Where is "pay tax to convert to Roth" in investing

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Ken Reckers
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Where is "pay tax to convert to Roth" in investing

Post by Ken Reckers » Thu Jun 14, 2007 11:14 am

For the general rule of thumb for investing priority, these four make sense to me:

1. 403b up to the match
2. Max out Roth
3. Max out 403b
4. Taxable investing

Where in the priority order would this be: "use investment dollars to pay for converting traditional IRA to Roth IRA"?

Assumptions for my case: marginal federal tax rate is 15%, and taxable income is about $25K less than the cutoff into the next higher bracket. Suppose I assume my marginal tax rate will never be lower than it is now, and I do want to convert. Also suppose that in the (near?) future I am not going to save enough to come anywhere even close to maxing out Roth *and* maxing out 403b *and* paying tax to convert all of the traditional IRA. (Employer contribution to 403b is a fixed percent regardless of whether I contribute or not.)

Part of me wants to get that conversion over and done with, thinking that the longer I wait, the more it will cost me to convert.

Another part of me thinks that taking longer to convert would actually give me more tax-deferred space. Also, maybe that conversion cost is the same now or later, when brought back to present value dollars, as long as my tax bracket remains the same.

But then the first part of me says I'm never going to run out of tax-deferred space anyway, because I don't save that much. Plus, my tax bracket might go up.

Any thoughts?
Last edited by Ken Reckers on Mon Jun 18, 2007 11:05 am, edited 2 times in total.

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Prokofiev
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Post by Prokofiev » Thu Jun 14, 2007 12:31 pm

Where would you convert from? Can't convert from a 403b or a 401k. Must first roll-over to an IRA.

If you are not presently maxing out your 403b and ROTH, why would you use extra taxable dollars to do this conversion, assuming it is possible? First put this money into your available tax-defered options.

Just my opinion . . . P
Everything should be made as simple as possible, but not simpler - Einstein

Lucija
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Post by Lucija » Thu Jun 14, 2007 12:36 pm

For me the ideal place for "tax for ROTH conversion" $$ would be between 3 & 4. Since you do not think you will be able to max out 403b contributions and you want to convert (at least a portion of your) TIRA to ROTH, I think you should insert "tax for ROTH conversion" $$ between 2 & 3.

I think, this may be a good move for you since you are currently in a pretty low tax bracket and you do not think your tax rate will be any lower in the future (either based on the assumption you will maintain/increase spending/pay or due to a belief that overall future tax rates will be higher). Also, this could be an especially good move if your 403b options are limited/costly.

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grabiner
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Re: Where is "pay tax to convert to Roth" in inves

Post by grabiner » Thu Jun 14, 2007 10:48 pm

Ken Reckers wrote:For the general rule of thumb for investing priority, these four make sense to me:

1. 403b up to the match
2. Max out Roth
3. Max out 403b
4. Taxable investing

Where in the priority order would this be: "use investment dollars to pay for converting traditional IRA to Roth IRA"?
If you expect to be in a higher tax bracket when you retire, then converting a traditional IRA to a Roth is better than investing in a Roth. If you expect to be in the same tax bracket when you retire, then converting is equal to investing in a Roth. If you expect to be in a slightly lower tax bracket, then converting is still better than taxable investing.

For example, suppose you are in a 25% tax bracket now, and can either pay $2500 to convert a $10,000 IRA to a Roth or use it for an investment. If you convert now, you will have $10,000 in a Roth, which is tax-free. If you don't convert, you will have $10,000 in a traditional IRA, which is worth $7500 if you retire in a 25% tax bracket; you will also have $2500 to invest.

If you invest that $2500 in a Roth IRA, it is worth $2500 tax-free, so it is just as good as using the money for a conversion in the 25% tax bracket, and better if you will retire in a higher tax bracket.

If you invest in a 401(k) or 403(b), you can invest $3333 because you get an $833 tax deduction. If you retire in a 25% tax bracket, this is worth $2500 tax-free, but is likely to be worth slightly less because the fees on your 401(k) or 403(b) are usually higher than the fees in your Roth. For example, if you pay 0.5% a year in extra expenses and the money doubles before expenses in ten years, you will have $6000 rather than $6667, which becomes $4500 rather than $5000 after tax.

If you invest that $2500 in a taxable account for the long term, you may lose about 30% of your investment to taxes, so it is only worth $1750. (This estimate is reasonable but quite variable). Thus, if you will retire in a 20% bracket, it is worth converting the traditional IRA to a Roth rather than making a taxable investment. If you will be in a 15% bracket at retirement, it is better to make a taxable investment unless you expect to lose 40% of your taxable stock to taxes, which is unlikely.

One other point: if the conversion would push you up to the next tax bracket if all done in one year, consider spreading it out over several years if you can do it all in the lower bracket.

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CABob
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Doesn't fit exactly

Post by CABob » Fri Jun 15, 2007 1:38 pm

For the general rule of thumb for investing priority, these four make sense to me:

1. 403b up to the match
2. Max out Roth
3. Max out 403b
4. Taxable investing

Where in the priority order would this be: "use investment dollars to pay for converting traditional IRA to Roth IRA"?
I'm not sure it should even be on this list since it seems to me to be a different consideration than the contributions involved with these four. If I am forced to put into this list it would have to be after #3 since it doesn't make sense to hold off tax deferred investing, then withdrawing from tax deferred and paying the taxes due. Where is falls in priority with regard to #4 would be debatable and subject to some personal and individual circumstances.

Bob

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alvinsch
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Re: Where is "pay tax to convert to Roth" in inves

Post by alvinsch » Fri Jun 15, 2007 1:45 pm

Ken Reckers wrote:For the general rule of thumb for investing priority, these four make sense to me:

1. 403b up to the match
2. Max out Roth
3. Max out 403b
4. Taxable investing

Where in the priority order would this be: "use investment dollars to pay for converting traditional IRA to Roth IRA"?...
I would consider it a subset of #2 which I believe should read "Max out IRA", using either traditional or ROTH depending on which is most advantageous to your current and future tax situation. If a ROTH is most advantageous for you in step 2, then it's likely a ROTH conversion is equally advantageous up to the top of your current marginal tax bracket.

Just my two cents.
- Al

Pangloss
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my vote

Post by Pangloss » Sat Jun 16, 2007 10:15 am

I'd place this option as #2.5 unless it'll push you into the next tax bracket. You could think of a roll over as essentially a bonus contribution to your Roth. Roth is paid with after tax money and the rollover is really just a lot more money you can put into Roth after paying taxes. For example, you pay taxes on $4K and then move the money from your checking account to your Roth or you pay taxes on $4K and move it from you rollover to your Roth. In both cases you've paid taxes on the money and increased your Roth by $4K. However, since the $4K in the rolloever is already tax sheltered, I'd not convert it at the expense of reducing my Roth contribution. Having said all that, I should add that I believe in maximizing Roth savings in the (perhaps foolish) hope that congress will not one day double tax me on the money.

Ken Reckers
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Post by Ken Reckers » Mon Jun 18, 2007 11:03 am

Thank you all for your well-reasoned replies. Each is very logical to me, although your conclusions vary. I appreciate both the numerical examples as well as the alternative ways to conceptualize the problem.

I will tell you that I had thought, for my own case, that "pay tax to convert to Roth" should be #1.5 in the list. Almost no one seems to agree, but I am not convinced that I am wrong, either.

Let's say I have $100,000 in the traditional IRA. (Some of it has always been trad IRA; most of it is 401k conversion from wife's former job.)

I am in the 15% marginal bracket. I therefore call $85,000 my (our) own. I regard $15,000 of it as belonging to my investment partner, Uncle Sam.

Code: Select all

		
             Mine    Sam's
Trad IRA   85,000   15,000
Roth IRA        0
Total      85,000	
If I invest $4000 directly to Roth, it will look like this:

Code: Select all

		
             Mine    Sam's
Trad IRA   85,000   15,000
Roth IRA    4,000
Total      89,000	
Alternatively, I can use the $4000 to "buy out" my investing partner Sam. I convert $26,667 from trad to Roth. $22,667 of that is mine anyway, and $4000 of it was Sam's. Here's the result:

Code: Select all

		
             Mine    Sam's
Trad IRA   62,333   11,000
Roth IRA   26,667
Total      89,000	
Either way, I now have $89000 that belongs to me.

I am assuming that the $26667 additional income will not push me into the next higher tax bracket.

Now a year goes by, and this earns 8%. If I had invested directly in Roth, I have this:

Code: Select all

		
             Mine    Sam's
Trad IRA   91,800   16,200
Roth IRA    4,320
Total      96,120	
Alternatively, if I had converted, I have this:

Code: Select all

		
             Mine    Sam's
Trad IRA   67,320   11,880
Roth IRA   28,800
Total      96,120	
Continue for a total of 4 years, either always investing directly in Roth, or always converting. I am now ready for another decision on what to do with the my annual $4000 investment.

Here I am, if I always invested directly in Roth:

Code: Select all

		
             Mine    Sam's
Trad IRA  115,642   20,407
Roth IRA   19,466
Total     135,108	
Here I am, if I always paid tax to convert:

Code: Select all

		
             Mine    Sam's
Trad IRA    5,332      941
Roth IRA  129,776
Total     135,108	
I think I'd rather be in the last situation, because I believe my tax rate is low. What happens if Sam decides he should get 25% of my trad IRA instead of 15%. Clearly the last table is better than the second to last one.

But what if, at that point, I find myself in a better financial state, able to invest a lot more each year than currently. With the second to last table, I have the ability to max out the annual Roth contribution, plus effectively contribute even more by converting. With the last table, there is practically nothing left to convert.

So thinking it through as I type, it seems I what I have to predict about the future is not only whether my tax rate will go down (I bet not) or up (I bet yes). I also have to predict whether I will wish to have the ability to "more than max out" the Roth in some future years, because that desire is in competition with the tax bracket consideration.

Oh, oh, here come the college years for my children in 6 years, making me seriously doubt I will find myself in a better financial state soon.

Does any of my thinking make sense? (Does anyone have actual experience in having already converted but regretted it, or vice versa?)

"Ken"

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grabiner
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You got it right

Post by grabiner » Mon Jun 18, 2007 10:57 pm

Ken Reckers wrote:Thank you all for your well-reasoned replies. Each is very logical to me, although your conclusions vary. I appreciate both the numerical examples as well as the alternative ways to conceptualize the problem.

I will tell you that I had thought, for my own case, that "pay tax to convert to Roth" should be #1.5 in the list. Almost no one seems to agree, but I am not convinced that I am wrong, either.
I agree with you (as I mentioned in an earlier reply), because of your situation. You are in the 15% tax bracket now, and you expect to be in a higher tax bracket at retirement.

And I use the same analogy in comparing traditional IRAs to Roths; your uncle Sam owns part of your traditional IRA, and you own the rest tax-free. If your uncle offers you a chance to buy him out at a bargain rate (because you are in a lower tax bracket now than you will be when you retire), take advantage of it.

DickBenson
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Effectively using IRA funds for conversion

Post by DickBenson » Tue Jun 19, 2007 2:53 am

The downside of using that 4000 to do a conversion is that this means there is 4000 less in your 403(b) or your IRA. This means that there will be 4000 less to be available to be converted to Roth status later on.

Believe that you would essentially be "using" IRA funds to make a conversion. Doubt that this would is wise even if you are in a 15% tax bracket.

Dick

xerty24
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Post by xerty24 » Tue Jun 19, 2007 4:07 am

Ken, I agree with your last analysis. Let's go with your assumption that your taxes are low now and will be higher later. Therefore after getting any matching in full, you will allocate your limited retirement savings to either your Roth IRA or converting your tIRA. Further contributions to the 403b are certainly out of the question until you have enough money to fund your Roth.

Grabiner and Dick make good points. If you're at 15% now and expect to be in 25% later, it's clearly a bargain to buy out your tIRA at 15% at some point before the 25% bracket kicks in... the question is when? Do it now and you forgo annual Roth contributions which you can't go back and fund later (should your savings rate increase), potentially reducing the total size of your tax-sheltered accounts. Do the Roth now and you'll need to come up with outside funds to pay for the conversion at some point, and the availability of those funds tends to correlate with increased income and hence higher taxes. Remember you can keep both options open by contributing to the Roth and potentially withdrawing the Roth contributions (principal only) tax and penalty free and spending that money later on the conversion should your hoped-for additional savings not materialize.

My advice is to look at the size of your tIRA relative to the $25K you have "left" in the 15% bracket. If your tIRA is large relative to this amount, say $100K, you will need to spend at least 4 years doing partial conversions to complete the rollover at a 15% tax rate. Therefore you might want to start early on this since it's hard to foresee your tax bracket 5+ years down the road and it would be a shame not to buy out your tIRA at 15%. On the other hand, if it's only $15K in the tIRA, I'd probably go the Roth route for now and hope you can come up with the extra savings some year (in excess of the Roth limit) to fund the conversion while you're still in the low bracket. In this case you only need to foresee your situation 1 year in advance and you can still change your plan and do the conversion instead of the Roth in the last year you'll be in the low bracket.

One tax aside to keep in mind - if you're in the 15% bracket and saving for retirement, you may qualify for the Retirement Saver's Credit on your Federal taxes. This can be a great deal and arranging to qualify for this may be more important than the issues you're currently considering. For married, you can get up to $2K in non-refundable credits if your AGI is under $30K (which can happen by making pretax 403b contributions, for example), which in almost all cases will entirely wipe out your Federal tax bill. You still can get a $400 credit up to $50K married. (For single, half the AGI cutoffs and half the credit amounts). One year me and my wife put in the max to our 403b's and managed to just get our income under $30K (from $60K+), which meant we paid almost nothing in Federal taxes on nominal salaries of $60K.

robiu977
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Defer tax the way to go?

Post by robiu977 » Tue Jun 19, 2007 7:07 am

I apologize to Ken as I am not trying to do a threadjack here but I did not want to start a whole new thread.

My rollover IRA just completed this morning and I also have an SEP-IRA I started a few weeks ago. I am filling out the paper work to convert these two to a Roth. On there, I can either withhold 10% federal or not do it. I assume it is better to not withhold, but I wanted to check here first. If I withheld, would my Roth decrease by the tax consequences? And then if I payed the taxes next year, could this tax consequence come basically from my bank acct then? Thanks.

Ken Reckers
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Post by Ken Reckers » Tue Jun 19, 2007 3:52 pm

grabiner, yes I admit I probably plagiarized the idea of my "investing partner" Uncle Sam from posts you made elsewhere about adjusting AA for expected tax bracket. I have appreciated your (and alvinsch's) analysis on that topic. That's probably what got me thinking about my question in the first place. It's difficult to bring oneself to make the conversion at all unless you look at it as having an investing partner. (The thing I don't like about my investing partner is that he might completely change the rules concerning what his share is, without consulting me.)

xerty, the $25K and $100K are approximately correct, so I like your analysis and advice about considering how far into the future can I make the prediction. 5 years is harder than 1 year. I actually had never heard of the Retirement Saver's Credit until you mentioned it. I doubt I can spare enough to reduce the AGI that low, but I will investigate.

I value all replies posted, and thank you.

robiu977, don't worry about the hijack. I have converted in the past, and I did not have anything withheld. I can't think of any reason to have tax withheld. The following April, either my refund was reduced, or I had to cough up extra dough. (Don't quote me on it, but I think you can put the amount withheld back in within X days. But if you don't put it back, I believe the amount withheld actually would count as a premature distribution, subject to penalty tax. As it says on the Vanguard form: "Important: In most instances, it is beneficial for you to elect not to have tax withheld.")

"Ken"

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