Author Topic: Roth Conversion  (Read 6107 times)

iamsoners

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Roth Conversion
« on: March 27, 2012, 12:33:15 PM »
Hi all, I'm wondering if you all can help me do the math on a Roth conversion.

I'm sitting on a medium sized IRA that I'm thinking of converting (about 20% of our total invested assets) to a Roth.  The tax hit would be significant, but nothing I can't pay for out of pocket.  A generous family member who wants to encourage me to save is offering to pay half the taxes when I convert the IRA.  Great deal, right?

But, I think that my 2012 taxes will be very high and 2013 should be significantly lower.  I expect for both my husband and I to have lower incomes next year as we switch to a different job market/location and consider one of us staying home with our child.  Furthermore I except we'll have many more deductions next year (baby, house).

Of course taxes may well go up in 2013 however I think our decreased income and increased deductions will make up for that.

All that said, I think my relative's offer may only be on the table for 2012.  Do I take it, or do I wait?  I have the nagging feeling that there's something that expires in 2012 that incentives doing this now but I can't seem to locate anything other than the tax cut expiration.

sol

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Re: Roth Conversion
« Reply #1 on: March 27, 2012, 12:53:20 PM »
I don't know of any expiring tax rules that would incentivise this for 2012.  I suspect your generous relative is merely trying to motivate you to do it sooner rather than procrastinate.

 

I bet if you explain to him/her that you really like the idea of converting to a Roth but that your tax liability will be significantly lower next year, saving you even more money, they might extend the offer.  If they are really acting out of your best interest, they should support such a decision.

 

One alternative is to do half and half.  You can convert to a Roth more than once, so you could do part of this year, enough to reach the top of your current tax bracket, and save the rest for next year when you're in a lower bracket.

 

Just out of curiosity, why are you converting to a Roth?  If you currently have a high savings rate and plan to retire in a lower tax bracket, the traditional IRA is probably a better option than a Roth IRA.   Roths are for people who will work long careers, not the ERE set.


iamsoners

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Re: Roth Conversion
« Reply #2 on: March 27, 2012, 02:52:10 PM »
Is the argument against Roths for EREs that we're in higher tax brackets now than we will be once we retire and we can do gradual conversions for withdrawal?  Certainly something for me to think about.

I like the idea of having tax-free growth and the freedom that Roth gives, plus ability to leave an estate if I ever get to that point.  But I think you're right, Roth-ing is something I did because I've always been very good at personal finance from a work-until-you're-65-and-retire-with-multi-millions-perspective.  Since I'm switching to an MMM perspective, I need to re-orient and analyze that thinking.

It would make for a good set of posts by MMM on what traditional financial advice is good for most people but not for us--maybe that already exists, I'll cruise the archives.

Jarvis

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Re: Roth Conversion
« Reply #3 on: March 27, 2012, 03:29:40 PM »
Just out of curiosity, why are you converting to a Roth?  If you currently have a high savings rate and plan to retire in a lower tax bracket, the traditional IRA is probably a better option than a Roth IRA.   Roths are for people who will work long careers, not the ERE set.

I've read your comments in a few places around the forum on this topic Sol, and I'm learning a lot from them.  I'm ready to switch my contributions from a Roth IRA to a traditional IRA, based on the following information:

-My taxable income is rising substantially this year and next year, firmly into the 28% bracket.
-I plan to retire early on an income at or below the 15% tax bracket.

If I choose a traditional IRA now, I avoid paying the 28% tax rate on $5,000.  After early retirement, I could convert the funds to a Roth IRA, paying, at most, the 15% rate.    Once in a Roth IRA, I've established the 5-year pipeline for withdrawing the principal penalty free.

Am I missing anything?  If I've got this right, I should switch my IRA contributions today.

sol

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Re: Roth Conversion
« Reply #4 on: March 27, 2012, 05:33:06 PM »
I've read your comments in a few places around the forum on this topic Sol, and I'm learning a lot from them.

Lol, don't take my advice as gospel.  I'm not a tax professional, and I've been learning this stuff right along with everyone else here over the past few months.

I'm personally still contributing the tiny max per year to my Roth IRA, as I have been for so many years, mostly out of habit.  I always thought of it as "tax diversification" but this new plan to retire before traditional retirement age was kind of thrust upon me by rising income and it has pushed me to really look at the tax implications of my investment strategy.  The more I read, the less I'm liking the Roth IRA.

Can somebody else here, more knowledgeable or insightful than me, offer up a good defense of the Roth over a traditional IRA for people with high savings rates and early retirement plans?

For example, is it like the Roth in that you can withdraw principle at any time?  Can you roll over a traditional IRA into a Roth IRA (while paying the taxes) in the same way that you can roll a 401k into a Roth IRA, to build that 5 year pipeline?  Is the regular penalty-free withdrawal age the same?  These are questions I can look up myself, but I thought someone here might chime and save me the trouble.

iamsoners

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Re: Roth Conversion
« Reply #5 on: March 28, 2012, 08:24:50 AM »
I'll take a stab at that.  Here are my thoughts on why a Roth sometimes outweighs a regular IRA for MMMs:

Better for long term savings.
A Roths growth will never be taxed.  Assuming the stock market grows at 7%, once you've kept your money in there for 8 to 10 years (for the 25% and 28% brackets respectively), you're overcoming the initial higher taxes via non-taxed growth (assuming you slip down to the 15% bracket)

Extra savings option
Traditional IRAs are not available to people already offered an employer plan (401k, 403b, etc.).  The Roth allows you to squirrel away an extra sum.

Much greater flexibility
Contributions can be withdrawn tax and penalty free for ANY reason.  Traditional IRA's have many more restrictions.

You'll need some Roth money to get started
If you're planning on utilizing some sort of Roth conversion strategy during the MMM phase, you'd need at least five times that yearly sum already in your Roth when you enter retirement.

Protection against future tax increases
Consensus seems to be that there's no where to go but up with the tax rates.  Relying on the aforementioned rollover strategy leaves you vulnerable to tax law changes.  Hell, they could even do away with Roth conversions at some point.

Self-Life-Insured?
There also might be an argument that this acts as good life insurance, especially for those with children, as, I believe, the money passed on to anyone would be tax free.  Once the stache is big enough, you're basically self-insured.  But I'm too young to be an expert on the estate side of things, so I may be wrong?

Not subject to Required Minimum Distributions
Again, I'm not an expert on the later in life stages of investing but I could see how being told you must withdrawal x amount from your plan every year could mess with your ERE math.

Finally, one of my biggest reasons for building Roths is that I just think it's generally wise to have a mix of types of assets available in ERE.  So, those are my reasons--I'm really not an expert though!  And I'll be giving more thought to how/why a conversion strategy might be a better option for me.

Jarvis

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Re: Roth Conversion
« Reply #6 on: March 28, 2012, 08:45:13 AM »
Extra savings option
Traditional IRAs are not available to people already offered an employer plan (401k, 403b, etc.).  The Roth allows you to squirrel away an extra sum.

I hadn't heard of this one - if this is the case, I'm disqualified from the traditional IRA.

I did some research, and from what I can find, you are not ineligible to contribute to a traditional IRA if you use a 401k, but the limits to your modified adjusted gross income for qualification are lowered.  This article was helpful: http://swold.hubpages.com/hub/can-you-have-a-401k-and-an-ira-at-the-same-time

I also found a very useful image at http://iracontributionlimits2010.com/ira-contribution-cheat-sheet-2012/, shown below:



Looks like a traditional IRA isn't an option for me after all!
« Last Edit: March 28, 2012, 08:49:47 AM by Jarvis »

sol

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Re: Roth Conversion
« Reply #7 on: March 28, 2012, 09:00:34 AM »
That chart seems to suggest that people who have employer sponsored 401k type plans can still be eligible for a traditional IRA if their income is low enough.

It shouldn't be that difficult for a hard core mustachian couple earning less than 92k total to put away 17k each in their 401k and 5k each in a traditional IRA.  That's 48% of their income they could shelter from taxes. 

Does anyone know what the withdrawal and rollover rules for a traditional IRA are?

velocistar237

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Re: Roth Conversion
« Reply #8 on: March 28, 2012, 10:30:02 AM »
Better for long term savings.
A Roths growth will never be taxed.  Assuming the stock market grows at 7%, once you've kept your money in there for 8 to 10 years (for the 25% and 28% brackets respectively), you're overcoming the initial higher taxes via non-taxed growth (assuming you slip down to the 15% bracket)

The money you put into a Roth is taxed. The money you draw out of a Traditional is taxed. The whole amount is taxed, it's just a matter of when.

For example, assume an amount A, a flat tax T, and a growth of G. When you receive A as income, it gets taxed to A*(1-T). Put that into a Roth, and eventually, it grows to A*(1-T)*G. If you use a Traditional IRA instead, amount A goes into the account. It grows to A*G. It then gets taxed to A*G*(1-T), the same amount as the Roth.

This is why the tax rate is what matters. You get taxed now or later. However, if you're taxed now, you're taxed at your marginal rate. If you're taxed later, you get the standard deduction, then the lowest rate, etc. The tax rates in the lowest brackets would have to increase by a lot in order for a Roth to beat a Traditional.

Still, a Roth is better than a taxable account.

I also found a very useful image at http://iracontributionlimits2010.com/ira-contribution-cheat-sheet-2012/, shown below:

Wow, it looks like a Traditional IRA is an option for me. I hadn't re-figured this since I got married. Thanks for the link. I need to think about this.

iamsoners

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Re: Roth Conversion
« Reply #9 on: March 28, 2012, 11:16:53 AM »
@Jarvis--Yes, I'd forgotten there was a phase out for this...  good call

@Sol--Distribution rules for Traditional IRAs: http://www.investopedia.com/university/retirementplans/ira/ira3.asp

@velocistar237  I had to whip out my graphing calculator for that one but, despite my initial skepticism, you're right.  So I guess that eliminates the Better for Long Term Savings argument.  Played around with the graphs a bit more and realized that tax rates on the current 15% bracket would have to rise to 33% to make this scenario favor the Roths.  Not going to happen.  So that eliminates the hedge against future tax increases argument.  I guess the one argument in favor of the Roth that this did bring up for me is the ability to save a larger amount up front by pre-paying taxes when you have a high income.  It's probably not right for everyone to Roth just because of that but it might make sense if you've maxed everything else and are still looking for tax-advantaged options.  I'd welcome anyone else's review of all this math though--my math skills are a bit dusty.