Roth Conversion Guide

[cat4ever]

Quote:

Originally Posted by sengsational cat, The easiest way to answer the question "for sure" is call your plan administrator. After I left the company, I called my plan administrator and was told that any withdrawal from Roth 401k would be a taxable event because it hadn't been opened more than 5 years.

Hmm, "taxable" doesn't seem right, and I don't think plan administrators are usually trained to give such advice. Mine told me yes, I can withdraw, but the rest is between me and the IRS. That being said, I think the 5 year rule is for triggering a penalty, not taxes. You pay the taxes when you do the conversion, I don't see them taxing it again because of the 5 year rule.

In the end, I'd like to know if when you are using the rule of 55, can you replace 59 1/2 in the below paragraph from the OP's guide, with 55, as I've done in the red text? In that case it would seem all distributions would be immediately penalty and tax free from the converted Roth...

Converted amounts are deemed to be distributed next. Again, there are no income taxes on
distributions of converted amounts because you’ve already paid taxes on these dollars.
Conversions may be withdrawn at any time by anyone with no income tax cost, including
people under 59½. A 10% early withdrawal penalty, however, may apply if you’re under 59½ (or under 55 if using rule of 55)
The purpose of the penalty is to prevent people who are under 59½ (or under 55 if using rule of 55) from circumventing the
10% early withdrawal penalty that applies to tIRAs. In other words, you can’t use Roth
conversions to do an end around the tIRA early withdrawal rules. That said, even if you are
under 59½ (or under 55 if using rule of 55), there are three ways to avoid the penalty.
First, hold converted amounts in your Roth for at least five years. Second, use the distribution
for what the IRS calls a “qualified purpose,” including: a qualified first-time home purchase,
qualified medical expenses, health insurance premiums while unemployed, or qualified higher
educational expenses. Third, die or become disabled.

[pb4uski]

Quote:

Originally Posted by cat4ever How does the rule of 55 affect access to a roth account in a 401K. Is it simply all the same rules as if you were 59 1/2 and outside of your 401K? e.g. If I did a conversion into my 401K roth from my 401K non-Roth account this year, would I have non-penalty, tax-free access to the converted amount immediately upon retirement (I'm 56 and retiring 1/6/2021), or would I have to wait 5 years? Or until I'm 59 1/2? I've read a lot of articles but they never seem to cover rule of 55 rules specifically.

No, I wouldn't think so... not to the amount converted... but you would have penalty free access to previous contributions assuming that you qualify for the rule of 55.

But if you qualify for the rule of 55 and just withdraw from the traditional 401k rather than convert, then you you would have penalty-free access but you would have to pay the tax just like you would on the conversion.

IOW, as I understand it the rules work the same as a tIRA and Roth IRA except for the penalty which is based on rule of 55 rather than ataining 59 1/2.

https://fitaxguy.com/roth-401k-withdrawals/

[DrBrisket]

Quote:

Originally Posted by schellem I'm in the conversion calculation dilemma, I just retired in June at 58, DW will follow in a year or so. We will have a lot of time to do conversions with little income. I've started on spreadsheet but just keeps getting more and more complex. The latest issue to add to the spreadsheet is to figuring out the road between shooting for low nearly tax free income and getting ACA subsidies versus trying to take advantage of the 24% bracket while we have it. I think we can get subsidies of around 8-10K. Anyone have any tips in relation to considering ACA subsidies?

I realize its too late for much adjustment for 2020 taxes, but I am in the process of revisiting my tax estimations for 2020 to finalize the last tweak available for me (IRA contributions since I had a bit of 1099 income in 2020). Our taxes are fairly complex due to royalty and rental income, W2 income from a non-qualified plan, 529 distributions, ACA subsidies, AOTC, child tax credits, and a long litany of other small complications. In short, serious levels of "first world problems"! LOL

Long story short, I did a "trial run" through TurboTax to get a better idea of the marginal tax increase of Roth conversions. Without getting into the minutiae, tIRA to Roth conversions are showing a ~40% marginal tax rate even though we are in the lower half of the MFJ 12% bracket wrt taxable income.

In our case, ACA subsidies are substantial (family of 6, with 5 on ACA plans in 2020), but I haven't taken the time to chase through all the turbotax calculations to understand where all causes of the insane tax cost of Roth conversions.

[RunningBum]

Maybe your bracket + subsidy loss + more capital gains being taxed? If you're collecting SS you could be pushing more SS into being taxed.

[pb4uski]

Interesting. If you're in the lower half of the 12% tax bracket, I would think that any Roth conversions would be 12% up to your ACA MAGI limit (400% FPL), then jump to 12% plus lost ACA subsidies... given the cliff aspect of ACA credits I guess I can see 40%.

If your income before Roth conversions is less than the ACA cliff, what is your marginal tax rate on Roth conversions to just under the cliff? And then the marginal rate from just under the cliff to the top of the 12% tax bracket? For the second one you should be able to see the impact of the increase in taxes and the lost ACA subsidy.

The TT What-If worksheet is handy for doing these calculations and comparisons.

[DrBrisket]

It is interesting, in the most pejorative sense of the word.

I am using TT Premier for the estimation and changing the amount of Roth conversion. Instead of trusting the number written down on a piece of paper from my efforts in December, this morning I reran the numbers. TT did an update, so not surprised to see differences today. It is better, but 33% marginal tax rate on conversions is still painful.

MFJ + 4 dependents, so we are nowhere near the ACA cliff (~$140k). No SS income. Income sources: rentals, royalties, 1099-NEC, non-qualified pension plan, 1099-INT, short-term cap gains. Tax credits/reductions: child tax credit, AOTC, LLC, QBI, PTC. Standard deduction. Also have 1099-Q distributions, but all gains are non-taxable as they are offset by qualified expenses.

Here's what TT is showing by simply changing the amount of Roth conversion on a 1099R:

Roth Conversion	Marg. Tax increase from previous row	Overall Decrease of PTC
$100	~0	~0
$5000	~0	~0
$10,000	540	536
$15,000	1,660	1,780
$20,000	1,660	2,750

[pb4uski]

Your table is a bit confusing. If I understand it correctly, if you add a $20k Roth conversion then your tax increases by $3,860 (19.3%). Is that just federal tax? I assume so. The 19.3% infers that before any Roth conversions that your taxable income was deep into the 12% tax bracket... so some of the Roth conversion is at 12% and the remainder at 22%.

And it appears that the PTC reduction also has a significant bite... and if you do a $20k Roth conversion that your overall economic cost is $6,610... and 33% of the Roth conversion. If it were me, I would hold off on Roth conversions until ACA credits were no longer in play.

The way you are fretting about it it seems that you think that Roth conversions should be free.

[DrBrisket]

Sorry about the confusion of the table. Your interpretation is correct and I have no state income tax. I have another related tax issue/opportunity that I was trying to understand and so I tried to pull out/summarize the relevant info in the table above.

I did hold off on conversions for now for exactly the rationale you stated.

I was not expecting the conversions to be free--in fact, I have been doing Roth conversions when it was at an advantageous marginal tax rate over the past 20+ years. Rather, I was surprised to find a marginal tax rate of 30%+ for the conversion even with a relatively low marginal tax rate.

[SevenUp]

Quote:

Originally Posted by DrBrisket Our taxes are fairly complex due to royalty and rental income, W2 income from a non-qualified plan, 529 distributions, ACA subsidies, AOTC, child tax credits, and a long litany of other small complications.

Don't know if it will handle all of those, but at a quick glance it seems the case study spreadsheet could do so, and automatically give you a marginal rate chart for whatever range of Roth conversions you wish.

[DrBrisket]

Quote:

Originally Posted by SevenUp Don't know if it will handle all of those, but at a quick glance it seems the case study spreadsheet could do so, and automatically give you a marginal rate chart for whatever range of Roth conversions you wish.

Thanks for the link! Haven't had time to do much yet, but as you point out, it is quite comprehensive and will save a lot of hassle for 2021 estimates.

Since my last post, I did find a helpful thread on another forum that shows the unusual marginal tax rate implications of Roth Conversions with the ACA for a simpler tax situation than mine. It is important to note that the IRS updates the values for calculating the ACA subsidies each year and a quick scan of prior years shows the marginal tax rate for incremental taxable income is slowly increasing.

Since it's water under the bridge for 2020 taxes, I have been spending time modeling the balance between the long-term implications of Roth Conversions versus the short-term higher taxes for our particular situation. Prior to this year, I had been converting when my tax rate was low and skipping conversions when our income had a significant bump. It is now clear that I need to have a "Micro-" and "Macro-" view of Roth conversions where Macro-planning is looking more carefully at the long-term (30+ years/legacy planning) along with Micro-planning on a yearly basis looking at the Roth conversion and Capital Gains Harvesting opportunities that arise from FAFSA planning, dependents becoming independent, known changes in income, etc. Still have more details to model better, but it looks like a strategically maximizing subsidies in some years and going over the fiscal cliff in other years is the best. All in all, what started as a seemingly "simple" tax estimation exercise is proving to be very rewarding-both monetarily and psychologically.

[ArmchairMillionaire23]

Quote:

Originally Posted by atlasshrugged i hope you find it useful. Here's the link to it. https://www.dropbox.com/s/istw0kr1ts...guide.pdf?dl=0

Capture.PNG

Link not working anymore...

[qwerty3656]

Quote:

Originally Posted by ArmchairMillionaire23 Attachment 38700 Link not working anymore...

+1 link not working

[braumeister]

The author sometimes takes his essays down for revision, but hasn't posted here in a couple of months. He may have lost interest.

[Bruno]

AtlasShrugged I just wanted to say "Thank You " for the papers you wrote. I hope you are doing OK.

Bruno

[frayne]

Quote:

Originally Posted by Bruno AtlasShrugged I just wanted to say "Thank You " for the papers you wrote. I hope you are doing OK. Bruno

+1 interesting and timely post.

[Dtail]

He is gone traveling.

[copyright1997reloaded]

Does anyone else out there have the paper that they can share?

[Time2]

Quote:

Originally Posted by pb4uski Excellent! A couple thoughts: An example of the communicative property might be helpful, but there is a wrinkle... a second order effect that makes keeping the assets in the tIRA suboptimal compared to converting earlier. For example, let's say you have $100,000 in a tIRA, $22,000 in a taxable account, a 22% marginal tax rate and expect that your investments will double in 10 years (earn 7.18%). If you convert and use the after-tax funds to pay the $22,000 in taxes due then the Roth will grow from $100,000 to $200,000 of after-tax value. OTOH, if you do nothing, the $100,000 tIRA will double to $200,000 and when withdrawn $44,000 of taxes will be due which will be paid with the after-tax money and growth... so the end result is $200,000 of after-tax value... so at first blush it appears to be a wash. But... the taxable account will really not grow to $44,000 because the 7.18% growth is taxed at 22% each year rather than tax-deferred like in the tIRA or tax-free in the Roth. In reality, the $22,000 taxable account will only grow to $37,931* rather than $44,000,

I'm only 13 months late on this, but why would you pay taxes on the 7.18% every year? I would expect this is in a mutual fund that averages 7.18% and you owe no tax on the gains until you sell it. (10 yrs) Granted, you will owe a little on the dividends.

[cat4ever]

Here's a link to a copy I downloaded in July...

https://www.icloud.com/iclouddrive/0...nversion_Guide