Author Topic: Roth IRA Conversion Pipeline - When to start  (Read 4079 times)

LiseE

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Roth IRA Conversion Pipeline - When to start
« on: March 04, 2015, 11:32:40 AM »
My hubby (47) and I (48) are both working full time.  I'm planning on "retiring" from my corporate job in 2 years (when I'm 50).  My hubby loves his work and while he doesn't have plans to retire early I'm going to say he will retire from his corporate job in 7 years when he's 55. 

It isn't until he's retired in 7 years that we will need to start withdrawing from our 401K/IRA's .. so do we start the pipeline in 2 years?  If we started it earlier would we HAVE to start taking withdrawals?  Are there any advantages/disadvantages to starting the pipeline conversions sooner rather than later?


Mississippi Mudstache

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #1 on: March 04, 2015, 11:39:07 AM »
If your husband has a well-funded 401k, you shouldn't need the pipeline. You can start making penalty-free withdrawals from the 401k immediately if your husband retires at age 55. If that will tide you over until you're 59 1/2, then you're all set.

Gone Fishing

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #2 on: March 04, 2015, 11:46:15 AM »
If your husband has a well-funded 401k, you shouldn't need the pipeline. You can start making penalty-free withdrawals from the 401k immediately if your husband retires at age 55. If that will tide you over until you're 59 1/2, then you're all set.

This could work, but there are a few caveats.  This article lays them out pretty well:

https://www.expertplan.com/articles/a022001.jsp

Most early retirees in their 30's and 40's are unwilling to go with the substantially equal payment method for IRAs because it locks them into a set withdrawal schedule until 59.5, but for a 55 year old, the risk is minimal.

I would avoid starting a pipeline while your husband is still working if you can.
« Last Edit: March 04, 2015, 11:51:56 AM by So Close »

MDM

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #3 on: March 04, 2015, 12:02:34 PM »
If we started it earlier would we HAVE to start taking withdrawals?
No.  You don't have to take distributions from a Roth.

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Are there any advantages/disadvantages to starting the pipeline conversions sooner rather than later?
If you are trying to minimize taxes (vs. gaining access to funds as Miss. Mud. and So Close answered) then you want the conversions to occur when your taxable income will be lowest.

LiseE

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #4 on: March 04, 2015, 12:42:15 PM »
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If you are trying to minimize taxes (vs. gaining access to funds as Miss. Mud. and So Close answered) then you want the conversions to occur when your taxable income will be lowest.

I will have to re-read through this conversion process, but I thought you put monies into the Traditional IRA and then convert to ROTH very soon thereafter to minimize any capital gain that would be taxed?  Isn't it only the gain that is taxed when converting?

seattlecyclone

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #5 on: March 04, 2015, 12:57:41 PM »
Quote
If you are trying to minimize taxes (vs. gaining access to funds as Miss. Mud. and So Close answered) then you want the conversions to occur when your taxable income will be lowest.

I will have to re-read through this conversion process, but I thought you put monies into the Traditional IRA and then convert to ROTH very soon thereafter to minimize any capital gain that would be taxed?  Isn't it only the gain that is taxed when converting?

I believe you may be thinking of a backdoor Roth IRA. That's a strategy to put money in a Roth account when your income is too high to do so in the normal way. The way this works is that you put non-deductible contributions into a traditional IRA and then roll it over to a Roth account. As you say, the sooner you do the Roth conversion, the less tax you have to pay on this money because it has not had time to grow much (if at all).

The Roth pipeline, on the other hand, mostly applies to pre-tax money (i.e. contributions that you took a tax deduction for when you made them). The purpose of this is to get penalty-free access to these funds before age 59. See, normally when you withdraw pre-tax money from an IRA or 401(k) before age 59, you have to pay income tax on this money plus a 10% early withdrawal penalty. However you can convert this money to Roth at any time and only pay income tax (no penalty). Then if you wait at least five years before withdrawing the amount you converted, you can get that money out without paying the 10% penalty then either.

In a simplistic scenario where you're still working and you have all of your savings in pre-tax IRA/401(k) accounts, you would want to start the Roth pipeline five years before retirement. You would convert enough that year to cover your expected spending in your first year of retirement. Then four years before you retire you would convert enough to cover your expected spending in your second year of retirement, and so on until you convert enough for the fifth year of retirement during your last year on the job. After you retire you would continue this process until you turn 55, always converting enough to pay your bills five years in the future.

The problem with this is that you're doing Roth conversions for five years while you're still working -- this means you're likely paying tax at a pretty high rate on these conversions. Depending on your circumstances you may find that you would pay less to simply withdraw the money directly from your traditional IRA when you retire, paying the penalty and all.

Many of us are different from the "simple" scenario I laid out above. We may have taxable assets that we can spend for the first few years of retirement, which would reduce or eliminate the need to do Roth conversions while we're still working. We may already have contributed directly to a Roth account; these contributions can be withdrawn penalty-free at any time, which would also reduce the need to do Roth conversions while working.

In your case, if your husband leaves his job after turning 55 you can simply withdraw from the 401(k) without penalty at that time, so a Roth pipeline may not be a great idea for you. You may decide to do Roth conversions anyway to minimize future taxation on that money and reduce the likelihood of required minimum distributions, but the pipeline strategy as a way to gain early access to your money does not necessarily apply.

dividendman

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #6 on: March 04, 2015, 01:03:49 PM »
Quote
If you are trying to minimize taxes (vs. gaining access to funds as Miss. Mud. and So Close answered) then you want the conversions to occur when your taxable income will be lowest.

I will have to re-read through this conversion process, but I thought you put monies into the Traditional IRA and then convert to ROTH very soon thereafter to minimize any capital gain that would be taxed?  Isn't it only the gain that is taxed when converting?

That's only true if you contributed after tax dollars to your Trad IRA. If you got the deduction when contributing to your trad IRA and then convert it, it will all show up as regular income (including any, albeit minimal, gains).

LiseE

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #7 on: March 04, 2015, 01:20:28 PM »
Quote
I believe you may be thinking of a backdoor Roth IRA.

Yes, I got my backdoor and pipeline confused!  We are high income earners so yes, we need to explore the Backdoor Roth IRA process and not so much the pipeline. 

With the backdoor IRA/Roth .. we work to move our 401K monies into a Traditional IRA and then quickly to a Roth so we can withdraw tax free from the Roth, correct?  Or is it only the earned interest that is tax free?  If our 401K money is growing with pre-tax dollars, it's got to get taxed somewhere along the lines.  Having our money in the Roth lets it earn tax free, correct?

MDM

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #8 on: March 04, 2015, 02:14:25 PM »
Quote
I believe you may be thinking of a backdoor Roth IRA.
Yes, I got my backdoor and pipeline confused!
...
With the backdoor IRA/Roth .. we work to move our 401K monies into a Traditional IRA and then quickly to a Roth so we can withdraw tax free from the Roth, correct?
And pay taxes at the time of the bolded word on all your pre-tax 401k contributions and the returns from them.

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If our 401K money is growing with pre-tax dollars, it's got to get taxed somewhere along the lines.
Yes, see above. 

Quote
Having our money in the Roth lets it earn tax free, correct?
Yes, see above.

If you don't totally get it yet, re-read seattlecyclone's post above.  Put together a simple spreadsheet showing the various (e.g., pre-tax, after-tax, traditional, Roth, conversions, withdrawals, penalties) scenarios for your options.  If you can develop the spreadsheet correctly, then you likely understand the applicable rules - and vice versa.
« Last Edit: March 04, 2015, 02:25:59 PM by MDM »

LiseE

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #9 on: March 04, 2015, 02:22:49 PM »
Was reading a response on another post and it seems that all this Roth Conversion/Backdoor effort might not be necessary ... according to this other poster response, if your income (when in retirement) is in the 10-15% tax bracket then long term capital gains and dividends are taxed at 0% so why not just keep monies in a brokerage account.   Can also take advantage of losses with a brokerage account.

For married filing jointly, the max income is 73K.  We will be living well below that number in retirement so just keeping a brokerage account might be a strategy?


MDM

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Re: Roth IRA Conversion Pipeline - When to start
« Reply #10 on: March 04, 2015, 02:29:36 PM »
Was reading a response on another post and it seems that all this Roth Conversion/Backdoor effort might not be necessary ...
Correct.

A lawyer once told me that, in a contract, one can replace the word "may" with "may not" without changing the meaning.  Don't know if that is strictly true, but it has proven useful over the years as a way to analyze what people are saying.

As with many things in life, "it depends...".