IRA questions
A couple of questions for Alan:
1) Just want to make sure…after 70 1/2 as long as you take RMD for the year, one can convert any amount from a trad IRA to a Roth ira and pay taxes for the conversion…is that right.
2) Theoretical question…convert 80k to roth…pay 20k taxes (25%)..beginning bal roth 100k-20k (taxes)+ 80k transfer=160K new balance..convert 200k next yr. ..pay tax 50k ..nex roth bal 160-50+200=310…have paid a total of 70k taxes…is there any advantage to doing this??? any way to figure the ROI??? it seems this is one way to convert trad ira to roth ( lifelong tax free)…I am not sure if this makes sense…since the 70 K is equivalent taxes on 280K (25% bracket ) if one converts gradually from trad ira..Alan, need your opinion…thanks in advance
Permalink Submitted by Alan Spross on Thu, 2011-05-26 17:57
1) Correct. The RMD amount must come out first and cannot be converted or rolled over. After this is done any additional amount desired can be converted to a Roth IRA. Of course, the total taxable amount for both the IRA and the conversion will be added to taxable income.
2) Your example appears to be paying the taxes either out of the Roth IRA after the conversion and that is basically the same as paying the taxes from the TIRA by withholding and converting the rest of the TIRA distribution.
However, the results can differ somewhat depending on age and other circumstances. If the taxes are paid out of the TIRA at the time of conversion, and taxpayer is under 59.5, the withholding itself will be taxed and penalized. And if the full distribution is converted and a Roth distribution is taken to pay the taxes, the taxes were also paid as part of the conversion, but there would only be a 10% penalty if the Roth distribution came from conversions less than 5 years old and taxpayer was under 59.5. In your example, since the Roth started with 100k the taxes could have been paid from prior regular contributions before getting to the conversion dollars. But if you are over 59.5 there is no penalty. For those under 59.5, having a Roth with prior contributions from which to pay the taxes could avoid the 10% penalty.
Standard advice is to pay taxes on Roth conversions from outside funds because paying from the conversion means that funds are lost to either type of IRA. When you convert 80k and pay out 20k in taxes, your total IRA balance actually went down by 20k. Another potential issue is if your conversion loses money and you recharacterize it, the Roth portion goes back to the TIRA, but the 25% is sitting in the IRS. You then lost the 25% in taxes but when you get your refund it will be too late to roll the funds back to the TIRA.
But there may be cases where this is not all that bad. Such cases might be:
1) Taxpayer has plenty of IRA assets and retirement plan assets, but no liquidity to pay the taxes at the time, and has a good opportunity to convert. Perhaps taxpayer is waiting for the real estate market to improve before selling property to create the liquidity, but in the current year the only money to pay the taxes has to come out of the IRAs.
2) Taxpayer may be expecting an inheritance of other windfall down the road and realizes that RMDs will put him in a high bracket when that happens. So he wants to convert now to reduce the RMDs in the future, and the loss of IRA funds to taxes is not a concern.
Any ROI calculation will be very complex because you will have to assume some ROI on the remaining Roth assets and make a projection using the current tax rate vrs some assumed rate in the future. It is basically the same exercise for deciding whether to convert or not convert and what amount to convert per year. You are paying income taxes, possibly a medicare premium surcharge and a Part D surcharge, and more of your SS income may become taxable, but then when the RMDs decrease in the future you will be saving on those same factors.