User:Fyre4ce/Roth conversion

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Fyre4ce/Roth conversions are permitted by US tax regulations. If you have a Traditional IRA, you can convert part or all of the account to a Roth IRA. Conversions may also be possible from employer plans (such as a 401(k)), which may allow in-service distributions and/or in-plan Roth conversions. You pay taxes as if you withdrew the entire amount converted, but without any penalty for early withdrawal; in return, the money will grow tax-free in the Roth IRA, and you will not pay any tax on that withdrawal if you meet the Roth IRA distribution rules. The gain or benefit depends on your current marginal tax rate, your expected marginal tax rate in retirement, and how you would otherwise invest the funds that you use to pay the taxes.

How to convert

With Vanguard, to convert, you buy shares (or open a new account) in your Roth IRA, and fund it by "selling" shares in your traditional IRA. If you convert shares in the same fund, you have not actually sold anything, so Vanguard will not charge a purchase fee or redemption fee on the conversion. Likewise, with other providers, notify the provider of which amount you want to convert.

If you are converting from an employer plan, you will need to either convert traditional or after-tax funds into a Roth sub-account (an in-plan Roth rollover), or roll a traditional or after-tax funds out into a Roth IRA (an in-service withdrawal). Plan providers aren't required to offer either of these options; contact your plan provider for details on what types of conversions are allowed and how they work.

All Roth IRA conversions are reported in Part II of IRS Form 8606. [1]

Whether and when to convert

A Roth conversion generates taxable income in the amount converted. In general, Roth conversions are beneficial whenever your marginal tax rate on the conversion is less than the marginal tax rate you expect to pay on withdrawals during retirement. However, if you expect your marginal tax rate to be even lower in future years, wait until that year to convert. If converting the whole amount from a traditional IRA would push you into a higher tax bracket, convert only as much to keep you in the current bracket, and convert the remainder in future years. Likewise, consider the possible effect on future marginal tax rates by making large Roth conversions - if you substantially reduce your pre-tax balance, your predicted tax bracket may be lower due to smaller taxable withdrawals or Required Minimum Distributions (RMDs), reducing the benefit of further Roth conversions.

Roth conversions may be beneficial in the following situations:

  • when unemployed or working fewer hours
  • when going back to school full-time instead of working
  • early in your career before you reach your peak income
  • when taking time off to care for a family member
  • in early retirement before Social Security is collected
  • when living in a low-tax or tax-free state, and expecting to move to a high-tax state

A Roth IRA is exempt from Required Minimum Distributions while you are alive. Therefore, if the Roth conversion is close to break-even but you might be forced to take distributions from your traditional IRA which are more than you need to live on, there is an advantage to conversion; you will keep more money growing tax-deferred for longer.

If your traditional IRA contains substantial non-deductible contributions, roll the pre-tax portion into an employer plan, or convert as soon as possible if it can be done for reasonable tax cost.

Paying conversion taxes with non-retirement funds

Because Roth dollars are worth more than pre-tax dollars, converting pre-tax money to Roth and paying the taxes with funds outside retirement accounts is a way to effectively contribute additional tax-protected money without counting toward annual contribution limits. Non-retirement funds could be cash flow from earned income, or from the sale of taxable investments. Roth conversions of this type increase the after-tax value of your accounts more than simply contributing the tax money directly into a Roth account, and so should be prioritized over unmatched Roth contributions in years when your marginal tax rate is lower than you expect in retirement. Roth conversions of this type also offer additional benefit when investment values have dropped due to a market crash, because you are able to convert the same number of investment shares for lower tax cost.

The following table gives the approximate investment priorities for different situations of your marginal tax rate now compared to your expected marginal rate at withdrawal:

Current rate less than future Current rate same as future Current rate slightly more than future Current rate significantly more than future
1. Matched Roth contributions 1. Matched Roth contributions(c) 1. Matched traditional contributions 1. Matched traditional contributions
2. Matched traditional contributions 2. Matched traditional contributions(c) 2. Unmatched traditional contributions(f) 2. Unmatched traditional contributions
3. Roth conversions with taxes paid from taxable(a) 3. Unmatched Roth contributions(c) 3. Roth contributions(f) 3. Roth contributions
4. Unmatched Roth contributions 4a. Roth conversions with taxes paid from taxable(d)(e) 4. Roth conversions with taxes paid from taxable 4. Taxable investing
5a. Unmatched traditional contributions(b)(e) 4b. Unmatched traditional contributions(e) 5. Taxable investing Do not Roth convert
5b. Taxable investing(b) 5. Taxable investing
Comments: (a) Conversions should only be done up to the point that current tax rate barely equals the future tax rate (b) the relative value of traditional and taxable investments in this situation depends on other factors; higher overall tax rates favor traditional, and lower favors taxable (c) The mathematical value of traditional and Roth contributions and Roth conversions are all equal, but contributions are preferred because they preserve more opportunity to convert in future years. Traditional contributions could be preferred over Roth when tax rates are equal, for example, when lower-tax years are expected in the future that would allow Traditional balances to be converted for lower cost. (d) Conversions should only be done up to the point that current tax rates barely exceeds the future tax rate (e) The net effect of traditional contributions and Roth conversions is the same as a Roth contribution. Therefore, if you have the opportunity to make traditional contributions in one account (eg. an employer plan) and Roth convert from another (eg. a Traditional IRA), it's worth doing both. (f) In high tax brackets and over longer time horizons, the future value of Roth contributions can exceed traditional when maxing out your retirement accounts

This table assumes similar-quality investments are available in all accounts. If certain accounts have inferior investments, performance and fees must be weighed against tax cost; see Traditional versus Roth.

Paying conversion taxes with converted funds

Roth conversions where the taxes are paid from the converted amount, as opposed to from non-retirement funds, are less valuable, because they do not increase your tax-advantaged account balances as much. Nonetheless, this type of conversion is still advantageous whenever your current marginal tax rate is lower than your predicted future marginal tax rate. This type of conversion makes sense in non-working years for those who have pre-tax assets but limited or no taxable assets.

Take heed that the IRS treats any taxes withheld from a Roth conversion as a distribution from the account, which will have early withdrawal penalties if you are under age 59½ and one of the early withdrawal exceptions does not apply. In these cases, the penalty will be 10% of the tax withheld (not the entire converted amount). In low-tax years, it may still make sense to do the conversion and pay the penalty if you do not expect a similar opportunity in future years. For example, if you expect a marginal tax rate in retirement of 22% and can convert a $100,000 pre-tax balance to Roth this year for a tax rate of 10%, you would pay a 10% penalty on the $10,000 withdrawal (= $1,000) and your overall tax rate on the conversion would be 11%, still much lower than the expected future tax rate.

Specific situations

If you might retire before taking Social Security, you are likely to be in a very low tax bracket before Social Security starts. To see if Roth conversions would benefit you during this time, estimate your taxes and marginal tax bracket during the early retirement period as well as for the years you are over age 70 and taking Social Security (if eligible) and Required Minimum Distributions (RMDs) from tax-deferred accounts. If your post-age-70 tax bracket is higher, it may be advantageous to you to convert during the early retirement period, while delaying Social Security. It can be an advantage for converting to a Roth early, as traditional IRA withdrawals are counted as income for determining how much Social Security is taxable, while Roth withdrawals, which are based on already-taxed money, are not taxed again (assuming the withdrawals occur when you are over age 59.5 and the Roth has been open 5 years).

Recognize three cautions regarding taking conversions during retirement:

  1. If you are drawing Social Security, a Roth IRA conversion could result in a one-year increase in the taxable portion of your Social Security benefits. Total income for Social Security purposes is defined as half of your benefits plus any other income, including tax-exempt income. This income level determines the taxable percentage of your benefits (0%, 50%, or 85%). Keep in mind that future distributions from a Roth won't affect the taxation of your Social Security benefits, which may help you in the long run.
  2. Medicare premiums depend on your modified adjusted gross income (MAGI) from the previous two years (for example your 2009 MAGI determines your 2011 premiums). A Roth conversion reported in a given year will increase your MAGI for that year and therefore may increase your Medicare premiums two years hence. Most retirees pay the standard Medicare Part B premium—about 25% of the total cost—with the U.S. government paying the rest. For affluent individuals, if your MAGI exceeds certain levels (for 2016, $85,000 MAGI single; $170,000 joint)[2] your premium will likely be higher. [3]
  3. After you reach the calendar year you attain age 72 and must start Required Minimum Distributions (RMDs) from Traditional IRAs and other traditional employer plans with employers for which you are no longer working. The full RMD must be completed before you make any Roth conversions. For example, if you perform a Roth conversion in the 4th day of the new year and take the RMD on the 5th day or later, the IRS will consider the Roth conversion funds to have actually been RMD funds that have been improperly moved into the Roth account.

Roth conversions may also be beneficial for estate planning:

  • to reduce the value of inherited pre-tax IRAs that will need to be fully distributed by your heirs within ten years
  • to reduce estate taxes, because Roth dollars are worth more than pre-tax or taxable dollars, but count equally toward the estate tax exemption

Using a spreadsheet

Forum member BigFoot48 has created a spreadsheet for use by retirees, or those nearing retirement, which will estimate the financial impact on your portfolio, including income taxes and RMDs, from doing Roth conversions. Use this spreadsheet to determine if Roth IRA conversions may be worthwhile for your personal situation.

Yearly results are calculated and provided (such as income, expenses, taxes, inheritances, and asset sales over a selectable 1 to 40 year period) for both doing conversions, and not doing conversions, so an easy comparison can be made.

Converting with non-deductible contributions

If you have non-deductible contributions in your traditional IRA, you do not pay tax on the amount of non-deductible contributions. If you make a partial conversion, you must prorate your deductible and non-deductible contributions across all traditional IRAs (including SEP and SIMPLE IRAs) as of December 31 of the year you convert. For example, if you had a traditional IRA worth $10,000 that contained $5000 in non-deductible contributions and you converted (or withdrew) $3000 leaving $7000 in that IRA at the end of the year, then half of the $3000 is taxable. To compute the taxable amount of your conversion, use IRS Form 8606. See the main page on the "pro-rata" rule for details.

If the tax cost of converting the entire IRA balance is too great, roll the pre-tax portion of the IRA into an employer plan (such as a 401(k) or Solo 401(k)), then convert the non-deductible amount separately for no tax cost. If you do not have, and do not expect to ever have, an employer plan with reasonable investments and that can accept incoming rollovers, it's best to convert the balance quickly rather than waiting. If you wait for your $10,000 traditional IRA with $5000 in non-deductible contributions to grow to $20,000 before converting, you pay tax on $15,000 rather than $5000, tripling the tax but only doubling the amount converted.

Roth conversions on mostly non-deductible balances are a central part of the Backdoor Roth IRA and Mega Backdoor Roth strategy, which involve non-deductible contributions to a Traditional IRA and After-tax 401(k) respectively, followed by Roth conversion of the entire amount. See the respective wiki pages for details on those two strategies.

See also

Forum discussions

References

  1. Instructions for Form 8606, IRS.
  2. Medicare Part B Premiums: Rules For Beneficiaries With Higher Incomes
  3. Roth IRA conversion: 4 things you may not know, "In the Vanguard", Summer 2010, page 3. Effective January 1, 2018, recharacterization is no longer allowed ("You have a chance for a “do-over” if you change your mind.").

External links