Roth Converstion – What’s the Big Deal?
I like this forum but only drop in here a couple of times a year. Perhaps this question has been beaten to death already. I do note that Alan still seems to be the workhorse here.
Roth Converstion – What’s the Big Deal?
I keep hearing that in 2010 you can now convert your IRA to a Roth IRA. But I don’t get why it is a Big Deal?
Here is my personal situation:
Married retired age 63/wife 56 working making $40k a year.
Annual Income: wife $40k + My SS $13k + My Defined Benefit Pension $17k = $70k annually income. I can easily keep my expenses under $70k if I want.
Rollover IRA $1.4M other assests $1.6M
Rollover IRA a TDAmeritrade Brockerage Account – nothing exotic.
IRA Beneficeries: wife 1/2, 3 adult children 1/6 each.
Should I roll to an Roth IRA? Why or Why not.
Am I “wasting” my current 15% tax bracket by not taking IRA withdrawals now?
Should I run my AGI up to the top of the 28% bracket?
What is the most tax efficent strategy for getting at the tax deferred monies? Die and leave it to my beneficeries?
What are the things that need to be considered.
Thanks Alan in advance!
Permalink Submitted by mk foss on Thu, 2010-08-12 16:53
The Roth is something to consider – especially if tax rates go up. In 7 years, you’ll need to take RMDs from the large IRA and your wife may still be working. The first RMD is about 4% of the balance – that would increase your taxable income by 50k. If you were to start conversions now and use up the lower tax brackets, it will reduce your future RMDs. Depending on your wife and children’s tax situations, it may be preferable for them to inherit a tax paid Roth IRA rather than a traditional IRA. The children need to start RMDs the year after you pass away – which could happen in their highest earning years piling extra taxes onto their income.
Taxes aren’t the only consideration though. Your personal situation is important. The health or you and your family is a key factor. The likelihood of the estate tax coming back with only a $1 million exemption is a factor. One of my high net worth clients is doing a large conversion to reduce his estate by the income taxes that he pays at 35% in 2010 versus 39.6% in later years on RMDs.
I’m sure Alan will have many words of wisdom but I wanted to give you another viewpoint as well.
Permalink Submitted by Bruce Steiner on Thu, 2010-08-12 21:45
Whether you should convert to a Roth (and if so, whether to convert all at once or over a number of years) is something you may wish to discuss with the attorney who handles your estate planning, who can give you specific advice based upon your particular situation and your objectives.
But yes, in most cases, the Roth conversion is likely to be beneficial, particularly where the income tax rate on the conversion is less than, the same as, or not much more than, the income tax rate that would otherwise apply when the money would otherwise be distributed from the IRA, and assuming the IRA owner has other assets with which to pay the tax on the conversion.
Here is a simple example, assuming a constant 30% tax rate. An IRA owner has a $100 traditional IRA and $30 of other money. He converts and uses the $30 of other money to pay the tax. He now has a $100 Roth IRA. Over some period of time, it grows to $200. Alternatively, he does not convert. Over the same period of time, his $100 traditional IRA grows to $200, or $140 after income tax. But since the income and gains on the $30 taxable account are subject to income tax each year, the $30 taxable account grows to something less than $60.
There are other advantages to converting as well.
Bruce Steiner, attorney
NYC
also admitted in NJ and FL
Permalink Submitted by Alan Spross on Fri, 2010-08-13 00:00
Bruce,
This is marginally off topic, but I wanted to get your take on the general subject of “location planning”.
For example, if a taxpayer works in NYC and maxes out all possible IRA and employer plan pre tax deferrals, it appears there would be large up front tax savings. Then if they turn around and convert to a Roth, they are only paying taxes based on their state of residence at a lower rate. This would also apply for workers in Portland OR who live in WA or possibly Boston who live in MA. If their is a city income tax the benefits would be even greater.
Is this a strategy that works in NY?
Permalink Submitted by Bruce Steiner on Fri, 2010-08-13 03:06
Yes. State and local income taxes are a factor to consider.
The NYC tax only applies to NYC residents, and NJ’s tax rates are comparable to NY’s. CT’s are a few points lower. Some people in NY and NJ retire to FL which has no income tax.
When considering converting, you have to consider the tax rate (including state and local taxes) on the conversion and the tax rate you or your beneficiaries would pay on the distributions if you don’t convert.
Permalink Submitted by Richard Rea on Fri, 2010-08-13 04:32
Mary Kay Foss CPA,
Wow Mary Kay! I remember you from past visits too. Sorry I failed to mention you.
As for LOCATIONS I would like to understand overseas locations too. Like Coast Rica, Thailand, Canada, Austrlia, etc.
I live in Washington State (no income tax, high sales tax 8.8%) and have one foot in Nevada (no income tax and modest sales taxes).
One of the better strategies is to live in Vancouver, WA just north of Portland, OR and pay no income tax to OR and shop in Oregon and pay no sales taxes to WA.
WA – no income tax and all sales tax
OR – all income tax and no sales tax
Other states with no income tax: AK, TX, FL, NH and ?????
Starve the Beast!
Permalink Submitted by Richard Rea on Tue, 2010-08-17 07:18
Here is a reply from a friend of mine who is still working at the Fortune 50 employer I retired from in 2005.
Dick,
I have not heard anything about reducing the age for MRD. It would not surprise me, since that will definitely generate tax revenue, and generate it sooner than current rules. Particularly if they do it when you take SS. The reason is, SS is taxed differently in the presence of other income. For us with a pension, it doesn’t really matter, because our pension income pushes us to declare 85% of our SS as income, which is the maximum rate anyway. For those who don’t have a defined benefit plan, this is huge. Instead of declaring zero SS as income, they will probably be forced to declare 50% or even 85% of their SS as income. This goes back to the 1983 SS reform, when they “fixed” Social Security. The one key thing they did not do in 1983 was to index the SS tax brackets to inflation. At the time, nobody cared since the brackets were set at a “high” level of income ($32,000 for married couples and $25,000 for singles was considered high in 1983).
I do my mom’s taxes, and she does not have a defined benefit plan, only an IRA. I have learned that there is a real fine line on how much you can take out of your IRA before you start paying significantly more taxes on SS. I have seen years where I have to scratch my head because she took out less from her IRA and didn’t really take a hit on her bottom line. The reason being the taxation of her SS was considerably less. I have tried to tell her to keep a cash reserve for emergencies because if she has to tap her IRA for big ticket items (like a car), she may have to withdraw a lot more because her SS will go from not being taxed to having 85% of it being taxed. Even at the 15% tax bracket, that’s a 4 figure bill, just for the simple fact of taking more out of her IRA. There is a real study here that I could pursue – but since I am not affected, I don’t really care about it. In other words, there is no way with a defined benefit pension that I will ever be able to avoid paying tax on 85% of my SS. But all those people who don’t have a defined benefit plan will all of a sudden be hit with a bigger tax bill than they expected.
In our situation I guess this would be a good thing as the Feds would squezz more money out of the other guy(s) ie “don’t tax me tax the other guy”.
Permalink Submitted by Alan Spross on Tue, 2010-08-17 16:39
The points are well made, and there has been many articles over the last decade about the tax “bubble” created with the first dollar of SS that must be included in AGI. Most people are in the 15% bracket, but the first dollars of SS included jacks the effective marginal rate up to 22.5% since 50% of SS is included in the first tier. But once that income increases around 12,000, then the 85% tier kicks in. The 85% tier frequently results in the marginal bracket rising from 15 to 25. So the effective marginal rate for those including 85% is 27.75% while in the 15% bracket and a whopping 46.25% once the 25% bracket kicks in.
For this reason, it is often worthwhile to convert every other year for double the amount and do no conversion in the off years. The reason is that the larger conversions will be taxed at 25% (or maybe 28 or 31) once the full 85% of SS has been included, and this replaces the 46.25% which is avoided in the off year.
Another strategy for early retirees is execute the bulk of conversions prior to filing for SS, and banking the 8% annual delayed retirement credit on SS benefits. You end up with a larger SS check for life by waiting and you avoid those high bubble tax rates triggered by the conversions. Of course if you non conversion income is high enough, you would still pay the bubble rates when you started SS benefits.
It was somewhat surprising that there was never enough political pressure for legislation applying an inflation adjustment to the 1983 and 1993 income thresholds for SS taxation. That opportunity was missed and now the deficit is so bad the adjustment will be deemed too costly. The added tax on SS benefits is supposed to be transferred to the SS trust fund.
Permalink Submitted by george collins on Wed, 2010-08-18 20:58
More thoughts on conversion for us retired:
I am 65, delaying SS till 70, wife is 2 yrs younger, delaying her SS to her FRA@66 for her spousal bene = My FRA/2.
this does several things besides tax free growth;
1 reduces my taxable income for 6 years to use for additional ROTH conversions
2 increases NPV of our total SS income, and increase her Suvivor income
3 reduces future RMDs
4 when I pass my wife’s taxable income will be so low that the amount of tax is very, very small.–close to Zero with todays regs.(her income will be my Survivor SS, investment accounts, and Roths
Yes I have a pension but the wife will only receive half when I pass
ps–Georgia for retired people is close to 0 state tax. There is a 35K$ exclusion for each at 62 yrs, SS is not taxed, Ga muni’s not taxed… after you take a normal deduction, you have to have more than 125K taxable income to pay any tax
,
ps 2–I will keep a small amount in my IRA as I plan to pass these on to the kids, so the wife will have 0 RMD’s–and or she can use this for a nursing home if necessary–basically this would also allow tax free withdrawals due to the large medical deductions.
2beachcombers, Savannah