Roth IRA Conversion Calculators?

Submitted by Jay Orman on Sat, 2010-03-27 18:35

I’ve pondered whether or not to do an IRA to Roth IRA Conversion for over a year now. This includes searching for discussions on the topic and for useful calculators. So far, I’ve come to no clear conclusion.

I’m looking for an IRA to Roth IRA Calculator that will help me decide whether or not a conversion would be advisable. But, I also want to know whether or not to spread a conversion over several years so as to avoid paying too much in taxes.

At 60 years old I’m in the 15% tax bracket. When I start Social Security and IRA Withdrawals my bracket will probably go up to 25%. I may want to convert up to $375,000.

Thanks

Flag as spam

Permalink Submitted by Alan Spross on Sat, 2010-03-27 20:17

While overly simplistic and superficial, you might find converting up to the top of your 15% bracket every year will work out best. You should be able to pay the taxes from non retirement account sources on these conversions, and if you have enough in the bank you should also delay SS for awhile so that your conversions do not cause too much of your SS benefit to be included in AGI. The marginal rate for SS inclusion in your 15% bracket is 1.5 times 15 or 1.85 times 15. That’s 27.75% when 85% of your SS is in your AGI. Once all your SS is included, even when you move into the 25% bracket, the rate drops to 25 from 27.75%. Most calculators do not address this well.

But in determining if 375k is a logical target, a raft of other info must be included, virtually your entire financial picture and estate plans as well. Even whether you will have coverage for long term care or not. If you don’t, you would generally convert less and plan to pay for LT care from traditional IRA withdrawals. The medical deduction will offset most of those costs, so you would less the IRS pay your taxes on these costs rather than converting and then having to draw from your Roth for these costs.

One positive is your recharacterization option. You can recharacterize all or part of any conversion up to the extended due date after your entire tax situation for the year is known which is a unique and flexible tool to use. You could do multiple conversions to different Roth accounts and only keep the best performer and recharacterize the rest. And if they both happen to perform very well, you could keep them both even if your tax bracket rises since the earnings will be tax free eventually, in your case within 5 years even if you do not have any Roth assets now.

Permalink Submitted by Jay Orman on Sun, 2010-03-28 01:09

alan-oniras,

I like and appreciate your response. In particular, the last paragraph contains alternatives I had not considered. But, I have a question about your first paragraph. It will save me further research if you can explain in more detail the following segment: [color=#0000BF]The marginal rate for SS inclusion in your 15% bracket is 1.5 times 15 or 1.85 times 15. That’s 27.75% when 85% of your SS is in your AGI. Once all your SS is included, even when you move into the 25% bracket, the rate drops to 25 from 27.75%. Most calculators do not address this well.
[/color]

Thanks,
hornman

Permalink Submitted by Alan Spross on Sun, 2010-03-28 03:28

SS benefits are tax free if half the benefits plus other income is less than 25,000 for singles and 32,000 for joint filers. At that point every extra dollar of income results in 50% of your SS benefit to be included in your income and after another 9,000 of income for singles and 12,000 for joint filers, the SS inclusion rises to 85%. Eventually, a full 85% of your SS is included in your income and after that you simply pay your marginal rate. But the first dollars you convert can be the dollars that drag your SS income into your AGI and that causes an effective higher tax rate while that process is going on. Many people will have income over the top threshold anyway and it does not matter, but if yours is not it can make a real difference.

The numbers are complex enough such that the best way of dealing with it is to buy tax software and experiment with entering different conversion amounts along with your SS income if you will be collecting it while converting. And if your income is considerably higher you will also run into a surcharge of your Medicare Part B premium that you would probably be paying starting at 65. The surcharge is made on the second year after your income reaches that level and conversions can trigger it. With all these variables to consider, it makes the development of highly comprehensive calculators almost impossible. Again, you can also use your tax software to calculate how much of a recharacterization to do after all your other income and deductions are known. For this reason, some people do not worry too much about how much to convert in the first place. They just convert the highest amount they would ever consider with the plan of recharacterizing part of it back until their tax bill drops to what they want to pay. So if you have the tax program, you can enter various scenarios regarding how much of your conversion you will actually retain.

All the above focuses on the actual cost of your conversion, which you CAN control. But whether it is wise or not depends on what happens in the future to both YOUR OWN financial situation and future tax rates. Conversions are a hedge against success costing you too much in taxes and NOT converting is a hedge against being poorer than you expected. The idea is NOT to pay more for your conversion than your marginal rate would be without it. With each dollar converted, your income from RMDs in the future is reduced and your marginal future rate is eventually reduced, so the first dollars you convert are worth more because they wipe out future income that would be taxed at your top bracket. Once you get a decent % converted, you would probably stop the conversions as you would then be paying more than you would save later on. If you have a decent amount of both Roth and non Roth accounts, it gives you flexibility regarding where you draw the money from. In a year that you have alot of deductions you might take more than your RMD out of the TIRA, and in a year that your income is already high and you have few deductions, you might tap the Roth to prevent your tax rate for that year from rising further.

Permalink Submitted by Bruce Steiner on Sun, 2010-03-28 14:00

If everything else were equal, then it might be sufficient to compare the income tax rate on the conversion to the income tax rate upon withdrawal. But there are other factors, most of which favor the conversion:

1. If you can pay the tax on the conversion out of non-IRA assets, you are effectively contributing to your IRA an amount equal to the tax. This is because the income and gains in the Roth IRA are tax-free, while the income and gains in your taxable account are currently taxable.

2. There are no required distributions during lifetime from the Roth IRA. The benefit of this can be significant, particularly for IRA owners who have enough other assets or income so that they can afford not to take distributions from the Roth IRA during lifetime.

3. Our clients generally provide for their children in trust rather than outright. This keeps the child’s inheritance out of the child’s estate for estate tax purposes, and better protects the child’s inheritance against the child’s potential creditors (including spouses). The cost of doing this, especially in the case of IRA benefits, is that trusts reach the top (35%) income tax bracket at $11,200 of taxable income. The Roth conversion allows you to leave the IRA in trust rather than outright, without it being taxed in the top bracket at a low level of income.

4. A Roth IRA is a more valuable asset to leave to a credit shelter trust, or to a grandchild or GST exempt trust.

5. IRA benefits are income in respect of a decedent (IRD). Under Section 691(c), the beneficiaries of a traditional IRA get an income tax deduction for the estate tax paid on IRD. This deduction covers the Federal, but not the state, estate or inheritance tax. For an IRA owner in a decoupled state (a state that has an estate tax), the Roth conversion avoids this problem.

6. State income taxes may vary depending upon (i) where the IRA owner now lives, (ii) where the IRA owner may move, and (iii) where the beneficiaries live. This factor could go either way.

A better general rule is that most people should convert if the tax rate on the conversion is less than, equal to, or not “too much” higher than the tax rate that would otherwise apply to the distributions.

Bruce Steiner, attorney
NYC
also admitted in NJ and FL

Permalink Submitted by Jay Orman on Sun, 2010-03-28 17:52

Thanks guys! Excellent responses!

Now, I’ve got some ideas on how to proceed.