure out a strategy for me.

 

[Stevewc]

Try this calculator over at vanguard. If you go through all the steps it touches on RMD just a little.
It might help some of you if you play around with the numbers once you see how it works. I've been checking it out trying to decide on some conversions.
Hope it helps,
Steve

http://www.archimedes.com/vanguard/roth/RothConsumer.phtml

 

[TromboneAl]

I just wish I were more skilled at determining the exact amounts to convert in which years, based on all the factors

In my situation the solution is to do my taxes in December. TaxAct has a preliminary version, so I can just do all the taxes, adjusting the conversion amount so that I'm in the bracket I want to be, then convert that amount.

I guess not everyone has all their numbers in December??

 

[harley]

In my case, I have children but inheritance is not a huge consideration, though it is something that I hope to do. Still, I see good reason to avoid RMDs when possible. The 4% SWR is not written in stone. The RMD will necessarily cause me to pay more income tax, including more tax on social security. This is money that may come in very handy down the road. I find it hard to imagine a situation in which I would feel that I should get busy and spend more money.

Ha

I'm with Ha on this one. In my case I wouldn't mind leaving an inheritence for DD, although I hope to be so old when I die that it won't do her too much good. But that's not my main reason.

I just prefer to be in control of my finances as much as possible. So I'd like to limit an required withdrawal. The tax issue is an unknown (lower, higher, the same). But in 16 years when I hit 70 I may not want to take money out of an account that could drive my taxes up. So I'm going to convert to a Roth as I go forward, doing the tax bracket and available cash to pay taxes thing. I think to some extent it comes down to whether or not you think you will need to take the money out of the IRA. If you absolutely will need it, then converting to the Roth may not be that important. But if you think you might not need to take it out, the Roth gives you more options.

 

[DeborahB]

I think I will need the money from the IRA to live on - but I think with SOME conversion to a roth, I have more options in terms of controlling my tax bracket. I can take some from each pot, and keep the taxable amount lower, maybe SS will not be taxed so highly...

I decided today to go to a CPA and get some strategic advice. I don't need my taxes done by a CPA - but I need strategy as to how to allocate, how to withdraw and from what as time goes on. There are tax implications. I don't have children so inheritance is not an issue for me.

I had been maxing out a roth ira for some time - as well as maxing out a 401k. So I already have money in roth iras. I'm also converting about $40K in an IRA to a roth this year. I do need CPA and your advice as to when to pay the taxes. It might be best to do it in 2010, knowing I'm in the 25% bracket - it will be higher later. $40K is all I can put in (I think) without going into a higher tax bracket. I'll know more later in the year.

Currently close to half of my investments are in IRAs/401K (which I'll be moving to self-directed IRA when I retire). About 17% in Roth after I convert the $40K. The rest is taxable.

NOT FUN, figuring all this out! And I LIKE math...

When considering what to convert, I chose bonds that were coming due in the next few years and paid well, and 2 dividend-paying stocks that yield well and haven't appreciated much - there is LTCG potential, untaxed in a roth. Obviously the dividends will not be taxable in the future.

I'm planning to retire at 62 in July.

 

[Nords]

I guess not everyone has all their numbers in December??

Our dividends & interest payments don't happen until the last business day of December.

I can guess what they are, but in 2008 that was an interesting exercise in futility... especially for dividend ETFs that were heavy on financial companies. So there's a heavy margin of safety thrown in, and some lost opportunity.

Some mutual-fund companies used to need 3-4 weeks to complete the conversion. You could claim that you started the process in December, but if that 1099-R has the wrong date on it then it's gonna be a tough time convincing the IRS. A couple years ago Fidelity upgraded their website to let people do it on the website within the next business day, which helps a lot.

Another niche issue-- I'm still waiting to see if we'll get any chance of college financial aid (I doubt it) but if there was any possibility of that then I'd be very hesitant to boost my AGI with a Roth IRA conversion.

 

[HiIRA]

negative income

I'm considering this strategy: retire early, do not take SS or employer pension for a couple of years, buy rental real estate, use the negative income it can create for a partial conversion of t-ira to roth. thoughts,comments, anyone?

 

[ronin]

If anyone is ambitious enough to wade through it, there is some interesting info in this current article.

Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model

 

[Finance Dave]

I'm considering this strategy: retire early, do not take SS or employer pension for a couple of years, buy rental real estate, use the negative income it can create for a partial conversion of t-ira to roth. thoughts,comments, anyone?

Let me first say I'm not an expert, and I've heard conflicting advice on this...so proceed with caution.

I own two rentals, and we're filing our first return under that scenario this week. A few notes for you:

1) Having a business that creates "negative income" in perpetuity is not one the IRS will stand for. Sure, you may lose money at times, but IMO any business that loses money, even if on paper, in the long term...is not worth doing.

2) Depending on how you set up your business (LLC? Split of ownership of the LLC? Inc? No LLC so put on Schedule E?), you may or may not be able to write off the losses. Since there is a passivity rule for rental income, you first must determine whether the losses for you are passive or active. If passive, you cannot write off active income against those losses (this is where I got conflicting advice...some people say yes you can up to $25k/year, others say you cannot write off any...I'm still confused).

3) Don't assume rentals are "no work" investments. They come with significant risks and loads of work...I'm living it now. IMO the first few years are rough...and then as you learn, build equity, pay off loans, and get the properties up to a robust level in terms of repair....things get easier. Of course that assumes you "do things right"....not using duct tape on everything that's broken. If you do, there will be no time when your properties are "up to a robust level". In 2011 I've put on two roofs, ceramic tile floors, built new walls, completed gutted a bathroom and rebuilt it (including the floor joists), completely rewired two houses (that means every single inch of wire, every light fixture, every switch, a new breaker box, riser, meter box..etc.), patched more drywall holes than Amelda Marcos has shoes, sanded and polyurethaned hardwood floors, rodent-proofed two crawlspaces, and much more. IMO this will pay off in spades 5 years from now...but the workload has been immense to this point.

4) Depending on your income level, having "negative income" may not be very valuable. It's great if you're in a 30%+ tax bracket..but at lower levels is it really worth it?

 

[Finance Dave]

If anyone is ambitious enough to wade through it, there is some interesting info in this current article.

Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model

Ok, I must admit I did not read every word...too long lol. However, below I've quoted what I see as the key aspect...at least as it applies to those with relatively high annual spending in FIRE.

"The other five informed strategies follow the same pattern, but the initial tax-deferred withdrawal is increased to fill to the top of the different tax brackets: (E) 10 percent, (F) 15 percent, (G) 25 percent, (H) 28 percent, and (I) 33 percent. "

Many of the "experts" simply say "save your tax-deferred for last"...but I don't think that's the right answer in my case...I prefer the above.

 

[LOL!]

This thread was started 2 years ago, but in the mean-time ... nothing much has changed.

But for more completeness, we might as well link the ZERO taxes in retirement thread: Bogleheads • View topic - How to pay ZERO taxes in retirement with 6-figure expenses

 

[Nords]

I'm considering this strategy: retire early, do not take SS or employer pension for a couple of years, buy rental real estate, use the negative income it can create for a partial conversion of t-ira to roth. thoughts,comments, anyone?

So, you're going to lose a little on each piece of real estate and make it up on Roth IRA conversions?

Once you're done exploiting these sucky money-losing investments (which presumably won't be hard to find) what will you do with them then? Sell them for a huge profit?

What about buying good rental real estate, making a profit from operating it, and using the profit to pay the taxes on your Roth IRA conversions? I think I'd rather pay the taxes on a $10K profit, and then use the leftovers to pay the taxes on the conversion, than to deduct a $10K loss to offset the tax due on the same conversion. When you're all done with the conversion you'd still have income-producing rental real estate.