Flat Tax Hypothesis

Submitted by george collins on Sun, 2010-12-19 10:06

I am starting to think that we may get to some kind of a Flat tax in the future. If I make the assumption that it will end up between 15 and 20% — it makes no sence to do Roth conversions in the 25% tax bracket today.?

Am I missing something?

jerry



Submitted by Bruce Steiner on Sun, 2010-12-19 15:27

You are correct. If the income tax rates (or, more specifically, your income tax rates or your beneficiaries’ income tax rates) that would apply when you or your beneficiaries would otherwise take distributions will be substantially lower than the income tax rate on the Roth conversion, then the Roth conversion will probably not be beneficial.

But there is also a chance that the income tax rates that would apply when you or your beneficiaries would otherwise take distributions will be higher than, the same as, or only somewhat lower than the income tax rate on the Roth conversion. In these cases, the Roth conversion will probably be beneficial.

Each person’s tax rates may vary depending upon his/her situation. As to tax rates generally, given what we know at present, I would not want to bet that future tax rates will be substantially lower than current tax rates. Others may see it differently.

It’s hard to make predictions, especially about the future, and especially over so many years. (The last required distribution will not be until the end of your beneficiaries’ life expectancy, measured from your death, which can be a very long time from now, depending upon how long you and your spouse, if any, live, and the age of your beneficiaries at your death.)



Submitted by george collins on Mon, 2010-12-20 13:30

bsteiner: thanks, especially for you thoughts about heirs.. This futher supports my tax thoughts as I expect to have one of my heirs to be in a low tax bracket.

My current plan is to just take the “tax-free” $—-for example, one of my roths was converted at 230K$, is currently sitting at 280K$, will reconvert 230K, and have a “tax-free” 50K$ ROTH. Will do the same for all the other ROTHS and repeat the process each year till the govm’t takes this reconversion process away.

jerry



Submitted by Edward Czapor on Tue, 2010-12-21 21:05

Jerry,
When you refer to reconversion, do you mean recharacterization? If so, then if you recharacterize a conversion the related earnings whether positive or negative will also go back to the TIRA. If your Roth that was converted at 230k is valued at 280k and recharacterized, then 280k will go back to the TIRA. You cannot leave 50k in the Roth “tax free”. This is true even with a single separate Roth account that did not exist prior to the conversion. When you recharacterize, it is as if the conversion never took place, and you end up with the TIRA plus or minus investment experience.

Ed C.



Submitted by george collins on Wed, 2010-12-22 13:34

ALAN: Please advise.

My understanding is that if I recharacterize a 280K$ Roth, that was converted to a Roth at 230K$, then the taxable portion
would be 230K??? And the 50K could remain in the ROTH???

jerry



Submitted by Alan Spross on Wed, 2010-12-22 18:30

Jerry,

Ed C. is correct. In any Roth recharacterization, an earnings calculation must be done and the earnings adjusted result must migrate back to the TIRA. So if you have gains, all those gains go back. If you recharacterize half your conversion, then half the gains go back. The taxable amount of your conversion is 230k if you retain it, but this has nothing to do with the required recharacterization formula.

What you may be thinking about is the rule for correcting an excess contribution after the due date. That’s an entirely different situation. If you contribute too much to a Roth IRA and do not correct it by the due date, you incur a 6% excise tax, but you can stop the excise taxes by withdrawing the contribution. In this case, the earnings DO stay in the Roth IRA, and you only take out the actual contribution amount. Perhaps that is the scenario you thought could be applied to a conversion, but not if you are able to recharacterize the conversion.



Submitted by george collins on Fri, 2010-12-24 13:02

Ed, Alan, Steiner, thanks for the clarity. I should have known there is no free lunch

jerry



Submitted by george collins on Fri, 2010-12-24 13:38

Alan and all: this is what confused me??

Alan said:

[i][b]1) If you recharacterize half of the 230k conversion, you will only report half of the original 230k conversion amount, not half of the value at the time of the recharacterization.

2) If your only conversion was the 230k, that Roth would have to grow to 383,334 for the effective tax on this conversion to be reduced from 25% to 15%. You are correct that if you recharacterized half of this conversion you would be left with a Roth worth 191,667 and you would owe tax @ 25% of 115,000. You need gains of 66.7% in the Roth to reduce your effective tax rate to 15%. Your current gain of 20% creates an effective tax rate on this conversion of 20.8%.[/b][/i]

jerry



Submitted by Alan Spross on Fri, 2010-12-24 21:46

By reporting I am referring to the amount you would show on your 8606 as the converted amount and on which you would be taxed. If you convert 230k and recharacterize half the conversion, then 115k is the reportable portion that remains and it goes on Form 8606. But whenever you recharacterize the earnings adjustment determines the amount that goes back to the TIRA, and therefore also affects the amount tha remains in the Roth IRA. Most recharacterizations in the future will be due to negative investment performance since the income limits are now history. If the performance is negative, less will be going back to the TIRA than the amount converted, and this lower earnings adjusted figure is what the custodian shows on the recharacterization 1099R.

The second part relates to the amount of gains you need in order to reduce the effective cost of your conversion per dollar remaining in your Roth. You would use that information to help you decide if you should recharacterize or not, and also how much of the conversion you choose to recharacterize.
Example: You convert 230 and pay 25% tax or 57,500.
If the value increases 50% you have 345,000 in your Roth, but the tax remains 57,500. That tax cost of 57,500 is now only 16.67% of the new amount including growth of the Roth. You might want to keep the conversion due to this bargain element.

But if the value drops by 50%, your tax bill is still 57,500, but the Roth is now worth only 115k. Your effective tax cost in this situation is 50% due to the losses, and this would be unacceptable to you and you would then recharacterize the conversion to eliminate that 57,500 tax bill. But whenever you recharacterize the earnings adjusted amount returns to the TIRA. You can’t leave the earnings in the Roth unless you also leave the converted amount in the Roth.

Hope this helps.



Submitted by george collins on Sat, 2010-12-25 16:54

I am finally getting to the correct jargon;

To confirm you advice, I think the following would be correct:

Converted 230k, Recharacterized 115k and pay tax on 115k. Recharacterization at 280k would resut in 140k in each of the TIRA and the Roth? At 25% tax the 140k in the Roth would be converted at 115k X 0.25 / 140k or 20% tax equivalent.

I understand your explanation of the equivalent tax if I converted at a gain, but I cannot convert more 115 without exploding in to higher tax brackets.

jerry



Submitted by Alan Spross on Tue, 2010-12-28 19:40

Jerry,
The second sentence is incorrect. Recharacterization amounts should be stated relative to the portion of the original conversion. So when you indicate 280k, you really mean that the entire 230k conversion is recharacterized. It just happened to have earnings that increased the balance to 280k at the time of recharacterization. As a full recharacterization, the entire conversion presently valued at 280 k has to return to the TIRA, so there is nothing left in the Roth.

Had you recharacterized half the conversion, that is when you would have 140k left in each type of IRA, and the remaining taxable amount of the conversion would be 115k. If taxes on more than 115k spills over to your 25% bracket, but that share of the conversion is now worth 140k, the effective tax is reduced to 20.5% from 25%. But if you do not want to incur a tax cost as high as that, you would recharacterize half the conversion leaving your conversion tax rate at 15% of 115,000.

However, the effective tax rate for the 115k (half the conversion) is reduced to 12.3%. Since both effective tax rates were reduced by your gains, if you look at the total conversion as one piece, you now have a total effective tax rate of 16.4%. Considering that this is only 1.4% more than your target, you might want to keep the entire conversion. If you are concerned about not recharacterizing and then having the balance take a loss afterwards, you can change the investments into something more conservative so that you don’t get burned by not having recharacterized.



Submitted by george collins on Tue, 2010-12-28 21:31

ALAN ❓
Thanks for your post, but now I have another question.
I do not understand where the 12.3% calculation came from?

Alan said:
[i]However, the effective tax rate for the 115k (half the conversion) is reduced to 12.3%. [/i]Since both effective tax rates were reduced by your gains, if you look at the total conversion as one piece, you now have a total effective tax rate of 16.4%. Considering that this is only 1.4% more than your target, you might want to keep the entire conversion. If you are concerned about not recharacterizing and then having the balance take a loss afterwards, you can change the investments into something more conservative so that you don’t get burned by not having recharacterized.

jerry



Submitted by Alan Spross on Tue, 2010-12-28 22:11

If you first assume that your tax rate for up to 115k of conversion income will be 15%, the tax on that amount of the conversion would be 17,250. But this half of the conversion has grown to 140k, therefore 17,250/140,000 = 12.3% effective rate on the balance that exists now.

The above is what you would have left if you recharacterized half of your conversion leaving 140k in both IRAs. I do not know if your actual marginal rate would be that low for the entire 115k, but if it was, the effective rate is 12.3% when you consider the gains you have.



Submitted by george collins on Wed, 2010-12-29 14:23

GOT IT–thanks. Your were correct in your assumption–the first 115K was not all in the 15% bracket. But I can figure the final taxes from my spread sheet and your recommendations.

thanks again
jerry



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