Knowledge Check on Roth Conversions

[Nuke]

I think I know the following facts about Roth Conversions, please correct me if I am wrong:

1) All money pulled out of a tax-deferred account (TIRA) is taxable in the year it is pulled out.
2) That money will be counted as ordinary income.
3) If I pull money out of an IRA before I turn 59 ½, then any money not rolled over into another IRA is also subject to a 10% early withdrawal fee.
4) The IRS (and state tax agencies) don’t care where I get the money to pay the taxes due so long as that is a legal money source.

So, if I wanted to roll $100K from a TIRA to a Roth. I could do that a few different ways:

1) Pull just $100K from the TIRA, paying 24% federal tax and 9.3% state tax on that amount with the taxes coming from the $100K. That would leave (100k -(100k*24%)-(100K*9.3%)= $67.7K actually deposited into the Roth.

2) Pull $150K from the TIRA, paying $36K to Uncle Sam and $14K to California. Actual deposit into the Roth is $100K.

3) Pull $100K from the TIRA then pay $24K to Uncle Sam and $9.3K to California from some other account (couch cushion, paper route, etc). Actual deposit into the Roth is $100K.

For scenarios 1&2, if I am under 59 ½, then I would owe a 10% penalty on the money pulled from the TIRA and not rolled over into the Roth IRA.

For #1, that would be an extra $4,330 coming out of the TIRA and not going into the Roth, leaving $63,370 going into the Roth.

For #2, that would be and extra $5,255 coming out of the TIRA and not going into the Roth. Still putting $100k into the Roth.

For #3, no penalty applies.

Am I missing anything?

Any pointers on how to model this in the Retiree Portfolio Model? On the setup page, I put in the amount I am rolling over and then a withdrawal amount to equal the taxes due using scenario #2.

I don’t want to pay the 10% penalty and I don’t have a large taxable account from which to pay the taxes. So I think that I should do option #2 and start the year I turn 60 and continue until 65. If I did my math right, I can convert a little over $300k per year and pay the taxes from the tIRA. That will take me to just below the limit of the current 24% tax bracket. That saves me about $600K in income taxes and reduces my RMD quite a bit. Which in turn reduces my taxes owed.

Please let me know if I've royally messed this up.

 

[SevenUp]

I think I know the following facts about Roth Conversions, please correct me if I am wrong:

1) All money pulled out of a tax-deferred account (tIRA) is taxable in the year it is pulled out. For the IRS, yes. State treatment varies.
2) That money will be counted as ordinary income. Yes.
3) If I pull money out of an IRA before I turn 59 ½, then any money not rolled over into another IRA is also subject to a 10% early withdrawal fee. Yes, unless you meet one of the exceptions documented using Form 5329
4) The IRS (and state tax agencies) don’t care where I get the money to pay the taxes due so long as that is a legal money source. Yes.

So, if I wanted to roll $100K from a tIRA to a Roth. I could do that a few different ways:

1) Pull just $100K from the tIRA, paying 24% federal tax and 9.3% state tax on that amount with the taxes coming from the $100K. That would leave (100k -(100k*24%)-(100K*9.3%)= $67.7K actually deposited into the Roth.

2) Pull $150K from the tIRA, paying $36K to Uncle Sam and $14K to California. Actual deposit into the Roth is $100K.

3) Pull $100K from the Roth then pay $24K to Uncle Sam and $9.3K to California from some other account (couch cushion, paper route, etc). Actual deposit into the Roth is $100K.
For scenarios 1&2, if I am under 59 ½, then I would owe a 10% penalty on the money pulled from the tIRA and not rolled over into the Roth IRA.

For #1, that would be an extra $4,330 coming out of the tIRA and not going into the Roth, leaving $63,370 going into the Roth.

For #2, that would be and extra $5,255 coming out of the tIRA and not going into the Roth. Still putting $100k into the Roth.

For #3, no penalty applies.

For #1, taxes would be $24K + $9.3K = $33.3K. 10% penalty would be $3330. To cover the 10% IRS penalty on the $3330 (don't know if there is a CA penalty) you would withhold $3330/(1-10%) = $3700. With all that, $63K would go into the Roth.

You can recheck #2 using the above steps.

#3 looks good.

Are you familiar with the Safe harbors to avoid underpayment penalties?

Any pointers on how to model this in the Retiree Portfolio Model? On the setup page, I put in the amount I am rolling over and then a withdrawal amount to equal the taxes due using scenario #2.

Don't know, but that looks like it should work.

I don’t want to pay the 10% penalty and I don’t have a large taxable account from which to pay the taxes. So I think that I should do option #2 and start the year I turn 60 and continue until 65. If I did my math right, I can convert a little over $300k per year and pay the taxes from the tIRA. That will take me to just below the limit of the current 24% tax bracket. That saves me about $600K in income taxes and reduces my RMD quite a bit. Which in turn reduces my taxes owed.

Whether, when, and how much to convert is worth at least a quick read.

Don't worry about taxes paid. Instead, look at the amount available after tax. For any one year those will be two sides of the same coin, but not when you look at multiple years.

E.g., compare converting $300K now and spending from Roth later, vs. withdrawing from traditional to spend later - and assume 33.3% tax now, 15% tax later, and investments triple between now and later. Converting now you pay $100K and have $600K to spend later. Withdrawing later you pay $135K and have $765K to spend. Different assumptions may lead to different conclusions.

When you reach age 63, IRMAA becomes a consideration. Roth Conversion with Social Security and Medicare IRMAA is a good article about that.

 

[Nuke]

Thanks for catching my math error.

Here's what the RPM shows for the Roth Conversion:

Converting as described above (taking the money for taxes out of the TIRA) saves $457,084 in taxes on RMDs and $370,200 in taxes on earnings. Th opportunity cost of paying the taxes from the TIRA is -$423,600.

That means a net savings of $400K or so by doing the Roth conversions.

Point taken about the IRMAA. I figure that I will pay about $4k more a year for two years due to the IRMAA adjustments. Roth conversion still looks like the better deal.

 

[Alex The Great]

When you reach age 63, IRMAA becomes a consideration. Roth Conversion with Social Security and Medicare IRMAA is a good article about that.

But you always can apply for SS later and reduce the impact a little bit.

 

[Nuke]

But you always can apply for SS later and reduce the impact a little bit.

Our intent is for DW to claim spousal at FRA (67) and me to claim at 70.

 

[Surewhitey]

Then there's the lesser option of moving to a no - tax state... Save the CA surcharge...

 

[Gumby]

You can avoid penalties for tIRA withdrawals before 59-1/2 by using Section 72(t) - Substantially Equal Periodic Payments (SEPPs)

Substantially equal periodic payments | Internal Revenue Service

Insights into substantially equal periodic payments under IRC section 72(t)(2)(A)(iv), with examples.

www.irs.gov

 

[Nuke]

Then there's the lesser option of moving to a no - tax state... Save the CA surcharge...

Not and take DW with me. I've dragged her all over the world for over 30 years; I reckon she gets a say in where we go (or don't) for the next 30 or so.

I realize that I'm going to pay taxes. I'm not opposed to paying taxes due. I don't want to pay more than I'm obligated. Taxes just are; like the weather.

 

[Nuke]

Taking a look a the SEPP article and using the Life Expectancy Table with my TSP value, I'll be able to withdraw ~$40K when I am 53 without penalty. That's the amount I use to pay federal and state taxes on what I convert to my Roth. That will cover ~$120K that year.

Looks like I can just do those calculations each year until I am 60 and then convert to the max of my tax bracket until 63 if I want to avoid IRMAA increases. I will run those numbers and see how it looks.

Appreciate the comments. as expected the collect wisdom of the board is seeing things I'm not.

 

[Alex The Great]

Then there's the lesser option of moving to a no - tax state... Save the CA surcharge...

Moving out of CA may save a little bit on income tax but sharp property tax increase would eat up all the difference, as home prices tend to rise in most parts of US.

 

[imjustawarrior]

Maybe I missed that someone pointed out that there is no penalty on a Roth conversion.

If all the money from the IRA makes it to the Roth in time, then there is no penalty.

I personally think the best way is as follows (just an example):
1. Convert $100k. Have $25k withheld for federal taxes. Have $10k withheld for state taxes.
2. Take $35k from taxable account and put it into your Roth and designate it as an indirect rollover.

The whole $100k makes it into the Roth. Taxes are essentially paid from taxable account. Withholdings are always considered timely, so there is no need to make estimated tax payments.

 

[Dash man]

Point taken about the IRMAA. I figure that I will pay about $4k more a year for two years due to the IRMAA adjustments. Roth conversion still looks like the better deal.

FYI, IRMAA with also apply to your spouse if she is also on Medicare.

 

[Exchme]

You should look at the final estate value, not the taxes paid. Roth Conversions are pre-paying taxes, so may reduce lifetime taxes paid even if they are reducing your final wealth, particularly when you are looking at them the way RPM does, on a nominal (not inflation adjusted) basis. You should also make a manual adjustment to the residual value your t-IRA for taxes that either you or your heirs will pay when the money comes out.

The benefits you are getting seem quite large for a $100,000 conversion, so you should remember that RPM works in nominal $, the present value is much less.

The big issue in models is to make sure your asset allocation remains the same as you do Roth Conversions, otherwise the results are driven by holding more stocks, not Roth Conversions.
If you hold the same stock/bond mix in each account, that is not an issue, but many people don't do that and that's when models will get you in trouble.

In RPM, the way to make sure you are holding your allocation constant is to select "returns by class" and not returns "returns by account" (cell E76 on the Setup sheet, Section 3 - you can go to View and then check the box next to Headings to see the cell addresses). Then to keep your asset allocation constant over time, select asset allocation method (cell E77 of the Setup sheet) of "t-r" (stocks preferentially in taxable, then Roth, then IRA) or "r-t" (stocks preferentially in Roth, then taxable, then IRA). I would model it as "t-r" as otherwise there are rebalancing costs in taxable that you would face in reality that would not be captured in the program.

 

[Nuke]

Maybe I missed that someone pointed out that there is no penalty on a Roth conversion.

If all the money from the IRA makes it to the Roth in time, then there is no penalty.

I personally think the best way is as follows (just an example):
1. Convert $100k. Have $25k withheld for federal taxes. Have $10k withheld for state taxes.
2. Take $35k from taxable account and put it into your Roth and designate it as an indirect rollover.

The whole $100k makes it into the Roth. Taxes are essentially paid from taxable account. Withholdings are always considered timely, so there is no need to make estimated tax payments.

My taxable accounts are not large enough to cover the tax bill. Once I went past 20 years of service and knew that I would have a pension, I put most of my savings into my TSP, Roth IRAs, and 529 plans. Along the way we've paid cash for cars and significant repairs and improvements for the house.

 

[Nuke]

You should look at the final estate value, not the taxes paid. Roth Conversions are pre-paying taxes, so may reduce lifetime taxes paid even if they are reducing your final wealth, particularly when you are looking at them the way RPM does, on a nominal (not inflation adjusted) basis. You should also make a manual adjustment to the residual value your t-IRA for taxes that either you or your heirs will pay when the money comes out.

The benefits you are getting seem quite large for a $100,000 conversion, so you should remember that RPM works in nominal $, the present value is much less.

The big issue in models is to make sure your asset allocation remains the same as you do Roth Conversions, otherwise the results are driven by holding more stocks, not Roth Conversions.
If you hold the same stock/bond mix in each account, that is not an issue, but many people don't do that and that's when models will get you in trouble.

In RPM, the way to make sure you are holding your allocation constant is to select "returns by class" and not returns "returns by account" (cell E76 on the Setup sheet, Section 3 - you can go to View and then check the box next to Headings to see the cell addresses). Then to keep your asset allocation constant over time, select asset allocation method (cell E77 of the Setup sheet) of "t-r" (stocks preferentially in taxable, then Roth, then IRA) or "r-t" (stocks preferentially in Roth, then taxable, then IRA). I would model it as "t-r" as otherwise there are rebalancing costs in taxable that you would face in reality that would not be captured in the program.

Thank you for those pointers. I will go take a look at that. Currently, I hold no bonds in any accounts. I will be able to cover all of my normal expenses with my military pension. I will use the next 20 months or so until I retire to build up a large cash account to handle lumpy expenses for 7 years or so until I can use the IRAs without penalty.

On the amount converted, over time I projected moving a total of $1.4M using SEPP withdrawals to pay the taxes on the conversions until I turn 60 and then doing two conversions of $300k and using normal withdrawals to handle the taxes.

The model doesn't show any years of negative balances doing that and still show considerable savings in tax payments in my later years.

 

[Nuke]

Good point, thank you.

FYI, IRMAA with also apply to your spouse if she is also on Medicare.

 

[Surewhitey]

Moving out of CA may save a little bit on income tax but sharp property tax increase would eat up all the difference, as home prices tend to rise in most parts of US.

We did exactly as stated. Even with Prop 13, property tax is not a major benefit as compared to property values in most places based on values. It all depends on the math you have. CA (at least where we lived) is a dumpster fire in the cities. If outside the cities, I'd still rather just visit vs live now.

 

[orbops]

How old are you - 53? Do you currently have a Roth IRA, and if so, when was it opened? Do you expect to be in the 24% tax bracket every year?

 

[Nuke]

How old are you - 53? Do you currently have a Roth IRA, and if so, when was it opened? Do you expect to be in the 24% tax bracket every year?

I'm 51 currently; I will retire just before my 53 birthday.

My wife and I both have Roth IRAs opened over 20 years ago. we have a little over $900K between the two of us in Roth IRAs.

As for the tax bracket, we will be in the 22% for sure. Once we start taking RMDs and SS, then we will be in the 24%. Of course, the exact bracket 20+ years from now is a bit up in the air.

 

[orbops]

I'm 51 currently; I will retire just before my 53 birthday.

My wife and I both have Roth IRAs opened over 20 years ago. we have a little over $900K between the two of us in Roth IRAs.

As for the tax bracket, we will be in the 22% for sure. Once we start taking RMDs and SS, then we will be in the 24%. Of course, the exact bracket 20+ years from now is a bit up in the air.

Your situation is somewhat similar to mine. I retired at 50, am currently 58. When I retired, we had only $400K in Roth IRAs. I've done small Roth conversions from my tIRA every year since I retired. Since you have over $900K in Roth, you should consider taking some of your contribution money out of your Roth until you're 59.5 to pay the taxes of any Roth conversion - since all contributions are always tax free in a Roth accout.

If you can stay within the 22% bracket with a small Roth conversion for each of the 9 years, then you won't have such a large tax bill between your planned 60 to 65 time frame and you can continue with small Roth conversions until you are 70 when SS kicks in. The RMD at 75 should be much lower if you do small Roth conversions for the 24 years between 51 & 75.

 

[Nuke]

Your situation is somewhat similar to mine. I retired at 50, am currently 58. When I retired, we had only $400K in Roth IRAs. I've done small Roth conversions from my tIRA every year since I retired. Since you have over $900K in Roth, you should consider taking some of your contribution money out of your Roth until you're 59.5 to pay the taxes of any Roth conversion - since all contributions are always tax free in a Roth accout.

If you can stay within the 22% bracket with a small Roth conversion for each of the 9 years, then you won't have such a large tax bill between your planned 60 to 65 time frame and you can continue with small Roth conversions until you are 70 when SS kicks in. The RMD at 75 should be much lower if you do small Roth conversions for the 24 years between 51 & 75.

Excellent point. More spreadsheets!

 

[amaranth]

I am still confused on how the 5 year waiting period rule works on TIRA to Roth conversions. Here is a specific example with a specific question.
1.I am 77 years old.
2. I have an existing Roth with a $100,000 balance that I have not contributed to in over 5 years.
3.In 2024, I did a TIRA conversion to my existing Roth for $25,000. Roth balance is now $125,000.
4.In 2025 I will cash out the entire $125,000 Roth balance. My Roth IRA balance will then be $0.

My question is "Will I be subject to any penalties/tax in 2025 on my $125,000 Roth Withdrawal?

 

[GATime]

I am still confused on how the 5 year waiting period rule works on TIRA to Roth conversions. Here is a specific example with a specific question.
1.I am 77 years old.
2. I have an existing Roth with a $100,000 balance that I have not contributed to in over 5 years.
3.In 2024, I did a TIRA conversion to my existing Roth for $25,000. Roth balance is now $125,000.
4.In 2025 I will cash out the entire $125,000 Roth balance. My Roth IRA balance will then be $0.

My question is "Will I be subject to any penalties/tax in 2025 on my $125,000 Roth Withdrawal?

The original $100k and any returns on it can be withdraw with no penalty. The $25k from 2024 can also be withdrawn without penalty. Any gains from the $25k will be penalized if withdrawn. The gains from the conversion must stay in the Roth for 5 years.

 

[TheWizard]

The original $100k and any returns on it can be withdraw with no penalty. The $25k from 2024 can also be withdrawn without penalty. Any gains from the $25k will be penalized if withdrawn. The gains from the conversion must stay in the Roth for 5 years.

No, not if over 59.5...

 

[SecondCor521]

I am still confused on how the 5 year waiting period rule works on TIRA to Roth conversions. Here is a specific example with a specific question.
1.I am 77 years old.
2. I have an existing Roth with a $100,000 balance that I have not contributed to in over 5 years.
3.In 2024, I did a TIRA conversion to my existing Roth for $25,000. Roth balance is now $125,000.
4.In 2025 I will cash out the entire $125,000 Roth balance. My Roth IRA balance will then be $0.

My question is "Will I be subject to any penalties/tax in 2025 on my $125,000 Roth Withdrawal?

If your first Roth contribution was on or before 12/31/2020, then no, you will not be subject to any penalties or taxes on the Roth distribution.

You can confirm this yourself by reading IRS Pub 590-B Figure 2-1 at

Publication 590-B (2023), Distributions from Individual Retirement Arrangements (IRAs) | Internal Revenue Service

www.irs.gov

which should show that it would be a qualified distribution. If you scroll up a bit from that link, you'll find that "You don't include in your gross income qualified distributions". Since it's not included in your gross income, it's not taxable. And as a general rule, penalties are only applied to the portion included in gross income, so no penalties either.