Traditional IRA to ROTH conversion

[charlie]

I think this topic is worth spending some time on.

If you are in the accumulation phase and not drawing SS income,
the Vanguard calculator looks as if it might be OK (first blush
examination).

However, if you are drawing SS income and are already into RMD,
none of the free calculators on the web are worth much, IMHO.

In my case, my wife and I are already drawing SS and I am, at 71,
into RMD. Lynda has 5 years to go for RMD.

One big problem in converting for us is that every dollar we
convert exposes more SS income to tax at the marginal rate.
Last year we had $15,640 taxable income which included only
$7082 of $20,575 total SS income. Up to 85% of SS income
(or $17,438 in our case) could be added to taxable income.

For a married couple, the top of the 15% bracket is $58,100
taxable income.

Can anyone tell me if conversion is a good idea (based on
numbers only) in my case? My wife's IRA is worth about
$107,000 right now and I would like to convert it if it makes
sense. Would it be better to dribble it out over time staying
in the 15% bracket with effective increase in the marginal
rate because of SS hit or just do it in one lump and get into
25% bracket ($117,250 limit).

My head is starting to hurt.

Cheers,

Charlie

 

[ERD50]

Charlie, I started converting from Trad to Roth last year. My income will increase in 5 years (collect pension, then SS) and my deductions may decrease. So, my thought process was to convert as much as I can now w/o going into the next tax bracket. I have a low enough income and enough deductions to allow some significant amount to be converted each year, and still stay in the 15% marginal bracket.

So, if you figure you will be in the 15% or 25% bracket in the future, it seems to make sense to convert (at least) up to the top of the 15% bracket, maybe the 25% bracket to give you flexibility on withdrawals later?.

I'm not collecting SS yet, so maybe I'm missing something there - is it any different than ordinary income?

I'm certainly not claiming to be an expert, just sharing my thought process. Hopefully others chime in to either back me up or shoot some holes in it (so I can learn, too).

-ERD50

 

[charlie]

I started playing with my 2005 return on Turbo Tax and discovered
that my marginal rate is about 20% on IRA distributions because
of the SS income problem.  This increases to about 27% at the
point where 85% of SS is taxed.  Surprise ..... if I transferred all
$107,000 in one lump, the marginal tax rate is 25.7% for our
case.  This is because they can't squeeze any more blood out
of the SS turnip.  

It looks like to me that if we don' t do any conversion, we will be
paying for IRA distributions at the 20-27% rate ad nausea because
of the taxable SS income.  

If we convert her IRA now and mine over a 5 year period, we can look
forward to paying almost no income tax in 5 years because ROTH
distributions do not add to taxable income, thus the tax on SS
income is ZERO!  

Am I missing something here?   I know I need to look at the
opportunity cost of paying the tax up front ..... but conversion
is looking better to me.

Cheers,

Charlie  

 

[ERD50]

Am I missing something here? I know I need to look at the
opportunity cost of paying the tax up front ..... but conversion
is looking better to me.

I hope someone else chimes in with their opinion, but when I looked at the 'opportunity cost' with a Roth conversion, I found it to be a 'wash'. That seemed strange to me, normally you never want to pay a tax now if you can pay it later. But (if I figured right), since the money is *growing* tax free - that compensates for the pay now/later. Example:

Roth Conversion of $10K: $10K taxed @ 15% now means $8,500 of 'real money'. Assume 5% return on $8500 for 20 years, no taxes, gives $22,553.

No Conversion: All $10K is growing @ 5%. This grows to $26,533. But, you need to pay taxes on withdraw - assume the same 15% rate, and..viola ... you have the same $22,553.

So, it all seems to be a bet against whether your tax rates go up in the future. Though, the Roth gives you some flexibility to pull tax free money one year, and maybe bunch deductions in one year.

This is what I based my decision on - hope I was right!

-ERD50

 

[Nords]

If we convert her IRA now and mine over a 5 year period, we can look forward to paying almost no income tax in 5 years because ROTH distributions do not add to taxable income, thus the tax on SS income is ZERO!

Am I missing something here? I know I need to look at the opportunity cost of paying the tax up front ..... but conversion is looking better to me.

No, your math is correct. You're proposing to pay 15% now to avoid paying 20-27% later. As long as Congress doesn't change the rules in the middle of the conversion, you should come out ahead. The hassle factor is only converting up to the top of the 15% tax bracket and being patient enough to spread it out over however many years that takes.

Congress & the IRS are patient. They know that if you don't screw up the RMD on a conventional IRA now, the odds are very high that your heirs will screw up the RMD on the Roth IRA later.

I hope someone else chimes in with their opinion, but when I looked at the 'opportunity cost' with a Roth conversion, I found it to be a 'wash'. That seemed strange to me, normally you never want to pay a tax now if you can pay it later. But (if I figured right), since the money is *growing* tax free - that compensates for the pay now/later.

Your calculation doesn't include a couple factors.

First is the SS taxation issue. IRA RMDs are pushing up income and resulting in paying more taxes on SS distributions. If retirees didn't have to worry about RMDs or about higher income, then we wouldn't have to pay more taxes on SS.

The second factor is how the taxes are paid. If you add a wrinkle to your math by paying the taxes from funds outside of the IRA, then the Roth's basis starts at $10K and compounds from there. That extra 15% in the Roth will compound far ahead of the conventional IRA.

 

[ERD50]

Your calculation doesn't include a couple factors.

First is the SS taxation issue. ....

The second factor is how the taxes are paid. ...

Nords, thanks for the feedback. Just to make sure I'm following you, both of the factors you list should make converting a Trad to a Roth even more favorable, correct?

-ERD50

 

[Nords]

Nords, thanks for the feedback. Just to make sure I'm following you, both of the factors you list should make converting a Trad to a Roth even more favorable, correct?

Yup.

Another factor for some is that paying the taxes outside of the Roth conversion would require them to sell more equities from taxable accounts, so there's a small additional tax bite to be factored into the equation.  However if you're doing this up to the top of the 15% tax bracket, the cap gains tax on selling those equities is pretty small.

Before some freakin' engineer curious poster asks the question, I wouldn't tap a home equity loan to pay the taxes on a Roth conversion. That math can be done but it makes my head hurt.

 

[cute fuzzy bunny]

Now if someone was really smart, they'd tie it all together by taking out a mortgage to do the roth conversion and then take social security early to delay the roth withdrawals as long as possible. Invest everything in blockbuster.

 

[WanderALot]

Now if someone was really smart, they'd tie it all together by taking out a mortgage to do the roth conversion and then take social security early to delay the roth withdrawals as long as possible. Invest everything in blockbuster.

I'm sure that maxing out one of those 0% credit cards offers and using the $$$ to invest in Icelandic bonds would be the better way to go!