Asset Allocation across the Roth Conversion Ladder

[fairfaxbiker]

Hello, I am early retired (thanks to the MMM face punch that it was possible) and have started the ladder but now am confused how to divide up my asset allocation across multiple conversion accounts.  I am 60/40 taxable and 85/15 tax deferred accounts.  I am wondering if the oldest conversion (2015) should hold my 15% bonds and the non-converted IRA or newest conversion (2018) should hold my equities?  Or do I build a three fund portfolio within each of the conversions?
Many thanks in advance.  I've been retired since 2014 and spend way too much time analyzing and second guessing all this stuff.  Ideally, I thought I would have my three fund portfolio of VTI/VXUS and BND set in taxable and non...set it and forget it but after a few years of conversions I am worried that I am not doing this right.  My biggest fear is keeping VTI in my oldest conversion (2015) and having it be cut in half by 2019 when I need it for spending money.  For clarification, I have enough taxable cash to cover me until 2019 and have that money invested 60/40.  Please advise...

[Monkey Uncle]

Assuming you are in the US, you'll want to minimize any bond holdings in your taxable account.  Interest payments from bonds in a taxable account get taxed as ordinary income, so they will use up some of your standard deduction space that you otherwise could use for Roth conversions at a 0% tax rate.  Conversely, selling stocks in your taxable account may generate capital gains, but those gains should be taxed at 0% if you are in the 12% tax bracket, and they do not use up standard deduction space (your Roth conversion takes precedence in occupying that space).  If your total asset allocation across all accounts gets too bond-heavy because you are spending down stocks from your taxable account, then you can sell some of the bonds in your IRAs (either Roth or traditional, doesn't matter) and re-invest the proceeds in stocks. 

Edit: Sorry, wasn't paying attention to the fact that you already have a substantial amount of bonds in your taxable account.  In that case, you'll have to evaluate your cost basis to see if it is worthwhile re-allocating those into stocks.  If you have a huge capital gain in those bond funds, you may not want to do that all at once.  In which case I would suggest just living off of those taxable bond funds to draw that allocation down gradually.

[Eric]

Normally I would say that you should view your portfolio as one whole entity, and the individual make up of each portion is not nearly as important as making sure that the total matches to your desired asset allocation.  But you raise an interesting point that I hadn't really considered.  If it worries you, you can easily swap out a portion of your stock holdings for bond holdings from that oldest conversion amount.  That's probably a good idea to reduce the volatility of that conversion, since you know you'll need to access it in a couple of years.  I'll be interested to hear what others do as well.

[fairfaxbiker]

Thank you both for your responses.  My original question really was about where in my Roth ladder to put the safer investments.  My thought was to keep the 15% bond allocation in the conversions that are most ready to harvest (oldest) and equities as far out in the pipeline as possible.  OR should I keep a "mini-three fund portfolio" inside each and every rung of the ladder?

[Monkey Uncle]

Thank you both for your responses.  My original question really was about where in my Roth ladder to put the safer investments.  My thought was to keep the 15% bond allocation in the conversions that are most ready to harvest (oldest) and equities as far out in the pipeline as possible.  OR should I keep a "mini-three fund portfolio" inside each and every rung of the ladder?

My understanding is that withdrawals from a Roth are always considered to come from your contribution/conversion basis first.  So it's all invested according to your target asset allocation, and you withdraw from stocks or bonds according to whichever asset class needs rebalancing.  There's no physical separation of the rungs of the ladder within your account.  Invest according to your asset allocation, and withdraw in a manner that maintains that allocation.  The withdrawals are always considered basis first, as long as you have the records to back it up.

It almost sounds like you are opening a new Roth account every time you do a conversion?  That should not be necessary as long as you are keeping good records of your contribution/conversion basis.  But even if you do that, it doesn't matter where you put the bonds and the stocks.  You withdraw whatever you need from your contribution basis, then you can rebalance as necessary.  Rebalancing within a Roth IRA doesn't generate taxable gains, so it doesn't matter if you sell stocks to fund your spending, then sell bonds and buy stocks to get things back in balance.

I'll qualify this post by stating that I haven't actually started my own Roth ladder conversions yet, so it would be good to hear from someone more experienced in this strategy.

[boarder42]

This is quite an interesting question i had not thought about in the withdrawal stages- it would seem to make the most sense to keep your money you will need soonest in your bond allocation - this allows the other monies to keep growing generating the same profits that can be withdrawn later after 59.5. 

Isnt it all one big pot though - i realize there is a contribution base and a roll over base tied to the date of the rollover - so how would you separate it - i dont know that this is even possible without multiple roth accounts as monkey uncle said makes it really confusing

[Monkey Uncle]

See "ordering rules for distributions" on page 33: https://www.irs.gov/pub/irs-pdf/p590b.pdf

1. Regular contributions.
2. Conversion and rollover contributions, on a first-in,
first-out basis (generally, total conversions and rollovers
from the earliest year first). See Aggregation
(grouping and adding) rules, later. Take these conversion
and rollover contributions into account as follows:
a. Taxable portion (the amount required to be included
in gross income because of the conversion or
rollover) first, and then the
b. Nontaxable portion.
3. Earnings on contributions.

Also, note that the aggregation rule lumps together all of your distributions from Roth accounts in a given tax year.

So the IRS doesn't care how you have the money invested.  They are only looking at whether you have at least X amount of contributions plus 5 year old conversions to cover X amount withdrawn from all of your Roth IRAs combined.  So you don't need to worry about whether you are selling a particular security that was purchased with funds that you converted 5 years ago.  Sell what you need to sell; it will always be considered to come from your basis of contributions and seasoned conversions, provided you have at least that amount of contributions and seasoned conversions somewhere in your Roth account(s).

[fairfaxbiker]

Let me expand further upon my strategy:
-Saved max 401k every year during working years
-Rolled over entire amount into a Fidelity rollover IRA account at FIRE date
-Each year beginning in 2015 I did a Roth conversion into a new Fidelity account titled "20XX Roth Conversion $XX,XXX dollars available Jan 1, 20XX "
-This was super easy to do online and now I have a definitive record of exactly how much can be taken out and on what date.
-I used the Fidelity "Planning and Guidance Tab" to create three virtual buckets; T+1, T+2-6 and T+7Beyond with T being the current year
-Fidelity allows you to use outside accounts as well as Fidelity accounts in this virtual tool so you can see all your money in one place and set/view/manage asset allocation across virtual buckets, taxable and non or slice and dice any way you like
-Each of my virtual buckets has a set asset allocation with the T+1 (100% cash, money market and CD ladders); T+2-6 (60/40 equity/bonds) and T+7 Beyond (85/15 equity bonds) all using Bogle 3 Fund Portfolio for a total overall AA of 75/25
-Right now I have assigned the rungs of the Roth ladder maturing (hitting five years) into the appropriate buckets.  So for example, I have two rungs inside my T+2-6 bucket that are not yet ripe to harvest but can bought and sold into whatever investments I want without any tax consequences allowing me to actively re-balance that bucket any time.  My understanding is that I can take out the "dollar amount" of the conversion regardless of what (VTI, VXUS, BND, CD Ladder, Money Market) I choose to currently hold in that account
-Getting back to the root of my question; since the oldest conversions will be available the soonest (and these conversions form the backbone of my entire ER strategy) would it not be wise to put the safer investments (BND, CD Ladder, MM) inside the oldest and the more risk as far out in the ladder as possible?
-Eventually my taxable cash would be exhausted and only the ladder rungs that I have will provide my living expenses so thinking keep the oldest rungs the safest?
Please poke some holes in this because this train has left the station...

[Arbitrage]

See "ordering rules for distributions" on page 33: https://www.irs.gov/pub/irs-pdf/p590b.pdf

1. Regular contributions.
2. Conversion and rollover contributions, on a first-in,
first-out basis (generally, total conversions and rollovers
from the earliest year first). See Aggregation
(grouping and adding) rules, later. Take these conversion
and rollover contributions into account as follows:
a. Taxable portion (the amount required to be included
in gross income because of the conversion or
rollover) first, and then the
b. Nontaxable portion.
3. Earnings on contributions.

Also, note that the aggregation rule lumps together all of your distributions from Roth accounts in a given tax year.

So the IRS doesn't care how you have the money invested.  They are only looking at whether you have at least X amount of contributions plus 5 year old conversions to cover X amount withdrawn from all of your Roth IRAs combined.  So you don't need to worry about whether you are selling a particular security that was purchased with funds that you converted 5 years ago.  Sell what you need to sell; it will always be considered to come from your basis of contributions and seasoned conversions, provided you have at least that amount of contributions and seasoned conversions somewhere in your Roth account(s).

Right.  You don't have X number of Roth IRA accounts according to the IRS, with your Fidelity accounts converted in one year, your Vanguard converted another year, your Schwab in year 3, etc. 

You have one Roth IRA.  It might be held in different places, but the IRS doesn't care.  Aggregate all of your Roth IRA accounts into one when making decisions about it.  I can see an argument for deviating from your overall AA within your Roth IRA (accounts), particularly if your conversions are the preponderance of your account balance (i.e. you would want to preserve the capital in your conversion ladder), but not for having different AA for different conversion years.  That makes no difference to the IRS, and it should make no difference to you.

[boarder42]

See "ordering rules for distributions" on page 33: https://www.irs.gov/pub/irs-pdf/p590b.pdf

1. Regular contributions.
2. Conversion and rollover contributions, on a first-in,
first-out basis (generally, total conversions and rollovers
from the earliest year first). See Aggregation
(grouping and adding) rules, later. Take these conversion
and rollover contributions into account as follows:
a. Taxable portion (the amount required to be included
in gross income because of the conversion or
rollover) first, and then the
b. Nontaxable portion.
3. Earnings on contributions.

Also, note that the aggregation rule lumps together all of your distributions from Roth accounts in a given tax year.

So the IRS doesn't care how you have the money invested.  They are only looking at whether you have at least X amount of contributions plus 5 year old conversions to cover X amount withdrawn from all of your Roth IRAs combined.  So you don't need to worry about whether you are selling a particular security that was purchased with funds that you converted 5 years ago.  Sell what you need to sell; it will always be considered to come from your basis of contributions and seasoned conversions, provided you have at least that amount of contributions and seasoned conversions somewhere in your Roth account(s).

excellent so there is no need to care about this at all.

[fairfaxbiker]

Thanks all.  Sounds like it will all work out.  Back to my normal ER activities...