Author Topic: Roth Conversion Ladder--is it legal?  (Read 8240 times)

VioletVixen

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Roth Conversion Ladder--is it legal?
« on: February 22, 2015, 08:32:55 PM »
So, I brought up the Roth Conversion Ladder to a family member and they hadn't heard of it before and they said it sounded illegal. It just got me to wondering if all of these "loopholes" that allow people to retire early ARE, in fact, legal and allowed? Are they just not "advertised" by the government because they don't want to make less money from people's taxes? Is there anything to worry about by "taking advantage" of the government's tax laws (or lack thereof)?

Ricky

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Re: Roth Conversion Ladder--is it legal?
« Reply #1 on: February 22, 2015, 08:37:10 PM »
ire.gov. It's plenty advertised. Knowledge is power.

Yes, legal. The IRA Conversion Spiral Staircase is borderline illegal, though.
« Last Edit: February 22, 2015, 08:39:41 PM by Ricky »

VioletVixen

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Re: Roth Conversion Ladder--is it legal?
« Reply #2 on: February 22, 2015, 08:59:30 PM »
ire.gov. It's plenty advertised. Knowledge is power.

Yes, legal. The IRA Conversion Spiral Staircase is borderline illegal, though.

I didn't see it advertised on irs.gov, unless I just can't find it?

Chuck

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Re: Roth Conversion Ladder--is it legal?
« Reply #3 on: February 22, 2015, 09:18:47 PM »
Why does it sound questionable?

MikeBear

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Re: Roth Conversion Ladder--is it legal?
« Reply #4 on: February 22, 2015, 09:19:03 PM »
http://www.irs.gov/publications/p590/ch02.html#en_US_2013_publink1000231030

Here's the whole thing: http://www.irs.gov/publications/p590/ch02.html#en_US_2012_publink1000231057

Quote

Conversions


You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used. Most of the rules for rollovers, described in chapter 1 under Rollover From One IRA Into Another , apply to these rollovers. However, the 1-year waiting period does not apply.

Conversion methods.   You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.

Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.


Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.


Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.



Same trustee.   Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.

Income.   You must include in your gross income distributions from a traditional IRA that you would have had to include in income if you had not converted them into a Roth IRA. These amounts are normally included in income on your return for the year that you converted them from a traditional IRA to a Roth IRA.

 


If you must include any amount in your gross income, you may have to increase your withholding or make estimated tax payments. See Publication 505, Tax Withholding and Estimated Tax.

More information.   For more information on conversions, see Converting From Any Traditional IRA Into a Roth IRA  in chapter 1.

VioletVixen

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Re: Roth Conversion Ladder--is it legal?
« Reply #5 on: February 22, 2015, 09:41:36 PM »
Why does it sound questionable?

Because you're not paying tax, essentially. Tax-deferred (Traditional) IN-->tax free growth-->rollover from Trad to Roth=Tax free OUT.

Also, why does it appear that there is a limited amount that can be rolled over every year (about $10,000)?

VioletVixen

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Re: Roth Conversion Ladder--is it legal?
« Reply #6 on: February 22, 2015, 09:44:55 PM »
http://www.irs.gov/publications/p590/ch02.html#en_US_2013_publink1000231030

Here's the whole thing: http://www.irs.gov/publications/p590/ch02.html#en_US_2012_publink1000231057

Quote

Conversions


You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used. Most of the rules for rollovers, described in chapter 1 under Rollover From One IRA Into Another , apply to these rollovers. However, the 1-year waiting period does not apply.

Conversion methods.   You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.

Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.


Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.


Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.



Same trustee.   Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.

Income.   You must include in your gross income distributions from a traditional IRA that you would have had to include in income if you had not converted them into a Roth IRA. These amounts are normally included in income on your return for the year that you converted them from a traditional IRA to a Roth IRA.

 


If you must include any amount in your gross income, you may have to increase your withholding or make estimated tax payments. See Publication 505, Tax Withholding and Estimated Tax.

More information.   For more information on conversions, see Converting From Any Traditional IRA Into a Roth IRA  in chapter 1.

Thanks, MikeBear. Does it matter which conversion method is used?

MikeBear

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Re: Roth Conversion Ladder--is it legal?
« Reply #7 on: February 22, 2015, 09:52:32 PM »
I don't know, but asking your 401k custodian this would certainly be the first thing I'd try.

I'm good at finding things on the web, but not the best yet at optimizing all this financial stuff. I've been nibbling around the edges since I found MMM a year ago, and only recently got to the point of checking out this additional strategy.

One thing I've figured out, is you DO pay some taxes on the conversion, so you need to do a little at a time when you have optimized everything so you are in a very low tax situation for that year. That way you can really limit how much that will "cost" you.
« Last Edit: February 22, 2015, 09:57:47 PM by MikeBear »

GreenHorn101

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Re: Roth Conversion Ladder--is it legal?
« Reply #8 on: February 22, 2015, 10:14:47 PM »
correct me if i am wrong, but at point of conversion, from your 401k to Roth IRA, the amount of distribution is treated as income.

you do pay income tax on the conversion. In order for Roth conversion to be tax free, you need to have very little/no income

http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/
« Last Edit: February 22, 2015, 10:17:51 PM by GreenHorn101 »

capital

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Re: Roth Conversion Ladder--is it legal?
« Reply #9 on: February 22, 2015, 11:03:52 PM »
Why does it sound questionable?

Because you're not paying tax, essentially. Tax-deferred (Traditional) IN-->tax free growth-->rollover from Trad to Roth=Tax free OUT.

Also, why does it appear that there is a limited amount that can be rolled over every year (about $10,000)?
The rollover is the step that is taxed. It's just not taxed very much if you're intentionally low-income, as our tax system is progressive.

VioletVixen

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Re: Roth Conversion Ladder--is it legal?
« Reply #10 on: February 22, 2015, 11:06:53 PM »
So, how do you make sure you are "low income" during this conversion period? Is it necessary to have taxable account savings to supplement your income during this time? Could someone post an example of how you would support yourself and still remain low-income enough for this to work?

rpr

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Re: Roth Conversion Ladder--is it legal?
« Reply #11 on: February 22, 2015, 11:17:26 PM »

So, how do you make sure you are "low income" during this conversion period? Is it necessary to have taxable account savings to supplement your income during this time? Could someone post an example of how you would support yourself and still remain low-income enough for this to work?
Yes, you would need additional savings either in a taxable account or an already existing Roth IRA.

Let's take the following simple example.
Required expenses 10k/year
Current taxable balance 50k
Current 401k balance 200k

Every year you rollover 10k from the 401k into a Roth IRA. This 10k will be available 5 years from the date of conversion. In the meantime you use 10k each year from your taxable balance. At the end of every year starting from year 5, you have Roth IRA 50k of which 10k can be withdrawn. For a single person, 10k is below standard deduction + exemptions and so tax paid = 0.
You can double these amounts if married filing jointly. Obviously, you will pay taxes if you need to convert more amounts.


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Monkey Uncle

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Re: Roth Conversion Ladder--is it legal?
« Reply #12 on: February 23, 2015, 04:33:29 AM »

So, how do you make sure you are "low income" during this conversion period? Is it necessary to have taxable account savings to supplement your income during this time? Could someone post an example of how you would support yourself and still remain low-income enough for this to work?
Yes, you would need additional savings either in a taxable account or an already existing Roth IRA.

Let's take the following simple example.
Required expenses 10k/year
Current taxable balance 50k
Current 401k balance 200k

Every year you rollover 10k from the 401k into a Roth IRA. This 10k will be available 5 years from the date of conversion. In the meantime you use 10k each year from your taxable balance. At the end of every year starting from year 5, you have Roth IRA 50k of which 10k can be withdrawn. For a single person, 10k is below standard deduction + exemptions and so tax paid = 0.
You can double these amounts if married filing jointly. Obviously, you will pay taxes if you need to convert more amounts.


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In this example your AGI would be the 10k from the conversion, plus whatever portion of the withdrawal from the taxable account consists of capital gains.  So if your AGI is, say, 13k, you would be paying taxes on 3k, right?  Or would the IRS consider that 3k to have come from the capital gains in your taxable account, which would be taxed at a 0% rate because of low overall income?  It gets confusing, because the conversion comes from a source that is taxed as regular income, whereas the money from the taxable account is taxed at the capital gains rate.  So which one is considered to be the source of the 3k that pushes you beyond the standard deduction + exemptions?
« Last Edit: February 23, 2015, 04:37:17 AM by Monkey Uncle »

boarder42

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Re: Roth Conversion Ladder--is it legal?
« Reply #13 on: February 23, 2015, 05:41:57 AM »
that 3k should be LTCGs.  and/or Qualified dividends which are taxed at 0% as long as your top tax bracket is 15% or lower. 

zolotiyeruki

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Re: Roth Conversion Ladder--is it legal?
« Reply #14 on: February 23, 2015, 11:15:23 AM »
In this example your AGI would be the 10k from the conversion, plus whatever portion of the withdrawal from the taxable account consists of capital gains.  So if your AGI is, say, 13k, you would be paying taxes on 3k, right?  Or would the IRS consider that 3k to have come from the capital gains in your taxable account, which would be taxed at a 0% rate because of low overall income?  It gets confusing, because the conversion comes from a source that is taxed as regular income, whereas the money from the taxable account is taxed at the capital gains rate.  So which one is considered to be the source of the 3k that pushes you beyond the standard deduction + exemptions?
It doesn't appear until you actually get to the step where you calculate your taxes on Line 44 of the 1040 form.  So your AGI is about $13k, your deductions and exemptions bring your taxable income (line 43) down to $3k.  Now, you head to the Long-term Capital Gains Tax Worksheet.  Since your AGI is below the top of the 15% tax bracket, the $3k from LTCGs is taxed at 0%.  The remainder of your income, which is near $0, is taxed at 10%.
« Last Edit: February 23, 2015, 11:18:44 AM by zolotiyeruki »

Frankies Girl

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Re: Roth Conversion Ladder--is it legal?
« Reply #15 on: February 23, 2015, 11:59:11 AM »
You can also play around with the numbers in TurboTax's Taxcaster:
https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

I read over on the Mad FIentist's site that Roth conversions would be input in the taxable wages (for either you or you spouse, don't think it makes much difference as long as it's in one or the other if you're married).

Then use the LTCG or dividends to live off of (or cash if you have it).

As long as you keep your marginal tax rate 15% or below, the dividends/LTCGs aren't taxed.

So for example, input 20K in the taxable wage section to account for that same amount converting from a traditional IRA into a Roth. Then add in 10K in dividends, and 30K for LTCGs for a total of $40K living expenses (which is pretty generous for MMM standards). Your marginal tax rate is 15%, so you pay no taxes on anything.

And I don't put much stock in any person saying that it must be wrong or illegal if they'd never heard of it before. Unless they were a tax or retirement expert, I wouldn't expect them to know about this (and how odd that they use that as a basis for whether something is real/legal or not).

 The older I get, the more I realize I don't know - and there are tons of things that I could claim that I'd never heard of before... ;)

« Last Edit: February 23, 2015, 12:00:51 PM by Frankies Girl »

Eric

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Re: Roth Conversion Ladder--is it legal?
« Reply #16 on: February 23, 2015, 12:11:32 PM »
So, how do you make sure you are "low income" during this conversion period? Is it necessary to have taxable account savings to supplement your income during this time? Could someone post an example of how you would support yourself and still remain low-income enough for this to work?

The level of your income (i.e. your spending, since you're now retired) doesn't really matter as far as the conversion goes.  The process works the same at all income levels.  When you rollover your T-IRA to a Roth IRA, that is a taxable event (taxed as regular income).  It's just that the higher it is, the more you will owe in taxes.  And since taxes need to be included in your spending number, the higher your spending, the higher your taxes, and the greater amount you'll be taxed on.  It's a vicious cycle.

So to use real numbers.  We'll look at a married couple in 2014:

If you convert $30K from traditional to Roth, you'd have income of $30K.  Minus your standard deductions/exemptions of $20,300, you're left paying taxes on $9700.00, which is $973.00.  This leaves $29,027.00 of that $30K to spend, or 96.76% of the conversion amount.

If you convert $50K from traditional to Roth, you'd have income of $50K.  Minus your standard deductions/exemptions of $20,300, you're left paying taxes on $29,700.00, which is $3551.00.  This leaves $46,449.00 of that $50K to spend, or 92.90% of the conversion amount.

boarder42

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Re: Roth Conversion Ladder--is it legal?
« Reply #17 on: February 23, 2015, 12:13:21 PM »
Remember your money has to be good in 5 years so you should roll enough to cover 3% inflation over the 5 years as well.

My plan roth principal for first 5 years + taxable ~ 70k - 35k each - Roth already been taxed no worries.  taxable only the earnings will be considered income ... so maybe 10k max of the 35k ...

roll over 75k per year in today's dollars ... i plan to live on the edge of the 15% tax bracket though.




Exflyboy

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Re: Roth Conversion Ladder--is it legal?
« Reply #18 on: February 23, 2015, 12:49:28 PM »
The only problem I see is that extra income is gonna hurt if your planning on ACA subsidies.

Am I right?


dandarc

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Re: Roth Conversion Ladder--is it legal?
« Reply #19 on: February 23, 2015, 01:02:37 PM »
The only problem I see is that extra income is gonna hurt if your planning on ACA subsidies.

Am I right?
Depends on how much - ACA subsidies maximize with MAGI just above the cutoff where Medicaid kicks in.

Not an issue while accumulating - still best to just make the maximum you can (within your individual constraints), but managing the withdrawal phase is an interesting problem.  And it may limit the tax gain harvesting you can do as well - usual tax-gain harvesting advice is to create gains up to the top of the 15% bracket (to fully take advantage of the 0% capital gains rate), but if you have a subsidy that will decline from $10K to 0 if you do that . . .

merula

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Re: Roth Conversion Ladder--is it legal?
« Reply #20 on: February 23, 2015, 01:07:20 PM »
The IRA Conversion Spiral Staircase is borderline illegal, though.

I'll admit it, I googled this to see if it was a real thing. Well played, Ricky, well played.

Exflyboy

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Re: Roth Conversion Ladder--is it legal?
« Reply #21 on: February 23, 2015, 01:09:29 PM »
The only problem I see is that extra income is gonna hurt if your planning on ACA subsidies.

Am I right?
Depends on how much - ACA subsidies maximize with MAGI just above the cutoff where Medicaid kicks in.

Not an issue while accumulating - still best to just make the maximum you can (within your individual constraints), but managing the withdrawal phase is an interesting problem.  And it may limit the tax gain harvesting you can do as well - usual tax-gain harvesting advice is to create gains up to the top of the 15% bracket (to fully take advantage of the 0% capital gains rate), but if you have a subsidy that will decline from $10K to 0 if you do that . . .

Right.. So emigrate first.. Then manage your income to $75k..:)

kpd905

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Re: Roth Conversion Ladder--is it legal?
« Reply #22 on: February 23, 2015, 04:54:04 PM »
We wouldn't be talking about it so much if it was illegal.