Roth Conversion Tax

[halo]

Hi

We all know that Firecalc is a tax-neutral tool, and that any taxes you pay must be paid out of the safe withdrawal you choose, be it 95% safe or 100% safe or whatever.

But if you convert from your TIRA to your Roth IRA, the tax you pay on such a conversion is not the same as regular taxes. Regular taxes do not create any future value. Taxes on Roth IRA conversion amounts are the price you pay for creating two forms of future value: 1) lower tax payments on lower TIRA MRD's after you reach the age of 70 1/2 and 2) the tax-free compounded growth over time of the amount(s) converted to the Roth (which are worth a lot more than if the same amount(s) had stayed pre-tax in the TIRA).

So, is it possible to regard this particular tax (the tax on converting a portion of your TIRA to your Roth IRA) as somehow different from all other taxes because it creates such future value(s), and not regard these particular taxes as having to be paid out of your safe withdrawal? Normally, spending is spending - it's money gone never to return. The same is true of taxes too - it's just money out that does not create future financial benefit. However, THESE conversion taxes are different, aren't they? They DO create future benefits. So, do they have to come out of your safe withdrawal the same way all other taxes do? Or not?

Is there any way to use Firecalc to adjust or add back for these future value created by such current Roth Conversions tax payments? How could they be quantified and/or factored into the program?

Any comments on this subject are much appreciated. I'm considering a 10-year program of Roth conversions from my TiRA that stay just under the 15% bracket each year (I'm 60 years old now). That will basically leave half tax-deferred money in my TIRA and the other half in my Roth by the time I'm 70 1/2, thus hedging my bets, so to speak. I'm just wondering if I can afford the tax payments out of my Firecalc safe withdrawal rate . . .

Thanks for your feedback.

[heyyou]

IMHO, tax is still spending. Can you tediously add the annual conversion (a negative withdrawal) to the Roth for the ten calculations to see what you end at? The actual returns on your whole portfolio will overwhelm whatever accuracy you wring out of the simulation.
Joe

[Brat]

I haven't tried to use FireCalc for that purpose, but I am exploring conversion too. WA has no income tax, in a couple years we will probably move to OR. Thought I should shovel from the regular IRA to Roth before moving.

Also, I learned the you can't take your RMD and put it in the Roth. Any Roth conversions at that point would be IN ADDITION to the RMD. Nuts!!

[hogwild]

Quote:

Originally Posted by Brat Also, I learned the you can't take your RMD and put it in the Roth. Any Roth conversions at that point would be IN ADDITION to the RMD. Nuts!!

But wouldn't you be able to use some of the RMD money to make a regular Roth contribution?

[REWahoo]

Quote:

Originally Posted by hogwild But wouldn't you be able to use some of the RMD money to make a regular Roth contribution?

Only if you have "compensation or alimony income" according to Farimark.com:

For each year you contribute to a Roth IRA, you (or your spouse, if you file jointly) must have compensation or alimony income. If you don't have compensation or alimony income you can't contribute, even if you have other types of income. And if your compensation or alimony income is less than the maximum contribution, the amount you can contribute is reduced.

* Compensation income. Compensation income includes amounts you receive from your employer of course, but also includes self-employment income from your own business or from a partnership that generates this type of income. There's a special rule that treats alimony income as compensation income, just for purposes of determining how much you can contribute to an IRA. That means you can contribute to an IRA if you receive taxable alimony payments, even if you don't work for a living. Compensation income does not include investment income, pension income or non-taxable income.
* Spousal Roth IRA. If you file jointly with a spouse who has compensation income, you don't need compensation income of your own. You can contribute to a Roth IRA based on your spouse's compensation income.

http://www.fairmark.com/rothira/contrib.htm

[halo]

I think maybe I found a way to use Firecalc to calculate the tax effect of my 10-year Roth conversion program at the top of the 15% tax bracket:

On the first page ("How Much Will You Spend?"), I entered the target amount of my conversion tax payments as an "increase" of my withdrawal starting this year (2006). I check the inflation-adjusted checkbox in order to keep up with the future 15% bracket creep.

Then I enter the same number (the target amount of my conversion tax payments) as a "decrease" in my withddrawal starting in the year of 2016 (10 years later). And I ask Firecalc for my results in terms of "how much (I) spend each year."

Question: should I check the inflation-adjusted checkbox for this "decrease?" It makes a significant difference in the results if this "increase" and "decrease aren't both inflation-adjusted (or not). So should I always keep this withdrawal "increase" and "decrease" the same in this regard, that is, they both should be inflation-adjusted or both not be inflation-adjusted? This is an important distinction, I think.

Does the above method properly use Firecalc to simulate the effect of the 10 years of tax payments caused by my proposed 10-year Roth conversion plan? Am I making any mistakes here?

I really appreciate any comments and suggestions on how to use Firecalc as accurately as possible for the purpose as set forth above. Thanks a lot, everyone, for all your help!

[runchman]

Quote:

Originally Posted by halo But if you convert from your TIRA to your Roth IRA, the tax you pay on such a conversion is not the same as regular taxes. Regular taxes do not create any future value. Taxes on Roth IRA conversion amounts are the price you pay for creating two forms of future value...

But you also have to consider the 'opportunity cost' of lost gains on the tax money that you pay to do the conversion.

As a (relatively) young guy in my early 40's, I just can't see converting a large TIRA to a roth and paying out a huge chunk in taxes. I'd much rather let that chunk continue growing for quite a few more years.

I see the choice as:
1. pay lump sum now to do conversion, losing lots of future growth from those tax dollars. Or...
2. don't convert, let balance grow. Pay taxes incrementally on the small portions of my total roth balance that I eventually begin taking out.

#2 seems like a much better choice for me. Maybe if I knew I was going to take a lump-sum distribution of my ENTIRE roth balance down the road, and have to pay taxes on the whole thing, then maybe I'd consider conversion.

Or maybe I'm just a dope and don't get it.

- John

[Brat]

Pay them now or pay them later, that is the question.

If you think todays income tax rate for you will be lower or the same as today conversion makes no sense. But, what if you knew (as I expect) that I will be paying an additional 9% in state income taxes on my regular IRA withdrawals and I don't expect to be tapping our Roths for at least 10 years?

I am still undecided.

[runchman]

Quote:

Originally Posted by Brat Pay them now or pay them later, that is the question. I am still undecided.

I still can't get past thinking that it's "Pay them ALL of it now" vs. "Pay them all of it spread out over many years, starting much later than today", and thinking I'd much rather delay as long as possible, and then once I'm withdrawing, STILL delay as long as possible. It isn't like at retirement they are going to hit you with a 9% state tax on your entire balance.

Sure I pay eventually, but paying it all out right now vs. waiting as long as possible just doesn't seem right to me.

I'm 1% undecided, 99% decided to not convert.

[HFWR]

Some, e.g.Nords, are converting up to the top of the next tax bracket, in order to avoid tax unfriendly RMDs down the road.

[ERD50]

Quote:

Originally Posted by runchman I still can't get past thinking that it's "Pay them ALL of it now" vs. "Pay them all of it spread out over many years, starting much later than today", and thinking I'd much rather delay as long as possible, and then once I'm withdrawing, STILL delay as long as possible. It isn't like at retirement they are going to hit you with a 9% state tax on your entire balance. Sure I pay eventually, but paying it all out right now vs. waiting as long as possible just doesn't seem right to me. I'm 1% undecided, 99% decided to not convert.

Actually, I did a big spreadsheet on this, and it kept telling me it didn't matter. I kept looking for the error - there wasn't one. It doesn't matter.

Example:

$100 minus 15% up-front tax = $85. Let it double in value over time to $170.

$100 untaxed doubles to $200 over the same time. After 15% tax, you have (drum roll, please)... $170.

It all comes down to a gamble over future tax rates. It really stinks that the gov puts us through this mess - heck, they don't know what they will do with taxes next year, how are we supposed to guess/plan for 20 years down the road?

-ERD50

[Nords]

Quote:

Originally Posted by HFWR Some, e.g.Nords, are converting up to the top of the next tax bracket, in order to avoid tax unfriendly RMDs down the road.

We're reliably in the 15% income-tax bracket so I make sure that we use the whole thing. But we know that our tax bracket will rise even further when spouse starts collecting her Reserve pension at age 60.

We also avoid having RMDs trigger taxation on our Social Security.

We think that today's tax brackets are probably lower than tomorrow's brackets.

We don't want to go through the hassles of RMD calculation.

[landover]

Quote:

Originally Posted by ERD50 Actually, I did a big spreadsheet on this, and it kept telling me it didn't matter. I kept looking for the error - there wasn't one. It doesn't matter. Example: $100 minus 15% up-front tax = $85. Let it double in value over time to $170. $100 untaxed doubles to $200 over the same time. After 15% tax, you have (drum roll, please)... $170. It all comes down to a gamble over future tax rates. It really stinks that the gov puts us through this mess - heck, they don't know what they will do with taxes next year, how are we supposed to guess/plan for 20 years down the road? -ERD50

I think there is a minor difference

IRA-> 100 (in) -> 200 (out)-> 170 (after tax 15%); Gain 170/100=70%
Converted to Roth-> 100(in IRA) -> 100 (in roth + 15 in tax) -> 200 (tax free); Gain 200/115=73.9%

so its 4% extra.

[ERD50]

Quote:

Originally Posted by landover I think there is a minor difference

Well, it is minor I guess, but at least it is in *favor* of the Roth conversion, so that makes me feel better

The real benefit will be if you find yourself in a 25% bracket or higher when you need to WD from a Trad IRA, and you only paid the 15% tax to convert.

So then I tried to look at it comparing $115 in the IRA (since you didn't 'lose' it to taxes, you still have it). The advantage gets cut about in half, but it is still an advantage. I'm not even sure if it makes sense to look at it that way, as you can't just come up with an extra $15 in your IRA that was not there before. My head is starting to hurt, this happened the last time I went through these calcs.

Anyway, Roth conversion can be good if you are in a position to take advantage of it, and if the Feds don't mess it up on us, which I figure a 50/50 chance of, so I'm just going to do it and hope for the best.

-ERD50

[Sheryl]

Quote:

Originally Posted by ERD50 My head is starting to hurt, this happened the last time I went through these calcs. -ERD50

So is mine and I didn't even do the calcs. I will wait until this thread plays out then do whatever you guys do.

I love this board.

[justin]

Quote:

Originally Posted by landover I think there is a minor difference IRA-> 100 (in) -> 200 (out)-> 170 (after tax 15%); Gain 170/100=70% Converted to Roth-> 100(in IRA) -> 100 (in roth + 15 in tax) -> 200 (tax free); Gain 200/115=73.9% so its 4% extra.

You got the tax amount incorrect.

If you contribute to a Roth IRA, you will pay tax of 17.64 on 117.64 of earnings. Then contribute the net of 100 to the roth. It doubles, and your gain is 200/117.64=70.0%, or exactly the same amount as the gain in the TIRA.

Your statement should look like this:

IRA-> 117.64 (in) -> 235.28 (out)-> 200 (after tax 15%); Gain 200/117.64 = 70%
Converted to Roth-> 117.64 cash in hand -> 100 (100 in roth + 17.64 in tax) -> 200 (tax free); Gain 200/117.64 =70.0%

[Patrick]

Quote:

Originally Posted by ERD50 Actually, I did a big spreadsheet on this, and it kept telling me it didn't matter. I kept looking for the error - there wasn't one. It doesn't matter. Example: $100 minus 15% up-front tax = $85. Let it double in value over time to $170. $100 untaxed doubles to $200 over the same time. After 15% tax, you have (drum roll, please)... $170. It all comes down to a gamble over future tax rates. It really stinks that the gov puts us through this mess - heck, they don't know what they will do with taxes next year, how are we supposed to guess/plan for 20 years down the road? -ERD50

One advantage to the Roth is that it goes tax free to your heirs. A TIRA is taxed as ordinary income at their rates.

[Nords]

Quote:

Originally Posted by Patrick One advantage to the Roth is that it goes tax free to your heirs.

I'm a bit confused about this. I thought a Roth heir had to withdraw the funds via RMD and pay ordinary income taxes on them.

I haven't bothered to learn how that works because I know I'll never be a Roth heir. Our progeny can go do her own darn research...

[Patrick]

Quote:

Originally Posted by Nords I'm a bit confused about this. I thought a Roth heir had to withdraw the funds via RMD and pay ordinary income taxes on them.

If the heirs take the RMD, it is tax-free to them. From: http://www.freemoneyfinance.com/2006...ras_make_.html

"If the tax-free growth of a Roth IRA wasn’t enough to wet your appetite, the estate planning benefits it offers should seal the deal. Bequeathing a Roth is much the same as setting up a life-time tax-free stream of income for your heirs. Because Uncle Sam has already taken his cut of the principal when you put the money in, withdrawals from a Roth can be made tax-free, either by you or by your beneficiaries. All this happens simply by naming the appropriate beneficiaries for your Roth."

Edit. From Kiplinger (http://www.kiplinger.com/basics/arch.../03/IRAs7.html): "With Roth IRAs, the money goes to your beneficiary tax-free. However, there is a minimum withdrawal schedule for heirs -- but again, withdrawals are tax-free."

[Martha]

FWIW, even though your heirs can avoid income taxes on the distributions, the Roth will still be part of your estate and if you have enough assets estate taxes will be due.