When to convert Traditional IRA to Roth?

[ultros1234]

Hi Mustachians --

My wife and I have a small 'stash in Traditional IRAs, which were rolled over from former employers' 401(k) plans. We've been pondering whether to do a Roth conversion.

Right now, we're sitting in the middle of the 25% tax bracket, and we could do the whole conversion without going into 28%. However, since we're not planning to be profligate spenders in retirement, we may never reap more than $70k per year, which would put us in the 15% bracket, if you assume that today's tax brackets stay the same. In that case, is it better just to leave the dough where it is?

On a related note, do Roth conversions count against your contribution limit for the year?

Thanks for your wisdom!

[JR]

As long as you have five years of living expenses available when you retire I would wait until then to do the conversion.  And then I would only do 1 year's living expenses per year after that.

[darkelenchus]

Hi Mustachians --

My wife and I have a small 'stash in Traditional IRAs, which were rolled over from former employers' 401(k) plans. We've been pondering whether to do a Roth conversion.

Right now, we're sitting in the middle of the 25% tax bracket, and we could do the whole conversion without going into 28%. However, since we're not planning to be profligate spenders in retirement, we may never reap more than $70k per year, which would put us in the 15% bracket, if you assume that today's tax brackets stay the same. In that case, is it better just to leave the dough where it is?

If at some point in the future you plan on having an income that puts you in a lower percentage tax bracket than the one you're in now, you'd be better off waiting to convert the IRA at a time when you're in a lower tax bracket. Of course, the amount you convert counts as ordinary income, so be sure that you don't convert so much that it bumps you into a higher tax bracket.

On a related note, do Roth conversions count against your contribution limit for the year?

No. It's a conversion, not a contribution. You can still contribute up to $5,000 ($6,000 if you're over 50) regardless of the amount you convert. 

[mushroom]

I think it matters how far off retirement is. Keep in mind that if you wait, in the future you will have to convert and pay taxes on a larger sum (assuming that your stash grows with interest) than if you convert now and then let the interest accumulate tax-free in a Roth. If you're talking about retiring pretty soon, it probably makes more sense to wait until your income drops, but you might want to run some numbers with estimates to what makes the most sense.

[bogart]

As long as you have five years of living expenses available when you retire I would wait until then to do the conversion.  And then I would only do 1 year's living expenses per year after that.

I am utterly perplexed as to the logic behind the suggestion.  The advantage of converting is that the income the converted (Roth) IRA generates will never be taxable.  Converting a small sum now should lead to noticeably larger, and untaxed, sums in the future (assuming a long future).  Converting on a year-by-year basis in retirement would be as close to having no benefit whatsoever as I could possibly imagine, as you have to pay taxes on the amount converted in the year it is converted -- instead, just withdraw (from the traditional IRA) and spend it, after paying the taxes.

[ultros1234]

Thanks folks. Let me clarify a couple of things:

• I'm about to turn 30 and my wife is a couple years younger. We're still paying off boatloads of student loan debt, and retirement is a ways off.
• I am assuming that our income will mostly continue to increase until we retire. But in retirement, I wouldn't imagine we'd take out enough money to put us in the 25% bracket most years.

Here's what I'm leaning towards: Unless I could transfer some of the Traditional IRA in the 15% bracket (maybe possible, since I was unemployed for about three months this year), I should probably hold onto the Traditional IRA until retirement and just draw directly from it then, rather than trying to move it to Roth. It would hurt me if I were withdrawing from the IRA after 59.5 and simultaneously working and earning income in a high bracket -- but in that case, I imagine I'd just sit on the IRA until I wasn't working anymore. Does that make sense?

And then there's the possibility that tax brackets will become less favorable after 2012:
http://www.mondaq.com/unitedstates/x/178778/Income+Tax/2013+Federal+Income+Tax+Update

[matchewed]

I am utterly perplexed as to the logic behind the suggestion.  The advantage of converting is that the income the converted (Roth) IRA generates will never be taxable.  Converting a small sum now should lead to noticeably larger, and untaxed, sums in the future (assuming a long future).  Converting on a year-by-year basis in retirement would be as close to having no benefit whatsoever as I could possibly imagine, as you have to pay taxes on the amount converted in the year it is converted -- instead, just withdraw (from the traditional IRA) and spend it, after paying the taxes.

Do some of the math on that one. Tax the amount needed to withdraw to have 25k income per year for 60 years. Then tax the lump sum necessary to provide 25k income per year for 60 years. You will probably pay less taxes on converting. I don't have time to outline the math atm.

The conversion on the year-by-year basis is meant to reduce the amount of taxes you pay as you will probably be (assuming you follow core tenets of Mustachianism) near poverty level. Another assumption is that taxes will be around the same as they are today.

My advice is just hold onto the Traditional IRA. It's not such a bad thing to have taxable and non-taxable accounts to draw on in retirement.

[darkelenchus]

Here's what I'm leaning towards: Unless I could transfer some of the Traditional IRA in the 15% bracket (maybe possible, since I was unemployed for about three months this year), I should probably hold onto the Traditional IRA until retirement and just draw directly from it then, rather than trying to move it to Roth. It would hurt me if I were withdrawing from the IRA after 59.5 and simultaneously working and earning income in a high bracket -- but in that case, I imagine I'd just sit on the IRA until I wasn't working anymore. Does that make sense?

Yes, this sounds reasonable. However, if you retire before 59 1/2 and want access to the money that's currently in your IRA, you'd have to convert it to a Roth and wait 5 years before you can take penalty-free withdrawals on the principle. In that case, you'd want to wait until you're in a lower tax bracket than you're in now (assuming this is possible) before converting, and you'll want to avoid converting so much that it bumps you into a higher tax bracket (since the converted money counts as standard income for tax purposes).

[mushroom]

I am utterly perplexed as to the logic behind the suggestion.  The advantage of converting is that the income the converted (Roth) IRA generates will never be taxable.  Converting a small sum now should lead to noticeably larger, and untaxed, sums in the future (assuming a long future).  Converting on a year-by-year basis in retirement would be as close to having no benefit whatsoever as I could possibly imagine, as you have to pay taxes on the amount converted in the year it is converted -- instead, just withdraw (from the traditional IRA) and spend it, after paying the taxes.

Do some of the math on that one. Tax the amount needed to withdraw to have 25k income per year for 60 years. Then tax the lump sum necessary to provide 25k income per year for 60 years. You will probably pay less taxes on converting. I don't have time to outline the math atm.

I agree that you shouldn't convert 1.5 million dollars into a Roth all in one year, and on a smaller scale potentially spread out conversions of smaller sums to a Roth with tax considerations in mind. But I think the point that Bogart and I are trying to make is that the main tax advantage of a Roth is the potential for tax-free growth over a long period of time. If you wait until a far-off retirement, convert just a small amount and then use it soon after you convert, you didn't really gain much from doing that and you might as well just spend it.

For example, I'll assume you have $10,000 in your traditional IRA right now. You retire in 22 years and let's say it's now $30,000 in today's dollars (assuming 5% interest beyond inflation). Assuming tax brackets remain the same, $4500 (15 percent of $30,000) is almost double 25 percent of $10,000. The difference becomes more marked the longer you wait, thanks to the beauty of compound interest. Then if you convert in retirement and end up using it 5 years later, all you gained from the conversion was not having to pay taxes on the interest for those 5 years, and you lost the flexibility to use it during those 5 years while you waited for it to season. So you do need to consider how far off retirement really is to figure out how many extra years of taxable interest growth you would have and how many years you would have post-conversion until you needed to use it. It may mean you don't end up converting at all and just withdrawing from it as you need it in retirement when you're in a lower tax bracket. But if you are going to convert, it may make more sense to do it sooner than later to get more of the benefits of long-term tax-free interest growth.

Also keep in mind that after the 5 years of seasoning, a Roth IRA offers a little more flexibility with early withdrawals and doesn't have the forced distributions of a traditional IRA. I think you first have to answer *why* you want to convert your IRA into a Roth - to meet which financial goals - and then decide on your timing based on that.

Sorry this got long-winded, but I'm not sure if I got my point across with my earlier post.

[mushroom]

Here's what I'm leaning towards: Unless I could transfer some of the Traditional IRA in the 15% bracket (maybe possible, since I was unemployed for about three months this year), I should probably hold onto the Traditional IRA until retirement and just draw directly from it then, rather than trying to move it to Roth. It would hurt me if I were withdrawing from the IRA after 59.5 and simultaneously working and earning income in a high bracket -- but in that case, I imagine I'd just sit on the IRA until I wasn't working anymore. Does that make sense?

Ha, I probably should have actually read this before I wrote my novel.  Yes, that definitely makes sense to me to just keep it as a traditional IRA.  But I would convert some of the traditional IRA in the 15% bracket to a Roth if you're able to.

[bogart]

Here's what I'm leaning towards: Unless I could transfer some of the Traditional IRA in the 15% bracket (maybe possible, since I was unemployed for about three months this year), I should probably hold onto the Traditional IRA until retirement and just draw directly from it then, rather than trying to move it to Roth. It would hurt me if I were withdrawing from the IRA after 59.5 and simultaneously working and earning income in a high bracket -- but in that case, I imagine I'd just sit on the IRA until I wasn't working anymore. Does that make sense?

Ha, I probably should have actually read this before I wrote my novel. 

No, thanks, you saved me the effort :) .

Yes, that definitely makes sense to me to just keep it as a traditional IRA.  But I would convert some of the traditional IRA in the 15% bracket to a Roth if you're able to.

Absolutely agree on the 15% part, and I expect taxes to go up in the future so might figure that into my thinking, though I realize the fully Mustachian rely on low expenditures/income to keep taxes low.

[ultros1234]

Thanks everyone! This has been super helpful to crystallize my thinking.

[JR]

As long as you have five years of living expenses available when you retire I would wait until then to do the conversion.  And then I would only do 1 year's living expenses per year after that.

I am utterly perplexed as to the logic behind the suggestion.  The advantage of converting is that the income the converted (Roth) IRA generates will never be taxable.  Converting a small sum now should lead to noticeably larger, and untaxed, sums in the future (assuming a long future).  Converting on a year-by-year basis in retirement would be as close to having no benefit whatsoever as I could possibly imagine, as you have to pay taxes on the amount converted in the year it is converted -- instead, just withdraw (from the traditional IRA) and spend it, after paying the taxes.

Bogart,
If you withdraw directly from the tradition IRA you must also account for the 10% penalty. 

Why shelter money from a 25% tax only to convert it all at one time and pay over 30% tax on it.  The benefit of the IRA to Roth conversion is being able to withdraw money from a pre tax retirement account at a (hopefully) lower rate than you put it in without waiting until 59.5.

[bogart]

Bogart,
If you withdraw directly from the tradition IRA you must also account for the 10% penalty. 

Why shelter money from a 25% tax only to convert it all at one time and pay over 30% tax on it.  The benefit of the IRA to Roth conversion is being able to withdraw money from a pre tax retirement account at a (hopefully) lower rate than you put it in without waiting until 59.5.

OK, a fair point on the 10% penalty, which I had not factored in. 

There remains the other potential benefit of the conversion, allowing the principal and its earnings to compound tax free over time, which what you are recommending doesn't really achieve (5 years not being very long).  But you are of course right that the accessibility of the money is improved by the conversion.