Roth Conversion strategy

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BobSnipes
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Roth Conversion strategy

Post by BobSnipes » Wed Mar 20, 2013 10:29 am

Dear Bogleheads,

Thanks for this wonderful resource! I've developed alternative strategies for my Roth conversion and will appreciate your comments.

I’m 64 and already retired with a pension. I’m currently in 15% tax bracket with $9-12k “headroom”, but only over the next six years. Soc Sec will push me into the 25% bracket when I begin drawing at age 70. My investment portfolio consists of about 105k untaxed $ in Vanguard LifeStrategy Moderate Growth Fund (VSMGX) in a Vanguard TIRA. I also have about $60k+ cash in a Sallie Mae MM fund earning .95% I don't anticipate withdrawing any IRA funds until after I'm 70.

Scenario 1: Total conversion this year. I have enough cash to pay taxes on a total conversion this year. My thought was to convert to Vanguard Target Retirement 2015 Fund (VTXVX) at the same time as it will handle rebalancing and AA for me going forward. I like the simplicity of this option and would just swallow hard and take the one-time tax hit managing tax consequences as best I could.

Scenario 2: Partial conversion between now and age 70. I ran figures for doing partial conversions which would completely utilize the 15% bracket each year each year between now and when I'm 70. About $46000 would remain unconverted using that strategy. So I would "front-load" the conversion, converting that amount this year as well as making max Roth contributions for 2012 and 2013 (total of $13000 additional). I would buy the underlying funds in VTXVX, spreading them across the a new Roth account and my existing TIRA. I would fund the new Roth with $59,000 worth of the stock funds, maintaining the same AA between international and total market. I would convert the remainder of the TIRA to the underlying bond funds. Starting next year, I would fund a "bond" Roth to receive the TIRA conversions I would make in that and subsequent coming years. My annual Roth contributions would flow into whichever account (stock or bond) was necessary to maintain the AA. I would use the Admiral version of the funds when available. I would recharacterize accounts that dropped during the available time period. When my TIRA was fully converted, I would consolidate all into VTXVX.

So would the tax savings (and I suppose flexibility) in scenario 2 be worth the extra hassles, or should I just get it all over with with the simple approach in scenario 1?

If I were to pursue scenario 2, is there any reason I should consider using EFT counterparts of the VTXVX constituent funds?

Other comments?

I'll be grateful to have your views.

Bob

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archbish99
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Re: Roth Conversion strategy

Post by archbish99 » Wed Mar 20, 2013 11:35 am

I'm assuming you're filing as single. From what you say, you've got ~$105k to convert, and only around $12k left in the 15% bracket. The 25% bracket is roughly $51k wide for single filers. That means the remaining $41k would get taxed at 28%, giving you an overall tax rate of 24.79%. On the other hand, by converting ~$12k/year for 5 years, then taking RMDs on the remaining $46k at 25% for the rest of your life, you're looking at an overall tax rate of 19.5%, plus you get the benefit of increasing brackets in future years and the ability to defer the taxes on the part you'll pay 25% on over the course of your life. I'd do it year-by-year, between those two options.

The other possibility, if you want, would be to stay in the 25% bracket but still plan to convert everything. That would free you from the hassle of RMDs by having everything in Roth by the time you reach Social Security, but still not put anything into the 28% bracket. So in years 1-4, you could go up to the top of 15% (~$12k/year); in year 5, convert the rest ($12k at 15%, $45k at 25%). Or, if you'd prefer to smooth your AGI, convert one-fifth of the IRA each year, going up into the 25% bracket a little each year.
Last edited by archbish99 on Wed Mar 20, 2013 11:57 am, edited 1 time in total.
I'm not a financial advisor, I just play one on the Internet.

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Peter Foley
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Re: Roth Conversion strategy

Post by Peter Foley » Wed Mar 20, 2013 11:56 am

Although our "headroom" numbers are different, I'm in the same boat. I will be doing my conversion over the next 3-4 years. I've tried to map as best I can my AGI numbers for the next 5-7 years. My intention is to fill up the 15% bracket and then use about $10,000 worth of the 25% bracket each year. This will help spread out the additional tax payments. If there is a significant market downturn during the next 3-4 years I will accelerate the process to convert more TIRA while it is worth less. If there is no market downturn, I'll be happy - my accounts will have grown. If there is a downturn, I will pay less in taxes on conversion to offset the loss.

The ability to employ this strategy would lead me to advise you to do the conversion over a number of years. Some individuals may also be able to tax loss harvest during a downturn to provide some additional headroom.

Topic Author
BobSnipes
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Re: Roth Conversion strategy

Post by BobSnipes » Wed Mar 20, 2013 1:10 pm

Thanks for the helpful comments thus far!

archibish99, the second of your two options is actually my number 2, though I had planned to invest the "remainder" the first year of partials instead of the last, in case it grows :!:

peter, your approach and your reasons for it appeal to me ... it's a little like dollar cost averaging, but with some control in that you can step up conversions during down times. It also allows adjustment for other unforeseen events with tax consequences.

Following what the two of you are suggesting, maybe I need not complicate things with multiple funds. Perhaps I should simply convert from VSMGX to VTXVX, spreading my encroachment into the 25% bracket over time, but before the predictable jump in income.

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House Blend
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Re: Roth Conversion strategy

Post by House Blend » Wed Mar 20, 2013 1:35 pm

Welcome to the forum.

From what you describe, scenario 1 would be much more tax costly. I would stick with partial conversions up to the top of the 15% bracket.

If you have any qualified dividends or LT cap gains, remember that those will be tax free while you stay inside the 15% bracket. (This is a reason why you might want split out your portfolio into its component parts and have more of your stock index funds like TSM in taxable.) Once you start taking SS benefits, then the taxation gets more complicated, but qualified dividends and LT cap gains are still given preferential treatment.

Note that the first RMD on a balance of $46K is about $1.7K.
BobSnipes wrote:So I would "front-load" the conversion, converting that amount this year as well as making max Roth contributions for 2012 and 2013 (total of $13000 additional
Is your spouse not retired, or are you only semi-retired? Otherwise, you aren't qualified to make new contributions to a Roth IRA. (Conversions are allowed.)

Or maybe what you are saying is that you retired this year, so still have qualifying income for 2012 and 2013. Just checking.

kaneohe
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Re: Roth Conversion strategy

Post by kaneohe » Wed Mar 20, 2013 2:21 pm

Peter Foley wrote: My intention is to fill up the 15% bracket and then use about $10,000 worth of the 25% bracket each year. This will help spread out the additional tax payments.
Remember that if you have >=10K of QDIV/LTCG and if you fill the 15% bracket and also use 10K of the 25% bracket w/ conversions, that last 10K will be effectively taxed at 30%.

Topic Author
BobSnipes
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Re: Roth Conversion strategy

Post by BobSnipes » Wed Mar 20, 2013 2:45 pm

Thanks for the additional posts. To respond... I am widowed with annual self-employment income in excess of the 2012 6k and 2013 6.5 contribution maximums. I have only the TIRA, which I will totally migrate to the Roth by age 70. So I have no taxable accounts or investments to benefit from 0% taxation of Q/DIV or LTCG in the 15% bracket. For that reason, I feel a little freer about making roughly equal annual contributions pushing me into the 25% bracket in order to complete conversion prior by age 70.

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VictoriaF
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Re: Roth Conversion strategy

Post by VictoriaF » Wed Mar 20, 2013 3:05 pm

My situation will be similar to yours, except that I will be converting to Roth within the 25% bracket with the goal of completely eliminating non-Roth accounts and avoiding RMDs all together. If I were to receive RMDs by the time I am 70.5, I would be in a high effective bracket with respect to the Social Security taxation. Take a look at the Bogleheads Wiki on Social Security, link. Depending on the pension amount, single tax payers could be in the 46.25% bracket.

Your options 1 and 2 are not the only options. With option-1 much of your conversions would be taxed at 25%, with option-2 you would have left-over traditional accounts subject to RMD. A better approach, in my opinion, is to divide your total tax-deferred assets by the six years you have to covert, and convert one-sixth each year. That way, you would eliminate RMDs, and the extra amounts subject to the 25% tax would be smaller than with your option-1.

Note that if you are planning to establish income-based eligibility for health-exchanges or other programs, you may need to hold off conversions until you become eligible for Medicare.

How to invest your funds is a different discussion, not related to your tax management strategies.

Good luck,

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

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elgob.bogle
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Re: Roth Conversion strategy

Post by elgob.bogle » Wed Mar 20, 2013 4:12 pm

FWIW - I retired at 63 and I am also delaying my SS until 70. I am married and I am covered by my spouse's medical plan & prescription plans. She is 7 years younger than me. This is important for us because it will allow me to do all of my TIRA2RIRA conversion before age 68. Therefore, since the government looks back 2 years at one's income when determining what one's Medicare Part B & Part D payments should be, I will have cleared the high income hurdle and will not have to pay excessively for two years (ages 70 & 71). The difference between what we pay for my coverage on her plan and what I would pay for Part B&D for those two years will buy a lot of gasoline.

As a consequence of your conversions, you also will face the prospect of the increased income elevating your Medicare parts B&D Payments. It may be possible to purchase a medical & prescription plan (equivalent to Parts B&D), just before age 65, that is cheaper than the projected elevated government B&D premiums. By this method you might legally delay enrollment in Parts B&D when you reach 65, and save a few $$.

I have not found any kind of calculator that will help one figure this out. I did my work longhand.

good luck
elgob

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VictoriaF
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Re: Roth Conversion strategy

Post by VictoriaF » Wed Mar 20, 2013 4:24 pm

elgob.bogle wrote:FWIW - I retired at 63 and I am also delaying my SS until 70. I am married and I am covered by my spouse's medical plan & prescription plans. She is 7 years younger than me. This is important for us because it will allow me to do all of my TIRA2RIRA conversion before age 68. Therefore, since the government looks back 2 years at one's income when determining what one's Medicare Part B & Part D payments should be, I will have cleared the high income hurdle and will not have to pay excessively for two years (ages 70 & 71). The difference between what we pay for my coverage on her plan and what I would pay for Part B&D for those two years will buy a lot of gasoline.

As a consequence of your conversions, you also will face the prospect of the increased income elevating your Medicare parts B&D Payments. It may be possible to purchase a medical & prescription plan (equivalent to Parts B&D), just before age 65, that is cheaper than the projected elevated government B&D premiums. By this method you might legally delay enrollment in Parts B&D when you reach 65, and save a few $$.

I have not found any kind of calculator that will help one figure this out. I did my work longhand.

good luck
elgob
Elgob,

This is something new to me. So you are planning to start Medicare parts B and D at the age of 70 instead of 65? I did not know it was possible, or that if it were possible it were prudent. I wonder if your situation is applicable to me, because I will be covered by the Federal Employee Health Benefits (FEHB) in retirement. It appears that I should accelerate my Roth conversions and delay taking Medicare parts B and D until two years after I have done the Roth. Is that right?

Thank you,

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

DickBenson
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Re: Roth Conversion strategy

Post by DickBenson » Wed Mar 20, 2013 5:19 pm

If you made a total conversion to Roth by the time you reach RMD age (doing some at 25%), would your income at that time (pension, SS, self employment, etc.) keep you within the 15% bracket?. If so, you might consider delaying some of the conversions over the next 6 years at 25%, and finish up the conversions at 15% while in the RMD period.

Dick

edit: Sorry, missed your statement in OP that "Soc Sec will push me into the 25% bracket when I begin drawing at age 70", so ignore the above. Thought that the 12K headroom, the end of self employment income and than not all of SS would be taxable, might keep you in the 15% bracket.
Last edited by DickBenson on Wed Mar 20, 2013 6:57 pm, edited 1 time in total.

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Peter Foley
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Re: Roth Conversion strategy

Post by Peter Foley » Wed Mar 20, 2013 5:43 pm

Kaneohe wrote:
Peter Foley wrote: My intention is to fill up the 15% bracket and then use about $10,000 worth of the 25% bracket each year. This will help spread out the additional tax payments.


Remember that if you have >=10K of QDIV/LTCG and if you fill the 15% bracket and also use 10K of the 25% bracket w/ conversions, that last 10K will be effectively taxed at 30%.
I think I follow you. Is this because I would use up the entire 15% bracket and therefore have QDIV that would be subject to taxation that would otherwise be tax free?
I have about $5,000 in QDIV each year. I don't forsee any capital gains.

That being the case one would be better off to aim for the top of the 15% bracket except for one year during which you use up more 25% space.

kaneohe
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Re: Roth Conversion strategy

Post by kaneohe » Wed Mar 20, 2013 6:01 pm

Peter Foley wrote:Kaneohe wrote:
Peter Foley wrote: My intention is to fill up the 15% bracket and then use about $10,000 worth of the 25% bracket each year. This will help spread out the additional tax payments.


Remember that if you have >=10K of QDIV/LTCG and if you fill the 15% bracket and also use 10K of the 25% bracket w/ conversions, that last 10K will be effectively taxed at 30%.
I think I follow you. Is this because I would use up the entire 15% bracket and therefore have QDIV that would be subject to taxation that would otherwise be tax free?
I have about $5,000 in QDIV each year. I don't forsee any capital gains.

That being the case one would be better off to aim for the top of the 15% bracket except for one year during which you use up more 25% space.
I think you got it.......imagine filling to the top of the 15% bracket w/ your Roth conversion. Your QDIV sits on top of your other income and is taxed at 0%.
Now imagine that you add another 5K of conversion income. That added income is taxed at 15% and pushes the QDIV into the 25% bracket where it also is taxed at 15%........the net result is that incremental addition of 5K conversion income is effectively taxed at 30%. However, once you have pushed all the QDIV into the upper brackets, there are no more surprises so additional conversion income is just taxed at the 25% bracket for awhile. Your idea of bunching might be more effective since you only take the 30% hit (an extra 5%) once as long as you stay within the 25% bracket. Best to check all assumptions w/ tax software/calculator.

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elgob.bogle
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Re: Roth Conversion strategy

Post by elgob.bogle » Wed Mar 20, 2013 8:38 pm

Victoria - not to steal the thread - but yes. We also will be able to keep our combined incomes (her salary plus my TIRa2RIRA) under the $250k limit that would bump us into higher tax bracket. The plan is to only enroll in part A at age 65, and parts B&D when I reach 70 & she retires (likely simultaneously).

elgob

PS - I think that this topic, fully developed, would be a good addition for the WIki. However, I am not an expert and would hope that others, like the SS & insurance wizards who visit this board would be able to flush out the ideas.

Carl53
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Re: Roth Conversion strategy

Post by Carl53 » Wed Mar 20, 2013 9:17 pm

OP, I suspect that your option 2 will be best. Once your SS kicks in your marginal bracket will no longer be 15% but likely 22.5% if 50% of SS is taxable, on up to 27.5% if 85% is taxable. If you are truly in the 25% bracket, you may have already have filled up the 27.5% bracket and headed to the dreaded 46.25% bracket.

The following link is to a rather dated post and graphic that will show you what is going on. Note that the brackets have changed since that post was made but the concept is still valid. The second graph shows the pain that a single person with a good SS benefit may have.

http://www.bogleheads.org/forum/viewtop ... =1&t=70229

Be sure to read the thread's first post to understand the axes, as it probably could have been labeled better.

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