Ken Schwartz et al. More on Roth Conversion

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
Beth
Posts: 366
Joined: Thu Apr 05, 2007 8:32 am

Ken Schwartz et al. More on Roth Conversion

Post by Beth »

First, thanks Ken for the referral to the Fairmark web site; I've bookmarked that one for future reference.

For those, like me, who are math challenged and have difficulty thinking in terms of present and future value of money, can you shed some light on my decision making process.

I have pulled off the irs.gov site the 2007 Form 1040 and Instructions and pre-figured our tax return this year. Ordinarily, we are in the 25% bracket. This year, b/c of a rough patch of unemployment, we are in the 10% bracket. I plugged in scenarios on Vanguard's "Should I convert..." calculator and this is what I get. VG's calculator is loaded with 2006 tax tables, but I suspect that doesn't really matter relative to my question.

If I limit conversion to stay w/in the 15% bracket, I can convert $55,000 and have $128,240 at a presumed w/drawal age of 65, a presumed 25% tax bracket in retirement and an allocation of the converted funds 100% stocks annually returning 8%. If I don't do the conversion, the $55K is worth $113,949 at age 65.

Conversely, if I bump up the conversion to $100,000, which pushes me to the 25% bracket, I have $233,164 and $225,985, respectively with the same assumptions as above.

Under the first scenario, there is a difference of $14,291 in the end results (tax owed=$8250). The spread narrows to $7,179 under the second scenario (tax owed=$25,000). I can pay the tax with non-IRA money.

I don't know how to interpret these results. Should I stay away from any conversion that pushes me into the 25% bracket (even tho' that's where we usually are)?

Any help appreciated in understanding the ramifications of a conversion. Thanks. Regards, Beth
xenial
Posts: 2704
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial »

Hi, Beth. I'm no expert, but I'll provide a few thoughts. Hopefully, more knowledgeable posters will add their opinions. Keep in mind that conversion decisions are a very inexact endeavor. The right answer depends on unknowable information, like your future income/deductions and future tax rates.
Beth wrote:This year, b/c of a rough patch of unemployment, we are in the 10% bracket.
Think of your difficulties as providing an excellent conversion opportunity.
Beth wrote:... a presumed 25% tax bracket in retirement...
Are you sure it will be that high? Keep in mind that even if your federal marginal rate is indeed 25%, some of your income will be taxed at 0%, then some will be taxed at 10%, and then some at 15%.
Beth wrote:....and an allocation of the converted funds 100% stocks annually returning 8%.
Yikes. Are you sure in retirement that you want to invest your Roth entirely in equities? Tax advantaged accounts are a good place for bonds.
Beth wrote:Conversely, if I bump up the conversion to $100,000,...
Watch out. There are income limits on conversion eligibility. From the Fairmark site,
For years before 2010, if your modified adjusted gross income is greater than $100,000, you can't roll a regular IRA to a Roth IRA.
This limit is scheduled for elimination in 2010. Of course, tax laws can always change.
Beth wrote:Should I stay away from any conversion that pushes me into the 25% bracket ...
Except for folks who anticipate a high income in retirement, this policy is worth considering.

Best wishes,
Ken
earlyout
Posts: 1436
Joined: Tue Feb 20, 2007 5:24 pm

Income limits on Roth conversion

Post by earlyout »

Beth,

Ken's response mentions the $100,000 modified AGI limit for converting a TIRA to a Roth. This modified adjusted gross income does not include the amount you convert from a traditional to a Roth IRA. The Fairmark site has the details.

EO
allancoleman
Posts: 406
Joined: Tue Sep 11, 2007 9:00 pm
Location: Alaska & Hawaii

Post by allancoleman »

I'm pretty much in agreement with Ken , Beth . I've never used any Roth calculators , but common sense told me years ago that if I didn't take advantage of Roth conversions that I would be in the highest tax bracket forever after RMD age of 70 . All of my Roth conversions have been done in the 25% marginal income tax bracket with a effective tax rate varying from 22% down to 14% with my last few coming in at approximately 14% as I've learned to fine tune my income using tax software . My average Roth conversion has been approximately $100k with this tax year being $85k .

I presently have all my Roths at Vanguard in a mix of their GNMA Admiral class fund ( VFIJX ) and their High - Yield Admiral class ( junk ) bond fund ( VWEAX ) . This is because my Roths are intended as my " last money spent " as I continue to convert more of my deferred accounts and will take future distributions from them in retirement until they are all depleted and then I'll turn to my Roth for either living expenses or a gifting program for heirs .
xenial
Posts: 2704
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial »

earlyout wrote:Ken's response mentions the $100,000 modified AGI limit for converting a TIRA to a Roth. This modified adjusted gross income does not include the amount you convert from a traditional to a Roth IRA. The Fairmark site has the details.
I didn't know that! Here's what the Fairmark site has to say.
Exclude Conversion Income

There's an additional modification that's made only when you're determining modified AGI for purposes of the Roth IRA. In this case you exclude any income you report as a result of converting a traditional IRA to a Roth IRA. Without his favorable rule, the income reported on the conversion could prevent you from making additional Roth IRA contributions — or even disqualify the very same conversion that is causing you to report the income!
Best wishes,
Ken
DickBenson
Posts: 809
Joined: Sun Apr 08, 2007 7:27 pm

Post by DickBenson »

In deciding conversion issues, I'm a big fan of using the interpretaion, that Larry has pointed out, that a TIRA is also a tax free investment. So I'm going to repost a response I made to someone who expected to be in a 25% bracket upon retirement, and was considering converting 100K.


"....as Larry has pointed out in earlier posts, your 75K is earning TAX FREE returns for you, and you are investing the government's 25K for them, also tax free. If this doesn't make sense, take a look at my long-winded post

http://www.diehards.org/forum/....a+tax+free

One interpretation is that if you are presently in the 25% tax bracket, and have 25K in your taxable account, you can put this in your IRA (by using it to convert your IRA to a ROTH). You've kicked the government out of your IRA, and your 25K is now generating tax free returns. You haven't "lost" any money by doing this as your IRA (ROTH) is now ALL yours.

Even better, if you can convert at 15%, you "pay off the loan" at a discount (assuming 25% at retirement). The only way you lose is if you convert at a higher rate than your rate at retirement."

Sorry if the link doesn't work. I bookmarked it, but I'm using Safari and I think the post was on the M* board, to which I no longer have access.

Dick
DickBenson
Posts: 809
Joined: Sun Apr 08, 2007 7:27 pm

Post by DickBenson »

Since my link does not seem to work, I'll post the following. However, since it is a little long-winded, I would recommend you read it only if you have difficulty with the tax-free TIRA concept.
..........................

In a post on the diehard board a few weeks ago, Larry Swedroe pointed out that a traditional IRA was really a TAX-FREE investment. After a couple of days I finally understood what he meant. In my opinion, it presents an interesting viewpoint for many of the issues involving TIRAs and ROTHs.

He also commented that even financial advisors have difficulty with this concept. So I thought I might try to develop a reasonable explanation of this interpretation of a TIRA. Consider this a beginning, and I hope that others will comment, edit, and/or present clearer explanations.

A MAJOR assumption in the following will be that your tax bracket will remain FIXED in the 25% bracket. (A change in tax brackets would have significant impact, but will deal with this later). Will also assume that all investments have an 8% return. With these assumptions then here are some examples.

TAX-FREE TIRA interpretation:

<b>If you have $4,000 in a TIRA (Traditional IRA) then:

$3,000 of it belongs to you (your share) and it is generating TAX-FREE returns for you.
$1,000 of it belongs to the government ("loan") and is generating TAX-FREE returns for the government.</b>

Essentially, you are acting as a financial manager for the government and investing their $1,000 for them (They of course receive all the income you generate for them tax free).

In return, you get to invest $3,000 tax free in your TIRA.

To see that this "view" is equivalent to the usual understanding that a TIRA generates TAXABLE returns, let's look at what happens to a $4,000 TIRA after one year from both viewpoints.

1. TAXABLE

$4000 generates taxable returns at 8% to achieve a value of $4,320.
Taxes due upon withdrawal would be $1,080.
Your share of the TIRA becomes........... $3,240.
Government's share becomes ...............$1,080

2. TAX-FREE

Your share ($3,000 at 8%} generates $240 tax free to become...........$3,240.
Government"s share ($1,000 at 8%) generates $80 to become.......... $1,080.

Thus, both views have the same result.

................................................................................................................

Use in a ROTH conversion decision. Assume you have:

$1,000 in a taxable account and
$3,000 (your share) of a $4,000 TIRA
(8% returns)

1. STAY with TIRA

After one year the TIRA grows to $4,320

Your 3000 share of TIRA grows tax-free to ..............$3,240
Your 1000 taxable grows (after tax 6%) to.................$1.060

TOTAL........<b> $4,300</b>

2. CONVERT to ROTH

Use the $1,000 in your taxable account to convert the TIRA to a ROTH (then ALL of your IRA belongs to you). You've paid off your government "loan". Somewhat similar to paying off the mortgage on your house. You really haven't changed your "net worth",....it's simply distributed differently.

After one year the ROTH grows to $4,320 (All yours)

TOTAL.........<b>.$4320</b>

GAIN............<b>$20</b>

Note: Although there is only a small dollar benefit with the ROTH conversion, that $20 annual increase will become larger and more significant with a larger account ($2,000 with a 400K IRA).

However, the main observation should be that, under the above assumptions of fixed tax rate, etc., you do not "lose money" by "paying off" that "government loan" and you quit acting as a "financial manager" for government funds.

It is difficult for many to overcome the feeling of loss when they pay taxes and they sometimes miss making appropriate moves. Perhaps the "paying off the mortgage" analogy might help with this issue.

.......................................................................................

Use in decision to contribute to ROTH or to a TIRA.....Assume you have earned $4,000.

Do you want to have a $4,000 ROTH, or do you want to have a $3,000 tax free investment in a $4,000 TIRA and $1,000 in a taxable account.

The latter would probably be best if you knew that your tax bracket would be less in retirement, or if you were unable to contribute the maximum amount to your IRA.

Otherwise, if you had the resources for annual $4,000 contributions, it probably would be best to contribute to a ROTH.

,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,

Impact of tax bracket changes

Again comparing the government "loan" in your TIRA, with a "mortgage" loan on your house, you could look at the impact of tax bracket changes upon a ROTH conversion in the following manner. Suppose you convert to ROTH.

If tax bracket increases at retirement you have paid off the loan at a discount.

If tax bracket decreases at retirement you have lost some equity.
..........................................................................................

Other considerations:

Tax bracket might increase at retirement due to government changes in tax code and/or increases in income due to pension, social security, RMD, etc. (in particular RMD might also trigger taxation of social security).

With ROTH (no RMD) you need not decrease your tax-free investments during retirement.

Inheritance of ROTH better than inheritance of TIRA.

Dick
xenial
Posts: 2704
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial »

Dick, here's your intended link. The trick is to do a Google search restricted to the desired website using a unique phrase from the post. So I tried "this interpretation of a TIRA" site:morningstar.com, and your conversation was the only hit.

Best wishes,
Ken
Topic Author
Beth
Posts: 366
Joined: Thu Apr 05, 2007 8:32 am

Thank you all who responded.

Post by Beth »

Your links will take me awhile to digest and I will be on the road for a week, but I wanted to acknowledge your help in aiding me to understand this undertaking. Ken, I took the calculator's question to mean that I would invest only the converted funds in stocks that I would expect to return 8% annually until I hypothetically started to w/draw at age 65. Overall, my AA is 55/45. At the Fairmark message boards I saw a conversation by a gentleman who is our age and with similar tax bracket who has methodically been converting with the plan to have everything in Roth by the time he and his wife retire. His motivation was the expectation that the economic policies today will inevitably wreak havor on his retirement thru an increased tax burden and he wanted to shelter his income from taxes. I believe that also, and it doesn't look like moving to another country to retire will enable us to escape Uncle Sam's taxing authority, so we are left with the idea that Roth is here to stay and that conversions are the best strategy to protect against a hurtful tax bite once you leave the workforce. I realize we should have started doing this before age 54, but there you go. I realize we have a golden opportunity this year with an abnormally low income during a year when we have sizable deductions that will essentially zero out our taxable income (ex-conversion amounts).

My basic question remains, however, is there any limit to what we should convert, as long as we have the non-IRA funds to pay the taxes?? Or should we stay within the 25% tax bracket where we normally reside when our employment situation is restored to its usual status? Thanks, Beth
Allan
Posts: 875
Joined: Wed Feb 21, 2007 9:15 pm
Location: Houston

Post by Allan »

I think the conversion issue is very simple. We typically contribute to our IRA/401(k) etc over a several years, I will call these contributions Event A. At some moment you will either voluntarily withdraw money or you will involuntarily withdraw because of RMD‘s. I will call that Event B, and of course these typically happen all over several years. The issue to convert (I will call Event C) can also be a multiple year occurrence..

Simply put, the goal is to contribute and defer (Event A) at a higher marginal tax rate than you are at Event B (withdrawal or RMD) or at Event C (conversion). Also, make sure Event C (conversion) happens before Event B (withdrawal or RMD). Seems to me nothing else really matters.

If you contribute and defer at 25% (or lower) and withdraw or convert at 25% (or higher), you’ve gained nothing, in fact because your withdrawals are taxed at ordinary tax rates rather than capital gains, you may even lose more than if you had simply invested in taxable accounts.
xenial
Posts: 2704
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial »

Beth wrote: Ken, I took the calculator's question to mean that I would invest only the converted funds in stocks that I would expect to return 8% annually until I hypothetically started to w/draw at age 65. Overall, my AA is 55/45.
I'm confused. Regardless of what the calculator assumes, where are you intending to put your 45% bonds? Bonds are tax-inefficient, so they don't usually belong in a taxable account.
Beth wrote:At the Fairmark message boards I saw a conversation by a gentleman who is our age and with similar tax bracket who has methodically been converting with the plan to have everything in Roth by the time he and his wife retire. His motivation was the expectation that the economic policies today will inevitably wreak havor on his retirement thru an increased tax burden and he wanted to shelter his income from taxes. I believe that also, and it doesn't look like moving to another country to retire will enable us to escape Uncle Sam's taxing authority, so we are left with the idea that Roth is here to stay and that conversions are the best strategy to protect against a hurtful tax bite once you leave the workforce.
I'm not quite that pessimistic.
Beth wrote:My basic question remains, however, is there any limit to what we should convert, as long as we have the non-IRA funds to pay the taxes?? Or should we stay within the 25% tax bracket where we normally reside when our employment situation is restored to its usual status?
Yes, there's a limit, but there's no way to know it, since it depends on future tax rates and changes in your personal circumstances. Normally folks have much lower incomes in retirement than they have while working. Keep in mind that it's not your marginal tax rate in retirement that matters, but your overall tax rate. As I commented earlier, some of your income will be taxed at 0%, then some at 10%, etc. Try to limit the influence of your political crystal ball in making conversion decisions, i.e., your apparent belief that tax rates will skyrocket. Unless you're expecting an abnormally high retirement income, you might think about converting only to the top of the 15% bracket.

Best wishes,
Ken
User avatar
alvinsch
Posts: 1612
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch »

Allan wrote:If you contribute and defer at 25% (or lower) and withdraw or convert at 25% (or higher), you’ve gained nothing, in fact because your withdrawals are taxed at ordinary tax rates rather than capital gains, you may even lose more than if you had simply invested in taxable accounts.
Huh? You believe that a taxable account will beat a ROTH or TIRA if one stays in the same tax bracket? That is clearly wrong. Consider the following example of investing $4000 in effective after tax dollars into a ROTH, a TIRA and a taxable account for 20 years where ones ordinary tax bracket is always 25% and CG bracket is 15%.

1. $4000 into a ROTH
$26910 = $4000 * 1.1^20

2. $4000 in a TIRA plus invest the $1000 tax savings in perfectly tax efficient taxable fund.
$20182 = $4000 * 1.1^20 * .75
$ 5868 = $1000 * 1.1^20 - 1000 * .85 + 1000
-------
$26051 = total after tax value

3. $4000 in perfectly efficient taxable account (no distributions)
$23473 = $4000 * 1.1^20 - 4000 * .85 + 4000

Clearly the taxable account loses to both the ROTH and TIRA (hard to beat an effective tax free investment). The ROTH beats the TIRA because you can effectively put more money in a ROTH so more grows tax free. This is often missed when people point out they are equivalent. They are equivalent only if one can put the same "after tax" value in each (i.e. putting $4000 in a ROTH would be equivalent of $5333 in TIRA in 25% bracket but one can't contribute $5333 to a TIRA).

Hope that helps.
- Al
Post Reply