15% bracket - Considering Roth conversion

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Tyr0ne
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15% bracket - Considering Roth conversion

Post by Tyr0ne » Fri Oct 19, 2012 10:09 pm

From Bogleheads wiki on roth conversions:
If your current marginal rate is lower than your expected retirement tax rate, you should convert in preference to any investment except a matched contribution to a retirement plan. If the rates are equal, max out your Roth contribution in preference to converting, but convert in preference to maxing out your 401(k).
Here is my current situation:
- Age 24, slated to make ~$55k in 2012.
- Taxable account: $10k (funded entirely in 2011 before I read Bogleheads)
- 401(k) w/ no matching: $10k (funded entirely in 2012)
- Roth IRA: $11k (funded entirely in 2012)
- I am also slated to inherit ~$150k in December, all cash, tax-free. Because of this, I want to fill my 401k as much as possible in 2012, but don't have the cash to do so until December. I'm thinking my 401k will be ~$16k by year end.

Theoretical 2012 tax return: $55k wages - $16k deductible contributions - $5.9k std deduction - $3.9k personal exemption = $29.2k taxable income (the 25% rate doesn't kick in until $35.5k)

Now, based on the quote from Bogleheads wiki above, based on an assumption that my marginal rate in retirement will be 25-28%, I should convert as much of my 401(k) until as I can until I hit the 25% bracket, right?

Not to mention, the traditional vs. Roth contributions argument always seem to come down to a bet on future tax rates. So lets there is a 50/50 shot that tax rates skyrocket in 40 years. So, theoretically, I want to split my Roth and 401k 50/50 as well, to minimize risk. But a Roth limits you to $5k a year, so unless you only contribute $5k to Roth and $5k to 401k (it seems likely that most will contribute more than $5k to 401k every year), you are breaking your own 50/50 target. Therefore, this is an ideal time to beef up my Roth IRA a little more, considering I may never be in the 15% bracket again, and that throughout my life, 401k contributions are almost certainly going to out pace my Roth contributions.

Also, what do you think about selling out of my taxable now (before December inheritance), so I have the cash means to max out my 401k by year end. This would allow me to convert around an extra $6k to Roth while still keeping me in the 15% bracket, assuming my previously mentioned thought process is somewhat on track.

Thoughts? Advice? I feel like I may be missing something here (I've been known to do so). Anything is greatly appreciated.
There are times when, at least for now, one must be content to love the questions themselves - Neil deGrasse Tyson

pkcrafter
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Re: 15% bracket - Considering Roth conversion

Post by pkcrafter » Fri Oct 19, 2012 10:43 pm

You are analyzing this beyond the limit of what you know or what you can predict. In the 15% bracket, use the Roth.
- Taxable account: $10k (funded entirely in 2011 before I read Bogleheads)
What is this money invested in, and have you held for more than 12 months?
- Roth IRA: $11k (funded entirely in 2012)
How did you get 11k into a Roth IRA in one year?

When you speak of converting to a Roth, you mean in the 401k? Why not take the money from taxable if you won't be hit by short term capital gains and just switch options to the Roth 401k. Switch even if you can't add a lump sum. Add new money, don't convert.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Tyr0ne
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Re: 15% bracket - Considering Roth conversion

Post by Tyr0ne » Fri Oct 19, 2012 10:56 pm

Thank you for your time and response Paul.
pkcrafter wrote: What is this money invested in, and have you held for more than 12 months?
My taxable is invested in tech stocks, with minimal gains/losses, all with long-term treatment at this point.
pkcrafter wrote: How did you get 11k into a Roth IRA in one year?
I funded $10k early this year from using my 2011 and 2012 contributions, since you have until April 15th of the following year to make your Roth contribution.
pkcrafter wrote: When you speak of converting to a Roth, you mean in the 401k? Why not take the money from taxable if you won't be hit by short term capital gains and just switch options to the Roth 401k. Switch even if you can't add a lump sum. Add new money, don't convert.
Yes, I mean converting my hypothetical $16k year-end balance to a Roth on December 31, 2012. I may be out of luck though. My 401k plan is through my employer (Fidelity as the custodian), and I don't think a Roth 401k is available. My Roth IRA is through Vanguard. It seems as if the logistics of a conversion may be against me.
There are times when, at least for now, one must be content to love the questions themselves - Neil deGrasse Tyson

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BL
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Re: 15% bracket - Considering Roth conversion

Post by BL » Fri Oct 19, 2012 11:28 pm

tycoryj wrote:From Bogleheads wiki on roth conversions:
If your current marginal rate is lower than your expected retirement tax rate, you should convert in preference to any investment except a matched contribution to a retirement plan. If the rates are equal, max out your Roth contribution in preference to converting, but convert in preference to maxing out your 401(k).
Here is my current situation:
- Age 24, slated to make ~$55k in 2012.
- Taxable account: $10k (funded entirely in 2011 before I read Bogleheads)Yes, you can cash this in to fund your 401K, assuming you wait for long-term gains, 1 full year, and keep AGI within the 15% tax. Even better would be to cut down spending so you don't have to cash it in.
- 401(k) w/ no matching: $10k (funded entirely in 2012)Fund the max
- Roth IRA: $11k (funded entirely in 2012)OK, $5k each for 2011 and 2012? but how did you get to $11k?
- I am also slated to inherit ~$150k in December, all cash, tax-free. Because of this, I want to fill my 401k as much as possible in 2012, but don't have the cash to do so until December. I'm thinking my 401k will be ~$16k by year end.

Theoretical 2012 tax return: $55k wages - $16k deductible contributions - $5.9k std deduction - $3.9k personal exemption = $29.2k taxable income (the 25% rate doesn't kick in until $35.5k) You might benefit from getting a tax program such as TurboTax soon and trying "what if" numbers.

Now, based on the quote from Bogleheads wiki above, based on an assumption that my marginal rate in retirement will be 25-28%, I should convert as much of my 401(k) until as I can until I hit the 25% bracket, right?I believe you could only convert 401k if you do not work for company anymore. You didn't mention any traditional IRA that you might convert to Roth IRA.

Not to mention, the traditional vs. Roth contributions argument always seem to come down to a bet on future tax rates. So lets there is a 50/50 shot that tax rates skyrocket in 40 years. So, theoretically, I want to split my Roth and 401k 50/50 as well, to minimize risk. But a Roth limits you to $5k a year, so unless you only contribute $5k to Roth and $5k to 401k (it seems likely that most will contribute more than $5k to 401k every year), you are breaking your own 50/50 target. Therefore, this is an ideal time to beef up my Roth IRA a little more, considering I may never be in the 15% bracket again, and that throughout my life, 401k contributions are almost certainly going to out pace my Roth contributions.

Also, what do you think about selling out of my taxable now (before December inheritance), so I have the cash means to max out my 401k by year end. Yes, if you can't come up with the money elsewhere. This would allow me to convert around an extra $6k to Roth while still keeping me in the 15% bracket, assuming my previously mentioned thought process is somewhat on track. You don't seem to have a tIRA to convert. Just max what you are allowed to do.

Thoughts? Advice? I feel like I may be missing something here (I've been known to do so). Anything is greatly appreciated. Missing a tIRA to convert.

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Tyr0ne
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Re: 15% bracket - Considering Roth conversion

Post by Tyr0ne » Fri Oct 19, 2012 11:52 pm

OK, $5k each for 2011 and 2012? but how did you get to $11k?
$1k in growth

Sounds like I will just max out the 401k and call it a day.

Thanks again!
There are times when, at least for now, one must be content to love the questions themselves - Neil deGrasse Tyson

Bob's not my name
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Re: 15% bracket - Considering Roth conversion

Post by Bob's not my name » Sat Oct 20, 2012 4:49 am

tycoryj wrote:Theoretical 2012 tax return: $55k wages - $16k deductible contributions - $5.9k std deduction - $3.9k personal exemption = $29.2k taxable income (the 25% rate doesn't kick in until $35.5k)
Yes, you have this mostly right. I think you are neglecting insurance deducted from your pay, but maybe you don't have employer insurance or you are riding on your parents' policy).

$55,000 gross income (assuming no significant investment income)
- $2,000? pre-tax health, dental, and disability insurance premiums deducted from your pay
- $0 FSA contributions?
- $17,000 401k contributions
-----------------
$36,000 AGI
- $3,800 personal exemption
- $5,950 standard deduction
----------------
$26,000 taxable income

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House Blend
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Re: 15% bracket - Considering Roth conversion

Post by House Blend » Sat Oct 20, 2012 7:03 am

tycoryj wrote:Now, based on the quote from Bogleheads wiki above, based on an assumption that my marginal rate in retirement will be 25-28%, I should convert as much of my 401(k) until as I can until I hit the 25% bracket, right?
Uhh, is this 401(k) from a previous job? It is fairly unusual for 401k plans to allow rollovers until you are no longer an employee or are 59.5 years old. Most likely you have no choice and cannot do this conversion. Check with your plan administrator.

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Taylor Larimore
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New taxable account ?

Post by Taylor Larimore » Sat Oct 20, 2012 7:31 am

tycory:
I am also slated to inherit ~$150k in December, all cash, tax-free.
It is important to start taxable accounts with only tax-efficient funds that can be held 'forever' (switching later can be costly). Vanguard Total International and Total Stock Market index funds are likely candidates.

Best wishes
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: New taxable account ?

Post by Bob's not my name » Sat Oct 20, 2012 9:13 am

Taylor Larimore wrote:
I am also slated to inherit ~$150k in December, all cash, tax-free.
It is important to start taxable accounts with only tax-efficient funds that can be held 'forever' (switching later can be costly). Vanguard Total International and Total Stock Market index funds are likely candidates.
As discussed in the OP's prior thread, $150,000 will not need to be held forever. All of it can be moved into tax-advantaged accounts pretty quickly, considering that the OP has not heretofore been able to max 401k and IRA, and considering that the OP is single and might marry and thereby have twice as much tax-advantaged space -- $45,000/year is a lot of tax-advantaged space. Furthermore, depending on the area, $150,000 may be a merely sufficient house downpayment.

Saving$
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Re: 15% bracket - Considering Roth conversion

Post by Saving$ » Sat Oct 20, 2012 10:12 am

1. Existing taxable account: If you are invested in tech stocks, it is likely not as diversified as it should be to be a Boglehead. You seem to imply there are not any significant gains or losses - a complete sell off of this account may be a wash? I'd recommend you go ahead and sell this stuff now even if you have some gains. In the short term this should be sufficient to bridge the cash flow issue so you can invest the additional $7k in your 401k to get you to the max allowed $17k. Put the remaining $3k in an emergency fund, since you did not mention having one, and even though you can use the Roth as an emergency fund, at your income level and age, it would be wise to have a $3k emergency fund. Put it in a (relatively) high yield savings, like Ally Bank or something.

2. 401k - Per above invest max allowed $17k for this year, cash flow covered with item 1 above. If you find you can eek out a bit more cash flow from your regular income, try to bump your emergency fund to $5k. Invest max allowed $17.5k for next year. Confirm with your employer there is nothing stopping you from investing the max.

3. Roth IRA - You have already maxed out your 2012 contribution. Max out your 2013 contribution in January 2013, funded from inheritance cash. If you find your inheritance cash does not come through on the timeline you thought (often happens) fund the Roth from the extra savings you eeked out in item 1 & 2 above.

4. Inheritance - You need to advise what your intent is for this money - retirement, buy house, both, etc. Your cash flow situation seems to be just right, where you could max out Roth and 401k annually and not need supplemental cash from this retirement. That is great, and you should keep that up. Taylor gave some great advice for investing the inheritance in appropriate funds. Post back if house buying is part of the equation.

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Tyr0ne
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Re: 15% bracket - Considering Roth conversion

Post by Tyr0ne » Mon Oct 22, 2012 5:23 pm

Thank you for the helpful responses.

I do have a sufficient emergency fund with my bank (Ally).

Based on the advice, I will cash out of my tech stocks to max my 401k this year, since cash will be a little tight without some stock sales. Once I receive the inheritance, I will put aside $5.5k for 2013 Roth contributions, and at least $8k cash to compensate for large 401k withholding in 2013. The rest will go towards a fund for a house down payment (I live in/near the Silicon Valley and will need a few more inheritances to eventually afford a decent house in this area :annoyed ). As suggested, I will use a handful of Vanguard's tax-efficient funds (abiding by the Bogleheads wiki of tax-efficient fund placement).

Thanks again. Best Regards.
There are times when, at least for now, one must be content to love the questions themselves - Neil deGrasse Tyson

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Socrativestor
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Re: 15% bracket - Considering Roth conversion

Post by Socrativestor » Mon Oct 22, 2012 7:24 pm

Also, you may find it useful to consider savings bonds to stash a chunk of your inheritance. You can buy $10,000 each of EE and I bonds per calendar year, so if you buy in December 2012 and January 2013 you can salt away $40,000 -- as long as don't need the funds for 12 months. The interest rates are decent, tax-deferred and ultimately state-tax free -- and you can keep the funds there up to 30 years. I.e. extra tax-sheltered space for free.

Good luck.
--Socrativestor | "Neither of us has any knowledge to boast of, but he thinks that he knows something which he does not know, whereas I am quite conscious of my ignorance."

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Watty
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Re: 15% bracket - Considering Roth conversion

Post by Watty » Mon Oct 22, 2012 9:53 pm

I didn't follow all the details and with trying to judge the merits of the choices there are a few things to consider.

1) If the stocks you are selling have any long term capital gains and you are still in the 15% tax bracket then you will likely qualify for the special zero percent long term capital gains tax rate that ends this year. If you fill up the 15% tax bracket with Roth conversions then you might end up having to pay some capital gains taxes.

2) An alternative way to raise some cash would be a margin loan on the taxable account, then pay it off in January. Another alternative way to raise some cash would be with a car loan if you have a paid off car then pay it off in January. You would want to use a regular car loan from a lender like a credit union, not some sort of title loan company. You may also be able to get a personal or signature loan from a credit union.

3) Single people get into the 25% tax bracket pretty quickly, if you are likely to get married, have some kids, and a mortgage interest deduction then you will likely have a lot of time in the 15% tax brackets. In that situation under the current tax laws it is very possible that a one income a family like that would owe no income taxes so I would not get too excited about being above the 15% tax bracket in the future.

4) You may be eligible for a fully deductible IRA, if so then I would take a hard look at your California tax rate, combined with you federal tax rate that might be enough of a deduction to make the IRA preferable to the Roth.

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