Oh goodness Nords, you just helped me identify the fact that I have so much more to learn. Where do I go to get smart on this conversion of Conventional IRA's to ROTH? I tried to read the IRS page about it but I couldn't grasp the "why" part of the exercise.
Please tell me if I understand this right...I have 100K in my TSP, and 100K in Roth IRA's...Dear husband, who is 7 years older than I, has a similar spread. When he retires and before my pension kicks in, we are hoping to be in e 15% tax bracket, and could begin converting his TSP's into Roth IRA's in 5K increments (as dictated by law). I could start mine 7 years later.
I'll describe the logic and the mechanics, but first let me talk about the risks when you do not convert. Maybe that'll help answer the "Why".
One risk is higher taxes. In the case of myself and my spouse, our current income is well into the 15% income tax bracket. When her pension starts in 2022, we'll be into the 25% income tax bracket. If we have a conventional IRA or a traditional TSP, then at age 70.5 (2032) we're required to take RMDs. This is taxable income (taxed at your income tax bracket) and the amount of the annual RMD is determined from tables provided by the IRS. If we had to take RMDs then we'd end up paying income taxes on our IRA or TSP withdrawals at the 25% rate. One way to avoid that fate is to convert those accounts now into a Roth IRA. By converting now, a little every year, we can pay taxes at the 15% rate today instead of at the 25% rate later.
Another risk is taxes on your Social Security distributions. RMDs add more taxable income to your tax return, and that quickly subjects your Social Security to taxation. Converting a conventional IRA (or a traditional TSP/401(k)) to a Roth IRA avoids RMDs, which reduces your taxable income, and reduces the amount of SS that might be subject to tax.
Those are the risks if you do not do a conversion. Now I'll describe a few risks that could happen even if you do a conversion.
The biggest risk of converting is political risk. For example, last year Congress proposed adding RMDs to Roth IRAs. Even though a Roth IRA withdrawal is not taxed after age 59.5, they still want people to spend them down. The "concern" is that retirees are holding on to Roth IRAs and not spending them, then letting their heirs spend them tax-free. Congress wants to "stimulate the economy" by forcing people to take RMDs from their Roth IRAs and either put the money back into taxable accounts or spend it on the economy.
Another political risk is that Congress might someday change the tax code to make Roth IRAs subject to tax after all. Ideally we'd all be grandfathered if we'd already paid taxes to convert to a Roth IRA, but the whole concept of political risk is that you can't predict how bad it will be.
Another (political) risk is that tax rates might actually go down. What if Congress changed the tax law so that conventional IRA withdrawals (and traditional TSP/401(k) withdrawals) are only taxed at 10% or even not taxed at all? Us conversion zealots would look pretty stupid for paying taxes before we had to.
I'm going to deal with the risks that I can predict, and I'm ignoring the unpredictable political risks.
Now here's the logic behind the conversions. If any of this is confusing, then see a fee-only CFP or a tax CPA to walk through the process with your own numbers.
Annual Roth IRA conversions have to be done before 31 December (You have a few more business days...) Around November you'll predict your total income for the year (salary, interest, dividends, mutual fund distributions, rental property, self-employment income) and then subtract your deductions and exemptions. (Most capital gains are taxed separately and not included in this rough estimate.) Ideally your taxable income will be below the top of the 15% income tax bracket. You'll convert an amount of your traditional IRA to a Roth IRA to bring you to the top of the 15% tax bracket. For myself and my spouse that usually results in a conversion of about $10K-$15K of conventional IRA principal which is taxed as regular income.
TSPs are a little tougher, and I'm only familiar with the rules for a military TSP (not a civil-service TSP). After leaving the military, veterans can make one partial TSP withdrawal (or rollover) before making their final TSP decision (like a second rollover, or RMDs, or buying an annuity). The idea is that you leave your investments in the TSP to compound for as long as possible with the low expense ratios. So next year I'm going to roll over part of our traditional TSP to a conventional IRA and then start converting that conventional IRA to a Roth IRA. If we do a little every year then we'll still pay taxes in the 15% bracket.
I'm not sure when you could start rolling over your traditional TSP accounts. You might have to be out of the civil service to do so (and you'd definitely have to be out of the military). I'm not sure about the $5K increments, either, but I'm not familiar with the civil-service TSP. Once you've rolled a traditional TSP over to a conventional IRA then you can convert any amount of your conventional IRA that you want to a Roth IRA.
So if I execute as many of these conversions as I can while we are still in the 15% bracket, we pay our taxes while they are cheap, and give ourselves lots of tax free money's to play with down the road, as long as we wait until 59-1/2 to start using any funds in the Roth IRA...and by then, we will likely be back up into the 25% tax bracket, so limiting our taxable income is key. Do I have that right?
Yes.
Just so you know, you can withdraw your Roth IRA contributions anytime for any reason, tax-free and penalty-free, and before age 59.5.
In addition, five tax years after you convert an amount to a Roth IRA, then you can also withdraw that amount (but not its gains, just the original principal) tax-free and penalty-free before age 59.5. It's referred to as a Roth IRA conversion ladder (because you have to wait five tax years after conversion). Here's the best description I've ever read: from CFP Michael Kitces, complete with links to the actual tax code:
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/Again, if anything in this article is confusing then show it to your CFP or CPA.
What if our income stays solidly in the 25% bracket regardless of conversions...is there any benefit to conversions at that point (other than paying taxes now so you dont pay them later?)
You have that right-- there's no benefit to conversions if you stay in the 25% tax bracket.
Unless you're worried that years down the road, your RMDs might subject your SS to taxation or even push you into the 28% income-tax bracket.
Good problems to have.
