Help understanding ROTH conversions

[Jerry1]

Can someone please help me get started with understanding ROTH conversions? I wouldn't ask anyone to try to summarize something like this in a forum response, but some basic terminology, logic and strategy would be helpful as I think about this and do some research.

My situation is that most of my retirement money is in IRA/401K's that will be taxed when I withdraw the funds. I'm trying to understand if conversion would even make sense. My thought is that I will be drawing income at a level that will put me at or slightly over the lowest tax bracket. Therefore, I'm struggling to understand how drawing out money that I have to pay tax on at a higher tax bracket just to do a conversion is a benefit to me. Of course, I understand that if I expect tax rates to go up significantly in the future, this would be a no brainer. I also understand that for any money I can get in a ROTH quickly (I'm 54) will have the benefit of the investment income being tax free, but what other logic would make a conversion make sense?

Note, my current income prevents me from contributing to a ROTH but I do expect to work a few years after I turn 55 in a part time status and would therefore have to opportunity to do some ROTH funding out of earned income.

Thank you.

 

[REWahoo]

Here's a great online source on Roth Conversions: Roth Conversions - Fairmark.com Fairmark.com

 

[pb4uski]

Roth conversions are commonly done between when one retires and one starts pensions, SS and RMDs, so typically between ER and age 70. The idea is that during this period your marginal tax rate is lower than what it will be once pensions, SS and RMDs start so it is advantageous to convert tax-deferred funds to a tax-free Roth at lower rates.

I'll use my situation as an example. I retired at 56 and we are living off of our taxable investments between now and when our pensions and SS start. When I was working I was in the 28% tax bracket. After I stopped working, our taxes would have been nil had we not done any Roth conversions since our income was just interest and dividends from our taxable accounts. Once SS and pensions and RMDs start, I expect to be in the 25% tax bracket if I do no Roth conversions.

With our current level of income, if I convert just enough so our taxable income is at the top of the 15% tax bracket, I pay about 7% in tax on the total amount converted because I fill up the 0% bracket (up to deductions and exemptions), 10% bracket and 15% bracket. So for us, it is better to pay 7% now to avoid paying 25% later.

You can use Taxcaster to play with your situation.

One thing to be cognizant of though.... if you go over the top of the 15% bracket by just a little, that excess is in effect taxed at 30%. But the saving grace is that it is easy to "recharacterize" a portion of your conversion as you are finalizing your tax return to reverse the excess conversion.

 

[NgineER]

Another aspect is that if you are married and your spouse passes, your tax brackets will change substantially and what was a 15% tax bracket married filing jointly is now 25%.
Inheritance is another aspect to consider.

 

[bingybear]

My situation is that most of my retirement money is in IRA/401K's that will be taxed when I withdraw the funds. My thought is that I will be drawing income at a level that will put me at or slightly over the lowest tax bracket. Therefore, I'm struggling to understand how drawing out money that I have to pay tax on at a higher tax bracket just to do a conversion is a benefit to me. Of course, I understand that if I expect tax rates to go up significantly in the future, this would be a no brainer.

Thank you.

pb4uski gave a really good example. Roth conversions are not a tax-wise move for everyone.

You stated "My thought is that I will be drawing income at a level that will put me at or slightly over the lowest tax bracket." If this is true, then it really may not be a good idea for you. But you note that you draw an "income", is that based on what you think you need to spend? At 70.5 you will need to withdraw RMDs which is just under 4% of your IRA/401k balances, plus you may have SS, a pension, and maybe other income. Note that depending upon income levels, part of your SS may be taxable.

If you considered all this and not just income needed to live, then is may not be best to move.

One other situation to consider, during a year with a non typical expense, you may need to withdraw more from IRAs to meet the expense. In this case it may be nice to have some $ in a roth as withdrawing from IRA could jump your tax bracket.

Don't assume that roth conversions are the right thing for everyone. It is likely right for some of us.

 

[pb4uski]

+1 unless you are temporarily at a lower tax rate, then the benefits are lower. However, some would argue that even if you have to convert at what your tax rate will be once SS, pensions and RMDs are in play that you are better off because the Roth grows tax free but I'm more skeptical of that argument, especially if you are going to eventually use the Roth money.

Another factor in our case is that it is most likely that the Roth will eventually be inherited by our kids who will still be working when they need to take distributions so that money would get taxed at a higher rate than the roughly 7% that I am paying now.

molof makes a good point that if one or the other of use were to die then we woudl be in an even higher tax bracket so the benefit is even more.

 

[Animorph]

If you don't have money in a taxable account that you will live on for the first few years in retirement, and pay Roth conversion taxes with, then you probably aren't a Roth conversion candidate.

However, it still may reduce your total taxes if you always withdraw from tax-deferred accounts up to a lower tax bracket. Such as filling up any 0% tax rate and probably 10% and maybe 15% tax rate brackets. You are trying to get the maximum out of your 401k at the lowest tax rate. If you need the withdrawals for expenses, fine. If you don't, then Roth convert it. A big factor is what your taxes might look like when you turn 70 and pensions, SS, and RMD's are all online. If that puts you in the 25% tax bracket you probably want to think about reducing RMD's in some manner either early withdrawals or Roth conversions.

 

[Rothman]

Jerry1 I suggest you go to i-orp.com and input your amounts by account and check the box to enable Roth conversions and see how the optimization would suggest conversions. As Animorph suggests you'll see taxable funds helping to convert tax deferred IRA into tax free Roth IRA. If you compare the run without Roth conversions enables to with conversions enabled it will show the difference. What you find is it minimizes taxes which is equivalent to maximizing your spending money. Now this scenario isn't like firecalc so if you want to model at your safe withdraw rate enter a estate value until the spending amount matches your target. But either way it shows the concept well.


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[Terryjm51]

I am in the same boat with Jerry. I have tried to understand the same thing. It makes sense now, living on after taxable accounts.



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[Jerry1]

Thanks for confirming that I wasn't really missing anything. I wish I would have been able to save more after tax money in my life, but I'm not going to let that stop me from retiring. I will pay attention to the tax brackets and if I find myself in a good position to do some converting, I will. I just don't think I will be in the lower tax brackets when I retire and I don't think my highest tax bracket is going up enough to make conversion a strategy for me. Of course like many things, I could get burned if the tax code changes drastically but I just can't protect against every possibility.

Thanks for the help!

 

[pb4uski]

Since you don't have a lot of taxable funds to pay the conversion taxes, then Animorph's suggestion to fashion withdrawals to the top of the tax bracket that is one step below the tax bracket you expect to be once pensions, SS and RMDs come online makes sense to me.

If that amount of withdrawal exceeds what you need to live on, then you can either just take the excess withdrawal and save it or split the excess between a Roth conversion and a withdrawal sufficient to pay the tax on the Roth conversion.

Either way, the reductions in your taxable account will reduce your RMDs later in life.

If you don't have money in a taxable account that you will live on for the first few years in retirement, and pay Roth conversion taxes with, then you probably aren't a Roth conversion candidate.

However, it still may reduce your total taxes if you always withdraw from tax-deferred accounts up to a lower tax bracket. Such as filling up any 0% tax rate and probably 10% and maybe 15% tax rate brackets. You are trying to get the maximum out of your 401k at the lowest tax rate. If you need the withdrawals for expenses, fine. If you don't, then Roth convert it. A big factor is what your taxes might look like when you turn 70 and pensions, SS, and RMD's are all online. If that puts you in the 25% tax bracket you probably want to think about reducing RMD's in some manner either early withdrawals or Roth conversions.