Age 65/$3.3M IRA - Deflate it before RMDs?

[Koolau]

This jogged my memory. I recall when I was ERing ten years ago that the conventional wisdom claimed it was a bad idea (from a notional and mathematical point of view) to pay the taxes on a Roth conversion with money from inside my tIRA.

The thing is, I basically *have* no money outside my IRAs. I would have to pay it from my tax-deferred money.

In the scheme of things is this a significant consideration?

I agree that there are advantages IF you can pay the taxes on your Roth conversion from money NOT in an IRA (or 401(K)). Gumby points out that he effectively ends up with a "contribution" to his Roth by doing so - even though he is no longer w*rking. BUT, if you don't have the funds, I think there is still a very good reason to get "rid" of tIRA money - EVEN if you keep some in a taxable account. 1) Reducing RMDs in the future but also 2) If you should NEED a big chunk of cash someday (who knows what for) you won't find yourself double dipping from your tIRA and causing even higher tax bracket(s). At retirement, I always felt uncomfortable having HALF my stash in a 401(k)/tIRA. Having virtually ALL of it in a tIRA would be something I'd be working on as soon as possible. Even if you have to pay a tax person to sit down with you and figure the ins and outs, it might be well worth it if you don't feel comfortable with Turbo Tax or whatever. Keep in mind, you have a "good" problem as problems go. YMMV

 

[Out of Steam]

I pay taxes on Roth conversions from my after tax account. It is like getting an extra Roth contribution even though I have no earned income.

That would be attractive, but the major weakness in our retirement plans was not having saved significant money outside retirement accounts. Pretty lucky to be able to have taxes withheld at our overall tax rate instead of the marginal rate on the Roth conversion.

 

[RunningBum]

That would be attractive, but the major weakness in our retirement plans was not having saved significant money outside retirement accounts. Pretty lucky to be able to have taxes withheld at our overall tax rate instead of the marginal rate on the Roth conversion.

I asked you before, just a few posts above. How is this possible? I don't think it is.

EDIT: Ok, you said withheld. That has nothing to do with the taxes you actually pay on the Roth conversion though. It's pretty meaningless really.

 

[Koolau]

I asked you before, just a few posts above. How is this possible? I don't think it is.

Deductions on Roth conversions:

I don't know about others, but when I take my RMDs, my 401(k) allows me a Federal dedication of (IIRC) a standard 20% OR lets me set my own rate. YMMV

 

[Gumby]

That would be attractive, but the major weakness in our retirement plans was not having saved significant money outside retirement accounts. Pretty lucky to be able to have taxes withheld at our overall tax rate instead of the marginal rate on the Roth conversion.

My hope and expectation is that my after tax accounts will be able to carry the tax burden of Roth conversions until RMDs hit. Once RMDs start, those tIRA/401k withdrawals must by law go to the after tax account, which will replenish it. If I run out of after tax money (outside of Roths) before RMDs, then I'll start paying the Roth conversion taxes out of the conversion itself (i.e. withholding).

 

[RunningBum]

Deductions on Roth conversions:

I don't know about others, but when I take my RMDs, my 401(k) allows me a Federal dedication of (IIRC) a standard 20% OR lets me set my own rate.

As I added to my post, that's meaningless. If you chose not to have any taxes withheld, would you be feeling lucky that your withdrawal or conversion was tax-free? Of course not. It gets resolved at tax time. When evaluating how much of one's IRA to convert to a Roth, you should be looking at the taxes that will actually be added due to the conversion, not how much was withheld.

 

[tmm99]

I imagine having too much in the tax-deferred accounts is a problem for many people here. (I don't have as much as you, but I have well over 1M in 401K/IRA.) I should have bit the bullet while I was still w*rking by not maxing out my 401K every year and just investing more with my after-tax money. My thought was to do a Roth conversion every year in a lower tax bracket after retirement.

But then I moved to Canada. Canada will cancel out the benefits of Roth IRA (the tax-free feature) if I add any money to it, so that's not an option for me. Plus, just by withdrawing $55K from my 401K (which raises my overall income to $80,000 with interests, dividends, a small company pension, etc), my combined marginal tax bracket (federal and provincial) shoots up to 43.7%. I don't want to think about what happens with my tax burden when SS starts or when I have to take RMD.

My goal now is to take the 43% hit now so things won't get exponentially worse when my SS and RMD start.

So if you have a way to take some beating now, I would do it. Like you said, you don't know how the tax treatments (brackets) will have changed in 7 years.

 

[Out of Steam]

How is this possible? A Roth conversion is marginal income, that is, income on top of everything else you have. So it has to be taxed at the marginal rate.

Do your taxes with and without your Roth conversion. The increase in taxes due over your converted amount is the marginal rate they are taxed at. It doesn't matter if you spread the conversion out over 12 months. And paying taxes out of your IRA means you have both a conversion and a withdrawal that you wouldn't have had without converting, so you have to pay a little more income tax on the extra amount you took from your IRA to pay your taxes.

We're having only enough withheld from the converted funds to cover the taxes at our overall rate, meaning that the other 30% or so of the tax liability of the conversion is coming out of our current income.

Other funds are having withholding taken out at a similar rate, so we shouldn't owe at the end of the year. I'm doing the monthly conversion so as not to bet on the market at a specific time.

 

[RunningBum]

We're having only enough withheld from the converted funds to cover the taxes at our overall rate, meaning that the other 30% or so of the tax liability of the conversion is coming out of our current income.

Other funds are having withholding taken out at a similar rate, so we shouldn't owe at the end of the year. I'm doing the monthly conversion so as not to bet on the market at a specific time.

OK, so you're paying ~70% of the conversion taxes out of the tIRA, and ~30% out of taxable money. Not as beneficial as paying 100% out of taxable, but it sounds like you're doing what you can.

 

[pb4uski]

I agree that there are advantages IF you can pay the taxes on your Roth conversion from money NOT in an IRA (or 401(K)). Gumby points out that he effectively ends up with a "contribution" to his Roth by doing so - even though he is no longer w*rking. BUT, if you don't have the funds, I think there is still a very good reason to get "rid" of tIRA money - EVEN if you keep some in a taxable account. 1) Reducing RMDs in the future but also 2) If you should NEED a big chunk of cash someday (who knows what for) you won't find yourself double dipping from your tIRA and causing even higher tax bracket(s). At retirement, I always felt uncomfortable having HALF my stash in a 401(k)/tIRA. Having virtually ALL of it in a tIRA would be something I'd be working on as soon as possible. Even if you have to pay a tax person to sit down with you and figure the ins and outs, it might be well worth it if you don't feel comfortable with Turbo Tax or whatever. Keep in mind, you have a "good" problem as problems go. YMMV

Agree....here are a few examples of the economics of using taxable account money to pay the tax... or not. Starting point is a tIRA with $10k and a taxable account with $2k and assumes 20% tax rate. Assume 7% return for 10 years.

Option A: Convert and pay taxes from taxable account... on day 2 Roth is $10k and taxable account is $0... 10 years later the Roth is worth $19,672 [$10,000 *(1+7%)^10]

Option B: Don't convert... in 10 years the tIRA is worth $19,672 and the taxable account is worth $3,449 [$2,000 *(1+7%*(1-20%))^10]... you withdraw from the tIRA and pay $3,934 in tax (20% of $19,672) and at the end of the day have $19,187 to spend.

Option C: Convert but pay tax from tIRA... on day 2 Roth balance is $8,000 and taxable account is $2,000... in 10 years the Roth is worth $15,737 [$8,000 *(1+7%)^10] and the taxable account is worth $3,449 for a total of $19,187... same as not converting.

The $485 benefit is effectively the benefit of not having to pay tax on the taxable account earnings over the 10 years because that money ends up in the Roth if you convert.... $3,934 [$2,000 *(1+7%)^10] vs $3,449 [$2,000 *(1+7%*(1-20%))^10]

 

[Gumby]

^^^ excellent illustration of the math!

 

[RunningBum]

Agree....here are a few examples of the economics of using taxable account money to pay the tax... or not. Starting point is a tIRA with $10k and a taxable account with $2k and assumes 20% tax rate. Assume 7% return for 10 years.

Option A: Convert and pay taxes from taxable account... on day 2 Roth is $10k and taxable account is $0... 10 years later the Roth is worth $19,672 [$10,000 *(1+7%)^10]
...

There is an argument in Option A that you may owe taxes (cap gains) to raise the $2K needed for conversion taxes. But this only reduces the advantage, because the basis will be more than $0.

 

[pb4uski]

^^^ Fair point, but I'm assuming that the taxable are cash-like investments.... and it wouldn't change the decision because the end result needs to be all cash available for spending.

 

[TheWizard]

Money is "fungible" as they say.
(I don't particularly like the word fungible.)

But let's say I use money from my SS or pension income to pay the tax on a Roth conversion.
And then I take additional money from my tax deferred account to bolster my regular living expenses.

Why is that better than doing the opposite?

 

[Gumby]

Money is "fungible" as they say.
(I don't particularly like the word fungible.)

But let's say I use money from my SS or pension income to pay the tax on a Roth conversion.
And then I take additional money from my tax deferred account to bolster my regular living expenses.

Why is that better than doing the opposite?

In the case you have outlined, it would be a wash.

But what people have been talking about is paying the conversion tax due by using after tax money that one has already amassed but doesn't actually need to finance current living expenses. In the latter case, you are actually transferring money from an after tax account where realized gains are taxed to a Roth account where they are not.

 

[BaseballDad1618]

As a mid 30s HI earner, this thread has been unbelievable to follow. It’s really engaging me in tIRA vs Roth as my assets start to accumulate. These discussions will also help set some conversations with pops to guide some of his retirement management. Thanks!

 

[madsquopper]

I'm in the process of doing this now. A bit limited in that my spouse's very generous pension gets in the way of going over my target limit which is typically at or near the IRMAA level 2 surcharge level. Plus once my SS and both RMD's kick in we'll be close to 24% marginal land. Mostly try to pay the conversion tax from money outside the conversion. But even worst case "break even" using the converted funds will eventually show a long term benefit it keeps us below the higher IRMAA rates later on.

 

[Koolau]

I'm in the process of doing this now. A bit limited in that my spouse's very generous pension gets in the way of going over my target limit which is typically at or near the IRMAA level 2 surcharge level. Plus once my SS and both RMD's kick in we'll be close to 24% marginal land. Mostly try to pay the conversion tax from money outside the conversion. But even worst case "break even" using the converted funds will eventually show a long term benefit it keeps us below the higher IRMAA rates later on.

Not yet close to the limits for this year, but went and checked the limits again - just to keep my withdrawal levels where I want them. I had forgotten how steeply the "surcharges" rise. Still, lots of folks would gladly pay those premiums for the decent HC insurance that is MC.

Once again, we have that "first world" problem of keeping within income limits to prevent higher HC costs - and other things. What a great problem to have compared to living in say, Afghanistan. I give thanks daily that most of my problems fall into such "manageable" things as AGI and MAGI levels!

For the youn'uns coming up now, let this be a lesson to you to manage your qualified accounts NOW and be certain you understand the consequences of having "too much" in qualified money. A word to the wise from someone who perhaps mismanaged the qualified accounts. As usual, YMMV.

 

[imnontrad]

Definitely draw that down, especially now when the tax brackets are low. Work with a fee-only Certified Financial Planner do develop a multi-year plan. You also need to factor in Medicare premium surcharges (IRMAA).

A pre-tax retirement account is the worst thing for someone to inherit because they must liquidate the account within 10 years and pay income taxes on the full amount. So, also ensure that if you plan to give to charities in your will that this money is taken from the pre-tax accounts. the rest of your heirs will thank you.

If you have not reached 59 1/2, you can draw the pre-tax account down by converting the funds to Roth. Also, if you are between 55 and 59 1/2 and you retire from your current employer, you can withdraw from that 401K using the "Rule of 55". And when you reach 59 1/2, a good strategy would be to then roll it into your pretax retirement account to not only simplify your estate but also possibly lower your fees.

But if you also have company stock in that 401K (or any prior 401Ks that you would roll over), you can remove the company stock completely as a NUA. The great advantage is that you only pay income tax on the cost basis. You do not pay taxes on the appreciated value until you sell - and at the capital gains rate. in addition, if you still hold that stock when you die, your heirs get it as a stepped up basis and no tax is due (but if rolled over to your pre-tax IRA, they would pay taxes on the full amount)

 

[a60dan]

I had a friend who was advised to do Roth conversion.

He later regretted how much his Medicare premium increased.

Watch the amounts….lots of moving parts….

 

[Curmudgeon44]

Diversification applied to retirement accounts

I firmly believe you will be better by diversifying your retirement into different tax categories. I myself have a ton in pre-tax and am doing Roth conversions right up to the point where taxes make me gag. But there is every reason to believe taxes will be higher in the future, so unless I'm going to die early I should bite the bullet, now.

To simplify: diversify.

 

[RunningBum]

I had a friend who was advised to do Roth conversion.

He later regretted how much his Medicare premium increased.

Watch the amounts….lots of moving parts….

Did it prevent them from having Medicare increased (IRMAA) multiple years because of high RMDs?

 

[Gumby]

I think the lesson for our younger members is to keep some money in after tax accounts. If I could do it all over again, I would only contribute to the 401k to: 1) get any match (I never had one) and 2) get us down to the next lower tax bracket, but not more. And I most certainly would not make non-deductible IRA contributions. What a tax preparation nightmare that is.

 

[Doribe]

T
Unless there is something you have not disclosed about your situation, I would be converting up to top of the 24% tax bracket, or possibly to the top of one of the IRMAA tiers.

This is what I did. I converted over three years and considered the IRMAA brackets. I wanted to complete the conversions before both my husband and my self were on Medicare. Paying the tax was painful but I happy it is done.

 

[RunningBum]

T Paying the tax was painful...

Not calling you out, especially since you understand and appreciate the benefit, but I find it funny how people feel so negatively about paying conversion taxes, which is really just a deferred liability. So many people are uber happy to pay off their mortgage, but hate paying off their deferred income taxes. They aren't that different. Both have to be paid off eventually, with the exception that you can avoid some or possibly all of the tIRA tax by giving it away to charity. Personally, I love seeing the tIRA shrink and my Roth grow after a conversion

Maybe my attitude is different because in my investment net worth spreadsheet I've always reduced my 401K/tIRA value by the taxes I estimate I'd have to pay. If I've estimated correctly, a Roth conversion has no impact on that investment net worth. I know some people do this, but it seems that many do not. But most people wouldn't consider their home value as part of their full net worth without reducing it by their mortgage balance.

I'm sure it helps that my taxable account holds the majority of my money, so paying conversion taxes don't come anywhere close to draining that account.