Roth IRA Conversion - The effects of taxation on this decision.
ESPlanner's March 12, 2009 article entitled "Convert your IRA to a Roth!" presents a compelling case for converting a regular IRA to a Roth IRA. However, it appears that the significant effects of taxation have been left out of the calculations.
There is a considerable tax bill due on the amount converted - up to 30% or more depending on one's tax bracket. This money has to come from somewhere, cash on hand if available, or from selling other investments which will in turn have other tax consequences.
In the case study that accompanies the article the fictitious couple, Tom and Janet, obviously don't have the cash on hand (they still have a mortgage balance of 80K) so where does the tax money come from? From Tom's 401(k) or from the proceeds of the IRA sale? Wherever it comes from it will significantly alter the calculations toward not doing the conversion.
I would love to have a clear explanation of how to perform this calculation and include the tax effects.
RSS
Yes, here's the case study we are discussing:
http://www.esplanner.com/case-convert-your-ira-roth
The couple would ordinarily have paid 74,275 in Fed tax and 19,344 in NY state tax in 2010. But because they get taxed on this conversion, they will now pay 172,879 and 41,115 respectively.
So where does this money come from to pay these taxes?
Remember, the couple is using ESPlanner for consumption smoothing. They are not burning through every available dollar each year. Instead, they are saving according to ESPlanner's recommendations so that they have the smoothest and highest living standard possible. They are also postponing SS to age 70 so that they can receive the highest possible benefit and thus raise their lifetime living standard. This is another reason they must set aside money--they need to bridge that income trough from age 65-69.
So without using the ROTH conversion, they will set aside about 91K each year until age 65 when they will begin to withdraw from regular saving in order to smooth their living standard. In the conversion case, they set aside about 89K each year until age 65, *except* for the year 2010 when they withdraw 31,213 from regular saving--that's a net gain to their economy in 2010 of about 120K (89K + 31K = 120K)--and this is pretty much the difference in the taxes between the two scenarios. In other words, instead of setting aside 89K in 2010 as they did in 2009 and as they will do each year through age 64, they withdraw 31K from that pool of regular saving funds in 2010.
Dan
Dan,
Thanks for the detailed explanation. If I understand you correctly:
- Tom and Janet converted a 300K IRA to a Roth IRA in 2010.
- This triggered a combined federal and NY state tax bill of $120,375 or 40.1% of the amount converted.
- They paid this tax with cash from current income and savings.
- The reduction in current income and savings used to pay the tax was entered into ESPlanner and included in the living standard projections shown in the table that accompanied the case.
Correct?
If so it would appear that the conclusion reached in this case, that it pays to convert, rests on the assumption that one has cash available from current income or savings to pay the substantial tax bill. I doubt that this assumption is true for most individuals. If not then the tax bill would have to be paid from other invested assets which would in turn have other tax consequences. It may still be advantageous to make the conversion but the decision would involve more complex calculations.
Will
Yes, I think you are right there. On the other hand, it does illustrate a principle I guess. Lots of folks also don't have 300K in a ROTH. It would be cheaper to do if you only had 50K in a ROTH.
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I created another case study, but this time with a much smaller amount to convert.
http://www.esplanner.com/case-convert-your-ira-roth-again
I reread the case, and it is complete. By NOT entering the IRA amount, you are offsetting the "Special" income amount that you post.
I have a ten year period of very low income between retirement and SS at age 70. I would like to be able to model doing a series of Roth conversions over this period to take advantage of a lower tax bracket and lower my eventual MRD.
Your case studies only work for a one time conversion. I was excited about the new "Special withdrawal" feature because a Special Withdrawals along with a Roth contributions would handle the serial conversion scenario. But you would have to relax the constriction on contributions after retirement and allow large amounts. Could this be done?
You can withdraw any amount once you start withdrawals from your retirement accounts. This restriction will be lifted in the next release. Unfortunately, I don't think you can make contributions after you start withdrawals. That is technically possible and the CE doesn't care, I believe the UI restricts your contributions to "pre-withdrawal" periods.
Best,
Dick Munroe
Actually you can "fool" the UI. Under Retirement Accounts->contributions set the age of last contribution to a year ahead of where you want to contribute now (My age of last contrib is 63 and want to convert an IRA amount to Roth IRA in 2010 so I set last contribution to 64) The UI complains but I ignore it, select Roth, give an amount and hit "apply". My value gets placed in the matrix successfully. Now I set age of last contribution back to 63. Go to the special withdrawals screen now which lets you do a withdrawal from an IRA in 2010 happily.
You can set any age of last contribution you want and use grow to place amounts in subsequent years - however you'll get a bogus value on the year that corresponds to the age of last contribution you set. Just set the age back to reality before leaving this screen - otherwise a bunch of stuff is greyed out and you can't generate reports.
The reports seem to use the information correctly even though the UI was unhappy. The results are consistent with what I'd expect from the conversion.
This all in ESPlanner 2.15.6 don't know about other revisions behavior.
Ted
As I understand it, the case under discussion takes the entire tax hit in 2010. You are allowed to defer the taxable income equally into 2011 and 2012 and pay taxes in those years on reduced incomes but prevailing tax rates. This appeals to me as I may retire in 2010 and have significantly less income in 2011 and 2012.
Can I model this correctly by:
1) Remove my IRA account and holdings and reinsert the holdings as a Roth IRA in 2010.
2) In 2011 and 2012 add in a special receipt of half the amount converted as taxable at ordinary rates and counteract this with a special expenditure of half the amount converted that is not tax related.
I think this properly burdens me with taxes in 2011 and 2012 but does not increase any investment holdings in those years. This happened in my 2010 conversion.
Does this make sense?
Thanks,
Tom Scanio
What if I decided to get an equity loan on my house to pay the tax for the conversion to Roth? Is it legal? Am thinking of an amount of $45K. I have some money in savings. Have $300K to convert.
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Thanks,
Nelson
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You'll need to model the effect of the equity loan to see if it works in your favor. Do the conversion as per the discussions elsewhere and add to that profile the equity loan income and your payments (you'll need to approximate the principle and interest payments to get the taxes right, but you could just add the equity loan to your mortgage and probably come close enough).
Best,
Dick Munroe
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