Author Topic: Roth conversion ladder, why not start early?  (Read 1917 times)

Penn42

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Roth conversion ladder, why not start early?
« on: March 28, 2018, 01:18:16 PM »
I've been thinking...

What rule is in place (there must be one) or misunderstanding I have that would prevent/make starting a Roth conversion ladder early a bad idea?

I'm going to be considerably below the 22 percent bracket this year, why not round it out with a Roth conversion?  I could continue doing this until I can't feasibly stay below the 22 percent bracket, right? 

Is there a rule how long your contributions have to be in the tIRA before you can convert?  Seems to me converting previous year's tIRA contributions this year would just help with cashflow once I'm actually close to FIRE.  I'm not close at all, but why not?

I know you can only touch any principle after 5 years, but I kind of assumed that when doing a Roth conversion the total converted wouldn't be considered all principle anyway.  E.g. if I made 5500 in tIRA contributions year 1, and now in year 2 that 5500 turned into 5800, which I converted, five years after the conversion I'd still only be able to access 5500, right?

Eric

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Re: Roth conversion ladder, why not start early?
« Reply #1 on: March 28, 2018, 02:33:57 PM »
You'd have to use actual numbers to know for sure, but I think you're going to end up paying more in taxes this way.  The 12% bracket is up to $38,700 for single filers.  Add in the $12k standard deduction, and you can have $50,700 in income and have a 12% top marginal rate.

If your projected income in retirement is less than $50,700, then you'd likely be better off waiting to pay.  You could lock in a 12% rate now, or if your conversion amount in retirement is $30k, for example, then you would end up paying 0% on the first $12k, 10% on the next $9525, and 12% on the remaining $8475.  That's a total tax of $1969.50, or 6.57%.

appleshampooid

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Re: Roth conversion ladder, why not start early?
« Reply #2 on: March 28, 2018, 03:17:14 PM »
I know you can only touch any principle after 5 years, but I kind of assumed that when doing a Roth conversion the total converted wouldn't be considered all principle anyway.  E.g. if I made 5500 in tIRA contributions year 1, and now in year 2 that 5500 turned into 5800, which I converted, five years after the conversion I'd still only be able to access 5500, right?
I believe you are incorrect on this - when doing a tIRA -> Roth IRA conversion, the full amount of the conversion becomes your Roth Basis that is available for withdrawal in 5 years. I have not actually done any of said conversions or withdrawals but that is my understanding.

The one I still don't have a sound answer to is a Roth -> Roth conversion, e.g. from a Roth 401(k) to a Roth IRA. I have gotten conflicting answers searching this board, Bogleheads, other places. Have a folder full of links that I haven't read through again to try to settle it for good.

josh4trunks

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Re: Roth conversion ladder, why not start early?
« Reply #3 on: March 28, 2018, 04:11:48 PM »
I know you can only touch any principle after 5 years, but I kind of assumed that when doing a Roth conversion the total converted wouldn't be considered all principle anyway.  E.g. if I made 5500 in tIRA contributions year 1, and now in year 2 that 5500 turned into 5800, which I converted, five years after the conversion I'd still only be able to access 5500, right?
I believe you are incorrect on this - when doing a tIRA -> Roth IRA conversion, the full amount of the conversion becomes your Roth Basis that is available for withdrawal in 5 years. I have not actually done any of said conversions or withdrawals but that is my understanding.

The one I still don't have a sound answer to is a Roth -> Roth conversion, e.g. from a Roth 401(k) to a Roth IRA. I have gotten conflicting answers searching this board, Bogleheads, other places. Have a folder full of links that I haven't read through again to try to settle it for good.

@Penn42 is correct incorrect (I read his post wrong!).
The full amount converted (as @appleshampooid said) is available penalty free 5 years later. Any gains during that 5 year period would be considered earnings. During Roth withdrawals you always withdraw contribution, then conversions (oldest first), then earnings.
« Last Edit: March 28, 2018, 04:14:05 PM by josh4trunks »

DreamFIRE

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Re: Roth conversion ladder, why not start early?
« Reply #4 on: March 28, 2018, 04:20:55 PM »
The one I still don't have a sound answer to is a Roth -> Roth conversion, e.g. from a Roth 401(k) to a Roth IRA. I have gotten conflicting answers searching this board, Bogleheads, other places.
I've checked a few places and got consistent answers on that.  The converted funds inherit the holding period of the existing Roth IRA.  If you were starting a new Roth IRA for the conversion, then that would be 5 years.

https://www.investopedia.com/articles/retirement/09/roth-401k-rollover.asp
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

seattlecyclone

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Re: Roth conversion ladder, why not start early?
« Reply #5 on: March 28, 2018, 04:28:54 PM »
The one I still don't have a sound answer to is a Roth -> Roth conversion, e.g. from a Roth 401(k) to a Roth IRA. I have gotten conflicting answers searching this board, Bogleheads, other places.
I've checked a few places and got consistent answers on that.  The converted funds inherit the holding period of the existing Roth IRA.  If you were starting a new Roth IRA for the conversion, then that would be 5 years.

https://www.investopedia.com/articles/retirement/09/roth-401k-rollover.asp
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

Not quite.

For qualified distributions, yes, the amount of time you have had a Roth IRA specifically (as opposed to another type of Roth retirement account) does come into play. To take such a distribution you must have had the Roth IRA open for at least five years. But remember that the other requirement for a qualified distribution is that you also be either 59 years old, disabled, or dead.

The Roth ladder relies on the rules for non-qualified distributions, since many of us plan to withdraw well before turning 59 years old.

When it comes to early distributions, the amount of time that you have had a Roth IRA is completely irrelevant. You can make direct contributions to a brand new Roth IRA and withdraw them the next week completely tax-free. You have to wait five years to withdraw converted funds penalty-free, but again, this five year period has nothing to do with the time you had the account open; instead what matters here is how long ago you did the conversion.

When it comes to money rolled from a Roth 401(k) to a Roth IRA, 26 CFR 1.408A-10 comes into play, specifically Q/A 3 on that page. It states that whatever amount counts as an "investment in the contract" (usually your direct contributions to the Roth 401(k)) will count as a contribution for the purpose of the Roth IRA withdrawal ordering rules, and the remaining balance will count as earnings.

DreamFIRE

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Re: Roth conversion ladder, why not start early?
« Reply #6 on: March 28, 2018, 06:32:58 PM »
For qualified distributions, yes, the amount of time you have had a Roth IRA specifically (as opposed to another type of Roth retirement account) does come into play.
The member I responded to specifically stated, "Roth IRA."  And this is what I was saying above about it inheriting the holding period of the existing Roth IRA for qualified no-penalty distributions.

Quote
You have to wait five years to withdraw converted funds penalty-free, but again, this five year period has nothing to do with the time you had the account open; instead what matters here is how long ago you did the conversion.
Those conversions are for non-Roth accounts, like a traditional 401K being converted to a Roth IRA, but the member I responded to had specifically stated, "Roth 401k to Roth IRA," so traditional 401K to Roth conversions are not relevant.

More on this, which Kitces links to:
https://www.law.cornell.edu/cfr/text/26/1.408A-6
https://www.law.cornell.edu/cfr/text/26/1.402A-1
« Last Edit: March 28, 2018, 06:41:25 PM by DreamFIRE »

DreamFIRE

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Re: Roth conversion ladder, why not start early?
« Reply #7 on: March 28, 2018, 07:03:53 PM »
I know you can only touch any principle after 5 years, but I kind of assumed that when doing a Roth conversion the total converted wouldn't be considered all principle anyway.  E.g. if I made 5500 in tIRA contributions year 1, and now in year 2 that 5500 turned into 5800, which I converted, five years after the conversion I'd still only be able to access 5500, right?
I believe you are incorrect on this - when doing a tIRA -> Roth IRA conversion, the full amount of the conversion becomes your Roth Basis that is available for withdrawal in 5 years. I have not actually done any of said conversions or withdrawals but that is my understanding.
You are correct about this.

Penn42 is correct incorrect (I read his post wrong!).
The full amount converted is available penalty free 5 years later. Any gains during that 5 year period would be considered earnings. During Roth withdrawals you always withdraw contribution, then conversions (oldest first), then earnings.
You are correct in your comments, but the last two statements were not relevant to Penn42 because his gains were while the money was still in the tIRA prior to the 5 year period, so they would not be treated as earnings in the Roth.

seattlecyclone

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Re: Roth conversion ladder, why not start early?
« Reply #8 on: March 28, 2018, 07:04:54 PM »
For qualified distributions, yes, the amount of time you have had a Roth IRA specifically (as opposed to another type of Roth retirement account) does come into play.
The member I responded to specifically stated, "Roth IRA."  And this is what I was saying above about it inheriting the holding period of the existing Roth IRA for qualified no-penalty distributions.

Right, but the thread was about doing the Roth conversion ladder, so talking about qualified distributions from the Roth IRA is a tangent at best; the whole reason to do the Roth ladder is because you aren't old enough to make qualified distributions!

Penn42

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Re: Roth conversion ladder, why not start early?
« Reply #9 on: March 29, 2018, 10:41:37 AM »
I know you can only touch any principle after 5 years, but I kind of assumed that when doing a Roth conversion the total converted wouldn't be considered all principle anyway.  E.g. if I made 5500 in tIRA contributions year 1, and now in year 2 that 5500 turned into 5800, which I converted, five years after the conversion I'd still only be able to access 5500, right?
I believe you are incorrect on this - when doing a tIRA -> Roth IRA conversion, the full amount of the conversion becomes your Roth Basis that is available for withdrawal in 5 years. I have not actually done any of said conversions or withdrawals but that is my understanding.

Ok, with that correction it definitely makes sense to me that letting a tIRA grow before a conversion could be advantagous. 

The rest of this thread has gone to places I didn't even know existed, but I'm glad for the discussion anyway.  More learning using bad.

josh4trunks

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Re: Roth conversion ladder, why not start early?
« Reply #10 on: March 29, 2018, 12:07:32 PM »
I know you can only touch any principle after 5 years, but I kind of assumed that when doing a Roth conversion the total converted wouldn't be considered all principle anyway.  E.g. if I made 5500 in tIRA contributions year 1, and now in year 2 that 5500 turned into 5800, which I converted, five years after the conversion I'd still only be able to access 5500, right?
I believe you are incorrect on this - when doing a tIRA -> Roth IRA conversion, the full amount of the conversion becomes your Roth Basis that is available for withdrawal in 5 years. I have not actually done any of said conversions or withdrawals but that is my understanding.
You are correct about this.

Penn42 is correct incorrect (I read his post wrong!).
The full amount converted is available penalty free 5 years later. Any gains during that 5 year period would be considered earnings. During Roth withdrawals you always withdraw contribution, then conversions (oldest first), then earnings.
You are correct in your comments, but the last two statements were not relevant to Penn42 because his gains were while the money was still in the tIRA prior to the 5 year period, so they would not be treated as earnings in the Roth.
I agree with everything you are saying. I just read things wrong originally, thought he was asking about gains after roth conversion.