Questions about I-ORP

[merlin3942]

Hi everyone,

Just ran my first I-ORP pass. What an amazing tool! Part of the reason I've been in "OMY" mode for a while is because I thought it was easier to just keep working than to try and figure out how to handle the withdrawl strategy on my own.

So, in looking at what the ORP results are showing me, I have a question about the IRA-2-ROTH conversion column. I'm currently 60, and ran it to retire at the end of this year. It has me doing about 25K/year conversion from IRA to Roth, which seems ok until I look at the "Taxes" column. That shows that I'm paying about 24% income tax, and I think that is solely from the the Roth conversion. In reading through the "ORP Explanation" documentation, I came across this paragraph:

RothIRA: The amount of money distributed from the Roth IRA account. No tax is paid on Roth IRA withdrawals. For IRA to Roth IRA conversions there is a 10% penalty charged for the withdrawal of the increase in account value within five years of the deposit in a Roth IRA. ORP conservatively assumes that the 10% applies to all of the early distribution. This will cause ORP to assess a larger than necessary economic penalty on early distributions and will cause ORP to prefer to avoid early distributions.

I'd never heard of that "10% penalty within 5 years" before ... unless that was just for folks under the age of 59.5? Or is that penalty really true for everyone? If so, it really seems unwise to to convert anything to Roth during those first 5 years? Of course, the vast majority of funds in the IRA have been in there much longer than 5 years, so I don't understand how/why that 10% penalty would apply anyway?

I'm sure I'm misunderstanding something ... maybe I was right, and it's easier to just keep working anyway! ;-)

One other question about I-ORP - it crunched all the numbers, and came up with an "annual spending amount" that should comfortably last me 35 years, and did all its withdrawal calculations based on that amount. However, that amount is more than twice what I think I'd ever be able to spend in a year (based on my current spending and lifestyle habits). Is there anyway for me to input that number into I-ORP somewhere, instead of relying on it to figure out how much I should spend each year?

Thanks!

 

[homestead]

You can increase the Estate in current dollars field until the calculated ORP spending matches what you want to spend.

 

[rodi]

As far as the Roth conversions. My understanding is there is a 5 year lookback on converted funds. In other words - it's hands off that money for 5 years - then you can withdraw the converted amount, and any gains, tax free. Some people do separate Roth accounts for each year's conversion, just to keep the book-keeping simple. EG - convert $10k year 1, call it account A. Convert 10k year 2, call it account B... rinse and repeat a few times... convert $10k year 6, call it account F... and you can withdraw from account A that year.

Does that help clarify?(or make it more confusing?... I'm not always the best person to explain.)

 

[merlin3942]

Thanks, Homestead - I wouldn't have thought to increase the Estate amount - that worked great!

Rodi,
Thanks! I think I understand what you are saying - you don't pay that 10% penalty at the time you do the conversion, only at the time you would make a withdrawal from those converted funds IF the conversion was done less than 5 years ago. I guess that makes sense. Since I think I'm only doing the conversion in order to try and minimize the RMD hit 10 years from now, and won't really need to withdraw any of those converted funds until well after that, I can probably get away with creating just one new ROTH IRA account for these conversions. I should have realized that "early distributions" meant withdrawal from the converted account, and not the conversion itself.

 

[Whisper66]

Merlin3942 - I am 55 and have just gone through the same questions as you. The financial advisors say I can make the tIRA to rIRA conversions without penalty as long as I pay taxes on the conversions. After converting, I can withdraw my contributions anytime from the rIRA without penalty. However, I cannot withdraw any earnings until the later of when I am 59.5 or the conversion has been in the account for 5 yrs.

Like you, I-oRP yields a higher annual spending than I need. As others have suggested here, you can just raise the estate value until you lower the annual spending to what you really wish to spend. That is the method suggested by the I-ORP author.


BTW - in another posting (not mine) Kaneohe posted a nice summary of the rIRA rules he got from another post.



Re: Roth IRA Rules - Table Approach
Posted by: KAWill (IP Logged)
Date: October 14, 2010 11:57PM


Roth IRA Distribution Table

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD NOT MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-Yes (Taxable Portion)
Conversions: Tax-No ;Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-No (Taxable Portion)
Conversions: Tax-No; Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

 

[ArkTinkerer]

As far as the Roth conversions. My understanding is there is a 5 year lookback on converted funds. In other words - it's hands off that money for 5 years - then you can withdraw the converted amount, and any gains, tax free. Some people do separate Roth accounts for each year's conversion, just to keep the book-keeping simple. EG - convert $10k year 1, call it account A. Convert 10k year 2, call it account B... rinse and repeat a few times... convert $10k year 6, call it account F... and you can withdraw from account A that year.

Does that help clarify?(or make it more confusing?... I'm not always the best person to explain.)

I think you can withdraw the conversion (capital you invested) but not the gains. Gains have to wait until full retirement age or you have to pay penalties.

Can someone verify which is correct?

 

[rodi]

I think you all are correct... Principal can be withdrawn prior to the 5 year or 59.5 tests.

 

[ArkTinkerer]

I think you all are correct... Principal can be withdrawn prior to the 5 year or 59.5 tests.

This I know is incorrect. Principal has to "age" 5 years or you have to reach retirement age (59.5).

What I question is the gains. I'm pretty sure gains have to stay in the Roth until 59.5 or you have to pay a penalty to take them out.

 

[ArkTinkerer]

I'm going blind--Whisper66 has it all laid out at the end of his post!

 

[sengsational]

...I've been in "OMY" mode...

One other question about I-ORP - it crunched all the numbers, and came up with an "annual spending amount" that should comfortably last me 35 years, and did all its withdrawal calculations based on that amount. However, that amount is more than twice what I think I'd ever be able to spend in a year (based on my current spending and lifestyle habits). Is there anyway for me to input that number into I-ORP somewhere, instead of relying on it to figure out how much I should spend each year?

I got similar news a few years ago. Rather than putting in a larger estate amount, I'd say you have two things to do:

1) Quit doing OMY
2) Have fun (without worrying about how much it costs)

 

[Ed_The_Gypsy]

It is my understanding that the IRS considers that you only have one Roth even if you have many Roth accounts and that the establishment date of your 'Roth' is the date you started your first one. Five years after that, withdrawals without penalty are allowed (provided you are over 59.5, IIRC), not just the first dollar but any and all, including more recent contributions.

Sent from my SM-G900V using Early Retirement Forum mobile app

 

[kaneohe]

Re: Roth IRA Rules - Table Approach
Posted by: KAWill (IP Logged)
Date: October 14, 2010 11:57PM


Roth IRA Distribution Table

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD NOT MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-Yes (Taxable Portion)
Conversions: Tax-No ;Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-No (Taxable Portion)
Conversions: Tax-No; Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

**********************************************************
Whisper66 has it right here with this table by KAWill from the fairmark.com site. To me the beauty of the table is that you don't have to think.....which can sometimes be a dangerous thing You do have to know the ordering rules of Roth withdrawals: Withdrawals are considered to be taken in the order listed in the table: 1) contributions first; then 2) conversions , oldest first and within each conversion , the taxable part first and then the non-taxable part (if any) and then finally 3) earnings. Also as mentioned by Ed_the_Gypsy, all your Roths are considered 1 account as far as considering this withdrawal hierarchy, so having multiple accounts does not change anything here.

 

[orplanner]

Merlin3942 -

Like you, I-oRP yields a higher annual spending than I need. As others have suggested here, you can just raise the estate value until you lower the annual spending to what you really wish to spend. That is the method suggested by the I-ORP author.

The whole point of i-orp is that some retirees underestimate their retirement resources. The Journal of Personal Finance article found on page 17 of http://www.iarfc.org/documents/issues/Vol.14Issue1.pdf is intended to establish the credibility of ORP as a retirement planning tool. ORP is not completely off the wall with its projections.

 

[pb4uski]

The issue that I have with i-orp is that it recommends much higher Roth conversions that would kick me into a higher tax bracket that I would have once SS and RMDs start because it doesn't seem to recognize the progressivity of tax rates.

Edited to add: I guess I spoke to soon... it does seem to recognize the progressiveness of tax rates, but it looks like it is kicking me into the 25% tax bracket for a number of years in early retirement (60 to 65) and then after that my marginal tax bracket would be 15%.... but why would I want to do Roth conversions at 25% if my ultimate tax rate is 15%? Doesn't make sense.

 

[user5027]

.... but why would I want to do Roth conversions at 25% if my ultimate tax rate is 15%? Doesn't make sense.

I've read that time and the rate of return on the tax free roth may make doing aggressive conversions (paying a higher tax rate at conversion than expected at RMD) better than leaving the money in the tax deferred IRA.

YMMV

 

[pb4uski]

I don't understand the logic in that, even if I pay the tax from taxable accounts at the end of the day Uncle Same still gets 10% more. I'd need to see the math on that hypothesis.

 

[hnzw_rui]

I've read that time and the rate of return on the tax free roth may make doing aggressive conversions (paying a higher tax rate at conversion than expected at RMD) better than leaving the money in the tax deferred IRA.

Not really. Assuming you have both tax deferred and Roth in the same investments and AA, rate of growth is the same. It doesn't really matter where you have the money. The only clincher is if you reach RMD age and your RMDs are much higher than your expenses or could possibly push you into a higher tax bracket. Since you can't convert RMD money into Roth, only choice is to put the excess funds in a taxable account.

 

[user5027]

Not really. Assuming you have both tax deferred and Roth in the same investments and AA, rate of growth is the same. It doesn't really matter where you have the money. The only clincher is if you reach RMD age and your RMDs are much higher than your expenses or could possibly push you into a higher tax bracket. Since you can't convert RMD money into Roth, only choice is to put the excess funds in a taxable account.

Yes, I did really read it and it was in a thread here beginning at post #71....
http://www.early-retirement.org/forums/f28/do-you-use-i-orp-68144-4.html#post1450022

Assumptions make.... (oh you know).

One thing I've learned is everyone's situation is unique and generalizations will not always be true in retirement planning........ hence my YMMV (<<< Your Mileage May Vary).

I agree if allocation is equal, rate of return is the same. The roth grows tax free while the traditional ira is taxed as income with an even bigger bite than the taxes on a taxable account (accounting for qualified dividends and long term gains), unless you are heavy munis in taxable (another unique situation).

I've considered perhaps a more aggressive allocation is appropriate in roth accounts if they will be spent later and have more years to recover from a bear run.

I've read the conversion discussion is focused on the time between retirement and taking social security and required minimum distributions.

After 70.5 I will be looking back and hopefully not thinking I should have converted more.

YMMV

 

[orplanner]

The issue that I have with i-orp is that it recommends much higher Roth conversions that would kick me into a higher tax bracket that I would have once SS and RMDs start because it doesn't seem to recognize the progressivity of tax rates.

Edited to add: I guess I spoke to soon... it does seem to recognize the progressiveness of tax rates, but it looks like it is kicking me into the 25% tax bracket for a number of years in early retirement (60 to 65) and then after that my marginal tax bracket would be 15%.... but why would I want to do Roth conversions at 25% if my ultimate tax rate is 15%? Doesn't make sense.

It would be helpful if I could see your run(s) before diving off into the shallow end; but what the hell. In many models for most of the plan IRA withdrawals are maxed out at the top of the 15% bracket and Roth IRA distributions fill in the difference between withdrawals and spending. If there is no Roth IRA then IRA withdrawals go into a higher bracket to satisfy spending. Therefore, in these cases IRA to Roth IRA conversions for a few years early in the plan that edge into a higher tax bracket are optimal. Only a relatively small portion of the withdrawal is taxed at the higher rate, not the whole withdrawal.

It is well to remember that ORP maximizes spending by minimizing taxes AND maximizing asset returns. This leads to some counter intuitive withdrawal schedules but which make sense when you disassemble them. After all, the justification for modeling is to explore the non obvious. If you are looking for the obvious then rules-of-thumb will do nicely. Using mathematically modeling to justify one's preconceptions is a common phenomenon in the operations research world.

 

[sengsational]

I don't understand the logic in that, even if I pay the tax from taxable accounts at the end of the day Uncle Same still gets 10% more. I'd need to see the math on that hypothesis.

Mine goes into 25% a little bit, which I also found unsettling. But it's not recommending that for this year, which is the only thing that is actionable. It's probably optimized, but even if it isn't, it's gotta be dang close. I've been working on pulling the output into a spreadsheet where I can do bottoms-up calculations which will allow me to run some what-if's and validate assumptions. Not quite there yet on that...too many other more fun things to spend my time doing, like getting my quad copter down from the tree.

 

[2017ish]

The whole point of i-orp is that some retirees underestimate their retirement resources. The Journal of Personal Finance article found on page 17 of http://www.iarfc.org/documents/issues/Vol.14Issue1.pdf is intended to establish the credibility of ORP as a retirement planning tool. ORP is not completely off the wall with its projections.

Thanks for the link. The article is good, and concludes that conversion (as well as which type of accounts to draw down when) is highly variable, depending upon the size of an individual/couple's nest egg, and the allocation among types of accounts.

Makes me reassess my preliminary plans.

Truly, YMMV.

 

[pb4uski]

I artificially forced my excel model to have very high Roth conversions similar to what i-orp is suggesting between now and age 70 and the age 100 NW is substantially higher than limiting Roth conversions to the top of the 15% tax bracket and NW is actually fairly close to i-orp.

I think it might be because at the end of the plan most assets are Roth and the growth in the Roth never gets taxed.

Interesting and definitely worth further study.

 

[hnzw_rui]

Yes, I did really read it and it was in a thread here beginning at post #71....
http://www.early-retirement.org/forums/f28/do-you-use-i-orp-68144-4.html#post1450022

Assumptions make.... (oh you know).

One thing I've learned is everyone's situation is unique and generalizations will not always be true in retirement planning........ hence my YMMV (<<< Your Mileage May Vary).

I agree if allocation is equal, rate of return is the same. The roth grows tax free while the traditional ira is taxed as income with an even bigger bite than the taxes on a taxable account (accounting for qualified dividends and long term gains), unless you are heavy munis in taxable (another unique situation).

I've considered perhaps a more aggressive allocation is appropriate in roth accounts if they will be spent later and have more years to recover from a bear run.

The aggressive Roth conversion strategy works if you plan on leaving a large estate because you avoid taxes on unnecessarily large RMDs and on taxable accounts.

However, purely on the math front, spreading out Roth conversions over several years at lower tax brackets is more beneficial than one giant conversion pushing you to higher tax brackets. Of course, that's assuming you don't have a taxable account (with LTCG) from which to pay taxes and assuming your RMDs will never be higher than your spending ergo making paying the higher taxes at the beginning unnecessary. No doubt the i-ORP model takes these factors into account and minimizes taxes at retirement while maximizing spending. That said, it doesn't appear to try to minimize taxes pre-retirement. Unfortunately, it doesn't quite handle more complicated state taxation rules, either.

 

[user5027]

The aggressive Roth conversion strategy works if you plan on leaving a large estate because you avoid taxes on unnecessarily large RMDs and on taxable accounts.

How does doing roth conversions avoid taxes on a taxable account?

 

[pb4uski]

How does doing roth conversions avoid taxes on a taxable account?

Because you use taxable account money to pay taxes on Roth conversions so it isn't earning income that is taxed because the money is gone.