Roth Conversion

Submitted by Tom Pate on Thu, 2009-07-30 21:20

newbie… great board!! glad to have found it!!

I wish to convert my entire IRA to a Roth.
Age: 64, expected taxable income for 2009



Submitted by Alan Spross on Thu, 2009-07-30 23:57

Welcome to the board!

For 2009, which is the last year that income matters for conversion eligibility, remember to look at your modified AGI, which will be higher than your taxable income in most cases. There is a worksheet on p 62 of Pub 590 to determine your exact modified of modified AGI.

Q1: There is no limit on the amount that you can convert. The conversion itself does NOT count in the modified AGI figure cited above. There is also no limit on the number of conversions you execute in a given year, ie conversions done on different dates. However, since your conversions coming from a pre tax IRA will be taxable, you may wish to avoid converting so much in any single year that your marginal tax rate is increased, both state and federal. For many people that means selecting an amount that can be converted at your current tax bracket, ie in the 15% bracket and avoiding spilling over to the 25% federal bracket. You can also recharacterize (reverse) any portion of any of your conversions by Oct 15th of the following year. This date allows you to determine your exact tax liability for the year of conversion and if it increases your bracket you can recharacterize just enough of the conversion to reduce that figure to what you want.

Q2: There is no waiting period to convert to a Roth IRA. For conversions in 2010 only, the additional taxable income from the conversion is reported in 2011 and 2012, but there is no hold up for actually doing the conversion. You might want to convert some in 2009 and some in 2010 or even spread out the conversions over more years. That decision can take some heavy analysis, more than what we can address here. Perhaps you should consult with a tax pro regarding how much to convert given your total financial situation. Note that a conversion while you are collecting SS income can produce a higher effective bracket while the conversion income adds more SS dollars into your AGI.



Submitted by Tom Pate on Fri, 2009-07-31 00:28

Thanks, Alan!

According to the FAQ on the Slott site:
[color=#0000FF]”Can I convert my IRA or employer plan to a Roth IRA?

These rules are changing in 2010. For 2009 the following apply.

You can convert to a Roth IRA if your MAGI (modified adjusted gross income) does not exceed $100,000. You must be single or married filing jointly. If you are married filing separate, you cannot do a Roth conversion. All funds in traditional IRAs, SEP IRAs, and employer plans such as 401(k)s are eligible to be converted to a Roth IRA. [b]Funds in a SIMPLE IRA can also be converted AFTER the SIMPLE account has been open for two years.[/b] A conversion before that date will be subject to a 25% penalty tax on the amount converted.”[/color]

It was this that caused me to ask Q2. I took the comment about “SIMPLE IRA” to apply to me (hence the 2-yr wait), but I’m probably a “Traditional IRA” and therefore there is no 2-yr wait (?). What is a “SIMPLE IRA”?… want to be sure I don’t have one.

Thank-you for your alert on modified AGI and also about taking less out to reduce tax hit.
I have done an extensive time-adjusted value of money simulation cash flow analysis of taking the entire IRA out now versus taking it out starting when required withdrawals force me to start. What I found was that I’m better off taking a 35% hit one time than taking 20 hits later at around 26% due to the forced withdrawals being so much more than my income requirements. And this was assuming no tax increase from 2009 which might be unlikely 🙄 .



Submitted by Alan Spross on Fri, 2009-07-31 02:49

There IS a two year waiting period to roll over a SIMPLE IRA. A SIMPLE IRA is an employer plan and is NOT a traditional IRA. You would not have rolled your 401k into a SIMPLE IRA, but if you did by error, it must be corrected. I really doubt that you have a SIMPLE IRA.

Re the 26% – where does that come from? This does not seem to be a likely total of your federal and state marginal tax rates. Note that RMDs start at less than 4% of the TIRA year end balance, but of course if you have other income not taxed at the 15% LTCG max, that income would impact your marginal rate in the same manner as an IRA RMD or conversion.

Also it sounds like you are well in excess of the rate caused by inclusion of SS income. Once all your SS income is included @ 85%, it no longer has an impact on your marginal rates. This usually occurs before you enter the 25% federal bracket.



Submitted by Tom Pate on Fri, 2009-07-31 20:59

Alan… Thanks for confirming.

You were right on the tax%… I remembered the percentage wrong. Also, the percentage is not a bracket but rather just a calculation of (the incremental tax caused by the projected forced IRA withdrawal) divided by (the amount of the withdrawal). The simulation doesn’t use rates, but rather uses the incremental $ amount of 2008 Fed and State tax calculated by Turbo Tax when the amount of the forced withdrawal for each year is plugged into the Turbotax taxable IRA withdrawal field and all else is held constant. Over the 19 years of IRA withdrawals in the simulation (to age 90), the calculated “rate” increases from 27.8% to 31.68% as the amount of the forced withdrawal increases.

In the case of a total conversion in 2009, the incremental tax amount is also provided by 2006 turbotax with the full IRA amount entered as the withdrawal amount. It is a check that will be hard to write! Certainly clarifies Ed Slott’s reminder that your IRA monies are not yours!

Then, adding up the 19 years of incremental taxes for the gradual tax withdrawal case and comparing that sum to the incremental tax for the single-withdrawal case, the single-withdrawal case is 25% less. The simulation also includes the longer retention, compounding at 5%, of the IRA funds in the gradual-withdrawal case, while the single-withdrawal case removes the huge chunk of taxes from assets up front. The ending asset balance is 35% less for the single-withdrawal case, but is 96% tax-free Roth versus 51% IRA and 38% Roth in the gradual-withdrawal case.

I think this is a best-case scenario for the gradual-withdrawal case since it assumes that taxes are not higher in later years when the postponed withdrawals occur.

Another question for you… if one were to take this drastic step, are there advantages to wait until 2010 and utilize the provision to pay the taxes in 2011 and 2012 versus converting in 2009? I am concerned about tax hikes in 2010, especially since they are supposed to be laid mostly on the rich, which I would be for that one year!



Submitted by Bruce Steiner on Fri, 2009-07-31 21:34

Another possibility might be to spread the conversion out over the years before you would otherwise have to start taking distributions.

Another possibility is to convert each year the amount that you can convert while not going beyond your desired top tax bracket for that year.



Submitted by Alan Spross on Fri, 2009-07-31 23:11

You have plenty of flexibility with a 2010 conversion, including the following options:
1) Either report half the taxable income in 2011 and half in 2012 OR opt out and report all of it in 2010. The 2 year deferral reduces exposure to the top rates, but it opens up exposure to rate increases. The Bush tax cut marginal rates expire on 12/31/2010. The decision to defer or opt out expires on 10/15/2011
2) The recharacterization deadline to reverse all or part of the conversion is also 10/15/2011, known as the extended due date. You would probably extend your 2010 return if your mind was not made up by 4/15/2011. You will also know the investment experience of your conversion several months after the conversion was done. While a rather short sighted factor, it may still affect your decision on whether to recharacterize.
3) It is also possible to utilize a file and suspend or return of SS benefit payments to eliminate this income during Roth conversion years, complete the conversions and then start benefits again with the delayed retirement credits of 8% a year between normal retirement age and age 70. Studies have shown that increasing SS benefits in this manner provides more dollars by a wide margin than you can purchase an immediate annuity for from any carrier. And 15% of SS benefits are the least amount that will be tax exempt.
4) General consensus is that the Bush top rate of 35% will go to 39.6% in 2011 and is also subject to other possible healthcare related surcharges. State deficits are also sky high and state tax rates are also expected to increase.
5) But there are still so many unanticipated developments that will occur over the next 3 decades, that even with the most thorough analysis possible, there will always be a large element of luck involved. It’s not just tax rates, but also what happens with the economy, currencies, and your own investment and health results.

This creates retroactive options when to report the conversion income and how much of the conversion to retain. By Oct 2011, you should also have a decent idea of your 2011 tax situation, but probably not your 2012 tax situation. Rates will probably not be raised retroactively, but tax rates have been known to change mid year in prior tax rate increases. That results in a pro rated increase.



Submitted by Alan Spross on Fri, 2009-07-31 23:18

Forgot another possibility:
You can have as many conversions in 2010 as you wish, but must defer or opt out on all of them. You cannot pick and choose. However, if your spouse has an IRA, the spouse can make a different election than you do, ie report entire conversion in 2010 while you defer to 2011 and 2012. Spouse also has the same recharacterization options. Remember, if both of you defer, no part of your 2010 marginal bracket will be used for conversion income.



Submitted by Tom Pate on Sat, 2009-08-01 01:47

Very helpful… thanks so much for the suggestions!

BSteiner, I will run the simulation with continuous withdrawals to get a comparison. And another run trying to set the withdrawals below an appropriate bracket breakpoint.

Alan… are all the advantages you mention for a 2010 conversion not available for a 2009 conversion… e.g. a 2009 conversion cannot spread the conversion ovr 2010 and 2011? Less recharacterization options?

Suspending the SS is a great idea!

Is it not likely that taxes will be increased above the Bush levels for 2010? I was assuming that I would be vunerable to tax increases if I waited until 2010 to convert.



Submitted by Alan Spross on Sat, 2009-08-01 02:41

For years other than 2010, each year the conversion is reported only in that specific year, so 2010 is unique. The recharacterization deadline for a 2009 conversion would be 10/15/2010. 2009 is also the last year that there is an income requirement. After 2009 anyone with an account to convert will be able to convert, but 2010 is the only year with a two year deferral option.

Re SS suspension return of contributions – you would have to return any Medicare premiums taken out as well, and you would have to re work the tax returns to claim either a credit or deduction for the prior years affected by returning the benefits. But you get to keep any earnings on the benefits, so the returned benefits can be considered tantamount to an interest free loan.

You are correct that you might well be hit with a tax rate increase in 2011 and 2012. However, you would probably know that by the deadline to opt out of the deferral and could report the conversion income totally in 2010. And if that was too much 2010 income, you could recharacterize part of the conversion. After that you would go year by year, reporting only conversions done in the respective year.



Submitted by Tom Pate on Sat, 2009-08-01 13:40

Got it, Alan… but is it likely that taxes for 2010 will be raised above the 2009 levels?… i.e. that waiting until 2010 to convert (to get the benefit to spread over 2 years) could result in being taxed at a new higher 2010 rate than the (I’m assuming) locked-in 2009 rate?



Submitted by Alan Spross on Sat, 2009-08-01 16:34

The general consensus is that 2010 tax rates will not change partially due to the continuing recession, but watch out after that. The lower qualified dividends and LT cap gain rates also expire 12/31/2010. Even healthcare tax increase proposals out there do not affect 2010 tax rates. But if you are eligible to convert this year (under 100,000 MAGI), you might want to convert a portion to utilize the full amount of taxable income in your current bracket. Note that Medicare Part B premiums are surcharged if your income, including conversions exceeds certain amounts. The surcharge applies for the second tax year after the income is reported, eg 2007 income affects 2009 Medicare premiums. Of course, incurring the surcharge due to conversions will also likely eliminate surcharges from RMDs later on since conversions reduce or eliminate future RMDs.

If you ever made non deductible TIRA contributions since 1987 and filed Form 8606 to report them, or if you rolled over any after tax employer plan contributions to your TIRA, a pro rated portion of all your distributions or conversions will be tax free. If you did not properly file an 8606 for the years you made non deductible contributions, you can file them retroactively without penalty, and should do that prior to converting so the IRS has those records when you report conversions.



Submitted by Tom Pate on Sat, 2009-08-01 20:24

Thanks so much, Alan… awesome help!!



Submitted by george collins on Fri, 2009-08-28 17:46

Delaying SS to 70 has another bene; If your spouse has SS income, you can take 50% once you are 66. This and the tax benefits of reduced taxable income can be significant. 😀

jerry



Submitted by Alan Spross on Fri, 2009-08-28 20:55

Agree. That’s the SS strategy known as “collect now, collect more later”. You can collect 50% of the unreduced spousal benefit at your NRA (not before), and then bank 8% bonus increase per year on your own benefit while waiting. You can then switch over to your own benefit anytime between 66 and 70.

Coordinating incremental Roth conversions during the period while you are on the spousal benefit helps keep your AGI down vrs collecting your full benefit while doing conversions. The Roth will be tax free and 15% of the added SS benefit will also be tax free. (Caution: Under current law).



Submitted by george collins on Sat, 2009-08-29 15:34

And with COLA, the 8% is more like 10% on the average(which is not in the SS form we get every year as COLA is unknown year to year).

My current tax strategy is to minimize my RMD before it is due. SS tax can be futher reduced from 85% level when non SS taxable income is reduced below the 55K level.

Can you speculate what would happen if the SS tax equations are changed again. And what happens to Roths if we go to a flat tax?

jerry

ps–excellent web site and even better answers



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