Roth IRA Conversion: A Bad Bet?

[sengsational]

It seems like it should be a wash.

If all the tax rates and rules stayed the same, and you stayed in the same tax bracket, it is a mathematical wash. Too many "ifs" though! My numbers (with my assumptions) suggest that the conversion decision is dwarfed by the decision to re-domicile (my state takes 7%). So no need to fret too much over this, so I'm going for tax diversity instead of an all or nothing, and sleeping well at night.

--Dale--

 

[kaneohe]

If all the tax rates and rules stayed the same, and you stayed in the same tax bracket, it is a mathematical wash.
--Dale--

If you were somehow able to pay the conversion tax from the TIRA w/o penalty (e.g. age), then it would be a wash.

However ......if all the tax rates and rules stay the same and you stayed in the same tax bracket and paid the conversion taxes from outside funds......the Roth would be at least as good as the TIRA.......and perhaps better by the amount of tax paid on the "side fund" owned by the TIRA owner. This is the concept of the "larger" IRA mentioned by others.

Ex: A has 100K in TIRA and 25K in side fund and is in 25% bracket. B has same.

1) A converts using side fund to pay taxes. A now has a 100K Roth. Some time later, investments double. A then has a 200K Roth.

2) B does not convert and has 100K TIRA and 25K side fund.
Some time later, investments double. B then has a 200K TIRA and something less than a 50K side fund (due to taxes).
B then withdraws 200K but has to pay 50K taxes so ends up with somewhat less than 200K (due to taxes on the side fund).

 

[GregLee]

I think I recall some talk of relaxing the rules requiring withdrawals from a TIRA, in the wake of the 2008 downturn, because it would force some retirees to sell stocks at the bottom of the market. I guess nothing has come of that, but the idea could be revived in the future, and that might make conversion less desirable.

 

[Koolau]

I think I recall some talk of relaxing the rules requiring withdrawals from a TIRA, in the wake of the 2008 downturn, because it would force some retirees to sell stocks at the bottom of the market. I guess nothing has come of that, but the idea could be revived in the future, and that might make conversion less desirable.

IIRC, the concept was not to require RMDs for a while since some folks would have to pay taxes on an inflated value (12/31 value) but the actual value might be considerably lower. I'm probably dense, but I don't seen how this affects the decision to convert or not. In fact, conversion of "distressed" TIRAs is sort of a "good" thing as it means less taxes would be due than when the TIRA was worth more. Ideally, one would convert TIRAs which had taken a big hit to reduce the tax consequences and then pray (to the financial gods) that the funds grew back (and then some) as ROTHs. Seems like the ideal situation. Again, sorry if I'm being dense.

If I were praying to the financial gods it would be to allow one to convert their RMDs to a Roth IRA instead of requiring one to simply take the funds completely out of the IRA. I don't look for that to happen, but why not wish (pray) big?

 

[GregLee]

I don't seen how this affects the decision to convert or not.

TIRAs are a desirable form of investment because since tax is deferred. If tax is deferred longer, TIRAs become more desirable, since you earn a dividend on the money you have not yet had to pay in taxes. The more desirable TIRAs are, the less you would want to convert them to another form of investment.

 

[kaneohe]

TIRAs are a desirable form of investment because since tax is deferred. If tax is deferred longer, TIRAs become more desirable, since you earn a dividend on the money you have not yet had to pay in taxes. The more desirable TIRAs are, the less you would want to convert them to another form of investment.

Greg.........this was my thinking too for a million yrs......time value of money,etc. that I read in Money magazine, etc. However, it is only a qualitative idea and the decision to convert or not should ultimately be a quantitative one. More recently, I have concluded that the back to basics idea of tax bracket at conversion vs tax bracket when you withdraw from TIRA is really the controlling factor and that if tax brackets are the same, the conversion is better (see example 3-4 entries above). Since I'm logically but not yet emotionally convinced, if you can poke holes in the math, I'm ready to listen. btw......I think the math holds no matter how long the time period is........

 

[bamsphd]

TIRAs are a desirable form of investment because since tax is deferred. If tax is deferred longer, TIRAs become more desirable, since you earn a dividend on the money you have not yet had to pay in taxes. The more desirable TIRAs are, the less you would want to convert them to another form of investment.

A tax deferred is a good thing. However, a tax increased is a bad thing. My understanding of the algebra is that while contributing to a TIRA defers taxes, while you pay now with a Roth, the deferred tax grows (assuming constant tax rates) at exactly the same rate your TIRA grows, so the tax treatment ends up being equivalent to the Roth case, unless you hit the IRA contribution limits or your IRA shrinks.

Having your investment compound-tax-free is also good thing. The ability to potentially have your investment compound-tax-free for longer in a Roth than a TIRA is certainly one of the advantages of a Roth conversion. If they changed the law so that Traditional and Roth IRAs both had the same required minimum distribution rules, that current Roth advantage would disappear.

However, that would still leave the Roth advantage of in essence contributing additional money to the Roth if you pay the conversion taxes with other funds. The more desirable IRAs are, the more desirable it is to increase one's IRA balances measured using their post-withdrawal-after-taxes value. By that calculation, a Roth conversion paying the taxes with non-IRA money definitely wins.

The wild card is of course how will the applicable tax rates change between now and whenever someone (you, surviving spouse, or other beneficiary) withdraws money from the IRA. Lots of no-pension FIRE types will probably have a number of years when they can convert at very low tax rates before starting to draw social security. That definitely looks like a sweet time to perform conversions. However, in general, with all the permutations of who is withdrawing how much when, combined with all the possible tax law changes at the federal, state, and local level anyone who claims to tell you they know the right answer is <self-censored>.

 

[GregLee]

However, it is only a qualitative idea and the decision to convert or not should ultimately be a quantitative one.

Indeed. But all I said was that it "might make conversion less desirable". I didn't say "undesirable".

 

[harley]

TIRAs are a desirable form of investment because since tax is deferred. If tax is deferred longer, TIRAs become more desirable, since you earn a dividend on the money you have not yet had to pay in taxes. The more desirable TIRAs are, the less you would want to convert them to another form of investment.

The problem I have with this argument is that there is a limit to the deferral. With a TIRA you will eventually run into the RMD date, which will occur no matter whether you need the money, and no matter what the current tax rates are, and no matter what the current state of the market is. IMO, and recognizing that this depends on whether you need the money in the IRA to live, the tax free growth plus the lack of a requirement to ever withdraw the money makes the Roth conversion the better choice, all other things being equal.

 

[audreyh1]

Don't have a Roth IRA because I never met the requirements, and then I retired (no earned income)

Conversion was a no-op for me this year as I have been working pretty hard to minimize AMT income as I recognized some large cap gains this year.

And I am still 20 years away from RMDs.

So it's kind of hard to get excited about converting and paying more in taxes.

I didn't realize until a few months ago, that I would be eligible to convert in future years.

I may be able to manage my income in the future and keep it lower. In fact that is my intent. This means that I should be able to do some conversions if I really wanted to.

But it's still hard to pay taxes now for way future gains. Just totally goes against my instincts. There's all that pesky uncertainty about where I'll even be 20 years from now..... Plus uncertainty about tax laws 20 years from now.

Really on the fence here....

Audrey

 

[kaneohe]

The problem I have with this argument is that there is a limit to the deferral. With a TIRA you will eventually run into the RMD date, which will occur no matter whether you need the money, and no matter what the current tax rates are, and no matter what the current state of the market is. IMO, and recognizing that this depends on whether you need the money in the IRA to live, the tax free growth plus the lack of a requirement to ever withdraw the money makes the Roth conversion the better choice, all other things being equal.

I believe there is a problem with the deferral argument even w/o the RMD limitation.........assuming tax rates at conversion and cash-in are the same.

Ex 1......same as given previously.....
A & B both start w/ 100K TIRA and 25K taxable side fund; both in 25% bracket
a)A converts to Roth, uses side fund to pay conversion tax and has 100K
Roth. N yrs later, the investment doubles and he has 200K Roth

b)B does not convert, has 100K TIRA and 25K taxable side fund. N yrs
later investments double and he has 200K TIRA and 50K taxable side fund.
Looks like he has more but he can't spend it w/o paying taxes within the yr.
He owes 50K taxes on the TIRA but actually has less than 50K in taxable because taxes are due on sale. Assume (charitably) that no taxes were due along the way for side fund and that it is a 20% LTCG tax on the 25K gain. 5K taxes are due so side fund only has 45K and B has total of 195K after paying 50K tax on TIRA.

What happens if instead of selling after investments double, you wait longer.
Ex 2: This time wait until investments are 25x larger

a) A starts again w/ 100K Roth and no side fund. A ends up w/
2500K Roth.

b) B starts again w/ 100K TIRA and 25K side fund. B ends up w/
2500K TIRA and 625K side fund. Making same assumptions as in 1)
side fund after taxes of 20% on 600K gain of 120K ends up w/ 505K.
2500K TIRA must pay 625K taxes so B ends up after taxes with
2380K which is even less than A has than in Ex 1 (both in absolute
and % dollars)........so deferring longer is even less favorable for TIRA.

Hopefully I didn't mess up the math too badly and, of course, the conclusion is 100% dependent on the specific assumptions of constant tax rate which may bear no resemblance to a person's real circumstances. TIRAs only look bigger because they are before tax and you can't utilize (spend) them
w/o paying tax.

 

[sengsational]

If all the tax rates and rules stayed the same, and you stayed in the same tax bracket, it is a mathematical wash.

If you were somehow able to pay the conversion tax from the TIRA w/o penalty (e.g. age), then it would be a wash.

You're right. It's not a wash. Not sure how I got that idea, but I tested it with a spreadsheet and it's certainly not a wash.

In my spreadsheet I let the 100K grow at 4% for 18 years to about 200K, then took 10K/year out for 25 years, down to about a zero balance (the 10K/year was adjusted for inflation).

When I take the net present value (at 2.5% inflation) of all future taxes on the side account and on the conversions, it comes to paying $45K in taxes which of course equates to the conversion scenario of paying $25K now. But all of this assumes a 25% tax rate on everything (no fav GC, no marginally higher rate now to convert...everything is 25%), and paying annually on the side account.

Here are the levers:

1. A larger difference between investment growth rate and inflation hurt the TIRA scenario.
2. Larger inflation and earnings rate hurt the TIRA scenario.
3. An ability not to pay annual taxes on the side account would help the TIRA scenario (not sure how this would be done, though).
4. A lower capital gains rate would help the TIRA scenario.

Lever 1 is a pretty long one, it seems. The NPV when both growth and inflation are 2.5% is about $28K. But if I put 2.5% for inflation and leave growth at 4%, the NPV of taxes paid jumps to $45K! Lever 2 matters, but it's not as big as 1; if both rates are at 6%, the NPV of taxes paid goes up to $31K.

I'll attach the spreadsheet if folks want to play with it.

--Dale--

 

[GregLee]

Thanks to Kaneohe for these comprehensible case studies. There's another wrinkle that I have to consider -- probably doesn't affect very many of you. That is the impact of state income tax, which is also deferred for IRAs. While my federal tax will probably be about the same during retirement as it was when I worked, I think my Hawaii state income tax will go down from 7-8% to zero, since all my pension income will be exempt, and the standard deduction and exemptions will cover my modest income from investments. So, if I were to convert my wife's 160k TIRA today, I guess it would cost me 25% + 8%, but without conversion, withdrawals from the TIRA will only cost 25%.

 

[rescueme]

But it's still hard to pay taxes now for way future gains. Just totally goes against my instincts. There's all that pesky uncertainty about where I'll even be 20 years from now..... Plus uncertainty about tax laws 20 years from now.

DW/me feel the same way as you on this subject. Since most of our retirement funds are in TIRA's (due to our age, when Roth's were not even an option) and very little in Roth's (that we contributed to, at the end of our accumulation years), we plan to use the Roth's to adjust our retirement income to manage our overall taxes (for withdrawals) during retirement.

We do have an abnormal situation, since a good portion of our TIRA's are going to named non-profit charities upon our passing. As the current tax laws are written, that money will be passed on completely tax-free, for their use.

Like you said, nobody knows what the tax landscape will be tomorrow, or many years from tomorrow. We can only make our plans/decisions on what we know now.

That's why we won't convert any TIRA's to Roth’s at this time.

 

[audreyh1]

DW/me feel the same way as you on this subject. Since most of our retirement funds are in TIRA's (due to our age, when Roth's were not even an option) and very little in Roth's (that we contributed to, at the end of our accumulation years), we plan to use the Roth's to adjust our retirement income to manage our overall taxes (for withdrawals) during retirement.

We do have an abnormal situation, since a good portion of our TIRA's are going to named non-profit charities upon our passing. As the current tax laws are written, that money will be passed on completely tax-free, for their use.

Like you said, nobody knows what the tax landscape will be tomorrow, or many years from tomorrow. We can only make our plans/decisions on what we know now.

That's why we won't convert any TIRA's to Roth’s at this time.

We're the opposite in that our TIRAs are only about 10% of our invested assets. That's another reason it's hard for me to get too excited about converting. I just don't think our annual required withdrawals will be so big.

And you know what? Maybe that's what we'll do with our RMDs if it ever comes to that and our taxable income is high in our 70s - gift whatever is withdrawn from our TIRAs to charity.

Audrey

 

[kaneohe]

Thanks to Kaneohe for these comprehensible case studies. There's another wrinkle that I have to consider -- probably doesn't affect very many of you. That is the impact of state income tax, which is also deferred for IRAs. While my federal tax will probably be about the same during retirement as it was when I worked, I think my Hawaii state income tax will go down from 7-8% to zero, since all my pension income will be exempt, and the standard deduction and exemptions will cover my modest income from investments. So, if I were to convert my wife's 160k TIRA today, I guess it would cost me 25% + 8%, but without conversion, withdrawals from the TIRA will only cost 25%.

Greg........that's an excellent YMMV point. I think I remember Nords mentioning what a great deal you HI retirees have w/ the pension & taxes.....just for my enlightenment, that pertains to state/federal pensions (have relatives w/ those), IRAs..........how about pensions from public corps? hmm......will have to keep that in mind and think about moving back someday.....does that apply if the public corp is not based there?

 

[kaneohe]

And you know what? Maybe that's what we'll do with our RMDs if it ever comes to that and our taxable income is high in our 70s - gift whatever is withdrawn from our TIRAs to charity.

Audrey

Audrey.........just be aware that unless they extend the recent tax law allowing old folks to donate directly to charity w/o being taxed or unless you have other deductions (mortgage/state taxes/etc) that equal or exceed the standard deduction, you may be taxed on at least part of those RMDs even if you donate them to charity.

 

[Koolau]

Thanks to Kaneohe for these comprehensible case studies. There's another wrinkle that I have to consider -- probably doesn't affect very many of you. That is the impact of state income tax, which is also deferred for IRAs. While my federal tax will probably be about the same during retirement as it was when I worked, I think my Hawaii state income tax will go down from 7-8% to zero, since all my pension income will be exempt, and the standard deduction and exemptions will cover my modest income from investments. So, if I were to convert my wife's 160k TIRA today, I guess it would cost me 25% + 8%, but without conversion, withdrawals from the TIRA will only cost 25%.

GregLee, sorry if I missed the details, but I don't understand how you would take withdrawals from a TIRA without state tax in Hawaii. I've both converted TIRA money to ROTH and taken TIRA money "to spend" while living in HI and both were state-taxable events. Again, sorry if I missed the details someplace. I need to find out the details (hope I've paid HI TOO MUCH - I know I haven't paid too little.)

Thanks!

 

[GregLee]

... that pertains to state/federal pensions (have relatives w/ those), IRAs..........how about pensions from public corps?

The instructions for my 2009 Hawaii state income tax forms say: "Hawaii does not tax qualifying distributions from an employer-funded pension plan." And later:

The following three types of distributions are not taxed by Hawaii ...

(1) Pension or annuity distributions from a public (i.e. government) retirement system (e.g., federal civil service annuity, military pension, state or county retirement system).

(2) Distributions from a private employer pension plan received upon retirement (including early retirement and disability retirement) if the employee did not contribute to the pension plan.

(3) Distributions from a pension plan at 70-1/2 that are made to comply with the federal mandatory payout rule do qualify as a retirement payment whether or not the employee is still working full time.

Distributions from a private employer pension plan received upon retirement are partially taxed by Hawaii if the employee contributed to the pension plan.

 

[GregLee]

... I don't understand how you would take withdrawals from a TIRA without state tax in Hawaii. I've both converted TIRA money to ROTH and taken TIRA money "to spend" while living in HI and both were state-taxable events.

As I understand it (an important qualification), TIRA withdrawals (or conversions) are subject to Hawaii state income tax. But nonetheless, personally, I expect not to pay any state income tax on my TIRA withdrawals just because they will be the only income I have that is subject to state income tax, and their amounts will be small.

 

[kaneohe]

Greg/Koolau........thanks for clarifying about IRA. I misunderstood Greg also.
So.......if you had a 401K and took RMDs, no HI tax? .....but if you rolled it over to IRA, RMDs would be taxed by HI?

 

[Alan]

Greg/Koolau........thanks for clarifying about IRA. I misunderstood Greg also.
So.......if you had a 401K and took RMDs, no HI tax? .....but if you rolled it over to IRA, RMDs would be taxed by HI?

FYI - I believe RMD's cannot be rolled into an IRA.

 

[harley]

As I understand it (an important qualification), TIRA withdrawals (or conversions) are subject to Hawaii state income tax. But nonetheless, personally, I expect not to pay any state income tax on my TIRA withdrawals just because they will be the only income I have that is subject to state income tax, and their amounts will be small.

That sounds like a great bennie. My only concern would be whether the same situation would be in place come 70.5. I'm not sure how close you are, but I suspect a great exemption like that would be the first to fall to any budgetary shortfall. They could spin it as "not a tax increase, just closing a loophole".

Not to say that I wouldn't do the same as you're planning. It would be a wash if they get rid of the exemption, and you'd come out ahead if they don't. A win-not lose situation. Good luck.

 

[kaneohe]

FYI - I believe RMD's cannot be rolled into an IRA.

Alan....you are of course correct. Sorry my poor writing misled you as to my real question. Take 2 below:

Greg/Koolau........thanks for clarifying about IRA. I misunderstood Greg also.
So.......if you had a 401K and took RMDs, no HI tax? .....but if you rolled the
401K into an IRA, RMDs would be taxed by HI?

 

[Koolau]

The instructions for my 2009 Hawaii state income tax forms say: "Hawaii does not tax qualifying distributions from an employer-funded pension plan." And later:


Quote:
The following three types of distributions are not taxed by Hawaii ...

(1) Pension or annuity distributions from a public (i.e. government) retirement system (e.g., federal civil service annuity, military pension, state or county retirement system).

(2) Distributions from a private employer pension plan received upon retirement (including early retirement and disability retirement) if the employee did not contribute to the pension plan.

(3) Distributions from a pension plan at 70-1/2 that are made to comply with the federal mandatory payout rule do qualify as a retirement payment whether or not the employee is still working full time.

Distributions from a private employer pension plan received upon retirement are partially taxed by Hawaii if the employee contributed to the pension plan.
Yesterday 12:40 PM

Okay, I'm still enough confused that I'll get with my tax guy to be certain, but here is my SWAG. Look at "rule 3". Notice it still says from a "pension plan". So I think that would be if you took your pension as a lump sum and placed it in a qualified plan (e.g., TIRA). Notice too, that anything put in (even to a pension plan) by the employee is subject to HI tax.

Now, I DO think that when I take out my employer's match (in stock) I may not have to pay taxes on that portion of my 401(k) - but I'm not certain. To be honest, I have left it in my plan and taken other 401(k) funds in "hopes" that the stock will rebound. In any case, when the time comes in 7 years, I'll be certain the tax guy and I agree as to what we should do. In the mean time, I'll check to see if maybe I should rethink my ROTH conversions. I don't think so, but I will check. Thanks to all who have contributed, even though, collectively, we're not 100% certain.

Can you say "flat tax?!"