Roth Conversion Caution

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ddb1419
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Joined: Sun Sep 14, 2014 10:54 am

Roth Conversion Caution

Post by ddb1419 »

This year I had enough latitude in my tax bracket (15%) to take some money out of my 401k and convert some of it to a Roth, and stay in my same bracket.

What I did not know at the time, was the IRS formula for the amount of my social security that is taxed. Most information says up to 85%, but if you have
a middle class income, the amount taxed, can be much less than the 85%. I converted $24k to a Roth, but I then moved from 40% of SS taxed to 85% taxed.
This increased my taxes by about $2,400. I thought the conversion would be a good idea to reduce future taxes, in which I will be in the 25% tax bracket,
when the RMDs begin.

However, since I had to pay taxes immediately on the conversion amount, and increased the amount of my social security taxed, it will take me until age
83 (currently 66) to break even. This is just based on my tax impact, and does not include the benefit of future tax savings on the Roth account. but I also lost
future growth from the account I paid the taxes from. This may be a wash. I'm rethinking my actions since the break even is so long. I know that I can
recharacterize the Roth.

Here is the URL for a web page that calculates the amount of SS taxed. Check that out if you want to do a conversion.

http://www.calcxml.com/calculators/how- ... n=#results

Sorry, you need to copy and paste into your brower.
teacher
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Re: Roth Conversion Caution

Post by teacher »

Thanks, ddb
I hadn't thought of calculating a break even date. This new (to me) information, along with the possibility of ROTH law changes down the pike has me totally unsure whether further conversions are prudent. I am showing sings of analysis paralysis. :(
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BL
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Re: Roth Conversion Caution

Post by BL »

I would double check it by using an actual tax program such as TurboTax. (Taxcaster might be similar to the link you gave.) Yes, you definitely want to check out the tax consequences of any such actions.
dolphinsaremammals
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Re: Roth Conversion Caution

Post by dolphinsaremammals »

I did some number crunching several years ago taking into account how it affected the taxability of SS. I did this for several possible level of converted amounts. That's how I knew how much I could convert with an okay impact. One of the benefits of doing taxes via colored pencils instead of with a software package, you know what's going on under the hood.
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BL
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Re: Roth Conversion Caution

Post by BL »

dolphinsaremammals wrote:I did some number crunching several years ago taking into account how it affected the taxability of SS. I did this for several possible level of converted amounts. That's how I knew how much I could convert with an okay impact. One of the benefits of doing taxes via colored pencils instead of with a software package, you know what's going on under the hood.
+1
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retiredjg
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Re: Roth Conversion Caution

Post by retiredjg »

It is unfortunate you learned this lesson the hard way. But such is our financial education life - much of it is "the hard way".

Your issue is why we usually say to convert after retirement, but before taking SS.
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House Blend
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Re: Roth Conversion Caution

Post by House Blend »

ddb1419 wrote:What I did not know at the time, was the IRS formula for the amount of my social security that is taxed. Most information says up to 85%, but if you have a middle class income, the amount taxed, can be much less than the 85%. I converted $24k to a Roth, but I then moved from 40% of SS taxed to 85% taxed. This increased my taxes by about $2,400. I thought the conversion would be a good idea to reduce future taxes, in which I will be in the 25% tax bracket,
when the RMDs begin.
There's a good explanation of taxation of SS benefits in the wiki:
http://www.bogleheads.org/wiki/Taxation ... y_benefits

As you discovered, if you are attempting to fill the 15% bracket with Roth conversions, but are not yet at the point where 85% of all of your SS benefits are taxable, then the rate you'll pay on at least some of the conversion is 1.85 * 15% = 27.75%.

So it's not a complete disaster if it is reducing future RMD withdrawals that will be taxed at 25%.

For those with enough alternative assets to postpone taking SS benefits, this is another argument for spending those assets down and waiting on SS until age 70.

Note that the 25%-in-the-future rate also depends on getting above the 85%-maximum-taxability-of-SS range. So if you are "lucky", your Roth conversion has saved you from having part of your future RMD's taxed at the rate of 1.85 * 25% = 46.25%.
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celia
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Re: Roth Conversion Caution

Post by celia »

ddb1419 wrote:This year I had enough latitude in my tax bracket (15%) to take some money out of my 401k and convert some of it to a Roth, and stay in my same bracket.

What I did not know at the time, was the IRS formula for the amount of my social security that is taxed. Most information says up to 85%, but if you have
a middle class income, the amount taxed, can be much less than the 85%. I converted $24k to a Roth, but I then moved from 40% of SS taxed to 85% taxed.
This increased my taxes by about $2,400. I thought the conversion would be a good idea to reduce future taxes, in which I will be in the 25% tax bracket,
when the RMDs begin.
This looks good if you only have to pay $2,400 on a $24,000 conversion. That is only a 10% tax rate, which is lower than your regular tax rate. Are you sure you are calculating it correctly using tax software? Or possibly you have some long term capital gains involved that are taxed at 0%.
ddb1419 wrote:However, since I had to pay taxes immediately on the conversion amount, and increased the amount of my social security taxed, it will take me until age 83 (currently 66) to break even. This is just based on my tax impact, and does not include the benefit of future tax savings on the Roth account. but I also lost future growth from the account I paid the taxes from. This may be a wash. I'm rethinking my actions since the break even is so long. I know that I can
recharacterize the Roth.
What do you mean that you had to pay the taxes immediately? Estimated taxes? Are you filing an extension to your 2013 taxes? Taxes on conversions done now aren't due until April 15, 2015. I hope you didn't pay the taxes using some of the amount withdrawn as that decreases how much you are putting into the Roth.

Also what do you mean that you won't break even until age 83? You will have to start taking RMDs at age 70 1/2. At that time, any distributions will also increase how much SS is taxed. To be safe, why don't you assume 85% of your SS is always taxed in further calculations. Then you will be pleasantly surprised when you are reminded that not all 85% of your SS is taxed.
ddb1419 wrote:Here is the URL for a web page that calculates the amount of SS taxed. Check that out if you want to do a conversion.

http://www.calcxml.com/calculators/how- ... n=#results

Sorry, you need to copy and paste into your brower.
Your link works, as is, for me.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.
Alan S.
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Re: Roth Conversion Caution

Post by Alan S. »

Using tax software, it is fairly simple to determine what your marginal rate is for various conversion amounts as effected by the amount of SS included in AGI. For those that do not face the 85% inclusion prior to the conversion, don't be surprised if the marginal rate varies considerably for different converted amounts. For example, for a small conversion the rate might be 15%, then rise to 27.75 while SS is being phased in, rise further to 46.25 when you hit the nominal 25% bracket, and then drop back to 25% once 85% of SS has been included. This can be tricky in selecting the amount to convert, but at least can be accurately determined. And if you eventually convert and choose to recharacterize all or part of the conversion, you can reverse the process to determine the actual post recharacterization tax bill.

Much more difficult is determining how much you will save in taxes by having converted and thereby reducing future RMDs and possible taxes on SS. You are now guessing about such things as the earnings in your IRA and therefore the RMD size. You also should be aware that the AGI tiers for SS inclusion have never been adjusted for inflation and are not going to be so if you are not yet at 85%, good chance you will be at some point. The IRMAA surcharge is subject to the same situation, ie a possible added cost 2 years after the conversion, but a savings if you reduce future IRMAA surcharges because you converted. You may also run into the possible effects of having LTCi vs not having it and spending big bucks on deductible medical expenses. All of these factors and many more will affect the benefit from conversion - or not. Some people may also want to factor in the expected tax brackets of their heirs vs their own, and possible state or federal estate tax savings from conversions.
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kramer
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Re: Roth Conversion Caution

Post by kramer »

You also should be aware that the AGI tiers for SS inclusion have never been adjusted for inflation and are not going to be so if you are not yet at 85%, good chance you will be at some point.
This is a huge issue and the reason that I have not been more enthusiastic about conversions. I am staying conservative in my annual conversion amounts.
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