Are Roth conversions worth it for us?

[cathy63]

We aren’t willing to pay up front $$ for the benefit of heirs. We don’t have any children. We’d only do this if the numbers show it will benefit us.

So if we contribute $21K and pay 12% federal plus several % state, we’ll have an immediate cost to convert of say $3-$4K. Then if it grows 10% the first year in the Roth, we don’t have to pay tax on $2.1K, a savings of $300-$400. How many years would it take for this to create a significant financial advantage? Seems like it would take 10+ years to break even, considering the time value of money.

You are not going to pay 12% fed tax if you only convert $21K of tIRA and have $80K of LTCGs and QDivs. The 12% bracket is just confusing the issue here because your ordinary income is all in the 0% bracket. What matters to you is the LTCG brackets, which are 0% up to $77.2K and 15% above that.

You first have $24K of standard deduction to use up, so the $21K of ordinary income from the conversion offsets that at 0% tax and leaves you $3k of deductions. Your $80K of LTCGs and QDivs first go against the remaining $3K deduction, leaving $77K. The $77K falls entirely in the LTCG 0% bracket. So your total Fed tax on your $101K income is 0%.

If you convert more than $21K, then you'll pay 25% on the next $19K (10% on the conversion and 15% on the LTCGs that get pushed out of the 0% bracket); and 27% on the subsequent $58K (12% plus 15% as you fill up the 12% bracket with ordinary income).

Sadly, the state of CA will not be as generous, but it's probably still worth it to convert up to $21K.

 

[Huston55]

To be clear though, if you have a 401k with pre and post tax contributions and roll it over, the pre tax will go into a tIRA and the post tax will go into a Roth.... but you can't do one and not the other.



OTOH, if you have a tIRA with pre and post tax contributions then it is essentially blended and any Roth conversions are blended a well but the after-tax contributions factor into the taxable amount of the distribution.

PB-

Is this a quote from your former employer’s 401k Plan Description?

I always thought this depended on the individual employer’s Summary Plan Description & options therein, which can vary from employer to employer. I’ve asked my former employer about this, and was sent written guidance that I can roll over “after tax” funds only into a Roth IRA via an “In-Plan Roth Conversion”; the plan allows “In-Plan Roth Conversions.” The only thing that would be taxed would be the ‘earnings’ on the “after tax” amount. Below is an excerpt from my former employer’s Summary Plan Description FAQ about this (my bolding).

”If you withdraw after‐tax contributions and associated investment earnings and roll them back into the Roth account, you will not owe any taxes on your contributions, as you have paid them already. However, you will owe current taxes on any associated investment earnings on these after‐tax contributions. But when you withdraw the Roth amounts in a “qualified distribution,” you will not have to pay taxes on any investment earnings on that money which has accumulated since you made the conversion.”

 

[omni550]

You are not going to pay 12% fed tax if you only convert $21K of tIRA and have $80K of LTCGs and QDivs. The 12% bracket is just confusing the issue here because your ordinary income is all in the 0% bracket. What matters to you is the LTCG brackets, which are 0% up to $77.2K and 15% above that.

You first have $24K of standard deduction to use up, so the $21K of ordinary income from the conversion offsets that at 0% tax and leaves you $3k of deductions. Your $80K of LTCGs and QDivs first go against the remaining $3K deduction, leaving $77K. The $77K falls entirely in the LTCG 0% bracket. So your total Fed tax on your $101K income is 0%.

If you convert more than $21K, then you'll pay 15% on the next $19K (0% on the conversion and 15% on the LTCGs that get pushed out of the 0% bracket); and 27% on the subsequent $58K (12% plus 15% as you fill up the 12% bracket with ordinary income).

Sadly, the state of CA will not be as generous, but it's probably still worth it to convert up to $21K.

cathy63,

I assume the above is for MFJ.

Trying to convert the numbers for a single and getting a bit lost. What would be a comparable analysis for a single taxpayer, please?

omni

 

[cathy63]

cathy63,

I assume the above is for MFJ.

Trying to convert the numbers for a single and getting a bit lost. What would be a comparable analysis for a single taxpayer, please?

omni

Yes, Scuba uses "we" when she talks about her situation, so I assume she's filing MFJ.

If you're single, then it's:

$12K standard deduction
up to $38600 0% tax on LTCGs and QDivs

So you could convert $12K of a tIRA to Roth and have $38,600 in LTCGs and QDivs and pay $0 in federal tax.

 

[pb4uski]

PB-

Is this a quote from your former employer’s 401k Plan Description?

I always thought this depended on the individual employer’s Summary Plan Description & options therein, which can vary from employer to employer. I’ve asked my former employer about this, and was sent written guidance that I can roll over “after tax” funds only into a Roth IRA via an “In-Plan Roth Conversion”; the plan allows “In-Plan Roth Conversions.” The only thing that would be taxed would be the ‘earnings’ on the “after tax” amount. Below is an excerpt from my former employer’s Summary Plan Description FAQ about this (my bolding).

”If you withdraw after‐tax contributions and associated investment earnings and roll them back into the Roth account, you will not owe any taxes on your contributions, as you have paid them already. However, you will owe current taxes on any associated investment earnings on these after‐tax contributions. But when you withdraw the Roth amounts in a “qualified distribution,” you will not have to pay taxes on any investment earnings on that money which has accumulated since you made the conversion.”

Sorry, I sould have included the link... it is directly from the IRS.

https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans

 

[Huston55]

Sorry, I sould have included the link... it is directly from the IRS.

https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans

I think I see the difference.

Your link is for a ‘distribution’ of after-tax amounts (with earnings) from a qualified plan (401k) to an outside Roth IRA, which requires the proration described in your original post.

My example is an ‘in-plan Roth rollover’ of after-tax amounts (with earnings) into the Roth account in the same plan, which taxes only the earnings. Then, one could subsequently rollover the Roth (401k in my case) amount into a Roth IRA as a non-taxable event. The catch is that the original 401k must have a Roth feature, you must have separately contributed to it, and you must ‘rollover’ the after-tax amounts (with earnings) into the 401k Roth first. See excerpt & IRS link below.

How are in-plan Roth rollovers taxed?

You generally include the taxable amount (fair market value minus your basis in the distribution) of an in-plan Roth rollover in your gross income for the tax year in which you receive it.


https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts#irr

 

[Scuba]

You are not going to pay 12% fed tax if you only convert $21K of tIRA and have $80K of LTCGs and QDivs. The 12% bracket is just confusing the issue here because your ordinary income is all in the 0% bracket. What matters to you is the LTCG brackets, which are 0% up to $77.2K and 15% above that.

You first have $24K of standard deduction to use up, so the $21K of ordinary income from the conversion offsets that at 0% tax and leaves you $3k of deductions. Your $80K of LTCGs and QDivs first go against the remaining $3K deduction, leaving $77K. The $77K falls entirely in the LTCG 0% bracket. So your total Fed tax on your $101K income is 0%.

If you convert more than $21K, then you'll pay 25% on the next $19K (10% on the conversion and 15% on the LTCGs that get pushed out of the 0% bracket); and 27% on the subsequent $58K (12% plus 15% as you fill up the 12% bracket with ordinary income).

Sadly, the state of CA will not be as generous, but it's probably still worth it to convert up to $21K.

Thanks Cathy63. It is a bit confusing to me. I ran several scenarios on i-Orp and was surprised to see that in our situation (yes, MFJ), our disposable income came out slightly higher with no Roth conversions. I contacted i-Orp to see if I had done something wrong since many others are such strong advocates of Roths. My model outcomes were validated and in fact, James Welch referred me to a paper he authored suggesting that Roths vs no Roths on average only make a difference of about 1%.

I can understand that Roth conversions are beneficial to heirs, but in our situation it doesn’t appear to be beneficial, unless we want to assume that future tax rates will be materially higher than the current rates. One thing about our situation that may be different than most is that we have a taxable portfolio that is about three times larger than our tax deferred investments. This already gives us tax diversity without having to do Roth conversions.

 

[ERD50]

...

I can understand that Roth conversions are beneficial to heirs, but in our situation it doesn’t appear to be beneficial, unless we want to assume that future tax rates will be materially higher than the current rates. ....

I thought that was always the basis for doing a conversion? And by 'current rates', we should be talking about our own personal current and future rates, which are a product of not just IRS regs, but our taxable income estimates.

Another thing to consider is flexibility. If you needed to make a large withdrawal in one year, you could take it from a ROTH, and not get pushed into a "rich people" tax bracket for that one year.

-ERD50

 

[pb4uski]

I think that Scuba has a somewhat unusual situation where there is value to Roth conversions, but the value is negligible.... as I recall they are in a high tax bracket currently and expect to be in roughly the same high tax bracket for life.

Very different from a more typical early retiree that has a low marginal tax rate from ER until pensions and/or SS start and expect to be in a much higher tax bracket once pensions and/or SS starts.

 

[JoeWras]

I think I see the difference.

Your link is for a ‘distribution’ of after-tax amounts (with earnings) from a qualified plan (401k) to an outside Roth IRA, which requires the proration described in your original post.

My example is an ‘in-plan Roth rollover’ of after-tax amounts (with earnings) into the Roth account in the same plan, which taxes only the earnings. Then, one could subsequently rollover the Roth (401k in my case) amount into a Roth IRA as a non-taxable event. The catch is that the original 401k must have a Roth feature, you must have separately contributed to it, and you must ‘rollover’ the after-tax amounts (with earnings) into the 401k Roth first. See excerpt & IRS link below.

How are in-plan Roth rollovers taxed?

You generally include the taxable amount (fair market value minus your basis in the distribution) of an in-plan Roth rollover in your gross income for the tax year in which you receive it.


https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts#irr

Thanks, and wow, I still continue to be confused.

So if I have a 401k with after-tax funds, and want to get them into my Roth IRA, I have to first rollover inside my 401k to the Roth portion before transferring them out to my Roth IRA? Do I have the correct?

 

[pjigar]

Thanks, and wow, I still continue to be confused.

So if I have a 401k with after-tax funds, and want to get them into my Roth IRA, I have to first rollover inside my 401k to the Roth portion before transferring them out to my Roth IRA? Do I have the correct?

Just keep it simple, tell your 401K custodian to give you one check for after-tax contributions made payable to future Roth-IRA custodian and another check for the reminder of the balance made payable to future rollover-IRA/another 401K custodian. That is what I did and it worked beautifully. In fact, I rolled the reminder of 401K balance to new employer's 401K which allowed me to have 0 balance in my regular IRA accounts. The regular IRA balance should be 0 for optimal backdoor IRA contributions.

 

[NgineER]

The numbers will likely change significantly if something happens to one of you and the survivor files single as opposed to a joint return.

I would strongly recommend that you study this scenario also before making a decision not to convert to Roths in your early years.

Also, you framed your question in terms of filling out your current tax bracket via Roth conversions or not. Have you computed how long it will take to convert your tax deferred account balances to Roth if you constrain yourself to remaining in your current tax bracket?

-gauss

SCUBA-Since there is negligible differences between converting from tax deferred to a Roth, you should take the above into account. It is a little morbid, but we all will die some day. If there is a substantial number of years where you or your spouse files as single, then the up front cost of conversion will pay off.

 

[Huston55]

Thanks, and wow, I still continue to be confused.

So if I have a 401k with after-tax funds, and want to get them into my Roth IRA, I have to first rollover inside my 401k to the Roth portion before transferring them out to my Roth IRA? Do I have the correct?

That is my interpretation of the rules from reading the IRS FAQ, my former employer’s 401k FAQ, and talking to the administrator of my former employer’s 401k. I’ve not yet done our conversion but, plan to. The key seems to be that your 401k plan has a Roth component, that you’ve previously contributed to that Roth component, and that you have ‘after tax’ 401k contributions to roll over. You will owe taxes on any ‘earnings’ on the ‘after tax’ contributions. I suggest you read your 401k Summary Plan Description, any FAQs, then talk to the 401k administrator.

 

[pb4uski]

^^^ No. I'm with pjigar that even if your 401k does not have a Roth 401k component that you can roll after-tax 401k contributions to an individual Roth and the remainder of the 401k into an individual tIRA.

 

[Dash man]

A few years ago when I rolled my 401k into IRAs, I was able to roll the after tax portion of my traditional 401k into my Roth 401k along with my Roth IRA. You don’t need to roll it into an in-plan Roth first.

 

[Huston55]

That is my interpretation of the rules from reading the IRS FAQ, my former employer’s 401k FAQ, and talking to the administrator of my former employer’s 401k. I’ve not yet done our conversion but, plan to. The key seems to be that your 401k plan has a Roth component, that you’ve previously contributed to that Roth component, and that you have ‘after tax’ 401k contributions to roll over. You will owe taxes on any ‘earnings’ on the ‘after tax’ contributions. I suggest you read your 401k Summary Plan Description, any FAQs, then talk to the 401k administrator.

^^^ No. I'm with pjigar that even if your 401k does not have a Roth 401k component that you can roll after-tax 401k contributions to an individual Roth and the remainder of the 401k into an individual tIRA.

I guess I didn’t word that very well.

If you want to avoid the proration issue described in PB’s original post, you must do it the way I described, which allows you to transfer/rollover only the ‘after-tax’ portion + associated earnings. But, you can also rollover the ‘after-tax’ portion directly to a Roth IRA if you’re willing to live with the proration requirements.

 

[JoeWras]

A few years ago when I rolled my 401k into IRAs, I was able to roll the after tax portion of my traditional 401k into my Roth 401k along with my Roth IRA. You don’t need to roll it into an in-plan Roth first.

That's what everyone at w*rk is saying.

I have to say, that IRS FAQ is the most poorly written piece of work I have seen in a long time.

 

[Dash man]

That's what everyone at w*rk is saying.



I have to say, that IRS FAQ is the most poorly written piece of work I have seen in a long time.

I’ll try to clarify my poorly written post.
I rolled the after tax portion (less earnings) of my traditional 401k directly into my Roth IRA. This happened at the same time as I rolled my Roth 401k into my Roth IRA and my traditional pretax portion of my 401k plus all earnings into my traditional IRA. There was no need for any in-plan rollovers and no taxes were paid.

 

[Scuba]

I think that Scuba has a somewhat unusual situation where there is value to Roth conversions, but the value is negligible.... as I recall they are in a high tax bracket currently and expect to be in roughly the same high tax bracket for life.

Very different from a more typical early retiree that has a low marginal tax rate from ER until pensions and/or SS start and expect to be in a much higher tax bracket once pensions and/or SS starts.

Yes this is correct. 22% bracket now. So if the tax law changes and increases the brackets later, then we might benefit from Roth’s, but at the current structure there is actually a slight overall negative impact per the I-Orp model.

One other factor that may or may not be unique is that we have a substantial taxable portfolio we can draw on rather than taking IRA withdrawals.

 

[Scuba]

SCUBA-Since there is negligible differences between converting from tax deferred to a Roth, you should take the above into account. It is a little morbid, but we all will die some day. If there is a substantial number of years where you or your spouse files as single, then the up front cost of conversion will pay off.

This is a good point to consider and I’ll definitely ask our tax CPA about this. In CA when a spouse dies, the surviving spouse gets a stepped up basis on the inherited assets so that would certainly help too, but will ask for an illustration specific to our situation and numbers. Thanks!

 

[JoeWras]

I’ll try to clarify my poorly written post.
I rolled the after tax portion (less earnings) of my traditional 401k directly into my Roth IRA. This happened at the same time as I rolled my Roth 401k into my Roth IRA and my traditional pretax portion of my 401k plus all earnings into my traditional IRA. There was no need for any in-plan rollovers and no taxes were paid.

Dashman, your post was fine. And I agree, everyone says you can do what you say.

I was referring to the IRS FAQ link which tries to clarify these things. It is very hard to understand .

 

[gauss]

This is a good point to consider and I’ll definitely ask our tax CPA about this. In CA when a spouse dies, the surviving spouse gets a stepped up basis on the inherited assets so that would certainly help too, but will ask for an illustration specific to our situation and numbers. Thanks!

I am probably stating the obvious here, but stepped-up basis only applies to after-tax accounts, not IRAs/401ks etc.

-gauss

 

[Scuba]

I am probably stating the obvious here, but stepped-up basis only applies to after-tax accounts, not IRAs/401ks etc.



-gauss

Yes, understood. Since we have a significant portion of our assets in a taxable portfolio, it makes a difference for us.

 

[indiajust]

Keep in mind that you can't touch the account for 5 years after the last rollover. I got laid off in the GFC and used mortgage deductions to counter the income created by the rollovers. I spent 6 years doing serial rollovers, now I have 2 more years to wait, but I'm only 54. If you rolled piecemeal for 5 years and then had to wait 5 years to access the money... you might be dead or otherwise need the funds.


It just seems a bit late in the game, and it sounds as though you have a fair amount of complexity to deal with.

 

[pb4uski]

If you are over 59 1/2 and the Roth has been established for more than 5 years you can withdraw as much as you want anytime that you want.