401k's, IRA's and RMD's - tax consequences

[Midpack]

I agree that I-ORP is helpful, but it's a tax impact axe vs scalpel by their own admission in this post http://www.early-retirement.org/forums/f28/do-you-use-i-orp-68144-3.html#post1449169. I'd be more comfortable seeing more detailed results and what tax code assumptions they're using - a 'black box' doesn't provide enough reassurance for me. However, I realize it's not easy after trying to develop a spreadsheet of my own...that's why I'd be willing to pay a pro, I know how difficult an exercise it is. I found a Boglehead that developed a spreadsheet, but it was very hard to understand, IMO you'd have to be the author to trust it. Sigh...the search continues.

 

[kaneohe]

Well, I like one of the ideas and I'm not going back to work.

......and if you do implement that idea, she will probably still be working and can provide the compensation for your spousal IRA , hopefully deductible, which might provide more room for the conversion.

 

[jim584672]

Every time I try to figure out Roth conversions, tax brackets, RMDs, Obamacare effects - I get a headache and give up.

 

[kaneohe]

I always heard that one should have their bonds in tax advantaged accounts and have equities in taxable accounts. I never drilled down to get the reasoning of this. But given that some of the gains in the taxable accounts are taxed as capital gains, and all distributions from IRA's/401k's are taxed as ordinary income - it makes sense to put all bonds in 401k/ira and equities in taxable accounts.

Here's a few answers from experts on nerd wallet.com. 2 interesting ways to postpone RMD's are marrying a much younger spouse, or keep working past 70.5.


How do I reduce my required minimum distributions (RMDs)?

Also from the link or implied there: (or from the 1040 listing of income)
in order to free up the 15% bracket for conversions:
1)put ordinary income generators (bonds except for muni , and CDs) in tax-deferred accounts
2)put equity in taxable....and make it passive index tax-efficient equity to rduce CG distributions..both LT/ST
3)Delay pensions if possible
4)Delay SS if possible

 

[GrayHare]

Maintaining some level of taxable income can be wise: since some deductible expenses are almost inevitable eventually (such as medical) for tax efficiency you want enough taxable income to deduct them against, otherwise those deductions expire worthless.

 

[kaneohe]

Can't you deduct those expenses against the conversion income that you are using to fill the 15% bracket?

 

[kaneohe]

Can't you deduct those expenses against the conversion income that you are using to fill the 15% bracket?

Perhaps you meant that you can overdo the conversions if that leaves you
w/o taxable income and diversity in income sources is useful.

 

[PatrickA5]

So just out of curiosity does anybody know the rough dollar amount saved in a tax deferred 401k/IRA that pushes people into this RMD withdrawal tax issue.

I have a pension also and a pension really presents a problem for RMD and keeping tax bracket low.

I am starting to think that I am saving too much in my tax deferred 401k.

Is there an actual ballpark dollar amount that could be considered a stop point in a tax deferred 401k/IRA. say 1 million. 3 million.

Having a pension, and to a lesser extent, Social Security makes it really hard to manipulate the numbers between tax deferred, taxable and tax free income to a point where it's easy to stay within the 15% bracket once RMDs start.

If you file MFJ, you basically have $20,300 of tax free income due to the standard deduction and the 2 exemptions. This income should probably come from the tax deferred bucket (401K, etc). Based on a 3.65% RMD factor for the first year, you can have around $550K in 401ks and Traditional IRAs that would produce that $20,300 of income that will be tax free. You could add all of the Roth distributions you want on top of those RMDs and you'd still pay zero taxes. Adding in Social Security will muddy up the waters to some extent and you'd end up having some of your SS taxable. You can play with the numbers to try and achieve zero taxes, or more likely, you can play with the numbers to try and stay in the 15% tax bracket (which would also make your qualified dividends and LTCG tax free). One of the best ways to do these "what ifs" calculations is to buy TurboTax and learn how to use it.

If you have a large fully taxable pension, then just assume you'll always be paying taxes forever.

 

[GrayHare]

Perhaps you meant that you can overdo the conversions if that leaves you
w/o taxable income and diversity in income sources is useful.

Exactly, it's possible to over-convert to Roth, but that largely depends on individual circumstances.

 

[LOL!]

Taking withdrawals from a 401(k) or traditional IRA has the same tax consequences as converting that money to a Roth IRA and also reduces future RMDs. Thus, I don't see any problems with converting which should be the default mode.

At age 70.5, if current laws do not change, one can make a QCD which covers their RMD. One may say, "But I need that money to pay expenses?" That's where all those previous Roth IRA conversions help you. Don't forget that you are allowed to withdraw from a Roth and not pay taxes on those withdrawals.

And later on in life when you are paying medical expenses in your nursing home bed, all those RMDs will be tax-free anyways because of your itemized deductions.

For those that use i-orp.com, but sure to run a real tax program such as TurboTax on the scenarios that it gives you. One may be surprised that one may be able to make larger conversions with lower taxes because of one's personal tax situation.

Finally, one doesn't use sequential withdrawals (all taxable first, all tax-deferred next, all Roth last), but one makes withdrawals from a mixture of account types in order to have the lowest taxes.

 

[davismills]

Well, I like one of the ideas and I'm not going back to work.

That's rich. Just spit out my evening cocktail. Marry too young and you'll have to go back to work.

 

[MBAustin]

I'm in the "it gives me a headache" camp like jim.

Basically, I've concluded that we benefited in our high-earning years (two good jobs plus decent bonuses) by being able to defer enough income to keep in a lower tax bracket, and the result is we pay taxes later. As much as it is annoying when it comes time to write the check, I'm convinced we are still better off.

 

[GTFan]

Taking withdrawals from a 401(k) or traditional IRA has the same tax consequences as converting that money to a Roth IRA and also reduces future RMDs. Thus, I don't see any problems with converting which should be the default mode.

If you're willing to ignore or are not able to gain the significant ACA subsidies for staying under 250% FPL, sure. The ACA throws yet another variable into the Roth conversion mix for those that don't have significant pension income.

My plan is simple, at this point - keep income low to maximize subsidies and ignore Roth conversions, knowing that I don't want to leave a huge chunk of money to my children. I'd much rather contribute excess RMDs to charities, which will also (with itemized deductions) greatly reduce Uncle's share. And I have about half of my port in taxable investments which means I can control income very nicely, at least until I have to start tapping tax-deferred stuff.

 

[ejman]

Since I have no pensions my strategy pre RMD has been to derive my living expenses from my taxable funds invested primarily in bond funds and high dividend balanced funds. My IRA's are in stock funds I also started SS at 62 so as to limit total income when RMD's start and in anticipation of taxing SS at 100%.

As RMD's start in 6 years I plan to convert all my taxable holdings to an index stock fund (S&P 500 or total stock Market Fund) the year before so as to limit dividend and CG distributions. Conversely, mi IRA's will be switched to Bond and balanced funds. Most of my income then will come from RMD's and I expect that if present tax rates hold my top fed tax rate will be 15% unless my IRA stock funds go up in value tremendously ( which would be a nice problem to have).

I will not be converting to Roth's for a couple of reasons:

With my psychological make up whatever I convert to Roth will never be coming out because I'd rather cut living expenses. So effectively I'd be paying taxes on money I will not use.

I just do not know what curves future tax laws will throw at Roth's either directly or in tangential ways.

My strategy of converting all my taxable funds to Index stock funds will result in a stepped up value upon my demise for my heirs since I intend not to touch Taxable funds once RMD's start.

I realize this strategy is exactly the opposite of what is generally recommended...

 

[karluk]

While I agree with the developer's assertion that going into a higher tax bracket for a short number of years can be offset by the tax free earnings gained by early Roth conversions, ACA has added a wrinkle to my personal plan.

I am coming to the conclusion that contributing to a donor advised fund is a partial solution to this dilemma, for me at least. I-ORP correctly recognizes that part of the key to minimizing RMDs is to get as much money out of the tax sheltered account as soon as possible. If I take a large distribution next year and then contribute it to a donor advised fund, I get a charitable deduction that would eliminate the additional taxes owed on the distribution.

We are in the situation that the standard deduction is more than our itemized deductions, so we can only itemize every other year by paying two years of property taxes in the same calendar year. 2015 is a year that we will itemize, so I will look into setting up a donor advised fund then.

So the tentative plan for 2015 is to make Roth conversions up to the limit of the 15% tax bracket and then open a donor advised fund with additional withdrawals that would normally push us into the 25% bracket. It seems to me that this strategy is likely to be just as effective as I-ORP's front loaded Roth conversions, but without incurring the large tax hit that the Roth conversions would entail.

 

[Sunset]

Since I have no pensions my strategy pre RMD has been to derive my living expenses from my taxable funds invested primarily in bond funds and high dividend balanced funds. My IRA's are in stock funds I also started SS at 62 so as to limit total income when RMD's start and in anticipation of taxing SS at 100%.

As RMD's start in 6 years I plan to convert all my taxable holdings to an index stock fund (S&P 500 or total stock Market Fund) the year before so as to limit dividend and CG distributions. Conversely, mi IRA's will be switched to Bond and balanced funds. Most of my income then will come from RMD's and I expect that if present tax rates hold my top fed tax rate will be 15% unless my IRA stock funds go up in value tremendously ( which would be a nice problem to have).

I will not be converting to Roth's for a couple of reasons:

With my psychological make up whatever I convert to Roth will never be coming out because I'd rather cut living expenses. So effectively I'd be paying taxes on money I will not use.

I just do not know what curves future tax laws will throw at Roth's either directly or in tangential ways.

My strategy of converting all my taxable funds to Index stock funds will result in a stepped up value upon my demise for my heirs since I intend not to touch Taxable funds once RMD's start.

I realize this strategy is exactly the opposite of what is generally recommended...

For SS its only a maximum of 85% of your SS can be taxable, even with 1 million dollar income, 15% of your SS will be tax free.

Why would you not take out from 401K/IRA's when 62 and let your SS build to full value at approx 65 ?

 

[Sunset]

As I'm under 59.5, My plan had been to capture Capital gains in taxable accounts by selling the stocks, and immediately buying them back, as up to 94,xxx income means dividends/capital gains are tax free. This will reduce our income later when we have to cover a big expense when doing RMD's.
However, due to this discussion, I'm thinking once I hit 59.5, I should take out from IRA's to max the 15% so there will be less RMD's later.
Personally I'm fine with putting the $$ into something like BRK as it has no taxable effect until sold.

 

[Cobra9777]

I'm in the "it gives me a headache" camp like jim.

Basically, I've concluded that we benefited in our high-earning years (two good jobs plus decent bonuses) by being able to defer enough income to keep in a lower tax bracket, and the result is we pay taxes later. As much as it is annoying when it comes time to write the check, I'm convinced we are still better off.

I'm in the "I want my cake and eat it too" camp. Just haven't figured out how yet.

I've spent quite a bit of time messing around with i-orp since this thread started. It's definitely a black box, which irritates me. I like to see calculations, assumptions, explanations, etc that I can then comprehend, recreate, and customize in my own spreadsheets. Maybe that's not possible with i-orp. It is fairly well documented, which is where I've spent most of the time.

In any case, like others here, I have pensions/rentals that fill out much of the 15% bracket. So my own spreadsheet analysis says Roth conversions are a bad idea, except as a possible legacy play. I-orp seems to agree, but interestingly, it wants me to make HUGE 6-figure withdrawals from tIRAs starting immediately (72t I guess, as I'm only 53). At first I just laughed. But then I manually plugged the WD profile into my own spreadsheet. It seems to max out the 25% bracket for 5-6 years and then backs off in smaller amounts necessary to eliminate RMDs altogether, while loading up the taxable account. The end result at RIP is a slightly higher overall portfolio value than my baseline scenario. Roth conversions always give me a lower ending value.

It's not a huge difference (about 3%). I definitely need to study this more. I'm curious why this works for my situation and Roth doesn't. I would have thought they are essentially equivalent strategies. And I had long-ago concluded that converting into the 25% bracket is a bad idea.

Maybe I'll join the "it gives me a headache" camp after all.

 

[karluk]

For the record, I am fairly certain that I will never adhere to I-ORP's aggressive strategy of voluntarily putting oneself into a higher tax bracket simply for the sake of doing early Roth conversions to allow tax free growth for the rest of retirement. I am willing to believe that there are reasonable assumptions that might make I-ORP's strategy optimal, but the problem I have with it is that there are equally reasonable assumptions that make it one of the worst possible ways to withdraw money from a 401k or traditional IRA. A typical example would be large unreimbursed medical expenses late in retirement that make most or all of an RMD tax deductible. If there's a realistic chance that an RMD is going to be essentially tax free, it makes no sense to pay 25% now just to avoid a 0% RMD later.

So as far as I'm concerned, the I-ORP strategy fails what I would call a "robustness test". To me a 401k withdrawal strategy should not only perform optimally under certain assumptions about the future, but it should also perform reasonably well using other assumptions. Since I-ORP's strategy doesn't, I have no intention of using it.

 

[samclem]

A typical example would be large unreimbursed medical expenses late in retirement that make most or all of an RMD tax deductible. If there's a realistic chance that an RMD is going to be essentially tax free, it makes no sense to pay 25% now just to avoid a 0% RMD later.

In some cases, it is worth considering the reverse situation (a higher % of income becoming taxable, or a higher than expected tax rate applied to the same income), and if applicable this could argue for the Roth conversions in early retirement even if it pushes the person into a higher tax bracket. The most common example might be a MFJ couple and the ramifications of one partner passing away. The drastically reduced standard deduction and exemptions (= higher taxable income on virtually the same RMD) and the reduced tax brackets (=higher tax rates on that taxable income) can be a real eye opener. Converting a big chunk of money to a Roth while both partners are still alive might prove to be a really smart move. But, a single surviving spouse in most cases would be expected to have lower expenses than 2 people, so it would be an unusual case in which these tax issues would significantly hurt. Still, worth considering for some people.


In addition to the case you cite (higher medical expenses), retirees could also find themselves in low tax brackets if their investments do poorly over the coming decades. It could clearly happen to most of us, and it would reduce the absolute value of RMDs and also of any cap gains from taxable accounts. I'd sure feel dumb if I went crazy and converted a lot of funds, paid tax at the 25% rate, and then our investments hit the skids and I found I'd be in the 15% bracket for a long, long time. That extra money paid in taxes earlier might come in handy.


I plan to do Roth conversions to the top of my "regular" expected bracket in early retirement (before I start taking SS). After that, I'll leave things alone and risk paying higher taxes well down the line --hopefully when it is apparent I've "won the game" and my nest egg is really going to outlast me.

 

[gauss]

I was going under the assumption that I-Orp models filing status, tax brackets, standard deduction, personal exemptions and social security taxation.

Do you think that this is a stretch on my part, or are there other tax rules that you would like for them to implement?

-gauss

 

[karluk]

In some cases, it is worth considering the reverse situation (a higher % of income becoming taxable, or a higher than expected tax rate applied to the same income), and if applicable this could argue for the Roth conversions in early retirement even if it pushes the person into a higher tax bracket.

It doesn't really make any difference at all what assumptions one makes about the future. In order to be "robust" in the sense I was using the word, a 401k withdrawal plan needs to perform reasonably well under most, and preferably all, likely future assumptions. Your scenario of getting hit with a massive tax bill in the future is certainly plausible, and incidentally shows that doing nothing at all until RMDs begin at age 70 1/2 is not a "robust" strategy. Doing nothing will be optimal under the scenario of large deductible medical expenses I outlined earlier, but will be a disaster in your scenario. Doing nothing is optimal under one set of future assumptions and is awful under another set, hence it's not a "robust" strategy, even though I suspect it's also the most common approach to 401k withdrawals.

I plan to do Roth conversions to the top of my "regular" expected bracket in early retirement (before I start taking SS). After that, I'll leave things alone and risk paying higher taxes well down the line --hopefully when it is apparent I've "won the game" and my nest egg is really going to outlast me.

I would defintely consider doing Roth conversions up to the top of one's current tax bracket to be a more robust strategy than either doing nothing or making massive Roth conversions regardless of tax bracket. That's because it avoids the worst case scenarios outlined above. Probably the retirees who use this strategy don't articulate their choice in terms of "robustness", but I suspect that their thinking is roughly that's it's a decent choice that's likely to save them some money in most cases and is unlikely to cost them very much in any case, i.e. "robust" in my sense of the word.

 

[samclem]

There's no telling based on what you've written, but in your working definition of "robustness" I'd recommend you consider the concept of marginal utility of the returns under various scenarios (rather than strictly using a definition of "robustness" that only includes maximizing returns under various future conditions). To most retirees (maybe you), the first $50K of annual retirement income is likely to have much greater utility than the second $50K. That's an argument for delaying taxes and risking paying higher rates as a result, if it helps assure the first $50K gets paid in those later years.

 

[kaneohe]

For the record, I am fairly certain that I will never adhere to I-ORP's aggressive strategy of voluntarily putting oneself into a higher tax bracket simply for the sake of doing early Roth conversions to allow tax free growth for the rest of retirement. I am willing to believe that there are reasonable assumptions that might make I-ORP's strategy optimal, but the problem I have with it is that there are equally reasonable assumptions that make it one of the worst possible ways to withdraw money from a 401k or traditional IRA. A typical example would be large unreimbursed medical expenses late in retirement that make most or all of an RMD tax deductible. If there's a realistic chance that an RMD is going to be essentially tax free, it makes no sense to pay 25% now just to avoid a 0% RMD later.

..............................

With Medicare and a good medigap supplement, I am hoping that out-of-pocket expenses will be near 0 (except for insurance premiums).

 

[ejman]

For SS its only a maximum of 85% of your SS can be taxable, even with 1 million dollar income, 15% of your SS will be tax free.

Why would you not take out from 401K/IRA's when 62 and let your SS build to full value at approx 65 ?

I know that current law sets a maximum of 85% OF SS benefits as taxable. It seems likely to me that the law will be changed to 100% taxable in the medium term future as current benefits being paid are higher than current taxes collected. When the current surplus is spent ( maybe 15-20 years at max) then either benefits will be reduced or taxes will have to go up substantially.

As to why take at 62 instead of letting it build up and collect more later. Many many threads on that subject at this forum. Suffice it to say that for a minority of posters at this board (including moi) controlling our own resources (401K/IRA) to the extent possible instead of relying on government payouts (SS) in the future adhering to current law for the foreseeable future is preferable given certain views of the political/socio economic world we live in.