performing the retirement account to cash feat

[kingcanute]

So, I'm curious as to how the conversion from say a 401k to an IRA to a roth IRA to cash works in practice.  Especially for those trying to do this all tax free or very close to tax free.

I've converted a 401k to an IRA before, and it's not so tough, but the process of slowly converting that to a ROTH seems a little tricky. What is the actual current rule. I gather that the taxes I would have to pay during this conversion are capital gains. If I was actually doing this extreme early retirement thing, how would I compute how much I could convert - tax free. I believe I saw somewhere that you're capital gains up to a certain amount are tax free if you keep yourself in the lowest tax bracket. Also, what are the actual tools people use to do this conversion. I imagine, it's like you contact an IRA maintainer - say Ameritrade or Vanguard, fill out some forms, and then you hopefully you can do this fairly painlessly yearly when you log into your account.

So again a) how do you figure out how much you can convert from IRA to ROTH IRA tax free and b) what do you actually physically do when you perform this process.

[kingcanute]

Actually, let me add to my previous question. The transfer wouldn't be a capital gain - so how does this work again, If I'm ERE and I'm giving myself $25k a year, and I want to transfer $10k from an IRA to a ROTH IRA - how do I not consider this income I never paid taxes on and have to pay taxes on it at this point? How can I call this a capital gain?

[Eric]

It's actually not the capital gains tax rate, but the regular income tax rate.  Since the money goes into 401k/T-IRA tax free, it gets taxed at the income tax rate on the way out.  It's the same for withdrawing from your Traditional IRA or 401k upon reaching 59.5, so it's specific to the tax free account, not the conversion aspect of it.

So in this case, it's variable how much you can convert from 401k/T-IRA to Roth IRA tax free, based on your own exemptions and deductions.  If you're married, no kids, and take the standard deduction, that's a $12,200 standard deduction and 2 personal exemptions at $3900, so a total of $20,000 can be converted tax free.  (tax year 2013) Of course this will vary based on your own personal situation.

Edit to add links:
http://www.gocurrycracker.com/never-pay-taxes-again/
http://www.madfientist.com/traditional-ira-vs-roth-ira/

[the fixer]

I did a partial IRA to Roth conversion a few years ago, so maybe I can explain how it works. This is all from memory so it's possible I got a detail or two wrong, but the key takeaway is that it's easy.

To actually execute the transaction with Vanguard, all you do is use their "Exchange" interface that you'd use any time you wanted to rebalance. You sell some assets in your traditional IRA, and use them to buy assets in the Roth. As you go through the steps to execute the transaction, Vanguard sees that you're requesting a conversion and asks you questions about it, like how much federal and state income tax you want withheld. [ETA: make sure you withhold taxes if you will owe, or the IRS will asses a penalty for underpaid taxes]

Come tax time, Vanguard will send you a 1099-R showing the value of the assets that were rolled over and indicate that they were taxable, as well as the tax they withheld. You report this income on your 1040 with "(conversion)" written on the line. The 1040 instructions explain this. It gets treated as ordinary income. [ETA: you will also need to report the amount of tax withheld on page 2 of the 1040]

Vanguard will also send you a Form 5498 that's for the Roth. It explains how much you contributed to your Roth IRA the previous year and what the source of each contribution was, in this case a conversion from a traditional IRA. You need to keep this form! Vanguard doesn't provide it electronically and you may need it to make a tax-free distribution from the Roth 5 years later. This is the only proof you have of how the money got into your Roth. Form 5498 is not sent to the IRS like 1099's are, so they may ask you for a copy during a future audit.
[ETA: reference http://www.obliviousinvestor.com/should-i-keep-my-form-5498/]

I've never taken a Roth distribution so I don't know exactly how that works. I imagine it starts by telling Vanguard to sell something from the Roth IRA account and send me a check, but from there I don't know what will happen.

[kingcanute]

Thanks everyone, so I still don't understand something, in the hypothetical example where you're living off around $25k of interest, dividends, and capital gains, while also transferring just enough money from an IRA to a ROTH to stay within the 15% tax bracket.  How do you not pay the 15% on this transfer - if I transfer 10k, how do I not pay 1.5k - 15% of the transfer - while doing this transfer?

[seattlecyclone]

The capital gains/qualified dividends tax is essentially calculated after your tax on regular income. Suppose you have $15k of regular income (from a partial Roth conversion) and $20k of capital gains/qualified dividends. You'll calculate the tax on the $15k regular income first. This amount is less than the standard deduction and personal exemptions for a married couple, so you pay no tax on this amount.

Then you calculate the capital gains/qualified dividends tax. This $20k of income doesn't put your total income above the 15% bracket, so your capital gains tax rate is 0%, giving you a total tax bill of $0.

In fact, you could have had a total of $20k of regular income and $72.5k of dividend/capital gain income (as a married couple filing jointly with no dependents) and still have a total tax bill of $0. If you have some appreciated stock, you may wish to sell some up to this cap (and buy it back again right away) in order to lock in your gains at the crazy low 0% tax rate.

[kingcanute]

Thanks - the harvesting gains thing is super cool.