Roth IRA Conversion
Hi,
I'm currently 67 and retired and I would like to determine what happens to my standard of living (SOL) if I convert a portion of my IRA into a ROTH IRA. When I calculated the affect of converted 50% this year, taxes were prohibitive and the SOL dropped. Even when I tried converting 25% in 2007 & again in 2008, SOL took a nose dive. So I tried converting 5% each year beginning in 2007 and ending in 2011. Problem was the program would not let me make a ROTH contribution beyond age 70 in the "Retirements Accounts/Contributions" window. I still have a sizable IRA balance but that shouldn't prevent me from make a ROTH contribution. I can't find any other input screen that's limiting what I want to do.
How can I get ESP to do what I want?
Thanks
James
RSS
HI JAMES, I REPLY IN CAPS BELOW. BEST, LARRY
I'm currently 67 and retired and I would like to determine what happens to my standard of living (SOL) if I convert a portion of my IRA into a ROTH IRA. When I calculated the affect of converted 50% this year, taxes were prohibitive and the SOL dropped. Even when I tried converting 25% in 2007 & again in 2008, SOL took a nose dive. So I tried converting 5% each year beginning in 2007 and ending in 2011. Problem was the program would not let me make a ROTH contribution beyond age 70 in the "Retirements Accounts/Contributions" window. I still have a sizable IRA balance but that shouldn't prevent me from make a ROTH contribution. I can't find any other input screen that's limiting what I want to do.
THIS IS A SHORTCOMING OF THE CURRENT PROGRAM THAT WE WILL FIX DOWN THE ROAD.
IN THE MEANTIME, WHAT I RECOMMEND IS THAT YOU FOLLOW THE FOLLOWING STEPS. IF THEY ARE CONFUSING, CALL ME AT 617 834-2148.
1) DO NOT ENTER AS RETIREMENT ACCOUNT ASSETS THOSE IRA ASSETS THAT YOU WANT TO CONVERT.
2) ENTER THE AMOUNTS OF THE IRA ASSETS THAT YOU'LL BE CONVERTING IN FUTURE YEARS AS SPECIAL RECEIPTS THAT ARE TAXABLE AT ORDINARY RATES.
3) ENTER AGAIN THE SAME AMOUNTS AS IN STEP 2 IN EACH AFFECTED YEAR, BUT THIS TIME ENTER THEM AS NON-TAX RELATED SPECIAL EXPENDITURES. THIS WILL KEEP THE PROGRAM FROM PUTTING YOUR IRA RECEIPTS INTO REGULAR ASSETS. YOU CAN LABEL THESE EXPENDITURES AS CONTRIBUTIONS TO YOUR ROTH IRA.
4) FIGURE OUT HOW MUCH YOU WILL WITHDRAW FROM THE ROTH IRA OVER TIME AND ENTER THOSE AMOUNTS AS NON-TAXABLE SPECIAL RECEIPTS.
Just for the record: I'm also trying to figure out the Roth IRA conversion issue -- how much, if any, to convert in a given year and what the benefit of doing so would be (such as change in SOL). So I'd be interested in any new ESP features that would help. And thanks Larry for the workaround suggestions for the time being.
I would like to evaluate Roth conversions too.
And another one, closely related as far as implementation I would like to be able to specify special charitable expenditures made directly from retirement accounts. IIRC the new tax law allows up to $100K per year to be given directly. The same workaround as for Roth conversions will sort of work for this, but if the contributions are well into the future then I think it becomes increasingly inaccurate.
Like a lot of people, I have been considering a Roth IRA, thinking that the window for conversion in 2010 would be a good opportunity. Since the growth in a regular IRA is taxed as income when withdrawn, and the growth on a Roth is tax free, that has to be a good deal – right? However, after a little analysis, it seems that I was wrong.
I tried running a Roth scenario in ESPlanner, but with the current version you have to cobble it up a little, and I was skeptical when it told me the Roth would hurt my Standard of Living. So I did a little yellow pad analysis.
Let me know if this makes sense, or if anyone thinks I have missed something.
Let’s say Bob has $100K in a regular IRA. His brother Bill has what is left after taxes of $100K of new earning or an IRA conversion, and Bill puts his money into a Roth IRA. For this case, let’s say that Bill paid the marginal rate of 25% in taxes on his 100K, and that Bob will pay the same rate when he withdraw from his regular IRA.
If both brothers get a 7% return on their IRAs, after five years, Bob will have $140K, and Bill will have $105K. The $105K in the Roth can be withdrawn tax free, and the after tax value of the regular IRA is also $105K ($140K X 75%). They are the same – and they always will be no matter how long you leave the money in the IRA!
This may seem obvious, but what it tells me is that the appeal of not paying taxes on the growth in my IRA is a mirage. The only way the Roth is a good deal is if you pay taxes at a lower rate when you put he money in than you will when you take it out. That is unlikely in most cases, especially when you are converting a large chunk from a traditional IRA.
So Larry, it doesn’t seem to me like there is a lot of benefit to developing a sophisticated Roth modeling capability. There is really only one variable I need to consider – the marginal tax rate when I put the money in versus the rate when I take it out.
Comments?
Quote:The only way the Roth is a good deal is if you pay taxes at a lower rate when you put he money in than you will when you take it out.
Yes. But I don't think that is too unusual a retirement situatiion. In our case (beginning retirement) we will be spending down non-tax-sheltered assets for a few years and will have a very low taxable income. Then, when those assets are gone we will begin drawing on the IRAs and taxable income will be quite a bit higher. During the low income years, our CPA has recommended that we convert some of the IRA assets to Roths -- the amount depending on our base tax rate and the tax rate that the conversions push us into. So I would like to evaluate that.
To support our scenario, it would also be nice if ESPlanner would provide for an ordering of withdrawals between taxable and sheltered accounts just as it provides for ordering withdrawals only among sheltered accounts now. To do this manually is a PITA and because of the one year granularity it also cannot be done all that accurately. I have mentioned this to Larry in a telecon. (Great support here, BTW!)
Another factor IIRC is that a Roth in an estate is treated in a more favorable manner than an IRA so even if it is a push for us, it is better for heirs. In case we fail to spend all the money, that is! :D
Quote:To support our scenario, it would also be nice if ESPlanner would provide for an ordering of withdrawals between taxable and sheltered accounts just as it provides for ordering withdrawals only among sheltered accounts now.But the program allows you to specify at what age you begin withdrawing from your tax sheltered accounts (and decides on it's own how much you'll withdraw from the taxable ones). Doesn't this allow you accomplish this?
Quote:Doesn't this allow you accomplish this?
Yes, but that's only a workaround. The one year granularity is an issue for fine tuning.
Suppose I want to draw out $120K per year from already-taxed assets of $420K, beginning in January of a year. Ignoring returns, the assets will run out on July 1, 3.5 years later. Then I want to start drawing from the IRA on July 1, which cannot be done. And as I fiddle with various parameters the date where the tax-paid assets run out will change, necessitating review and tweeking of the workaround. Specifically, this arises when trying to decide when to begin drawing social security.
In the big picture of the program this is maybe not a huge deal as the envisioned time horizon is decades of work before retirement. But the workaround is kludgy, where they could just allow us to prioritize draws on all resources as they allow prioritization of draws on only tax-sheltered assets right now. Then the cutover would happen smoothly and without any manual fiddling, just as it does with the tax sheltered accounts.
Hi Folks,
Roth conversions can make sense or not depending on whether you expect to be in a higher or lower tax bracket in the future.
For example, in 2010, as I understand it, there is supposed to be a window for everyone to convert. If the AMT is still in place and still has a top bracket rate of 28 percent, while the regular income tax still has a top bracket rate of 35 percent, it may make sense for those paying the AMT in 2010 to convert if they think they'll be hit by the 35 percent rate in the future (i.e., have taxable income in future years that is high enough to put them in the top regular federal income tax bracket, but not high enough to make them pay the AMT).
For those with more moderate income and who can convert now, converting may make sense. Bear in mind that Uncle Sam may raise tax rates in the future (which you can explore using the Tax Assumptions screen). Also, by converting you advoid having retirement account withdrawals trigger taxation of your Social Security benefits down the pike. But there is no general rule for whether converting will raise or lower your living standard. You have to run the program both ways and see for yourself.
As for the timing of spending of regular (taxable) assets, the program determines that internally. We can't have users set that and also hope for the program to smooth their living standard.
Either regular saving or consumption can be set by a program, not both. Other programs put your saving on autopilot and let your consumption and living standard fluctuate with changes in your income and off-the-top expenditures. That's putting the cart before the horse.
best, Larry
Thanks, Larry
Just to clarify since my example was perhaps badly chosen:
I am not asking to set a consumption level. Obviously, that is not the paradigm of ESPlanner. I just used the consumption example to illustrate a mid-year transition to tax sheltered assets.
All I would like to see is to have ESPlanner do what it does now with consumption, assets, etc. but to automate the transition to drawing from tax-sheltered accounts after the tax-paid assets have been exhausted. Said another way, I don't want to have to tell it a first withdrawal age. I want it to determine the age based on when the tax-paid assets go to zero.
Then, for example, I can change social security start dates and see the results without having to tweek anything. Earlier social security will delay the transition date, later social security will accelerate it -- but I really won't care except to see what the changes do to recommended consumption. In fact it is this social security question that drew me to ESPlanner in the first place, as my current advice is to begin drawing at 62 in order to delay tapping the IRAs and this is contrary, IIRC, to your general feeling on the subject.
Mitty wrote:All I would like to see is to have ESPlanner do what it does now with consumption, assets, etc. but to automate the transition to drawing from tax-sheltered accounts after the tax-paid assets have been exhausted. Said another way, I don't want to have to tell it a first withdrawal age. I want it to determine the age based on when the tax-paid assets go to zero.
Interesting thought...
A more general solution to this would be to allow ESPlanner to accept "conditional" statement for some/all of it's dates, e.g., Start withdrawing from accounts to keep my standard of living > 100k/year or Start withdrawing from accounts when I run out of savings. I'll have to think about the problem, but I suspect that this introduces a whole lot of additional complexity in the primary planning process. We might be able to figure out a way to fold something like this into contingent planning (which currently is defined as contingent upon death of a spouse).
Can't guarantee anything, but I'll chew on it once I'm back in the world and Larry and I have a chance to clear our decks of the current development work.
Best,
Dick Munroe
Quote:A more general solution to this ...
Creeping elegance has killed many a good idea. :D But if you want to make the solution fancy, certainly that would be interesting.
I am looking for something pretty simple, I think. In fact it seems like the idea of having to specify a starting age for tax sheltered withdrawals is almost antithetical to the philosophy of the program. I would just like that to go away. (Other than somehow considering the fact that earlier than age 59 1/2 would almost always be a bad idea.)
Mitty wrote:Creeping elegance has killed many a good idea.
I couldn't agree more and I can point to any number of good products to which that's happened (Microsoft Office for one) so while I might find the idea attractive, I suspect that the more general case won't happen.
But it would be cool, wouldn't it?
Best,
Dick Munroe
By the way, you should not just assume that you are best off drawing down your taxable accounts before withdrawing from your tax deferred accounts. In my case, the program shows that I am better off beginning withdrawals from my retirement accounts as soon as possible (even before age 59 1/2), and supplementing those with additional withdrawals from my taxable accounts.
Although deferring withdrawals from retirement accounts allows tax deferred growth, it also results in a higher effective tax rate when you do withdraw (you can be, in effect, moving some money from the lowest tax rate to a higher tax rate, because you are withdrawing more per year by delaying withdrawals). Whether the advantage of the tax deferred growth outweighs the tax disadvantage on the remainder of the money depends on how much you have in your accounts, how long you are planning to live, what investment return assumptions you make, and what assumptions you make about future tax rates.
Compounding this is the effect on the income tax on your Social Security income, which is even more progressive than the tax on the retirement account withdrawals, and, again, is negatively effected by delaying withdrawals from your retirement accounts (because that give you more non-Social Security income).