Negative Federal Income tax--where to put retirement savings?

[zolotiyeruki]

I had a thought the other day about our retirement plans and tax minimization.  Rather than write it out, I'll set out the facts in bullet point form:

Family situation:
--I'm 33, my wife is 31
--5 kids, with one on the way.  Oldest is 9.

Our income tax situation
--AGI: $81k
--Exemptions: 7 (we have 5 kids).  This will increase to 8 exemptions for the 2014 tax year
--Taxable income (after deductions, exemptions): $26k
--Income tax: $2800
--Refund after child tax credits: $2200

Our savings so far:
--Current traditional IRA: about $140k (was a 401(k) at previous employer, rolled over into traditional IRA)
--Roth IRAs: $70k
--Employer 401(k) and other investments: about $25k

Yep, we're in the infamous 47%.

So here's the question: Given our low taxable income, is there any reason why I couldn't (or wouldn't want to) start converting the traditional IRA into a Roth?  As I understand it, as long as we're in the 15% tax bracket, and as long as we keep our AGI under $110,000 and our taxable income under $72,500, our tax bill would not be affected at all by the rollover.  In short, I'm looking at starting a Roth IRA ladder, just without withdrawing the Roth contributions.

Am I understanding this correctly?

[Gin1984]

Are you planning on adding to your Roths as well as doing the ladder?

[Catbert]

Rollovers to Roths are taxed as "income" not" capital gains".  Staying in the 15% tax bracket (under 72K or so of taxable income) would mean you could harvest capital gains at 0% income tax.  For Roth conversions (AKA income) you'd pay up to 15%.

To pay no tax you'd just be able to fill up your 0% tax bracket.  Sorry, not sure what that is.  Probably worth filling up your 10% bracket also.

[zolotiyeruki]

Are you planning on adding to your Roths as well as doing the ladder?

If I get a raise this year (chances are good), then we will put it toward adding to our IRAs or Roths.

Rollovers to Roths are taxed as "income" not" capital gains".  Staying in the 15% tax bracket (under 72K or so of taxable income) would mean you could harvest capital gains at 0% income tax.  For Roth conversions (AKA income) you'd pay up to 15%.

To pay no tax you'd just be able to fill up your 0% tax bracket.  Sorry, not sure what that is.  Probably worth filling up your 10% bracket also.

Thank you! for clarifying my misconception about the conversion.

Because of the child tax credit, we could drive our taxable income all way to $0 before we'd lose out on all tax reduction/refund increases, so there's really not a "0% tax bracket" for us.

I see now that the trick to the Roth ladder is keeping the "earned income" (really IRA to Roth conversion) amount as close as possible to the amount of exemptions and deductions, and then use withdrawn Roth contributions and long-term capital gains for living expenses, while keeping the total under the magic $72,500.  For us, we currently have over $50k worth of exemptions and deductions, but as kids grow up and move out, and we pay off the house, those deductions/exemptions will decrease by about $30k.

[Joel]

Figure out your marginal tax rate, and it is worth converting your IRA to a Roth IRA at a 0% marginal tax rate. It may be worth it at a 10% marginal tax rate as well. In your position, it may not be worth it at a marginal 15% tax rate.

[teen persuasion]

So you do not qualify for the EITC, correct?  It looks to me as if you could convert something like $20k and drive your refund down to zero, figuring in the extra exemption and extra child tax credit.

I've been trying to figure out something similar, we've also got a negative tax rate, but some of the details are different.  We've got 5 kids, but a lower AGI, so we are eligible for the EITC.  Raising our AGI (by converting to Roths) would reduce the EITC, so it is counterproductive at this time for us.  Also, our state matches CTC at 33% for kids over 4, and matches EITC at 30%, so our refunds are pretty large.  I use them to fund our Roths.  We fully fund DH's 401k, to lower our taxable income to zero, which also increases our EITC as a nice side benefit.

You will also have to see how this would affect your state return.

[zolotiyeruki]

@Joel-- our marginal rate is 15%, and while it *may* be possible to drive it down to 10% with the new baby and by increasing our before-tax 401(k) or IRA contributions, we frankly don't have the room in our budget for that right now.

@teen persuasion - We don't qualify for EITC (earned income and AGI both way too high).  Driving our refund down to 0 would actually be counter-productive--we'd be able to convert $20k at a cost of about $3k of lost refund.  If I could, I'd actually go the *other* way, by increasing IRA contributions--that would save the 15% on taxes, which would increase our refund up to the maximum Additional Child Tax Credit of $1k/kid.

Increasing pre-tax contributions would also have the benefit of saving us an additional 5% on Illinois' stupidly-high income taxes as well.

[teen persuasion]

So your best option is to lower your AGI by contributing more to pre-tax accounts: HSA, 401k, tIRA for you and your spouse.  How close are you to maxing them? 

The concept of marginal rate is interesting to me.  We are in the zero bracket, but each additional $ we earn can cost us nearly .50 in taxes/lost refunds:  21% EITC phaseout, 6.3% state EITC phaseout, 10% fed tax, 4% state tax, 7.65% FICA.  And then there is the loss of financial aid for the college kids based on higher income.

[zolotiyeruki]

When talking about *effective* marginal rates, there are a lot of factors.  Contributing to an IRA or 401(k) decreases your income tax but not your FICA, if I understand correctly.  In my case, the effective marginal income tax rate is 20%-- 15 from federal and 5 from Illinois.

We're a loooong way from maxing out our tax-advantaged investments.  We're not contributing at all to our IRAs right now, and are contributing 5% (+4% employer match) to the 401(k).  (as an aside, this is primarily due to the fact that we bought a big house a few years back in a state with stupidly high property taxes)

[Gin1984]

So your best option is to lower your AGI by contributing more to pre-tax accounts: HSA, 401k, tIRA for you and your spouse.  How close are you to maxing them? 

The concept of marginal rate is interesting to me.  We are in the zero bracket, but each additional $ we earn can cost us nearly .50 in taxes/lost refunds:  21% EITC phaseout, 6.3% state EITC phaseout, 10% fed tax, 4% state tax, 7.65% FICA.  And then there is the loss of financial aid for the college kids based on higher income.

EITC is not affected by these.

[teen persuasion]

Agreed, but they are way outside EITC levels, and want to reduce taxable income and capture more of CTC.

Regarding FICA: you can reduce that thru contributions to an HSA thru your employer.