401K to IRA to Roth... and effective tax rates

[Frankies Girl]

I've been reading over at the Mad Fientist about converting your 401k over to a Roth to avoid paying any taxes whatsoever, and it sounds awesome and like something I'd be well-placed to take advantage of in a few years.

I just checked and my effective tax rate for 2012 was 8.75%. We had some large medical expenses (had the money, did not go into debt) so that allowed us to itemize and got us a pretty nice refund (usually end up in the 15% rate and owing about $100-200). We had the same expenses for 2013, so will likely have a repeat for the taxes this year, but after that, it will be back to the low end of the 15% range until we retire.

It looks like we will not be taxed on any capital gains or dividends either as most of our holdings are in tax sheltered accounts, but I do have about $325K in a taxable account, and all of it is in the Spartan total stock market index fund (FSTVX) with low turnover. This is what we'll be tapping in the early days of retirement...

So basically, I could take a payout as income on the IRA, up to 11,000 (spread between both of our Roths) and still take somewhere in the neighborhood of $30-40K as dividend/cap gains out of the taxable to live on, do that every year, pay NO taxes since we'd be in the 15% effective tax rate, and the Roth money would be no tax when we get to the point of needing to withdraw as well? And there is no penalty for early withdrawal for shifting the traditional IRA money into the Roths?

Is there anything I'm missing on how this works? It almost seems too easy.

[xocotl]

So basically, I could take a payout as income on the IRA, up to 11,000 (spread between both of our Roths) and still take somewhere in the neighborhood of $30-40K as dividend/cap gains out of the taxable to live on, do that every year, pay NO taxes since we'd be in the 15% effective tax rate, and the Roth money would be no tax when we get to the point of needing to withdraw as well? And there is no penalty for early withdrawal for shifting the traditional IRA money into the Roths?

From my understanding of it, the $5,500/yr/person limit is only for contributions and doesn't apply to conversions, so you should be able to convert more than $11,000/yr. You just want to keep it below about $20,000 (standard deduction + exemptions, assuming you take the standard deduction) to avoid paying taxes.

[beltim]

I'm confused - the Mad Fientist strategies relies on a 0% tax rate.  If you stay in the 0% tax bracket, yes, you can convert it over to a Roth IRA.  If you're in the 15% tax bracket, you'll pay taxes on the conversion.

[Frankies Girl]

I'm confused - the Mad Fientist strategies relies on a 0% tax rate.  If you stay in the 0% tax bracket, yes, you can convert it over to a Roth IRA.  If you're in the 15% tax bracket, you'll pay taxes on the conversion.

I may be muddling my thought process, but according to this post http://www.madfientist.com/traditional-ira-vs-roth-ira/
there's no mention of having to be a 0% tax rate to get this to work. He also links to this calculator so you can fuss with the numbers, and even at a 15% tax rate, I can still pay 0 in taxes... I went up to $20,000 in the taxable wages (the IRA-> Roth part) with close to $70K in dividends and long-term cap gains, and it was still showing me at 15% tax rate, with nothing owed in taxes. (Link is using 2012 rules)
https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

Early retirees are usually able to live on modest amounts of income that generally come from tax-efficient sources like long-term capital gains and dividends. Long-term capital gains and dividends aren’t taxed at all unless you are in the 15% tax bracket or above. That means someone could happily live off of $45,000 of long-term capital gains and dividends without paying income tax.

So that takes care of the cap gains and dividends that we'll actually be living on, all the while shifting over $10-15K or so to our Roths. I can't find an exact link that explains why it said "cap gains and dividend aren't taxed at all unless you are in the 15% bracket or above" and yet with a 15% effective tax rate (which does sound like I should be taxed at least a little), but I'm seeing zero taxes owed, so I'll probably need to do some more investigating unless someone else can point me in the right direction.

[msilenus]

Would you mind providing some links to the MF articles you're discussing?  I'm having trouble following along, but the general thrust of this discussion sounds really interesting.

EDIT: Sorry, I found the link in past posts.  Apologies for missing it so many times:
http://www.madfientist.com/traditional-ira-vs-roth-ira/

[beltim]

I'm confused - the Mad Fientist strategies relies on a 0% tax rate.  If you stay in the 0% tax bracket, yes, you can convert it over to a Roth IRA.  If you're in the 15% tax bracket, you'll pay taxes on the conversion.

I may be muddling my thought process, but according to this post http://www.madfientist.com/traditional-ira-vs-roth-ira/
there's no mention of having to be a 0% tax rate to get this to work. He also links to this calculator so you can fuss with the numbers, and even at a 15% tax rate, I can still pay 0 in taxes... I went up to $20,000 in the taxable wages (the IRA-> Roth part) with close to $70K in dividends and long-term cap gains, and it was still showing me at 15% tax rate, with nothing owed in taxes. (Link is using 2012 rules)
https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

Early retirees are usually able to live on modest amounts of income that generally come from tax-efficient sources like long-term capital gains and dividends. Long-term capital gains and dividends aren’t taxed at all unless you are in the 15% tax bracket or above. That means someone could happily live off of $45,000 of long-term capital gains and dividends without paying income tax.

So that takes care of the cap gains and dividends that we'll actually be living on, all the while shifting over $10-15K or so to our Roths. I can't find an exact link that explains why it said "cap gains and dividend aren't taxed at all unless you are in the 15% bracket or above" and yet with a 15% effective tax rate (which does sound like I should be taxed at least a little), but I'm seeing zero taxes owed, so I'll probably need to do some more investigating unless someone else can point me in the right direction.

Oh, I think I see.  To me it looks like your calculation of the tax you owe is correct, but the Turbotax calculator is leading you astray when it comes to the marginal tax rate.  Your marginal tax rate in this case is 0% – as a test, add $1000 and see what the difference in tax is.  If the difference in tax is 0, then your marginal tax rate is 0.  And you do, in fact, need a marginal tax rate of 0 to make the Mad Fientist strategy work.

[xocotl]

I'm confused - the Mad Fientist strategies relies on a 0% tax rate.  If you stay in the 0% tax bracket, yes, you can convert it over to a Roth IRA.  If you're in the 15% tax bracket, you'll pay taxes on the conversion.

I may be muddling my thought process, but according to this post http://www.madfientist.com/traditional-ira-vs-roth-ira/
there's no mention of having to be a 0% tax rate to get this to work. He also links to this calculator so you can fuss with the numbers, and even at a 15% tax rate, I can still pay 0 in taxes... I went up to $20,000 in the taxable wages (the IRA-> Roth part) with close to $70K in dividends and long-term cap gains, and it was still showing me at 15% tax rate, with nothing owed in taxes. (Link is using 2012 rules)
https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

Early retirees are usually able to live on modest amounts of income that generally come from tax-efficient sources like long-term capital gains and dividends. Long-term capital gains and dividends aren’t taxed at all unless you are in the 15% tax bracket or above. That means someone could happily live off of $45,000 of long-term capital gains and dividends without paying income tax.

So that takes care of the cap gains and dividends that we'll actually be living on, all the while shifting over $10-15K or so to our Roths. I can't find an exact link that explains why it said "cap gains and dividend aren't taxed at all unless you are in the 15% bracket or above" and yet with a 15% effective tax rate (which does sound like I should be taxed at least a little), but I'm seeing zero taxes owed, so I'll probably need to do some more investigating unless someone else can point me in the right direction.

It think the confusion comes from the fact that tax brackets are usually referred to by their rate for regular income. If you're in the "15%" bracket, your rate on long term capital gains is 0%. Brackets get filled up by regular income first, and then long term cap gains/dividends.

So in terms of tax buckets you have the following:

Deductions/Exemptions - 0% regular/0% cap gains
10% bracket - 10% regular/0% cap gains
15% bracket - 15% regular/0% cap gains
25% bracket - 25% regular/15% cap gains

So you pay zero tax as long as your regular income is less than your deductions and exemptions, and your regular income + cap gains/dividends is less than the top of the 15% bracket.

I don't have a pointer to a concise official summary of how this works, but if you have a lot of patience you can figure it out by looking at the intructions for the Schedule D Tax Worksheet in the 1040 Schedule D instructions from the IRS.

[Frankies Girl]

Okay, I think I'm getting it now! I did get the terminology muddled. ;)
Thanks beltim and xocotl!

I am still amazed at how this will work out. So not only am I reducing my taxable income NOW, I'm going to eliminate income tax completely in retirement... that is a sweet deal!