Author Topic: Help me understand the Roth conversion pipeline idea and its benefits  (Read 30254 times)

secondcor521

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Hi all,

I've read about the Roth conversion pipeline idea a few times here and am interested in possibly seeing if it would be useful or beneficial to me.  I've searched the web and not been able to get a clear description of the idea and its benefits.

So suppose next year I will be a 45 year old single male.  Suppose I spend $20K per year, and I have a Roth with $100K of contributions and a traditional IRA with $400K.  Let's ignore inflation and earnings just to make things simple.

What I understand the Roth pipeline idea to be is this:  Each year I convert $20K of my traditional IRA to my Roth IRA for my living expenses 5 years from now.  Each year I pull $20K from my Roth IRA to live on.

What I could also do is just withdraw $20K from my traditional IRA and live on that.

In the Roth pipeline case, my understanding is that I would pay ordinary income tax on the conversion amount every year.  I would also pay the 10% early withdrawal penalty once I had depleted the $100K of my Roth contributions and started withdrawing the converted amounts (when I would be about 50 years old in this example).

In the alternate case, I would pay ordinary income tax plus the 10% penalty on the $20K withdrawal from my traditional IRA.

So if I understand the idea correctly, with this idea I am able to defer the annual $2K (10% of $20K) penalties out five years in the future.  In exchange for that I have to predict my living expenses out five years in the future.

Questions:

1.  Do I understand the idea correctly?
2.  Am I missing some benefit of this idea?

Regarding the second question, I am wondering if there is some assertion that I can avoid the 10% penalty on the converted amounts because of the 5 year seasoning process.  I don't read the IRS regulations that way, but if someone can clarify how that can be possible I would appreciate it.

Thanks!!

velocistar237

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There's no penalty involved in the Roth pipeline. You would roll over and pay taxes on the amount you need in 5 years, then when that 5 years comes, you can use that money out of your Roth with no penalties or further taxes. The distribution ordering rules put rollovers before earnings.

You would need to account for inflation. Roll over $24K now because that's what your expenses will be in 5 years at 3.5% inflation.

secondcor521

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Thank you for the reply.

In the real world, of course I would account for inflation.  Let's use your $24K number for the purposes of discussion.

If the appeal of the Roth pipeline is that I avoid the 10% extra tax, great.  But I don't read the tax rules that way.  Here's my logic, help me see what's missing.  I'm referring to IRS publication 590 pages 70 and 71.  Here's the link:  http://www.irs.gov/pub/irs-pdf/p590.pdf.

1.  The withdrawal of the $24K in five years from now would not be a qualified distribution because it doesn't meet condition 2 on page 70 left side, and in order to be a qualified distribution it would have to meet both conditions 1 and 2.

2.  Third paragraph second column page 70 states:  "Unless one of the exceptions listed later applies, you
must pay the additional tax on the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover."  I read this to mean that since I had to include the $24K in income because of the conversion when I was 45, I must pay the additional tax unless one of the exemptions applies.

3.  Since none of the exemptions apply (first home, disabled, etc.), I must pay the additional tax.

Where is my logic wrong or where do we disagree on the interpretation of the rules?

chad

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At the bottom of p. 69 it explains that "You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)." So you're right that a distribution of contributions would not be a "qualified distribution". But that doesn't mean you'd pay the penalty on such a distribution, since you would not include that sort of distribution in your gross income.

grantmeaname

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2.  Third paragraph second column page 70 states:  "Unless one of the exceptions listed later applies, you
must pay the additional tax on the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover."  I read this to mean that since I had to include the $24K in income because of the conversion when I was 45, I must pay the additional tax unless one of the exemptions applies.
The first part of that same paragraph reads "If, within the 5-year period starting with the first day of your tax year in which you convert an amount from a traditional IRA or rollover an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the 10% additional tax on early distributions." I'm reading that as limiting the scope of the remainder of the paragraph, but it's definitely murky and I don't totally understand it.

Prior discussions of this topic: here, here, here, here...
« Last Edit: June 08, 2013, 09:02:40 AM by grantmeaname »

TLV

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2.  Third paragraph second column page 70 states:  "Unless one of the exceptions listed later applies, you
must pay the additional tax on the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover."  I read this to mean that since I had to include the $24K in income because of the conversion when I was 45, I must pay the additional tax unless one of the exemptions applies.

That paragraph is under the header "Distributions of conversion contributions within 5-year period", hence the requirement to have a 5-year pipeline. Immediately after that section is a short paragraph with the header "other early distributions", which says the 10% penalty only applies to the taxable portion." Regular contributions are excluded in the paragraph grant quoted, but conversion contributions aren't, so to figure out the taxable portion, you have to fill out form 8606.

Within 8606, there's a line for "basis from conversions" that you get to subtract from the distribution amount. The instructions for that line are very complicated-looking because they take into account previous withdrawals, but it comes down to the amount that you converted more than 5 years ago that hasn't already been withdrawn.

athomeintheworld

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #6 on: December 02, 2013, 10:26:36 PM »
Anyone out there actually doing this? 

secondcor521

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #7 on: December 03, 2013, 12:29:24 PM »
If the information on this thread checks out to my satisfaction, I plan on using it.  It's much more flexible than 72(t) for very early retirees, and that flexibility is valuable to me given the particular circumstances I anticipate.

My plan is to re-read the IRS rules given what TLV wrote, and then maybe go through some mock tax returns.  If I'm convinced after that, great.  If not, I plan to consult a local CPA who is highly knowledgeable in retirement issues.

MandyM

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #8 on: December 03, 2013, 12:49:54 PM »
I found this helpful: http://www.fool.com/money/allaboutiras/allaboutiras07.htm

One thing I learned on that website is the required ordering of distributions, i.e. you have to take out the non-taxable contributions before you can take out the conversions.

nawhite

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #9 on: December 03, 2013, 02:44:08 PM »
One thing I learned on that website is the required ordering of distributions, i.e. you have to take out the non-taxable contributions before you can take out the conversions.

I'm confused why that matters or is bad for us in any way? The non-taxable contributions aren't taxed or penalized ever. The conversions aren't taxed but are penalized if withdrawn within 5 years and aren't taxed or penalized if withdrawn after 5 years. So seems like this ordering is the best possible situation for us and allows us to do things like withdraw non-taxable contributions for the 5 years we are priming our conversion ladder. As long as you never touch the earnings until you are 59.5 the ordering rules shouldn't hurt you at all?

MandyM

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #10 on: December 04, 2013, 06:03:16 AM »
One thing I learned on that website is the required ordering of distributions, i.e. you have to take out the non-taxable contributions before you can take out the conversions.

I'm confused why that matters or is bad for us in any way? The non-taxable contributions aren't taxed or penalized ever. The conversions aren't taxed but are penalized if withdrawn within 5 years and aren't taxed or penalized if withdrawn after 5 years. So seems like this ordering is the best possible situation for us and allows us to do things like withdraw non-taxable contributions for the 5 years we are priming our conversion ladder. As long as you never touch the earnings until you are 59.5 the ordering rules shouldn't hurt you at all?

Oops, you are right, I got tangled up again.

CommonCents

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #11 on: December 05, 2013, 10:16:10 AM »
What happens if you already have all of your money in a Roth IRA and aren't doing any conversions?  Can you take out any money penalty-free before 59.5?

matchewed

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #12 on: December 05, 2013, 10:21:09 AM »
What happens if you already have all of your money in a Roth IRA and aren't doing any conversions?  Can you take out any money penalty-free before 59.5?

You can take out contributions at any time. Earnings will receive a penalty.

Eric

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #13 on: December 05, 2013, 10:22:02 AM »
What happens if you already have all of your money in a Roth IRA and aren't doing any conversions?  Can you take out any money penalty-free before 59.5?

You can remove contributions to a Roth at any point penalty free.  You can't remove earnings before 59.5 w/o penalty.  So if you contribute $5500 this year, and it grows to $6000, you can always remove the $5500 but the extra $500 will need to wait until age 59.5.

The reason the conversion from traditional IRA (or 401k) to Roth is so powerful, is that all of that conversion money is counted as a contribution as long as it marinates for 5 years before withdrawal.

CommonCents

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #14 on: December 05, 2013, 10:32:33 AM »
What happens if you already have all of your money in a Roth IRA and aren't doing any conversions?  Can you take out any money penalty-free before 59.5?

You can remove contributions to a Roth at any point penalty free.  You can't remove earnings before 59.5 w/o penalty.  So if you contribute $5500 this year, and it grows to $6000, you can always remove the $5500 but the extra $500 will need to wait until age 59.5.

The reason the conversion from traditional IRA (or 401k) to Roth is so powerful, is that all of that conversion money is counted as a contribution as long as it marinates for 5 years before withdrawal.

Gotcha.  I started making some contributions to a Roth IRA back when I was 18, so I can't really undo it and go back 16 years.  Going forward we actually may be limited to a traditional IRA anyhow.

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #15 on: December 05, 2013, 12:33:49 PM »
What happens if you already have all of your money in a Roth IRA and aren't doing any conversions?  Can you take out any money penalty-free before 59.5?

Yes.  If it has "seasoned" for five years, you may take out the (after-tax) contributions (but not earnings). 

Eric

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #16 on: December 05, 2013, 01:09:46 PM »
What happens if you already have all of your money in a Roth IRA and aren't doing any conversions?  Can you take out any money penalty-free before 59.5?

Yes.  If it has "seasoned" for five years, you may take out the (after-tax) contributions (but not earnings).

To be clear, you can take our your contributions at any point, with no seasoning needed.  You can contribute $5500 on Dec 6th and remove it on Dec 7th penalty free.  The only time the waiting period applies is for the rollover/conversion funds

Nords

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #17 on: January 14, 2014, 07:00:50 PM »
If the information on this thread checks out to my satisfaction, I plan on using it.  It's much more flexible than 72(t) for very early retirees, and that flexibility is valuable to me given the particular circumstances I anticipate.
My plan is to re-read the IRS rules given what TLV wrote, and then maybe go through some mock tax returns.  If I'm convinced after that, great.  If not, I plan to consult a local CPA who is highly knowledgeable in retirement issues.
I realize that this thread has run its course, but Michael Kitces recently published a blog post which clarifies the five-year rule(s) and then beats it to death (in a good way) with examples.

http://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

It gave me an epiphany, and I'm going to pass  it on to my readers in a future blog post.


Jags4186

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #18 on: January 14, 2014, 08:22:03 PM »
If you contribute $5500 on Dec 6, withdraw $5500 on Dec. 7 you can't contribute an additional $5500 on Dec. 8 can you?

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #19 on: April 26, 2014, 10:33:24 AM »
@Jags.  No you can't, the contribution max every calendar year is $5,500.  You can wait until may of the next year and put in another 5,500 though.  Actually this is an area regarding the conversion pipeline i'm still confused about.  How can you rollover $20k plus into a Roth IRA and have it still count as a contribution?  Does this sidestep the $5,500 yearly contribution limit rule?

Eric

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #20 on: April 26, 2014, 12:47:19 PM »
@Jags.  No you can't, the contribution max every calendar year is $5,500.  You can wait until may of the next year and put in another 5,500 though.  Actually this is an area regarding the conversion pipeline i'm still confused about.  How can you rollover $20k plus into a Roth IRA and have it still count as a contribution?  Does this sidestep the $5,500 yearly contribution limit rule?

I don't think this is true.  I did a lot of google searching for this scenario a while back, and while it's not a commonly covered topic everything I found seemed to imply that the only important number is your total contribution amount for the tax year.  If you contribute $5500 Dec 6th and withdrawal $5500 Dec 7th, your total contributions for 2013 are $0.  Therefore, if you withdrawal your $5500 contributions on Dec 7th you can re-contribute on Dec 8th (or anytime w/in the same tax year), because your TOTAL contribution for the tax year is still within the contribution limit.

Otherwise, yes, rollovers sidestep the contribution max.  There's no rollover limit.
« Last Edit: April 26, 2014, 12:51:11 PM by Eric »

johnhenry

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #21 on: August 28, 2014, 12:27:26 PM »
The very first response in this thread mentions that conversions to Roth IRAs are taxable.  But the thread doesn't really hash out that to use the Roth pipleline strategy, you have to avoid that tax and the way to do that is to incur the conversion income in a year when your taxable income is able to be shielded by deductions and exemptions.

There are other threads on this forum that discuss the Roth pipeline in more detail, but I thought it was worth adding a note to this thread in case anyone is trying to get a handle on the strategy.

matchewed

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #22 on: August 28, 2014, 12:40:25 PM »
You don't have to avoid any taxes to do a pipeline conversion, just understand when taxation occurs and how to minimize it.

seattlecyclone

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #23 on: August 28, 2014, 12:54:32 PM »
You don't have to avoid any taxes to do a pipeline conversion, just understand when taxation occurs and how to minimize it.

Yes, many (most?) people would want to start their pipeline in advance of retiring, so some taxes would be inevitable. The main exception to this would be if you have at least five years worth of expenses saved up in taxable accounts.

johnhenry

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #24 on: August 28, 2014, 01:52:44 PM »
You don't have to avoid any taxes to do a pipeline conversion, just understand when taxation occurs and how to minimize it.

Yes, many (most?) people would want to start their pipeline in advance of retiring, so some taxes would be inevitable. The main exception to this would be if you have at least five years worth of expenses saved up in taxable accounts.

Good point.  I had been focusing on the variation of the pipeline which would allow me to get money from the tax-deferred TIRA to the tax-free Roth without ever paying the tax on it.  I do have more than five years of expenses in taxable accounts and assumed (incorrectly) that to make it worthwhile, one would have to be in that situation.  But I guess the pipeline strategy can still make sense even if you do have to pay tax on the converted amount. 

Daisy

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #25 on: August 28, 2014, 01:57:45 PM »
I'm going to start my Roth conversion pipeline right after FIREing. Well actually a year after FIREing. I expect my first year in FIRE to be paid a severance pay.

I can't do it while employed because the income taxes would kill me. I'm already in a high income tax bracket while employed.

After FIREing, I want to transfer as much from traditional to ROTH as possible, even if it takes me to the top of the 15% tax bracket. I wouldn't go above that because then my long term capital gains would be taxed. I want to stay in the 15% bracket. I want to move as much as I can over before I collect Social Security, because then those benefits get taxed if you have other income.

But then I will have to keep tabs on how maximizing the 15% tax bracket in the conversions will affect any ACA subsidies. It will be a fine line to walk.

What a mess our tax code is...but you play with the cards you are dealt with.


Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #26 on: August 28, 2014, 02:13:21 PM »
One more optimization note:

Once FIRE, establish permanent residency in FL, TX, WY, NV, or various other tax friendly states if feasible during your conversion. State taxes could be higher than federal if you fill all/most of the 15% bracket and report a lot of qualified taxable investment income. Not logical for most people, but if you live on a border (like Lake Tahoe) or already planned to jump ship (like Spoonman) you might want to consider it if you haven't already.

Daisy

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #27 on: August 28, 2014, 02:16:56 PM »
One more optimization note:

Once FIRE, establish permanent residency in FL, TX, WY, NV, or various other tax friendly states if feasible during your conversion. State taxes could be higher than federal if you fill all/most of the 15% bracket and report a lot of qualified taxable investment income. Not logical for most people, but if you live on a border (like Lake Tahoe) or already planned to jump ship (like Spoonman) you might want to consider it if you haven't already.

Well, I've got the FL thing down, so I don't have to worry. ;-)

Another optimization, check out my "Standard Deduction Games" thread. A little bit of self-promotion never hurt...

Summary is you maximize and bunch up itemized deductions one year and then take the standard deduction the following year. More space for the Roth conversion pipeline games.

I did mention I was an optimizing freak on some other thread. :-)

johnhenry

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #28 on: August 28, 2014, 02:20:22 PM »
I'm going to start my Roth conversion pipeline right after FIREing. Well actually a year after FIREing. I expect my first year in FIRE to be paid a severance pay.

I can't do it while employed because the income taxes would kill me. I'm already in a high income tax bracket while employed.

After FIREing, I want to transfer as much from traditional to ROTH as possible, even if it takes me to the top of the 15% tax bracket. I wouldn't go above that because then my long term capital gains would be taxed. I want to stay in the 15% bracket. I want to move as much as I can over before I collect Social Security, because then those benefits get taxed if you have other income.

But then I will have to keep tabs on how maximizing the 15% tax bracket in the conversions will affect any ACA subsidies. It will be a fine line to walk.

What a mess our tax code is...but you play with the cards you are dealt with.

Thanks Daisy.

So SS income is taxed only if you have other income?  Does that have to be earned income?  I wasn't aware of that.... but I'm a long way from SS age, so I'm hardly versed on the subject.

Concerning staying in the 15% tax bracket to avoid LTCG.  Very good idea.  I was not aware until recently that the LTCG tax is marginal.... I had read several places, and heard from a CPA that it was all or nothing (10 or 15% bracket = 0% LTCG tax, while any higher bracket = 15% LTCG tax).  It was refreshing to learn that if your income does barely put you above the 15% bracket, you only pay LTCG tax on the amount in the higher bracket.

Yes, on the ACA subsidies, I understand those are hard cliffs, with all subsidy going away if you are over 400% of the FPL for household size.  So staying under that threshold will be very important.

You're right, it is a shame that it takes so much dancing to make it through the maze of the tax code.

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #29 on: August 28, 2014, 02:41:18 PM »
So SS income is taxed only if you have other income?  Does that have to be earned income?  I wasn't aware of that.... but I'm a long way from SS age, so I'm hardly versed on the subject.

SS is taxable from 0% to 85%. So if you get 20K in benefits the range of how much is taxable will be between $0 and $17,000. This range is determined by income from virtually all other sources. Income < $20K is safe. Beyond that it gets dicey. However, the idea is you likely don't need the social security income if you have other sources, so it's sort of a means test as to whether or not they should actually be giving it to you.

In any case, if you want to keep gaming the system, get all your TIRAs into Roths before drawing SS, then make sure all income is < $20K from then on.

http://www.irs.gov/uac/Is-Social-Security-Taxable%3F-(ASL)-YouTube-video-text-script

catccc

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #30 on: October 17, 2014, 09:31:31 AM »
You don't have to avoid any taxes to do a pipeline conversion, just understand when taxation occurs and how to minimize it.

Yes, many (most?) people would want to start their pipeline in advance of retiring, so some taxes would be inevitable. The main exception to this would be if you have at least five years worth of expenses saved up in taxable accounts.

Another exception is if you have had the Roth for some time and have built up a cushion of non-conversion contributions, or conversions in prior years, in which case those can come out at any time tax free.  My direct roth contributions since entering the workforce now amount to $57K (started post collegiate career in 2003), and I converted some former workplace 401Ks in 2009 amounting to maybe $50K, so that's coming up on 5 years soon.  So all in all I have over $100K accessible w/o taxes or penalties, and I am still at least 5 years out from FI, so there will be more direct contributions in coming years.

MooseOutFront

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #31 on: January 14, 2015, 03:00:37 PM »
Has anyone seen a good blog or forum post on exactly what the ACA subsidies do to the theoretical Roth conversion pipeline?  My original plan was to convert up to the top of the 15% bracket after FIRE, but the best subsidies go quick above the 2X poverty level.  For a family of 4 that's about $48k, so doing conversions on up from there could have a high marginal tax rate, thus defeating the purpose.

nawhite

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #32 on: January 14, 2015, 03:57:54 PM »
Has anyone seen a good blog or forum post on exactly what the ACA subsidies do to the theoretical Roth conversion pipeline?  My original plan was to convert up to the top of the 15% bracket after FIRE, but the best subsidies go quick above the 2X poverty level.  For a family of 4 that's about $48k, so doing conversions on up from there could have a high marginal tax rate, thus defeating the purpose.

Last time I did the math for my situation, each additional dollar I converted during the 5 years I was priming the pump would decrease my subsidy by $0.13. YMMV. Fortunately this doesn't hurt you after the 5 years of priming (when you have your current income source, and additional "income" due to the conversion) because afterwards, your conversion approximately equals your spending (assuming you have no other income sources). However, during those years of increased "income" you I would have effectively a 13% tax on conversions.

MooseOutFront

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #33 on: January 14, 2015, 04:26:44 PM »
Thank you for the insight.  I seem to remember seeing 13% somewhere else too.  That's a painful number in my opinion.

seattlecyclone

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #34 on: January 14, 2015, 05:06:38 PM »
For getting the ACA cost-sharing reduction plans, it looks like 133-200% of the poverty level (roughly $20-30k for a two-person household) is the sweet spot for income. If you can live on that much, just convert that much each year to Roth and call it a day.

If you want to spend more and still get that type of plan, you might need to get a little bit more creative. If you have a taxable account, you can sell shares that have minimal gains (or even losses) to get some cash without affecting your income much. Don't forget about HSAs either. You can withdraw from these tax-free as long as you have receipts to prove sufficient medical expenses.

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #35 on: January 14, 2015, 06:35:30 PM »
Hey Moose, just wait a few years. I don't think these ACA rules will exist as they currently do for very long. No need to make firm plans yet. Unless you're quitting in the next year or two.

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #36 on: January 14, 2015, 07:37:54 PM »
If you contribute $5500 on Dec 6, withdraw $5500 on Dec. 7 you can't contribute an additional $5500 on Dec. 8 can you?

I'm not an expert on this!!

So typically with Roth it's FIFO (first-in-first-out) with regards to contributions.  If I put $5500 in on December 6, when I take out $5500, it's $3000 from 2006, and $2500 from 2007, because that's when I first contributed (I could be wrong on the exact values though).  You can recharacterize your $5500 from December 6th, but I think there's other steps to do that other than just taking out $5500.  If you recharacterize, you can put $5500 back in, but there might be a 3 month waiting period, or something like that.  Although you can put in 2014 money through April 15th 2015. 

I haven't done as much research on recharacterizations, but I read fientists's post about the Roth Horse Race, which uses recharacterizations.  And that's a more complicated version of this Roth Ladder:
http://www.madfientist.com/roth-ira-horse-race/

The order when you take money out of a Roth is something like this:
1) Contributions
2) Converted Contributions (from a tIRA)
3) Earnings on the above

MooseOutFront

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #37 on: January 14, 2015, 08:49:08 PM »
Hey Moose, just wait a few years. I don't think these ACA rules will exist as they currently do for very long. No need to make firm plans yet. Unless you're quitting in the next year or two.
I hear you.  But this is still discouraging since the roth pipeline was my silver bullet.  I know you have the philosophy of max tax minimization in the present, but this could be at least a reasonable tie breaker to go ahead with Roth contributions while in the 15% bracket instead of tIRA.

Daisy

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #38 on: January 18, 2015, 01:15:15 PM »
Hey Moose, just wait a few years. I don't think these ACA rules will exist as they currently do for very long. No need to make firm plans yet. Unless you're quitting in the next year or two.
I hear you.  But this is still discouraging since the roth pipeline was my silver bullet.  I know you have the philosophy of max tax minimization in the present, but this could be at least a reasonable tie breaker to go ahead with Roth contributions while in the 15% bracket instead of tIRA.

I'm in the same boat. I would like to maximize the Roth conversions before Social Security age as well. Social Security gets taxed a bit when you have other income. But then you run into the ACA limits...and unsubsidized ACA plans are way too pricey for my taste.

I sure wish the ACA subsidies get rejected and high deductible catastrophic health plans that are not dependent on income are re-allowed again. That would be my perfect scenario. But I realize this is a pipe dream and likely won't happen. I don't have the healthcare choices I would like for my situation. But oh well, I guess I will play the Roth-ACA-income limit game if that's the only game in town.

Midas

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #39 on: January 20, 2015, 10:36:37 AM »
Does it only make sense to do the conversions during years where you are in a low tax bracket if you expect to be in a low tax bracket when you retire? Like if you are already at the 28% bracket you wouldn't want to do the conversion during that year, right?

Like:
Earliest retirement years: live off say $25k a year from taxable, rollover as much as you can since your tax bracket can stay so low.
Later: Live off Roth contributions.
Later: Live off rollover to Roth that has been there >5 years.
Even later: Take 10% penalty on TRA withdrawals.
Even later: You're old enough to not get hit by penalties now! If you've even exhausted the other accounts.

EDIT: Actually hmm, with a couple considering the standard deduction/exemption, could you optimize by alternating years where one member of the couple does nothing but a roth conversion while the other person pays living expenses, then alternate the next year who makes the roth conversion? Would you be able to convert more tax-free or with very little tax that way?
« Last Edit: January 20, 2015, 11:22:45 AM by Midas »

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #40 on: January 20, 2015, 12:09:28 PM »
Does it only make sense to do the conversions during years where you are in a low tax bracket if you expect to be in a low tax bracket when you retire? Like if you are already at the 28% bracket you wouldn't want to do the conversion during that year, right?

Like:
Earliest retirement years: live off say $25k a year from taxable, rollover as much as you can since your tax bracket can stay so low.
Later: Live off Roth contributions.
Later: Live off rollover to Roth that has been there >5 years.
Even later: Take 10% penalty on TRA withdrawals.
Even later: You're old enough to not get hit by penalties now! If you've even exhausted the other accounts.

EDIT: Actually hmm, with a couple considering the standard deduction/exemption, could you optimize by alternating years where one member of the couple does nothing but a roth conversion while the other person pays living expenses, then alternate the next year who makes the roth conversion? Would you be able to convert more tax-free or with very little tax that way?

You want to convert with the lowest possible tax cost. If you're in the 28% bracket but you're about to inherit $5M from your Mom's T.IRA with RMD's, you might be in the 33% bracket next year, so you'd want to convert now at 28%.

Most people will be in the 15-33% bracket while working, then the 0-15% bracket when retired. That's when you would begin.

Do your best to not take a 10% penalty on withdrawals, it's not really necessary if you plan properly.

On that last bit are you talking about single, married filing separately, married filing jointly? I'm not sure it matters, but I don't know what you're getting at here.

Just figure out how to fund your first 5 years of retirement with post-tax money, begin the conversion ladder in year 1 and continue it each year, then from year 6 to year X you will have Roth principal to withdraw tax free.

Scandium

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #41 on: January 20, 2015, 12:11:31 PM »
One more optimization note:

Once FIRE, establish permanent residency in FL, TX, WY, NV, or various other tax friendly states if feasible during your conversion. State taxes could be higher than federal if you fill all/most of the 15% bracket and report a lot of qualified taxable investment income. Not logical for most people, but if you live on a border (like Lake Tahoe) or already planned to jump ship (like Spoonman) you might want to consider it if you haven't already.

I hadn't really considered state taxes. Good point.
New Hampshire and Tennessee are also options, as they tax dividends and interest only. Out of all the options I personally think I'll target NH as my home right after FIRE. Deserts and swamps aren't my thing.. :)

http://www.taxadmin.org/fta/rate/ind_inc.pdf

HI and CA of course look the worst. I'm sure some of the others work out to a pretty low rate of a couple percent for a modest income.
« Last Edit: January 20, 2015, 12:22:54 PM by Scandium »

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #42 on: January 20, 2015, 12:37:03 PM »
One more optimization note:

Once FIRE, establish permanent residency in FL, TX, WY, NV, or various other tax friendly states if feasible during your conversion. State taxes could be higher than federal if you fill all/most of the 15% bracket and report a lot of qualified taxable investment income. Not logical for most people, but if you live on a border (like Lake Tahoe) or already planned to jump ship (like Spoonman) you might want to consider it if you haven't already.

I hadn't really considered state taxes. Good point.
New Hampshire and Tennessee are also options, as they tax dividends and interest only. Out of all the options I personally think I'll target NH as my home right after FIRE. Deserts and swamps aren't my thing.. :)

http://www.taxadmin.org/fta/rate/ind_inc.pdf

HI and CA of course look the worst. I'm sure some of the others work out to a pretty low rate of a couple percent for a modest income.

My state doesn't recognize qualified rates. So if I stay put and have $40K T-R conversions and $40K Qualified investment returns, I will pay about $1,000 Fed tax and $3,000 state tax. Silly. I have other ways to reduce the state bill, but we might jump ship. Who knows.

pzxc

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #43 on: January 20, 2015, 12:55:22 PM »
Quote
I did a lot of google searching for this scenario a while back, and while it's not a commonly covered topic everything I found seemed to imply that the only important number is your total contribution amount for the tax year.  If you contribute $5500 Dec 6th and withdrawal $5500 Dec 7th, your total contributions for 2013 are $0.  Therefore, if you withdrawal your $5500 contributions on Dec 7th you can re-contribute on Dec 8th (or anytime w/in the same tax year), because your TOTAL contribution for the tax year is still within the contribution limit.

I don't believe that's correct.  I think if you contribute $5500 on 12/6 and withdraw $5500 on 12/7, your total contributions for the year are already $5500 -- withdrawals don't reduce the amount you've already contributed.

Quote
After FIREing, I want to transfer as much from traditional to ROTH as possible, even if it takes me to the top of the 15% tax bracket. I wouldn't go above that because then my long term capital gains would be taxed.

If you are $500 below the top of 15% tax bracket, only the first $500 of capital gains is tax-free.  The rest is taxed as if you were in the 15% bracket (or even higher if you have enough capital gains).  You can't avoid capital gains by staying just barely within the 15% bracket.  If you are $10k below the top of the 15% bracket, then $10k of your capital gains will be tax-free but no more.

Quote
It was refreshing to learn that if your income does barely put you above the 15% bracket, you only pay LTCG tax on the amount in the higher bracket.

Well, if your adjusted gross income (AGI) is below the 15% bracket, and your capital gains would put you barely above the 15% bracket, then yes you pay tax only on the amount in the higher bracket.  However, if your AGI is $1 below the 15% bracket, only one dollar will be sheltered from capital gains - the rest is taxed as if you were fully in the 15% bracket (or even higher if there are enough capital gains).  I don't think that's refreshing at all -- it would be much better if the entire capital gains were taxed at your AGI bracket, because then you could have a gross income just below the 15% bracket and shelter an unlimited amount of capital gains.  But it doesn't work that way.

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #44 on: January 20, 2015, 01:06:30 PM »

HI and CA of course look the worst. I'm sure some of the others work out to a pretty low rate of a couple percent for a modest income.

Why would CA be one of the worst state once you reach FI for taxes?

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #45 on: January 20, 2015, 01:09:09 PM »
pzxc, it doesn't work that way because the capital gains are income, and tax brackets are based on income, whether it's taxable income or not.

Also, don't confuse AGI with taxable income, they are very different.

Your last 2 quotes seem to be a simple miscommunication/misunderstanding. I don't think those were quotes of me, but based on what was said I think you're reading what they're saying incorrectly. I think they are simply trying to fill up the 15% bracket, not exceed it.

So maybe they have $25K qualified capital gains and they fill up the 15% bracket with $22K conversions. That gives them about $47K AGI, but after ded/exe of about $10K they are right at the top of the 15% bracket with 37K taxable for a single filer. No tax on the capital gains due to the 0% rate. Taxes on $12K in conversions after deducting the $10K, so only a federal tax of about $1,400. Not a bad deal.

Scandium

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #46 on: January 20, 2015, 01:33:27 PM »

HI and CA of course look the worst. I'm sure some of the others work out to a pretty low rate of a couple percent for a modest income.

Why would CA be one of the worst state once you reach FI for taxes?

Because CA has a top state tax rate of 12.3%. I have no idea what the brackets look like though, but unless it's extremely progressive it doesn't sound great (and CA is expensive as well)

pzxc, it doesn't work that way because the capital gains are income, and tax brackets are based on income, whether it's taxable income or not.

Also, don't confuse AGI with taxable income, they are very different.

Your last 2 quotes seem to be a simple miscommunication/misunderstanding. I don't think those were quotes of me, but based on what was said I think you're reading what they're saying incorrectly. I think they are simply trying to fill up the 15% bracket, not exceed it.

So maybe they have $25K qualified capital gains and they fill up the 15% bracket with $22K conversions. That gives them about $47K AGI, but after ded/exe of about $10K they are right at the top of the 15% bracket with 37K taxable for a single filer. No tax on the capital gains due to the 0% rate. Taxes on $12K in conversions after deducting the $10K, so only a federal tax of about $1,400. Not a bad deal.

I think I understand now, maybe.. Brackets are based on all income; salary, capital gains, poker winnings etc. If all this is in 15% bracket (after deductions) capital gains has zero tax. If you have $100 in capital gains above that, the $100 is taxed at 15%.

At the moment the 15% bracket for married couple is $72,500. Plus deduction and exemptions are about $20,000. So if we retired now and had no other income we could convert $92,500 to a Roth and pay no more than 15% tax on it? (Plus state tax. And assuming we lived on $0)

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #47 on: January 20, 2015, 01:51:45 PM »
I think I understand now, maybe.. Brackets are based on all income; salary, capital gains, poker winnings etc. If all this is in 15% bracket (after deductions) capital gains has zero tax. If you have $100 in capital gains above that, the $100 is taxed at 15%.

At the moment the 15% bracket for married couple is $72,500. Plus deduction and exemptions are about $20,000. So if we retired now and had no other income we could convert $92,500 to a Roth and pay no more than 15% tax on it? (Plus state tax. And assuming we lived on $0)

Taxable income (which is AGI less standard/itemized deductions and exemptions) determines your tax bracket. In the 15% bracket there is a 0% tax on Qualified investment income. Any qualified income above the 15% bracket would be taxed, you are correct.

In 2015 the 15% bracket is 74,900, and married standard deduction with 2 exemptions totals 20,600, so you can convert $95,500 and you will pay exactly $10,312.50 in federal income tax. 10.8% of AGI. Ideally you would have a mix of conversions and qualified income and end up paying a much lower rate, but you're getting the idea. If you did $50K conversions and had $45K qualified investment income you would pay $3,488 in federal income tax ($50,000-20,600=29,400 - apply to tax table = 3,488). Big difference in taxes when you utilize some qualified investment income as well.

I linked this on another thread earlier today, but in case anyone wants to download I refer to this little fact sheet often at work:
http://www.paychex.com/a/d/accounting/CCH_Fed_Facts_and_Figures_2015.pdf

pzxc

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #48 on: January 20, 2015, 02:20:49 PM »
Quote
Any qualified income above the 15% bracket would be taxed, you are correct.

That's what I just said.

Though I did mix up AGI and taxable income.

Cheddar Stacker

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Re: Help me understand the Roth conversion pipeline idea and its benefits
« Reply #49 on: January 20, 2015, 02:33:33 PM »
Quote
Any qualified income above the 15% bracket would be taxed, you are correct.

That's what I just said.

Though I did mix up AGI and taxable income.

Yes it is. On the part you just quoted I was re-assuring scandium. You are correct in everything you said as well, it just seems like someone said "fill up the 15% bracket" and you took that to mean fill up that bracket, then add qualified investment gains on top. That's the impression I got anyway.

I think most people considering this plan intend to reach the top of the 15% bracket and stop. That's all I was saying when I used your name.