Background Info
I was 59 1/2 this year and am considering converting a portion of my IRA to a Roth IRA to the top of my current tax bracket for each year until I need to take RMDs. This will reduce my tax bill in the years after I am forced to take RMDs. I am planning on paying most of the current taxes on this rollover from the proceeds of the rollover. I believe that this allows for a direct comparison of the tax savings of this strategy.
Question
Most financial planning websites seem to recommend paying the current taxes on a conversion of this types from other non-retirement accounts so that the total amount can be rolled over. However, isn't that equivalent to increasing your effective retirement savings? I don't see adding money from a non-retirement account to pay for this conversion a part of this comparison. Isn't saving more always better? What am I missing?
If you are planning to do “a” Roth conversion, the first term you want to investigate is “recharacterization”. This is basically a way to say “oops”, “never mind”, “undo” that.
The key is to open new Roth accounts at your broker for each symbol you are planning to convert and then do each conversion into a separate Roth account. Yes, you can do that, talk to your broker. If everything is in one account the calculations are done on the group of symbols, not one by one!
Determine up front how much you plan to convert, say enough to take you to the top of the 25% bracket. Then, do more individual conversions than you need to do.
You then have until April, but I do this in December, check the rate of return of each individual conversion. If any of them lost money, tell your broker to “undo”, “recharacterize” them, like they never happened! Why lose money in a tax free account when you can lose it in a taxable account!
Next, list the symbols by their rates of return and undo the lowest returns. This will keep you in the 25% bracket, or whatever your limit is, and give you the best bang for your buck.
Just remember, you are calculating all of this based on their values at the time of conversion, not today’s value.
We just did this using the BRexit drop in the market. For the sake of discussion, let’s say our combined federal, state, and local tax rate is 33.33% and the pre BRexit value of the symbol was $30,000. When England dropped out of the European Union the market dropped for two days. For example, let’s say that symbol dropped 15% to $25,500 and we did the conversion at the close on Monday. The taxes due would have been $8,500. On Thursday it would have been $10,000!
By the end of December let’s say that the symbol regains its loss and gains an additional 10%, now selling at $33,000 which would cost $11,000 to convert in December. So, we do not undo this one, pay the $8,500 taxes due back in June and end up with $33,000 in our Roth account!
$8,500 taxes on $33,000 is only 25.76%, way less than 33.33%!
Remember that the estimated taxes you paid along the way are on the final total, not on each symbol!
We also convert another symbol that dropped 10%, but it never regained its loss and actually lost more, so we “undid”, “recharacterized” that one so we lost that money in the taxable IRA account!
If multiple symbols gain well over 10%, we can just ignore our 25% rate limit and take the high gains tax free!
Research recharacterization on your own and talk to your broker about it!
As far as using “other money” for the taxes, that is like making additional Roth contributions over the max allowed, and yes that is a good idea!
