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Presume this is one of the most commonly posed IRA questions on fool.com

Should I convert Rollover IRA to a Roth IRA.

Situation:

1.) I'm 40, 25 years until retirement
2.) have $220K in equities in a Rollover IRA (allocated according to MDP for the most part - so expect 8% gain over 25 years?)
3.) plan to invest another $625,000 before retiring via 401k/403b plans that I have to put in broader mutual funds, not much control there.
4.) I earn approx 110k per year, guess im 25% tax bracket, married, spouse does not work
5.) no mortgage. we have a $650k home with $80k equity line

If I remain at current employer for the next 25 years, the $625k i put away will be in tax differed 401/403 plans. Therefore I'm thinking to at least shift over the $220k over to Roth, start 15-20% this year, then let advantages of time-phasing amounts to transfer over when new laws kick in next year.

Do I even bother if I need to use IRA funds to make tax payments on the rollover?

Thanks!
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Do I even bother if I need to use IRA funds to make tax payments on the rollover?

No. Assuming that you have to pull enough out of the IRA to pay the taxes, and penalties on the part that is not converted, you will only be able to convert about $725 out of every $1000 that you pull out of the account. The rest will be paid to the Feds in taxes and penalties. And if your state imposes taxes and penalties on premature withdrawals, the amount available for conversion will be even less.

AJ
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There may be better ways to get money into a Roth.

There is now a Roth 401k. If your employer does not offer it now you can try to get them to add the Roth 401K option.

I didn’t see a regular IRA or Roth mentioned. Assuming that you file a joint return, even though you are in the 401K you can almost certainly make normal Roth contributions each year for your spouse and probably for yourself too. You may be able to put up to a combined $10,000 a year into a Roth and even more when your turn 50.

You can also structure your savings so that you have very low taxable income the first few years that you are retired and Rollover some of the money to a Roth each year when you are in a lower tax bracket.

Greg
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Yes, I think you should convert your IRA to a Roth as much as you can. Your tax rate will be no lower in retirement and might be higher when you get to mandatory distributions on your other tax deferred plans.

Keep a close eye on your tax rate. I would guess you will not be able to convert the full $220K and still be in the 25% bracket, but I would do a series of partial conversions using up the rest of your 25% bracket every year.

And note, this is easier to do while stock prices are down. The taxes due are lower. You hope to get it done before stock prices recover.

The main advantage of the Roth is that no taxes will be due on your investment gains in the account, and you hope that those will be substantial. So conversion should save you considerable amounts assuming your investments do as well as you hope.

But do pay the income taxes due out of your after tax savings if you can. The penalties add quite a load to the tax bill if you use IRA funds to pay those taxes.
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The main advantage of the Roth is that no taxes will be due on your investment gains in the account, and you hope that those will be substantial. So conversion should save you considerable amounts assuming your investments do as well as you hope.

This is false logic. Yes, you would pay more dollars in taxes by taking it out of a traditional IRA, but the amount left in your pocket will be the same assuming equal tax rates.

Consider $1000 converted. Paying 25% now will leave you with $750. Assuming it grows to 10 times it's current value in a Roth, you'll have $7,500.

Leave it in a traditional IRA and $1000 grows to $10,000. Pay 25% and you have exactly the same $7500.

Personally, I wouldn't convert. If you're like me, you have no pension and any income you get will be from IRA withdrawals and other investments.

At today's tax rates, HR Block says you'll pay $14,400 in taxes on $110k of income with no deductions or 13% marginal tax rate. If a retired person took $110k out of a traditional IRA today with no other income, they would only pay $14,400 in taxes while the OP would be paying at least 25% x $110k or $27,500 in taxes or nearly twice as much.

I wrote a more detailed example of how you could end up with less money in your pocket by converting to a Roth here: http://boards.fool.com/Message.asp?mid=26499081

Personally, I would keep the traditional IRA and direct extra cash towards a Roth.

-murray
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At today's tax rates, HR Block says you'll pay $14,400 in taxes on $110k of income with no deductions or 13% marginal tax rate. If a retired person took $110k out of a traditional IRA today with no other income, they would only pay $14,400 in taxes while the OP would be paying at least 25% x $110k or $27,500 in taxes or nearly twice as much.

In my prior post, I wrote the above statement. It should have said 13% effective tax rate instead of marginal tax rate

And to clarify, to convert $110k to a Roth IRA, the OP would pay at least 25% in taxes or $27,500 which is nearly twice as much as he would pay taking that amount out today assuming no other income.

Sorry for the confusion. Again, have a look at my older post where I lay out more details: http://boards.fool.com/Message.asp?mid=26499081

-murray
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Consider $1000 converted. Paying 25% now will leave you with $750. Assuming it grows to 10 times it's current value in a Roth, you'll have $7,500.

You have forgotten the 10% penalty on the $250 used to pay taxes. The OP will only end up with $725. Then, assuming it grows to 10 times the current value, the OP will end up with $7250.

Leave it in a traditional IRA and $1000 grows to $10,000. Pay 25% and you have exactly the same $7500.

Actually, it will be $7500 after paying taxes on the traditional IRA vs. $7250 in the Roth, because of the penalty.

AJ
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Thanks AJ.

I understand that taxes must be paid, but that there are no penalties as long as the transfer is direct (have 60 days in total to convert over to Roth, once withdrawn).

See You won't pay penalty for moving to Roth IRA
http://www.oregonlive.com/business/index.ssf/2009/05/you_won...

Thanks!
Osho
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I understand that taxes must be paid, but that there are no penalties as long as the transfer is direct (have 60 days in total to convert over to Roth, once withdrawn).

True, as long as you use money from outside the IRA to pay for the taxes.

Your original post said Do I even bother if I need to use IRA funds to make tax payments on the rollover?

So - do you have the money to pay for the taxes, other than using part of the IRA you are converting?

If you have to use IRA funds to pay the taxes, that money is not converted. You will owe both taxes and a 10% penalty on the amount used to pay for the taxes.

AJ
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See You won't pay penalty for moving to Roth IRA
http://www.oregonlive.com/business/index.ssf/2009/05/you_won......


From the answer bottom:

Make sure you have enough cash to cover the taxes without raiding the IRA you'll be converting.

There's no penalty as long as you're able to do this, that is, cover the taxes with cash, not funds from the IRA. Your original plan to use the IRA to pay taxes would result in a penalty.

I'm thinking of doing this, but my plan is to wait until I reach 59-1/2, so there would be no penalty. The idea would be to convert only an amount that will keep me in a lower tax bracket. I figure the main advantages will be the flexibility it will give me to stay in a lower tax bracket and the tax free inheritance I'll be able to leave.
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Ah, I did not catch that. Thank you AJ!
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This is false logic. Yes, you would pay more dollars in taxes by taking it out of a traditional IRA, but the amount left in your pocket will be the same assuming equal tax rates.

Consider $1000 converted. Paying 25% now will leave you with $750. Assuming it grows to 10 times it's current value in a Roth, you'll have $7,500.

Leave it in a traditional IRA and $1000 grows to $10,000. Pay 25% and you have exactly the same $7500.

Personally, I wouldn't convert.


This topic has been hashed over for going on 10 years. I can't believe that after all this time that there are so many (presumably astute) advisors who say it's a no-brainer to convert. Of course, it is a valid question for someone new to ask, but the general answer is pretty well solid.

For most people, it does not make sense to convert. As Murray said, the math comes out the same.

But.....there is no reason to pay taxes before you absolutely have to. Why would you pay taxes now in order to avoid paying the same amount of tax in the future?

Also, when you retire and no longer have W-2 income, it is very easy to shift the timing and amounts and taxability of getting your income. I've been surprised at how easy it is to stay in the 15% tax bracket even with a very comfortable income.

Not to mention the political risk, that a few decades in the future the folks in Washington will see all the money that "greedy rich" people are taking from their tax-free accounts, and decide that it just isn't fair for them to now pay income tax on it. Indeed, that's what they did with Social Security income in the '86 tax reform.
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Personally, I wouldn't convert. If you're like me, you have no pension and any income you get will be from IRA withdrawals and other investments.

I did convert part of an IRA to a Roth, and also made new contributions to a Roth. My reasoning was this: I don't know what the tax laws and tax rates will be in 10 or 20 years, so it will probably pay to have some of various kinds of money--Roth IRA, regular IRA, 401k, etc. When the time comes, I can arrange things to the best benefit.

It also helps that my situtation puts me at the 15% federal tax rate right now (four kids, mortgage, etc.). If I were at 3X%, it might be harder to justify paying tax now vs. later.

Final piece of information for thought: You can put "more" money into a Roth...after taxes. Because the amount you can put in either a traditional or a Roth is the same, think of it this way: The traditional IRA lets you put in the amount you'll keep plus the amount you'll pay in tax on the principal and the gains. For the Roth, you're putting in the full amount as what you'll keep, and paying the taxes with other money.
Example: Put $2000 into a traditional IRA, it grows 5x to $10K, you pay 25% tax, so you keep $7500.
Put $2000 into a Roth IRA, it grows 5x to $10K, you keep $10000. The catch is you have to have paid the 25% (assuming same tax rate) up front. The $500 you pay in taxes the year you make the contribution to cover the $2000 would've grown to the $2500 difference between the two IRAs. Math-wise, it's the same, but with the Roth, more money is left after taxes at the end.
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It also helps that my situtation puts me at the 15% federal tax rate right now (four kids, mortgage, etc.). If I were at 3X%, it might be harder to justify paying tax now vs. later.

This, to me, is the key and, so long as you remain in the 15% tax bracket with the conversions, I think you made the right decision. Going into the 25% tax bracket makes it more of a crap shoot with the odds going to the house IMHO.

-murray
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This, to me, is the key and, so long as you remain in the 15% tax bracket with the conversions, I think you made the right decision. Going into the 25% tax bracket makes it more of a crap shoot with the odds going to the house IMHO.

My view of the risk is slightly different. If you remain in the same tax bracket (convert now vs. when you withdraw from the Roth), then mathematically it makes no difference if you convert or not. The after-tax value is the same.

The one risk that everybody is aware of is that maybe your future tax bracket will be higher, so you'll have a higher tax then.

But the other risk that very few consider is: the possibility that Roth withdrawals will *not* be tax-free in the future. If that happens, you'd pay tax twice, once on the conversion and again on the Roth withdrawal.
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If you remain in the same tax bracket (convert now vs. when you withdraw from the Roth), then mathematically it makes no difference if you convert or not. The after-tax value is the same.

Where will your income come from that will put you into that tax bracket?

If, like me, it's from IRA withdrawals and we keep our current tiered tax system, then I think you will pay less in taxes with a traditional IRA even though you are in the "same tax bracket".

-murray
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Where will your income come from that will put you into that tax bracket?

If, like me, it's from IRA withdrawals and we keep our current tiered tax system, then I think you will pay less in taxes with a traditional IRA even though you are in the "same tax bracket".


I don't know (where the income would come from).

But every time I read an article about converting, they *always* say that you might be in a higher tax bracket. I think maybe this is just a way to either add drama or to tilt the argument toward their desired position (which is usually to convert).

I agree with you. Since I've retired I have discovered that it's almost trivially easy to stay in a low tax bracket. The ability to choose where your money comes from gives you a lot more flexibility than if it's from W-2 income.
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I agree with you. Since I've retired I have discovered that it's almost trivially easy to stay in a low tax bracket. The ability to choose where your money comes from gives you a lot more flexibility than if it's from W-2 income.

In fact, my retired parents currently pay $0 in federal income tax so the taxes they paid to convert to a Roth was totally wasted.

Personally, I expect to withdraw from my traditional IRA for several years before I start taking social security while paying between 10-12% in federal income taxes using the current brackets. That's about 1/3rd the rate I'd pay today to convert.

YMMV, but there seems to be this opinion that married retirees will magically have an $80k+ income that will pop them into the 25% tax bracket despite pensions being few and far between.

-murray
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In fact, my retired parents currently pay $0 in federal income tax so the taxes they paid to convert to a Roth was totally wasted.

Maybe not. As I understand it, when you get to 70 1/2, you MUST take out a certain percent of a regular IRA every year whether you want/need to or not, but with a ROTH IRA you can happily leave it there until you decide it's time to take it out. So they can save that ROTH money for the later years when their costs might be significantly higher due to medical costs, or they can just enjoy the option of taking more or less out each year as they see fit without the feds telling them how much they MUST take out....

RDW
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Maybe not. As I understand it, when you get to 70 1/2, you MUST take out a certain percent of a regular IRA every year whether you want/need to or not, but with a ROTH IRA you can happily leave it there until you decide it's time to take it out. So they can save that ROTH money for the later years when their costs might be significantly higher due to medical costs, or they can just enjoy the option of taking more or less out each year as they see fit without the feds telling them how much they MUST take out....

My Dad is 92, he's been paying RMD's for 20+ years. Trust me, they would have more money if they never converted to Roths.

-murray
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Maybe not.

Certainly yes.

They're paying NO tax now. How can you pay less than that? They would indeed have been better off converting less of their IRA to a Roth. Now it is possible that they took advantage of some situation earlier in their working life that allowed them to convert their traditional IRA to Roths at little or no tax. If that were the case, then they are no worse off for having done so.

As long as the tax code has personal exemptions, a standard deduction, and graduated tax rates, everyone will want to have some income subject to tax in retirement. Those bits of tax code cause income that would normally be tax to become tax free or taxed at low rates. And that means NOT converting all of your retirement savings into Roth accounts. If all you have to retire on is your Roth IRA, you have overpaid your taxes earlier in life.

As I understand it, when you get to 70 1/2, you MUST take out a certain percent of a regular IRA every year whether you want/need to or not,

Correct. The first required withdrawal is less than 4% of the balance in your IRA. On a $1 million IRA account, that's less than $40k. If that's your only source of taxable income and we're talking about a married couple, that's barely enough to get them into the 15% bracket.

So they can save that ROTH money for the later years when their costs might be significantly higher due to medical costs,

Except that medical costs are tax deductible (to some extent). That's when you WANT to take the taxable money out - when you have tax deductible medical expenses that can offset the taxable income.

or they can just enjoy the option of taking more or less out each year as they see fit without the feds telling them how much they MUST take out....

RMDs are nothing to be afraid of. They just aren't that big. The first RMD is less than 4%. They get to 5% at age 79, and 10% at age 93. If you ask me, they just aren't that big.

--Peter
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RMDs are nothing to be afraid of. They just aren't that big. The first RMD is less than 4%. They get to 5% at age 79, and 10% at age 93. If you ask me, they just aren't that big.

I agree. I plan on taking around 4% out of my IRAs long before I turn 72. If RMDs pop me into a higher tax bracket later on, it means my savings strategy was successful and I should have plenty of cash to last through retirement.

-murray
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I am still considering converting my wife's IRA
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Thought-provoking thread, all.

I am still considering converting my wife's IRA this year. We only have about $330K in savings, & currently over 2/3 of it is in taxable 401(k) & IRA. By converting her $40K account (most at 25% bracket - taxes paid out of other savings - not enough to hurt our emergency fund), I would shift more of our savings into the "never taxed" category (I know, if the politicians will keep their hands off it). I believe this will give us more flexibility when she reaches 59.5 in 21 years.

By having the ability to withdraw from both taxable & non-taxable accounts, I believe we will be able to minimize our tax at that time, when I also believe rates will be significantly higher than now.

Finally, I plan to have more income in retirement than we do now, due largely to no longer saving over 30% of current income.

Any more thoughts?

Byron
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Any more thoughts?

Byron


--------------------

Ziggy over on the campfire board offered up a perspective that i hadn't seem before. Thought provoking. Kudos to ziggy...


http://boards.fool.com/Message.asp?mid=28373766
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--------------------

Ziggy over on the campfire board offered up a perspective that i hadn't seem before. Thought provoking. Kudos to ziggy...


http://boards.fool.com/Message.asp?mid=28373766


yup.

looking at it from the back-end.

..something i've been thinking about for several weeks.

conclusion:

complicated,
sensitive to details.

..balancing IRA, RMD, Roth, and *estate*



=
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By having the ability to withdraw from both taxable & non-taxable accounts, I believe we will be able to minimize our tax at that time, when I also believe rates will be significantly higher than now.
All things being equal, since multiplication is commutative there is no difference between paying taxes now vs. later.
So what's the advantage to paying now instead of a few decades from now? Do you pay your annual taxes in January or delay it until next April 15th?

Finally, I plan to have more income in retirement than we do now, due largely to no longer saving over 30% of current income.

Any more thoughts?


Don't confuse "money coming in" with "taxable income". I have been surprised at how easy it is to minimize my taxable income in retirement. You have a lot of control over where the money comes from---unlike W-2 income.
Our total income is almost as much as my last annual salary, yet our taxable income is trivial. Our total 2009 Federal tax (line 46) is $1300. And no FICA, either.
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All things being equal, since multiplication is commutative there is no difference between paying taxes now vs. later.

Correct.

But the OP's comments indicate that they are not assuming all things are equal. They are assuming that tax rates are going to be higher in the future. With that assumption, paying now is favorable to paying tax at a higher rate later.

You are assuming that rates will be the same now as in the future. And someone else might assume that rates will be lower in the future than they are now. Each assumption about the future leads to a different logical conclusion about the correct action to take today.

--Peter <== who neither agrees nor disagrees with any of these assumptions, but believes it is each person's assumption to make.
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You are assuming that rates will be the same now as in the future. And someone else might assume that rates will be lower in the future than they are now. Each assumption about the future leads to a different logical conclusion about the correct action to take today.

It is not even that simple. Due to tax brackets, you have to assume how many dollars in each assumption are in the last bracket. You can get different results even if the rates don't change.
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