Roth conversion?

[meleana]

Our FP is having us live off cash for the next few years until age 70 and then both collect SS.

He wants us to do some Roth conversions in the meantime to lower the Traditional IRA balances before RMDs hit at age 72.

But I hate the idea of having to use even more bank account cash or $ from our very tax efficient brokerage account to pay the taxes on the conversions. I was wondering why not just draw down the traditional IRA money now? Doesn’t that achieve the same thing? It will leave more cash and the brokerage account for later and less of a hassle I would think.

I guess I’m missing something here

 

[RunningBum]

You're missing the advantage of moving 100% of your tIRA to your Roth.

Let's say you're converting $10K, and your taxes will be 20% ($2K), and you have $10K in cash (taxable account).

If you convert and pay taxes from cash, you now have $10K in your Roth, and $8K in your taxable account.

If you pay taxes out of the conversion, you will have $8K in your Roth, and $10K in your taxable account.

Since all growth in your Roth is tax free, it's to your advantage to get the most in there that you can. Growth in your taxable account is taxed.

ETA: So the difference is the tax you'd pay on growth of the amount of the conversions taxes. Probably not a huge deal, but it is an advantage, which is why your FP advised it. If you have to liquidate some holding to come up with that conversion tax money in your brokerage account, the effect is somewhat negated by the tax you pay on that. Hope that's clear.

 

[RetireBy90]

Browse some past threads and you will find many that address this. By living off taxable accounts you don't have to pay taxes on funds you withdraw to spend, except for cap gains and dividends, in most cases keeping your tax bill lower. If you draw from a tax deferred IRA you add that amount to regular income, thus owing a full measure of taxes. This is a reason to live off cash rather than IRA withdraws while you can.

Then there is the conversion topic. This is a different topic, but just as important as which accounts to draw from. If you think that for whatever reason your tax rates will be higher once you start drawing from your IRA then it can be an advantage to pay taxes today on some amount from your IRA and then they will be tax free when you or your beneficiaries draw them from the Roth. Lots of reasons to think your income taxes will be higher later including:
- Current tax rates are set to revert to higher rates in 2025. Could be extended or made permanent of course.
- You presumably file as Married Joint return and rates are based on the 2 of you. Once one passes, the one remaining behind will be looking at rates for single person which are higher.
- Once you are done living off the cash, if you will depend on IRA withdraws for living expenses which are taxable as regular income. This will add to any other income and tends to push you into a higher rate.

- Once you start SS you will likely have to declare some of it as income again adding to your income and a higher rate.



There are lots of things to consider, but most I have heard from favor converting enough to Roth so that your income is at the top of your current tax rate or perhaps higher depending on the size of your IRA and your other income. I'm currently in 22% tax rate so I convert enough so that my income for 2021 is close to $168K which is the top of my tax bracket.

Hope this helps, but I would suggest searching on Roth IRA conversion and reading some of the threads. RunningBum is a good source as are many others.

 

[meleana]

You're missing the advantage of moving 100% of your tIRA to your Roth.

Let's say you're converting $10K, and your taxes will be 20% ($2K), and you have $10K in cash (taxable account).

If you convert and pay taxes from cash, you now have $10K in your Roth, and $8K in your taxable account.

If you pay taxes out of the conversion, you will have $8K in your Roth, and $10K in your taxable account.

Since all growth in your Roth is tax free, it's to your advantage to get the most in there that you can. Growth in your taxable account is taxed.

ETA: So the difference is the tax you'd pay on growth of the amount of the conversions taxes. Probably not a huge deal, but it is an advantage, which is why your FP advised it. If you have to liquidate some holding to come up with that conversion tax money in your brokerage account, the effect is somewhat negated by the tax you pay on that. Hope that's clear.

Thanks. But the cash I have gets taxed very little because interest rates are so very low. If I just take $20,000 out of a traditional IRA and pay taxes out of it as well, and live on that balance instead of cash accounts, does it really make that much of a difference? Still decreasing the traditional IRA balances.

I’m not good at this stuff.

 

[TheWizard]

We don't know how big the OP's various accounts are, so it's hard to put together a real plan.
I would generally avoid Roth converting an excessive amount.
What I've been doing is converting a modest amount each year such that there was no big jump in my income (AGI) last year when I started age 70 SS and there should be no jump in AGI or taxes next year when I start RMDs.

And when I start RMDs, that will pretty much be the end of my Roth conversion career...

 

[meleana]

Browse some past threads and you will find many that address this. By living off taxable accounts you don't have to pay taxes on funds you withdraw to spend, except for cap gains and dividends, in most cases keeping your tax bill lower. If you draw from a tax deferred IRA you add that amount to regular income, thus owing a full measure of taxes. This is a reason to live off cash rather than IRA withdraws while you can.

Then there is the conversion topic. This is a different topic, but just as important as which accounts to draw from. If you think that for whatever reason your tax rates will be higher once you start drawing from your IRA then it can be an advantage to pay taxes today on some amount from your IRA and then they will be tax free when you or your beneficiaries draw them from the Roth. Lots of reasons to think your income taxes will be higher later including:
- Current tax rates are set to revert to higher rates in 2025. Could be extended or made permanent of course.
- You presumably file as Married Joint return and rates are based on the 2 of you. Once one passes, the one remaining behind will be looking at rates for single person which are higher.
- Once you are done living off the cash, if you will depend on IRA withdraws for living expenses which are taxable as regular income. This will add to any other income and tends to push you into a higher rate.

- Once you start SS you will likely have to declare some of it as income again adding to your income and a higher rate.



There are lots of things to consider, but most I have heard from favor converting enough to Roth so that your income is at the top of your current tax rate or perhaps higher depending on the size of your IRA and your other income. I'm currently in 22% tax rate so I convert enough so that my income for 2021 is close to $168K which is the top of my tax bracket.

Hope this helps, but I would suggest searching on Roth IRA conversion and reading some of the threads. RunningBum is a good source as are many others.

Thanks. I guess I should have mentioned we have no pensions so we are literally living on our cash until we start collecting SS at age 70. No other income.

But yes- our FP has explained what you have but just having a hard time wrapping my head around it.

 

[N02L84ER]

We are living solely on our investments also. If we did $0 Roth conversions, our federal taxes would be $0, but we would be giving up tax free conversions. So, we do at least enough conversions to equal our federal deductions. For us in 2021 that means doing around $27,000 in Roth conversions.

 

[RunningBum]

Thanks. But the cash I have gets taxed very little because interest rates are so very low. If I just take $20,000 out of a traditional IRA and pay taxes out of it as well, and live on that balance instead of cash accounts, does it really make that much of a difference? Still decreasing the traditional IRA balances.

I’m not good at this stuff.

I assume your FP is suggesting you convert up to a certain tax bracket or some other limit. If you pay taxes out of the conversion money (or take out additional money from the tIRA for the taxes, which is basically the same thing), you don't get as much moved into your Roth.

How much does it matter? A lot of it depends on how much on how much the money grows after conversion, and what your tax rate is, and how long it stays invested. Your FP has your numbers and you are paying them, so I would ask them. It's probably not that much, but it is something.

Since your cash is earning very little, that would seem to make it a great source to pay the taxes from. Maybe you don't have enough cash to live on until 70 and pay the conversions taxes? Do you ever plan to sell the other investments in your brokerage account?

 

[TheWizard]

We are living solely on our investments also. If we did $0 Roth conversions, our federal taxes would be $0, but we would be giving up tax free conversions. So, we do at least enough conversions to equal our federal deductions. For us in 2021 that means doing around $27,000 in Roth conversions.

Sounds like a good start, but a lot of retirees get bumped up out of the 0% bracket in their early 70s...

 

[N02L84ER]

Sounds like a good start, but a lot of retirees get bumped up out of the 0% bracket in their early 70s...

We plan to bump the number up considerably after we are off of ACA health insurance. I am just trying to get Meleana to realize that doing at least a small conversion may not cost her much at all.

 

[lordjust]

Our FP is having us live off cash for the next few years until age 70 and then both collect SS.

He wants us to do some Roth conversions in the meantime to lower the Traditional IRA balances before RMDs hit at age 72.

But I hate the idea of having to use even more bank account cash or $ from our very tax efficient brokerage account to pay the taxes on the conversions. I was wondering why not just draw down the traditional IRA money now? Doesn’t that achieve the same thing? It will leave more cash and the brokerage account for later and less of a hassle I would think.

I guess I’m missing something here

I have a similar issue. I prefer to use a 72T for my normal spend(I am 47) and let it grow in my brokerage account. My logic was to use the money from the brokerage for future large purchases. I would get around the rmd for later using the 72T. The tax incentives noted here are very motivating but I will try to keep my spend rate down to stay in the lower tax bracket of 12%. Maybe sometimes cross over into 22. I have not FIRED yet.

 

[pb4uski]

Our FP is having us live off cash for the next few years until age 70 and then both collect SS.

He wants us to do some Roth conversions in the meantime to lower the Traditional IRA balances before RMDs hit at age 72.

But I hate the idea of having to use even more bank account cash or $ from our very tax efficient brokerage account to pay the taxes on the conversions. I was wondering why not just draw down the traditional IRA money now? Doesn’t that achieve the same thing? It will leave more cash and the brokerage account for later and less of a hassle I would think.

I guess I’m missing something here

I agree with your FP.

When you do a Roth conversion and pay taxes from taxable accounts, what you are effectively doing is to transfer money in the amount of the taxes from the taxable account to the Roth.

The money is better off in the Roth because any future growth is tax free vs it is taxed if the money stays in the taxable account.

Think of it this way.... that money that you put in the Roth rather than use it to pay the taxes can be withdrawn from the Roth at any time you wish... just like if it were in the taxable account.... just a few clicks and it can be in yor checking account.

I think you are fretting unnecessarily.