How do you treat taxes on ROTH transfers?

[walkinwood]

Fellow Early Retirees,

Do you treat the taxes on IRA to ROTH transfers as part of the year's expense? Or do you treat that as an "investment expense" and take it out of your portfolio total?

In case I'm not clear, here's an example.
Say your annual withdrawal (based on your SWR) is $40,000 based on a portfolio of $1,000,000. You moved $X from a rollover-IRA to a ROTH and the tax on that move is $1000. To make things easy, your portfolio return is 0% for the year.
Do you consider that $1000 an expense against your $40,000 annual withdrawal?
Or,
Do you deduct it from your year-end portfolio value. ie. $1,000,000 - $40,000 - $1000(Tax)? = $959,000

Here's my thinking:
Since the ROTH transfers are done with the hope of a better return from your IRAs, it should count as an 'investment expense' and just be accounted for in your year-end portfolio value.

PLEASE do not turn this thread into a discussion on the benefits (of lack thereof) of IRA to ROTH transfers.

 

[REWahoo]

No matter the reason for incurring them, taxes are an expense for me. But then I'm not very creative.

 

[ERD50]

What difference does it make to you?

If you are paying the taxes from other sources (not from the withdrawal itself), then it certainly adds to your cash flow for the year - no way around that. But it wasn't a 'consumption' as I see it, it doesn't reflect money you plan to spend each year, or that you can't do w/o. It has no bearing on anything else, so I would tend to look at it as a reduction in portfolio amount. But again, I don't know what I would do with this info, either way.

On a related note, the money to fund our IRAs each year comes from our checking account. I null that out when I am analyzing money I 'spent' for the year - as that money was just transferred from one account to another, no change in NW. Some people argued that since it was cash flow, it was indeed 'spent'. I can't see that at all.

edit/add: Actually it is all the same right? If you normally spend $40,000, and this year (ignore inflation for simplicity) you need to 'spend' an added $1,000 for those ROTH conversion taxes, well, that $1,000 comes out of your portfolio. So it comes out of your portfolio no matter what you call it. I don't get the point of the distinction.

-ERD50

 

[Alan]

Taxes are an expense item for me regardless of where they come from and count as part of my WR %.

 

[pb4uski]

There is no one "right" answer, but it seems to me that for that year that your withdrawals were $41,000. In other words, I would consider the $1,000 as an expense.

If in our personal "books" we kept a liability for deferred taxes like companies do, then it would be a non-event, but since we don't account for deferred taxes IMO the tax is expensed when due to the government.

 

[Gone4Good]

A dollar spent is a dollar spent. The longevity of your portfolio won't distinguish between various types of expenses, so neither should you.

The way I'd think about it is that I pulled forward my tax expense this year and overspent my budget as a result. I therefore have to underspend my budget in future years, which should be made easier by virtue of the fact that I prepaid some taxes. But I still need to underspend in those future years.

Pretending that I didn't really spend that money might give me license to just overspend each and every year as long as I can think of interesting new ways to categorize my spending as something different.

 

[Texas Proud]

No matter the reason for incurring them, taxes are an expense for me. But then I'm not very creative.

Taxes are an expense item for me regardless of where they come from and count as part of my WR %.

I make #3 on this method....

 

[Gotadimple]

Taxes! I can't see how decreasing the return on a portfolio makes sense when you are talking about an expense.

It needs to be the same on all sides of the equation: if you do a withdrawal from your Traditional IRA you pay taxes, if you sell stock in your after tax account you pay taxes on the gain, and if you convert a portion of your Traditional IRA to a Roth IRA, you pay taxes (hopefully from some other source than the T-IRA).

Rita

 

[Nova]

I treat it as an expense, too.

 

[MichaelB]

I make #3 on this method....

+4

 

[ERD50]

Taxes are an expense item for me regardless of where they come from and count as part of my WR %.

(and to the follow up posters) But the difference is, as G4G points out, this is really a pre-payment on money that would be spent anyhow (all else being equal, with the hope/expectation of spending less). That is why I differentiated it from a 'consumption' expense.

Look at it this way: If I could get a 20% discount to pre-pay next year's annual grocery bill, it would not really matter to my portfolio that I spent two years groceries in one year (other than the cash flow implications) and zero the next. Over two years it washes out, and I'm ahead by 20% minus the holding costs. That's a lot different than just spending $X on consumables which do not offset future expenses. I would not count it the same, if I were to count it at all.

-ERD50

 

[73ss454]

I moved 44K over last year to bring me to the top of the 15% bracket.

 

[chemist]

I have a different method.

I have an excel sheet in which I list all my assets - taxable, Roth, tIRA, employee stock options.

In Column A is the nominal value, Column B the tax rate they will be hit with, Column C the contingent tax (the part of the account that belongs to Uncle Sam) and Column D is the account value net of contingent taxes due.

I base my SWR on a percentage of the sum of column D.

Thus if I perform a Roth conversion, (it is a conversion not a "transfer"), my net worth after contingent taxes changes not one iota.

This is also useful for seeing where you stand year on year as well as tax adjusted asset allocation. In other words, someone with $1MM in stocks in a tIRA and $1MM in bonds in a Roth has a different (riskier) AA than someone who has the reverse. Because the IRS owns (say) 25% of the tIRA, he does not have the 50:50 allocation he thinks he has.

This is kind of advanced but discussed in detail over in the Bogleheads wiki.

It took me a while to figure all this out but before when I looked at "gross" net worth I got poorer every time I exercised stock options and paid 35% Fed, 3% state, 1% local tax on them. If you base your (say) 4% SWR on your true, after tax net worth it doesn't matter when you CHOOSE to pay the taxes.

 

[Animorph]

If it's not in the budget, then I'd treat it as an investment expense. You don't want to avoid doing a large beneficial Roth conversion just because you can't fit the extra taxes into your budget for the current year.

 

[pb4uski]

I have a different method.

I have an excel sheet in which I list all my assets - taxable, Roth, tIRA, employee stock options.

In Column A is the nominal value, Column B the tax rate they will be hit with, Column C the contingent tax (the part of the account that belongs to Uncle Sam) and Column D is the account value net of contingent taxes due.

I base my SWR on a percentage of the sum of column D.

Thus if I perform a Roth conversion, (it is a conversion not a "transfer"), my net worth after contingent taxes changes not one iota.

This is also useful for seeing where you stand year on year as well as tax adjusted asset allocation. In other words, someone with $1MM in stocks in a tIRA and $1MM in bonds in a Roth has a different (riskier) AA than someone who has the reverse. Because the IRS owns (say) 25% of the tIRA, he does not have the 50:50 allocation he thinks he has.

This is kind of advanced but discussed in detail over in the Bogleheads wiki.

It took me a while to figure all this out but before when I looked at "gross" net worth I got poorer every time I exercised stock options and paid 35% Fed, 3% state, 1% local tax on them. If you base your (say) 4% SWR on your true, after tax net worth it doesn't matter when you CHOOSE to pay the taxes.

What you are doing is in your net worth calculations providing for a liability for deferred income taxes (the estimated taxes that will become due as certain assets are converted to cash). While most individuals don't recognize this 'liability" until the taxable event happens and it becomes due, it is common in corporate accounting.

For me, the conundrum is what rate to use. If I converted my entire tIRA today, the rate would be very high and using that high rate would overstate what I really expect to pay. The reality is that I'll convert bits and pieces to stay within the 15% tax bracket, which will probably result in a 10% effective tax rate but once RMDs start then who knows what the effective rate will be.

 

[ERD50]

If it's not in the budget, then I'd treat it as an investment expense. You don't want to avoid doing a large beneficial Roth conversion just because you can't fit the extra taxes into your budget for the current year.

Right. If we look at these as 'current year expenses', then no one would lump-sum-pre-pay a mortgage. It would be a huge hit to the budget and it would be unsustainable. But it's not, it is moving money from one account (portfolio) to another (the house).

In the Roth case, the taxes are moving in time, but they are just a move, not 'gone' or 'saved' (though you are hoping for eventual savings).

-ERD50

 

[Texas Proud]

(and to the follow up posters) But the difference is, as G4G points out, this is really a pre-payment on money that would be spent anyhow (all else being equal, with the hope/expectation of spending less). That is why I differentiated it from a 'consumption' expense.

Look at it this way: If I could get a 20% discount to pre-pay next year's annual grocery bill, it would not really matter to my portfolio that I spent two years groceries in one year (other than the cash flow implications) and zero the next. Over two years it washes out, and I'm ahead by 20% minus the holding costs. That's a lot different than just spending $X on consumables which do not offset future expenses. I would not count it the same, if I were to count it at all.

-ERD50

Using your example, you are a wash after two years as long as you account for it at some time... IOW, you put down two years of expenses in year one and zero in year two.... or one in year one and one in year two.... the OP will not account for the spend at any time in the future.. it is like if he lost value in an investment... a lower total portfolio with no spend...

 

[Alan]

(and to the follow up posters) But the difference is, as G4G points out, this is really a pre-payment on money that would be spent anyhow (all else being equal, with the hope/expectation of spending less). That is why I differentiated it from a 'consumption' expense.

Look at it this way: If I could get a 20% discount to pre-pay next year's annual grocery bill, it would not really matter to my portfolio that I spent two years groceries in one year (other than the cash flow implications) and zero the next. Over two years it washes out, and I'm ahead by 20% minus the holding costs. That's a lot different than just spending $X on consumables which do not offset future expenses. I would not count it the same, if I were to count it at all.

-ERD50

So, to be clear, when you pre-pay something this year to save money on the same item next year, you actually change the calculation on your WR % to account for this?

No problem, but too much like w*rk for me with no significant impact.

 

[ERD50]

the OP will not account for the spend at any time in the future.. it is like if he lost value in an investment... a lower total portfolio with no spend...

As chemist is pointing out, a TIRA really has a tax liability that should be accounted for. It's there whether you call it out or not. So he pays the $1,000 tax now, and he won't be paying it in the future.

Example, assume a simple overall 15% tax rate in/out of retirement:

$100,000 in an TIRA; $100,000 in a ROTH

That TIRA money is really only 'worth' $85,000 - you will pay $15,000 in taxes as it is removed. But you get the entire $100,000 in the ROTH.

So, If I convert from TIRA to ROTH and pay the same tax rates on the conversion, I moved the tax payment from some future date to this year.

To view it as chemist is (I think), the TIRA is already 'charged' with the taxes, and discounted by that amount.

So, to be clear, when you pre-pay something this year to save money on the same item next year, you actually change the calculation on your WR % to account for this?

No problem, but too much like w*rk for me with no significant impact.

No, I don't track/compute these sorts of things. Once I understand what it is, I just go with the flow. My WR will be changing at many points; DW retiring, pension and SS points. I don't micro-manage my budget, I look big picture.

edit/add: That is why I asked the OP: "What difference does it make?" I never got an answer - I really don't understand the point of categorizing it.
-ERD50

 

[Alan]

No, I don't track/compute these sorts of things. Once I understand what it is, I just go with the flow. My WR will be changing at many points; DW retiring, pension and SS points. I don't micro-manage my budget, I look big picture.

edit/add: That is why I asked the OP: "What difference does it make?" I never got an answer - I really don't understand the point of categorizing it.
-ERD50

+1

 

[Gone4Good]

In the Roth case, the taxes are moving in time, but they are just a move, not 'gone' or 'saved' (though you are hoping for eventual savings).

-ERD50

The problem I see is the potential to never recognize the expense. For someone who is adjusting their budget based entirely on an initial withdrawal amount + inflation, and ignoring portfolio fluctuations for budgeting purposes, then the pre-paid tax expense just disappears from consideration. You might spend less in the future because you owe less taxes, but more likely you'll spend what the 4% + inflation calculation tells you to spend. But if we do that we're really over spending our budget because we're disguising some of our tax expense as negative portfolio return.

 

[haha]

I do not treat it as an expense. IMO that would make no sense, and in fact so doing might dissuade you from making a intelligent long term move that would improve your balance sheet.

Does a corporation expense stock buybacks that result in cancelled stock?

No, because they are changing the capitalization, not incurring an operating expense or a tax item that needs to be counted against revenues. Similarly, when a taxpayer makes a Roth conversion from a TIRA, he is in effect buying back stock from the governments, since the taxing authorities have an ownership interest in TIRA balances that they do not have in Roth balances. Furthermore, since tax rates can and will change, governments % of the stock in our TIRAs may be on sale right now.

IMO, the only argument against this is that you expect to be relatively poor in retirement.

Ha

 

[Gone4Good]

Similarly, when a taxpayer makes a Roth conversion from a TIRA, he is in effect buying back stock from the governments, since the taxing authorities have an ownership interest in TIRA balances that they do not have in Roth balances.

So the accounting would be as follows:

Year 1 Earn $100 and contribute it to an IRA
Revenue: . . . $100
Tax Expense: . . ($15)
Net Income . . . $85


Assets: Stock in IRA $100
Liabilities: Taxes Payable $15
Equity (Net Worth): $85

Year 2 Convert to Roth:

Assets ($15) . . . $85
Liabilites ($15) . . . $0
Equity . . . $85

The problem with our accounting is that we generally ignore the tax liability on our balance sheet. Now were suggesting ignoring the expense on our income statement when we extinguish the liability. And yet the taxes are real.

 

[walkinwood]

Thank you all for your thoughtful replies.

To answer a question that kept coming up - What difference does it make?
The additional tax as a result of the ROTH transfers amounts to over 9% of our annual budget, so it will require us to spend significantly less this year.

One aspect that I should have made clear in my OP is that we use a percentage of portfolio value (as of Jan 1) to determine the year's budget. We do not use the more traditional SWR formula that is automatically adjusted for inflation & is independent of portfolio value. I hadn't thought of this aspect earlier. (Thanks G4G)

I am leaning towards not including the tax in this year's expense, but taking it as a hit against the portfolio value. Given my method of determining annual budgets, my budget for next year will be lower since I am taking the tax hit against the portfolio. However, that decrease is a LOT less than taking the hit in this year's budget. So, the 'expense' is being taken into consideration, but like an amortization rather than a current expense.

I tried valuing at my T-IRA holdings net taxes, but as pb4uski pointed out, I couldn't decide what factor to use, so gave up.

Thanks again to all those who took the time to reply. You guys are the best!

 

[RunningBum]

I do use the same method as chemist. And the main reason is exactly because of what walkinwood followed up with:

To answer a question that kept coming up - What difference does it make?
The additional tax as a result of the ROTH transfers amounts to over 9% of our annual budget, so it will require us to spend significantly less this year.

It makes no sense to me whatsoever that my expenses for the year would have to decrease because of a decision to do a conversion. They may both really be expenses, but they are very different types of expenses. Likewise, I know that $100K in a TIRA isn't worth as much as a ROTH.