When it is advantageous to convert to a Roth IRA?

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
User avatar
Topic Author
verbose
Posts: 673
Joined: Thu Aug 28, 2008 10:05 am

When it is advantageous to convert to a Roth IRA?

Post by verbose »

I've been thinking for years that we should have some of our retirement assets in Roth IRAs, but it never works out. I wonder when it's best to convert existing IRAs?

We are both programmers who switch jobs frequently, so most of our retirement savings are in TIRAs that have been funded by 401k rollovers. We currently work for the same contracting company with an expensive 401k plan (I don't have all the facts yet, but it looks like the expenses are 1.1% on top of the ER for all the funds. At least some of the funds are Vanguard Signal index funds). Roth 401k is not available.

We are well over the AGI threshold for Roth IRA contributions, and can't get down there by additional FSA and 401k contributions (HSA not available).

Since I'm asking about account distribution, not asset allocation, I haven't provided the fund breakdown. I'm happy with the asset allocation.

Ages: 40, 39

Federal tax: 25% - 28% (taxable income close to next bracket)
State tax: 6%

Total retirement accounts value: low 6-figures

Her Vanguard rollover IRA: 44%
His Vanguard rollover IRA: 53%
His 401k: 3% (new job, also contributed to prior company 401k and rolled that over)
Her 401k: 0% (new job, contributions begin next month, also contributed to prior 401k and rolled it over)

It certainly looks like this is not the year to convert assets to a Roth IRA or use a backdoor strategy. I wonder, though, will that year ever come? I understand that it's advantageous to have both tax-deferred and tax-free retirement accounts.

What kind of tax/income situation would make it advantageous to use a backdoor Roth or convert existing traditional IRA assets to a Roth IRA?
User avatar
Prokofiev
Posts: 1311
Joined: Mon Feb 19, 2007 8:45 pm
Location: New Orleans

Re: When it is advantageous to convert to a Roth IRA?

Post by Prokofiev »

In general, you should wait for a year when your marginal tax rates are less - say 15% fed and 0-3% state. This is unlikley to happen while you both are working, unless one or both should lose your jobs. Usually the best time to Roth-convert is after you retire but before you receive SS or a pension. Since you can wait til 70 for SS and many today have no pension or can elect a lump-sum and roll it over to an IRA, there should be 5-15 years where you can have limited taxable income and do a Roth-conversion thru the 15% bracket. Converting beyond the 15% bracket to 25% MAY make sense for some, depending on total assets and future tax rates. Depends on your personal situation.

But paying 25% years in advance to avoid paying 25% in the future is seldom a good idea. And to avoid the 28% bracket - is cutting it close. So many things can happen to knock you into a lower bracket. My parents spent the last 4 years of their lives paying near 0% tax despite cashing in cap gains, deferred annuities and doing Roth conversions. Medical, dental and nursing home expenses wiped out virtually all tax liability for those final years. To have converted to a Roth prior, even at the 15% bracket would have been a mistake. But then again they had relatively small IRAs. It helps to model your assets and income and have a basic understanding of our present tax law to work thru your individual case.
Last edited by Prokofiev on Sat Aug 11, 2012 3:56 pm, edited 3 times in total.
Everything should be made as simple as possible, but not simpler - Einstein
livesoft
Posts: 86077
Joined: Thu Mar 01, 2007 7:00 pm

Re: When it is advantageous to convert to a Roth IRA?

Post by livesoft »

I am gonna wait to convert when my tax rate is ZERO. See some of the ideas in the ZERO taxes thread: http://www.bogleheads.org/forum/viewtopic.php?t=87471

There was just this article also about the 400 tax returns reporting the highest AGI. 6 of those folks paid no taxes. I want to join that elite 6.
http://www.nytimes.com/2012/08/11/busin ... sense.html
Wiki This signature message sponsored by sscritic: Learn to fish.
rustymutt
Posts: 4001
Joined: Sat Mar 07, 2009 11:03 am

Re: When it is advantageous to convert to a Roth IRA?

Post by rustymutt »

When you can afford to pay the taxes that transaction would generate, and hold the Roth long enough to recover those expenses.
Even educators need education. And some can be hard headed to the point of needing time out.
User avatar
Kuckie
Posts: 164
Joined: Tue Feb 23, 2010 9:59 am

Re: When it is advantageous to convert to a Roth IRA?

Post by Kuckie »

But paying 25% years in advance to avoid paying 25% in the future is seldom a good idea. And to avoid the 28% bracket - is cutting it close. So many things can happen to knock you into a lower bracket.
Thanks, Prokofiev. I had been pondering the same question for some time and after reading your comments have decided to definitely NOT convert. Converting is good for younger people but not for retirees remaining in the same 25% tax bracket after receiving SS. Even though taxes will be going up, so may medical expenses, as you mentioned, which then provides a deduction. And if I am lucky and medical expenses did not go up I shall pay the additional tax, and consider myself fortunate.

Besides what if the market crashes sometime in the future when too late to re-characterize. Conversion assumes that investments will rise in value over the long term, but there is no guarantee this will happen. Probably the best time to convert is when there is a major crash, like that of 2008-2009, which will allow you to convert many more shares for the same dollar value. And if there is no crash and your investments continue to rise, you can be thankful for that, even though you did not convert.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: When it is advantageous to convert to a Roth IRA?

Post by grabiner »

verbose wrote:What kind of tax/income situation would make it advantageous to use a backdoor Roth or convert existing traditional IRA assets to a Roth IRA?
See Roth IRA conversion on the wiki.
Wiki David Grabiner
User avatar
Watty
Posts: 28860
Joined: Wed Oct 10, 2007 3:55 pm

Re: When it is advantageous to convert to a Roth IRA?

Post by Watty »

Also be sure to look at the tax rates and tax laws of the state you will be in when you retire. If you will retire in a state with a higher or lower tax rate then the conversion might be easier or harder to justify.

A number of states exepmt all or some of your retirment income after a certain age. In my state, Georgia, a significant amount of retirment income is exempt from taxes due to some recent tax law changes so doing a Roth conversion at an earelier age is harder to justify.
User avatar
Prokofiev
Posts: 1311
Joined: Mon Feb 19, 2007 8:45 pm
Location: New Orleans

Re: When it is advantageous to convert to a Roth IRA?

Post by Prokofiev »

Kuckie wrote:Converting is good for younger people but not for retirees remaining in the same 25% tax bracket after receiving SS. Even though taxes will be going up, so may medical expenses, as you mentioned, which then provides a deduction. And if I am lucky and medical expenses did not go up I shall pay the additional tax, and consider myself fortunate.

Besides what if the market crashes sometime in the future . . .
I really think that is the proper way to look at it.

I am reasonably sure that for me, converting thru the 25% bracket will give me some, albeit slight, tax reduction over the course of my retirement. If everything goes as planned that is. But if something bad happens - accident, sickness, medical bills, nursing home or just a terrible real ROR for the next 12 years, that will not necessarily be true. I would hate to pre-pay my taxes at 25%+6% state only to find that I was running short of assets later in life and could have avoided ALL the tax if only I had waited. OTOH, if everything goes as planned, I will end up very wealthy and can afford the extra taxes which should be only slightly more unless we have a radical change in tax rates.

But another point I had not thought about is the level of insurance an individual has. The reason my parents could convert almost 100% of their TIRA to Roth at 0% tax was primarily due to nursing home costs. Medical, drugs and dental were relatively minor due to Medicare and additional health coverage. They had no interest deduction and didn't itemize prior to those final years. But what if they had a LTC insurance policy that paid the majority of their nursing home costs? (They didn't). Then it would have possibly made sense to Roth convert at higher tax rates since one would be unlikely to ever have the large future deductions needed.

Still another point is where you are with respect to 70.5 (RMDs). For me, with 12-13 years to go, I cannot predict future tax rates, tax law and future TIRA balances with enough accuracy to risk the 25% or more bracket conversion. But at age 67,68 or 69 - that extrapolation is not as difficult. I will recalculate as I near RMDs and change course as necessary. The 25% and 28% brackets are broad enough that you can make relatively large conversions during those last 2-4 years prior to SS and RMDs when you will have a better handle on the actual numbers.
Everything should be made as simple as possible, but not simpler - Einstein
bberris
Posts: 2420
Joined: Sun Feb 20, 2011 8:44 am

Re: When it is advantageous to convert to a Roth IRA?

Post by bberris »

rustymutt wrote:When you can afford to pay the taxes that transaction would generate, and hold the Roth long enough to recover those expenses.
Recover the expenses how? The holding time is irrelevant. This is simple. The only thing that matters is the tax rate you pay when you convert, and the tax rate in retirement. If its lower now, convert. If its the same, it doesn't matter what you do. If its lower in retirement, stay with a standard ira.
rustymutt
Posts: 4001
Joined: Sat Mar 07, 2009 11:03 am

Re: When it is advantageous to convert to a Roth IRA?

Post by rustymutt »

bberris wrote:
rustymutt wrote:When you can afford to pay the taxes that transaction would generate, and hold the Roth long enough to recover those expenses.
Recover the expenses how? The holding time is irrelevant. This is simple. The only thing that matters is the tax rate you pay when you convert, and the tax rate in retirement. If its lower now, convert. If its the same, it doesn't matter what you do. If its lower in retirement, stay with a standard ira.
Time does make a difference. The longer you hold those tax free holdings, the more you'd save by not paying taxes on the distributions. If you convert and spend it in the same year, you're not coming out ahead. If you convert and spend it 10 years later, then you might have saved by doing the conversion. There is a time factor involved in this type of conversion. There are more than 3 factors to consider here, income, taxes, time, and in some cases other factors.
Even educators need education. And some can be hard headed to the point of needing time out.
jaj2276
Posts: 581
Joined: Sat Apr 16, 2011 5:13 pm

Re: When it is advantageous to convert to a Roth IRA?

Post by jaj2276 »

I'm pretty sure I screwed up by converting in 2010 when I converted my IRA (rollover from 401k) to a Roth. My account was around $62k in value but I was also in the 31% tax bracket. My thinking at the time was that if I could leave the money in the Roth for 30+ years, the fact of only paying 31% on $62k was better than paying 15% on ~$275k ($62k compounded for 30 yrs at 5% return). I also thought it was a great deal to be able to spread the tax hit over two years (2011, 2012) instead of paying it all in 2010. At best I hope to come out about even regarding this decision.
User avatar
BigFoot48
Posts: 3115
Joined: Tue Feb 20, 2007 9:47 am
Location: Arizona

Re: When it is advantageous to convert to a Roth IRA?

Post by BigFoot48 »

I just finished a major update to the Excel model I created that helps evaluate the financial impact of doing Roth conversions. It's fairly simple and now much easier to use, and the link to version 3.0 can be found here: http://www.bogleheads.org/forum/viewtop ... 8#p1462078
Retired | Two-time in top-10 in Bogleheads S&P500 contest; 18-time loser
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: When it is advantageous to convert to a Roth IRA?

Post by grabiner »

rustymutt wrote:
bberris wrote:
rustymutt wrote:When you can afford to pay the taxes that transaction would generate, and hold the Roth long enough to recover those expenses.
Recover the expenses how? The holding time is irrelevant. This is simple. The only thing that matters is the tax rate you pay when you convert, and the tax rate in retirement. If its lower now, convert. If its the same, it doesn't matter what you do. If its lower in retirement, stay with a standard ira.
Time does make a difference. The longer you hold those tax free holdings, the more you'd save by not paying taxes on the distributions. If you convert and spend it in the same year, you're not coming out ahead. If you convert and spend it 10 years later, then you might have saved by doing the conversion. There is a time factor involved in this type of conversion. There are more than 3 factors to consider here, income, taxes, time, and in some cases other factors.
Whether time makes a difference depends on the alternative use of money for the tax payment. If you pay the conversion tax with money that would have otherwise gone to the same account or an equally good account, then time is irrelevant. If you pay the conversion tax with money that would have otherwise gone to an inferior account (either a high-cost 401(k) or a taxable account), then the benefit increases with time.

For example, suppose that you are in a 28% tax bracket now, and are considering converting your $10,000 traditional IRA to a Roth IRA and paying $2800 in tax. You will retire in a 25% tax bracket, and I will assume 6% returns on investments.

If you convert, you will have $10,000 now, $17,908 in 10 years, $32,071 in 20 years, $57,435 in 30 years.

If you don't convert, you will have $7500 after-tax now, $13,431 in 10 years, $24,054 in 20 years, $43,076 in 30 years, plus whatever you can do with that $2800.

If you can contribute an additional $3889 to a 401(k) which is as good as your IRA (this costs $2800 after tax), then it will be worth $2917 after-tax now for a total of $10,417, $5223 in 10 years for a total of $18,244, $9354 in 20 years for a total of $33,508, $16,752 in 30 years for a total of $59,828. Thus you do 4.17% better by not converting, regardless of how long you wait.

If you can contribute an additional $3889 to a bad 401(k) which costs an extra 1% in expenses, then it will be worth $2917 after-tax now, $4751 in 10 years for a total of $18,182, $7738 in 20 years for a total of $31,782, $12,606 in 30 years for a total of $55,782. Thus converting comes out ahead if the money stays in the bad 401(k) long enough.

And if you are already maxing out your 401(k) and the alternative investment is in a taxable account, you get the same type of benefit, as the taxable account will lose at least 15% of its gains plus an annual dividend tax every year until you retire.
Wiki David Grabiner
Sidney
Posts: 6784
Joined: Thu Mar 08, 2007 5:06 pm

Re: When it is advantageous to convert to a Roth IRA?

Post by Sidney »

livesoft wrote:I am gonna wait to convert when my tax rate is ZERO. See some of the ideas in the ZERO taxes thread: http://www.bogleheads.org/forum/viewtopic.php?t=87471

There was just this article also about the 400 tax returns reporting the highest AGI. 6 of those folks paid no taxes. I want to join that elite 6.
http://www.nytimes.com/2012/08/11/busin ... sense.html
But how far up the tax bracket are you going to convert? Only the zero bracket?
I always wanted to be a procrastinator.
Bob's not my name
Posts: 7417
Joined: Sun Nov 15, 2009 8:24 am

Re: When is it advantageous to convert to a Roth IRA?

Post by Bob's not my name »

When is it advantageous to convert from a Roth IRA?

http://www.bogleheads.org/forum/viewtop ... 10&t=98625

Not being facetious (well, a little). The linked thread may provide some useful perspective. This one may be useful too: http://www.bogleheads.org/forum/viewtopic.php?t=69833
User avatar
Cernel
Posts: 306
Joined: Sun May 04, 2008 11:06 am

Re: When it is advantageous to convert to a Roth IRA?

Post by Cernel »

Prokofiev wrote:In general, you should wait for a year when your marginal tax rates are less - say 15% fed and 0-3% state. This is unlikley to happen while you both are working, unless one or both should lose your jobs. Usually the best time to Roth-convert is after you retire but before you receive SS or a pension. Since you can wait til 70 for SS and many today have no pension or can elect a lump-sum and roll it over to an IRA, there should be 5-15 years where you can have limited taxable income and do a Roth-conversion thru the 15% bracket. Converting beyond the 15% bracket to 25% MAY make sense for some, depending on total assets and future tax rates. Depends on your personal situation.
The strategy outlined by Prokofiev in the above paragraph is one that I am following. I found myself in a similar situation as you, meaning I was in the 25% Federal Tax bracket and 6+% State tax bracket while I was working, and I couldn't justify the conversion. So I waited until I retired to start the conversions since I dropped down to the 15% Federal tax bracket.

Upon retirement, I took my Pension as a lump sum and combined with my severance package I rolled that all into my 401(k) which I subsequently rolled over to an IRA. I ended up with about 75% of my portfolio in an IRA with about 10% in a Roth IRA, 10% Non-Retirement account and 5% cash.

Currently, I am 60 years old and do not plan on taking SS until 70, so for the next 10 years, I will be converting an amount that keeps me in the 15% Federal tax bracket. As far as the State is concerned, since I am over 59 1/2 I get to exclude the 1st $20k of the conversion.
JW-Retired
Posts: 7189
Joined: Sun Dec 16, 2007 11:25 am

Re: When it is advantageous to convert to a Roth IRA?

Post by JW-Retired »

verbose wrote: Total retirement accounts value: low 6-figures

Her Vanguard rollover IRA: 44%
His Vanguard rollover IRA: 53%
His 401k: 3% (new job, also contributed to prior company 401k and rolled that over)
Her 401k: 0% (new job, contributions begin next month, also contributed to prior 401k and rolled it over)

It certainly looks like this is not the year to convert assets to a Roth IRA or use a backdoor strategy. I wonder, though, will that year ever come? I understand that it's advantageous to have both tax-deferred and tax-free retirement accounts.

What kind of tax/income situation would make it advantageous to use a backdoor Roth or convert existing traditional IRA assets to a Roth IRA?
The situation that makes a backdoor Roth advantageous is not to have any TIRAs. You can do a backdoor Roth every year without paying any extra tax all if you can hide all your TIRA accounts. That would generate $10k/yr or after age 50 $12k/yr in Roth savings. Hiding the IRAs means rolling them into your current 401k's.
See if your 401k providers allow that. (If you are going to stay with this company for a long time this probably isn't a good idea given your expensive 401k. )

I would not do any conversions at the 31-34% Fed + state brackets.
JW
Retired at Last
User avatar
Topic Author
verbose
Posts: 673
Joined: Thu Aug 28, 2008 10:05 am

Re: When it is advantageous to convert to a Roth IRA?

Post by verbose »

Thanks for the replies. I've had rollover funds in TIRAs since the mid-90s. There's no way we can predict how long either of us will work for the current employer. It's a much better situation than our last few jobs, and could be many years. I'm not willing to roll into an expensive 401k just for the chance to do a backdoor Roth. Our employer is known for being stingy with employee benefits. I don't expect any improvement in the 401k, though it will be interesting to see what happens when the full costs are disclosed. The disclosure that I've seen are the minimum costs for employers considering opening a new 401k plan with this provider, not the costs actually paid for our plan.

There have been years in the past that would have been good for contributing/converting to Roth. Of course, we were having problems making ends meet in those years and retirement savings was very low on the list.
Post Reply