401K & IRA Conversion to Roth Tax Stategy

[Trawler]

Hi All

Looking to retire in 16 months at 52 and was looking for advice on the tax minimization of 401K and Traditional IRA $$.
Will be living off other non qualified investments until SS kicks in.
Our 401K 's will be rolled to Tradional IRAs at time of retirement.
My thought is while I have lower income bracket untill SS kicks in is to rollover a portion each year from Tradional IRA to Roth IRAs and staying in the lower brackets. This would also minimize required minimum distribution later on for Traditional IRA. My question is can I rollover IRAs to Roths with no earned income? I understand the principal can be withdrawn prior to 59.5 after the 5 year seasoning term? I dont plan to need Roth prior to 59.5 but you never know.
Thanks

 

[ronin]

You can certainly do what you are proposing. There is no income requirement for a Roth conversion. As you probably know, it is best to pay any tax on the conversion with after-tax $$.

 

[Animorph]

I'll be doing the same. Great time to convert while your taxes are low.

 

[harley]

I'm doing the same thing, maxing out the 15% bracket each year. However, it makes sense for me to do this sinceI'm hoping to not have to draw down from the Roth, and I'm using it more for estate planning than for my own use. You should run through some Roth conversion calculators and make sure the numbers work out to your benefit. They don't always.

 

[teejayevans]

I would not go wild on the conversions unless you are sure you will in a higher tax bracket later in life. If given a choice between paying 15% now or 15% later, I would choose to wait.
TJ

 

[walkinwood]

This has been discussed before in depth here and at bogleheads.org. Do a search for ROTH conversion & you'll see plenty of threads on the subject.

It is definitely an option, but you need to make your own determination of your future tax rates.

 

[FIRE'd@51]

My gut feeling is that it's not a good idea to prepay taxes, so I am not doing any conversions.

 

[kaneohe]

I would not go wild on the conversions unless you are sure you will in a higher tax bracket later in life. If given a choice between paying 15% now or 15% later, I would choose to wait.
TJ

One might ask why? Here's one version of the math:
suppose you had 15K in taxable and 100K in TIRA...

Option 1) convert to Roth, pay 15K in taxes ; have 100K in Roth
Option 2) leave as is; have 15K in taxable plus 100K in TIRA

n yrs later investments have doubled
Option 1) have 200K in Roth
Option 2) have 200K in TIRA and 30K- (somewhat less than 30K since some taxes have been paid along the way or will be paid to cash out). The aftertax
value of the TIRA is 200K - 30K taxes and the taxable account is less than 30K so the after tax value of all combined is less than 200K.
Doesn't it look like the Roth is better? perhaps I'm missing something obvious.

 

[LOL!]

If given a choice between paying 15% now or 0% later, I would choose to pay 0% later.

This means you do not need to convert 100% of your 401(k) and tIRA to a Roth because I doubt the 0% tax bracket is going to go away. However, you will have some RMDs later in life if you do not, so be sure to take that into account.

It may be complicated, but I intend to run TurboTax scenarios for my future ages of 55, 60, 65, 70, ..., 100 in a kind of manual www.i-orp.com calculation(s) and save the results in a spreadsheet to look at.

 

[Animorph]

In my case I'm converting up to the top of the 15% bracket while I have no other income. That also gives you some of the conversion at whatever ends up under the 15% bracket, so the effective rate will be less than 15%. When SS, pension, and RMD's kick in I'll be in the 25% bracket and any additional RMD avoided by converting earlier would be coming out at 25% marginal tax rate.

I wouldn't worry too much about conversion, other than for diversification, if you expect to be in the same tax bracket before and after retirement.

 

[Trawler]

Thanks All.
To add:
yes tax bracket will be higher later on. 15% early in retirement and 25% at RMD time if do not convert to Roth to down 401K and TIRA thru conversersion to due to RMD and SS income and other income.
Would rather pay tax early at 15%. Example convert 50K Roth at 15%=7.5K tax leaving $42.5K invested. assuming 6% Rate of return and 15 year time horizon. the $42.5K would be worth $101.8K with tax free withdraw. If left in Tradional IRA the $50K would worth $119.8K less 25% TAX would have after tax of $89.8k .

 

[Independent]

One might ask why? Here's one version of the math:
suppose you had 15K in taxable and 100K in TIRA...

Option 1) convert to Roth, pay 15K in taxes ; have 100K in Roth
Option 2) leave as is; have 15K in taxable plus 100K in TIRA

n yrs later investments have doubled
Option 1) have 200K in Roth
Option 2) have 200K in TIRA and 30K- (somewhat less than 30K since some taxes have been paid along the way or will be paid to cash out). The aftertax
value of the TIRA is 200K - 30K taxes and the taxable account is less than 30K so the after tax value of all combined is less than 200K.
Doesn't it look like the Roth is better? perhaps I'm missing something obvious.

I believe you are missing the $15k you paid in taxes. In (1) you started with $115k, in (2) you started with $100k.

 

[walkinwood]

Surprising (to me at least) is that if your current & future tax bracket is the same, you'll be better off converting to a ROTH IRA.

I attached my spreadsheet & would appreciate someone looking it over to see if I made a mistake. No macros in the spreadsheet, but please use an AV.

I made the assumption that you pay your conversion taxes from your taxable savings, and took the opportunity loss on that tax amount into consideration. I taxed the returns on the opportunity loss annually.

 

[Trawler]

Thanks for the heads up on the future value of tax paid today. In recalculating the number for my scenario the $7.5K paid out of taxable saving would have grown to $17.9K or (lost oportunity) at 6% per year for 15 years less tax on dividends and capital gains along the way. Tradional IRA the $50K would worth $119.8K less 25% TAX would have after tax of $89.8k. A Roth starting at $50K would valued at $119.8K-$17.9 (Lost opportnity)=$101.9K. If tax rate were to remain the same at 15% vs 25% later the tradional IRA would be valued after tax at $101.8K. When using a shorter time frame 5 years If the tax bracket stays the same at 15% and calculating opportunity cost of tax up front it bascially washes out however if tax bracket move to 25% at end of 5 years much benifit for Roth. So I conclude that one must carefully look at time horizen until $$ needed, Rate of return % ,tax bracket at time needing $$ and weather leaving in Estate to determine weather a Roth Rollover is the way to go.

 

[Nords]

I would not go wild on the conversions unless you are sure you will in a higher tax bracket later in life. If given a choice between paying 15% now or 15% later, I would choose to wait.
TJ

My gut feeling is that it's not a good idea to prepay taxes, so I am not doing any conversions.

If given a choice between paying 15% now or 0% later, I would choose to pay 0% later.
This means you do not need to convert 100% of your 401(k) and tIRA to a Roth because I doubt the 0% tax bracket is going to go away. However, you will have some RMDs later in life if you do not, so be sure to take that into account.

I have a hard time believing that future taxes will be the same as today's taxes, let alone lower.

In my case I'm converting up to the top of the 15% bracket while I have no other income. That also gives you some of the conversion at whatever ends up under the 15% bracket, so the effective rate will be less than 15%. When SS, pension, and RMD's kick in I'll be in the 25% bracket and any additional RMD avoided by converting earlier would be coming out at 25% marginal tax rate.

Same here-- when spouse starts getting her pension in 2022 we'll be in the 25% bracket (hopefully it hasn't been "adjusted" to be a 30% bracket or even worse). So we're converting a little every year while the converting is good. 2008 & 2009 were very good years for that since we didn't have much "gain" in the IRA to be taxed on, but we still have 2-3 years to go.

The biggest problem with conventional IRAs is the stealth time bomb of RMDs. After age 70, RMDs will not only bump you up to a higher tax bracket but will also beat the crap out of your Social Security by subjecting it to taxation. Far better at that age to be able to leave a Roth IRA untouched and make do with cap gains from taxable accounts.

 

[Independent]

Surprising (to me at least) is that if your current & future tax bracket is the same, you'll be better off converting to a ROTH IRA.

I attached my spreadsheet & would appreciate someone looking it over to see if I made a mistake. No macros in the spreadsheet, but please use an AV.

I made the assumption that you pay your conversion taxes from your taxable savings, and took the opportunity loss on that tax amount into consideration. I taxed the returns on the opportunity loss annually.

I think you've got the math right. The assumption is that you've got some amount of money equal to the tax, that you aren't going to need for a long time, that is sitting in a taxable account. If you're in that situation you should probably look for a way to shelter the earnings on that money until you need it. Using it to pay the tax on a Trad-to-Roth conversion is one way.

 

[LOL!]

I have a hard time believing that future taxes will be the same as today's taxes, let alone lower.
...
The biggest problem with conventional IRAs is the stealth time bomb of RMDs. After age 70, RMDs will not only bump you up to a higher tax bracket but will also beat the crap out of your Social Security by subjecting it to taxation. Far better at that age to be able to leave a Roth IRA untouched and make do with cap gains from taxable accounts.

If I convert most of my 401(k)/tIRA, but leave $10K after age 70.5, then the RMD is something like $300 to start with. I can say that goes into the 0% tax bracket. That would not beat the crap out of my SSS benefits.

The trick is to figure out how much of one's tIRA can be left, if any, for the future and taxed at 0%. I think there will always be a 0% tax bracket. There is also the possibility that there is less than 0% tax bracket like there is now with some folks getting payments due to credits from the IRS.

 

[walkinwood]

The trick is to figure out how much of one's tIRA can be left, if any, for the future and taxed at 0%..

A big, difficult, trick!
Unless all your money is in a ROTH IRA, you also have to figure out what your taxable Mutual Funds will distribute in any year.

 

[walkinwood]

I think you've got the math right. The assumption is that you've got some amount of money equal to the tax, that you aren't going to need for a long time, that is sitting in a taxable account. If you're in that situation you should probably look for a way to shelter the earnings on that money until you need it. Using it to pay the tax on a Trad-to-Roth conversion is one way.

Glad to see a vote on the math being correct.

Even if you treat the opportunity cost as being tax-free (ie. no tax on any appreciation), you come out equal to leaving the IRA untouched. So unless you believe you'll be in a lower bracket in the future, it makes sense to convert now - up to the top of the relevant bracket.

I truly wish they'd make all this simpler.

 

[LOL!]

A big, difficult, trick!
Unless all your money is in a ROTH IRA, you also have to figure out what your taxable Mutual Funds will distribute in any year.

This is relatively trivial as my taxable funds are very tax efficient and distribute only dividends and no cap gains. The dividends are very close to the published yield from the previous year and almost 100% qualified dividends.

 

[Animorph]

Surprising (to me at least) is that if your current & future tax bracket is the same, you'll be better off converting to a ROTH IRA.

I attached my spreadsheet & would appreciate someone looking it over to see if I made a mistake. No macros in the spreadsheet, but please use an AV.

I made the assumption that you pay your conversion taxes from your taxable savings, and took the opportunity loss on that tax amount into consideration. I taxed the returns on the opportunity loss annually.

That's what the Fidelity calculator comes up with too.

I think the simplest way to look at it is that a $100k TIRA holds $85k "tax free" for you and $15k for the IRS, both growing with the market. When converted into a $100k Roth IRA, with $15k taxes paid by other funds, you now have $100k tax free in the Roth. You've given the IRS their $15k. Your $15k in previously taxable funds is now growing tax free (that's the reason conversion is good even if tax rates stay the same). The Roth is allowing you to shelter more after-tax value than the TIRA. The longer it grows, the better the conversion benefit.

 

[kaneohe]

The biggest problem with conventional IRAs is the stealth time bomb of RMDs. After age 70, RMDs will not only bump you up to a higher tax bracket but will also beat the crap out of your Social Security by subjecting it to taxation. Far better at that age to be able to leave a Roth IRA untouched and make do with cap gains from taxable accounts.

good points about RMDs and higher brackets and SS taxation. If you're getting Medicare , you may also get subjected to the medicare surcharge based on higher income.

 

[kaneohe]

I believe you are missing the $15k you paid in taxes. In (1) you started with $115k, in (2) you started with $100k.

I believe you may have misread.......in both cases, started w/ 15K side fund in taxable and 100K TIRA. In one case, side fund was used to pay conversion tax. In other case nothing was changed until the end when the after tax comparison was made and side fund was taken into account.

 

[walkinwood]

That's what the Fidelity calculator comes up with too.

I think the simplest way to look at it is that a $100k TIRA holds $85k "tax free" for you and $15k for the IRS, both growing with the market. When converted into a $100k Roth IRA, with $15k taxes paid by other funds, you now have $100k tax free in the Roth. You've given the IRS their $15k. Your $15k in previously taxable funds is now growing tax free (that's the reason conversion is good even if tax rates stay the same). The Roth is allowing you to shelter more after-tax value than the TIRA. The longer it grows, the better the conversion benefit.

Well put! Thanks.

 

[devans0]

I have come up with what I believe is a good plan. I have money roughly divided into thirds, with taxable being the largest, followed by IRAs and finally Roth IRAs. My own plan is before 60 years old, I will be using taxable equity. At 60 years old I will start to use a modest pension, at 62, wife's Soc Sec and a small annuity to fund the bare basics. I will then switch so that the bills beyond the basics will come from and draw down the IRA and excess funds to rollover to a Roth while keeping the tax at a low level ($83,000 approx for two? at current rates). When those funds are depleted (if they are), I will start on taxable equities. If I start breaking tax thresholds here, I will draw on Roth IRAs. Somewhere in this time, I will reach full retirement age and put in for my own Soc Sec.
There are other complexities of efficient taxed money location but this plan will keep the tax bites fairly low throughout our retirement. If I make good returns on investments, I could have too much money to be fully tax efficient, but if too much money is the problem, I will be happy to suffer those consequences.
Any input of things that I have overlooked will be appreciated. The work that I have today is to start consolidating Roth funds while still keeping the five year rules met. If the SHTF, that may be necessary to keep all options open.