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Here's my situation:

I am 27.

I have a Traditional IRA with about $3,000.

I have a Roth IRA with about $42,000.

I have read that it's good to have tax diversification, and this makes me think it's safe to have 2 accounts. However, I believe the Roth is superior to the Traditional IRA, so I feel that I should convert. What do you think? Thanks in advance for any feedback.

Edyboom
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Whoa!
You are really young.
And the amount to convert is really small.
Do it.

Me .... I have a traditional IRA and I'm not really young.
And it would be a humongous tax zap if I decided to convert.
Not really worth it for me.

But for you... yes.
Go ahead.
Whatcha waitin' for?

:)


AM
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Missing from your narrative was your marginal tax rate, i.e., the rate at which your last dollar of taxable income is taxed. That lets you know what the conversion will cost you.

The question then becomes, what will you do with that money if you don't convert? If you invest it rather than blowing it on Twinkies (I mention no names and make no charges) and your marginal tax rate in retirement is the same as today it doesn't matter. The outcomes are mathematically equal. A lower rate in retirement argues against conversion, a higher rate in retirement favors conversion.

It really all comes down to what you think your rate will be in retirement, and your youth works against you there. (BTW, this same analysis applies to your decision between a deductible traditional IRA contribution and a Roth contribution.)

If you're currently in or below the 15% marginal bracket I'd say convert. Above that, I'd probably leave it alone.

Phil
Rule Your Retirement Home Fool
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I have read that it's good to have tax diversification, and this makes me think it's safe to have 2 accounts. However, I believe the Roth is superior to the Traditional IRA, so I feel that I should convert. What do you think? Thanks in advance for any feedback.

There is a lot to think about. Let us assume that congress does not change the rules for IRAs and Roth IRAs (an extremely dubious assumption, IMAO). In this case you have to find out if the tax-free returns on your investments will grow fast enough in the Roth IRA to recover the cost of sinking some of the investment in the regular IRA into income tax. So you are going to have to know what your income tax rate will be when you start making minimum required distributions from your regular IRA. Can you pay the income tax from funds not in your IRA?

The next thing I worry about, but you may not, is that they may pass the "Retirement Preservation and Security Act" (I made up the name) that requires you to invest 15% (I made up that number) of your IRA in US treasury bonds, or a government annuity or something. The advantage of making you get a government annuity is that at your death, the government, not your heirs, get any remaining assets of the annuity And you will need to know if they do the same to Roth IRAs as well. They are despairate to raise revenue and with all the money lying around in retirement accounts, what better place to get it? NJ made the state retirement funds invest in NJ bonds, and now the pensionners are screwed. How they got an actuary to sign off on that I cannot imagine. If a state can do it, I assume the feds can do it too.
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Both my Roth and Traditional are fully invested in stocks.

What's my tax rate? Honestly, I don't know. It's sort of nonexistent at the moment. I am teaching in Korea, and I am tax exempt for up to about $91,000. How much I make depends largely on the exchange rate, but I'd guess around $30,000 with the current rate. I have no idea how this would affect my tax rate on a conversion though.


Edyboom
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As others have pointed out, there are other factors here such as tax rate, that could make a differance.

However, given the low balance of the traditional IRA, I'd roll over just for simplicity - one less account to keep track of.
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Do you have another tax deferred account such as a 401k or do you expect to have one in the future? Are you currently contributing to the IRA?
I think that it is desireable at time of retirement or withdrawal to have a mixture of accounts (tax deferred, tax free, and taxable) so you can tax manage your withdrawals to an extent.
If the $3K IRA is currently stagnant I would be inclined to convert unless there are other factors.

Bob
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Hey,

I don't contribute to the Traditional IRA. I only have it because I worked at a grocery store and at the local park. It provided me with 2 measily retirement accounts that totaled $713. I rolled them into the Traditional IRA and 2.5 years later it's worth $3,000!

I don't contribute to the Traditional one, because in my eyes, a Roth is better.


Edyboom
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I am teaching in Korea, and I am tax exempt for up to about $91,000. How much I make depends largely on the exchange rate, but I'd guess around $30,000 with the current rate. I have no idea how this would affect my tax rate on a conversion though.

You really must stop scaring me. I could be forced to take to drink.

Something didn't sound right here, but before I panicked I went back and looked to see if you were involved in the discussion we had about making IRA contributions while excluding foreign earned income. You were, and just to reassure me, you have about $30,000 of income in excess of the foreign earned income exclusion, right?

Line 3 of the tax calculation worksheet you use to figure your tax gives you the taxable income that you'd add the conversion amount to. You can then check that amount against the tax rate schedules to find your marginal rate. It sounds to me like you'd be in the 28% bracket.

Phil
Rule Your Retirement Home Fool
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Hey Phil,

Off the topic: Thanks for hanging around these boards. It's always nice to see the TMF screennames on the free discussion boards.

Yes, it's me!

What you said:

"Something didn't sound right here, but before I panicked I went back and looked to see if you were involved in the discussion we had about making IRA contributions while excluding foreign earned income. You were, and just to reassure me, you have about $30,000 of income in excess of the foreign earned income exclusion, right?"

I make about $30,000 a year TOTAL. I don't make 30k in excess of 91k for a total of 121k. I think you might have misunderstood me. I don't know too much about taxes. I guess that explains my questions!

Edyboom
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I make about $30,000 a year TOTAL. I don't make 30k in excess of 91k for a total of 121k.

OK, back into panic mode. How did you qualify for the Roth contributions that resulted in your current Roth balance? The reason I'm concerned is that in the earlier conversation it sounded like you had made some illegal contributions based on your excluded foreign earned income. What's the situation there?

BTW, on the conversion question, I'd say convert, given your clarification.

Phil
Rule Your Retirement Home Fool
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Phil,

Thanks, I'll convert. Half of my contributions were made when I was working in the US. I made..let me think...3 years of contributions when I was in Korea not knowing that I couldn't.

Since I have a pro here, I guess I'll ask you what to do. I looked this up recently when I learned that I had a problem, and I didn't attempt to fix the problem yet. I will be in the US in 2 weeks, and I figured I could redeem the problem then.

Here is what I read and here is my plan. I guess you can tell me if it's good or bad! Here are my excessive contributions (made while in Korea with no US income).

2009 contribution - 5,000
2010 contribution - 5,000
2011 contribution - 5,000

Here is what I read:

To correct an excess contribution, an individual must remove the excess amount and any applicable income from the IRA by the owner's tax-filing deadline, which is generally April 15. But if you miss the April 15 deadline, you may still be able to make the correction, as individuals who file tax returns by April 15 receive an automatic six-month extension on the deadline for removing the excess amount. An excess contribution that is not removed by the deadline accrues a 6% penalty for every year it remains in the IRA.

Read more: http://www.investopedia.com/articles/retirement/04/033104.as...

If I understand this correctly, I can withdraw my 2011 contribution with no penalty.

I can withdraw my 2010 contribution with no penalty as long as I withdraw it by October 15, 2011 - 6 months after the April 15.

I will have to pay a penalty of $600 (6% * $5,000 * 2 years)...or will it count as $900 for 3 years on my 2009 contribution?

I know that I made a booboo. However, I am not worried about it. I've had great gains in MAKO, PANL, IMAX, MPEL, and more over the past few years. I may have to pay 6-900 in a penalty tax, but my gains far outweigh that penalty.

Anyways, does my interpretation of the law/plan sound ok? What would you recommend?

Also, is there any way that I can contribute to any kind of tax sheltered account while in Korea? Is it possible for me to contribute to an HSA? I don't think I can since I've read that you need a high deductible health plan to contribute to one of those, and I don't have one.

It wouldn't be a bad time for me to withdraw $15,000. I am planning on going back to school soon, and that will cost me $5,000. Gotta look at the positives!

As I am typing this, I came up with an evil scheme. While I am in Korea, I can't contribute to a Roth. If I do, the contribution must be removed by October 15 of the following year if I want to avoid a penalty.

THEORETICALLY speaking, check out this future scenario:

It is January 1, 2012. I am in Korea, and I see an explosive stock idea with a severely undervalued stock. I contribute $5,000 to my Roth when I shouldn't. I buy $5,000 in that stock, and I just wait. Before October 15 of 2013, I sell the stock and withdraw $5,000 from my Roth.

Essentially, I used the Roth to avoid paying potential capital gains taxes, and I withdrew in time to avoid any penalties. Is this legal? Would I have to pay any penalties?

Obviously, I realize the stock may go down. It may stay flat. It may go up. BUT could I put money in every year on January 1 and give a stock 20 months to move before I withdraw it while avoiding penalty?

I am not asking if this is the right thing to do ethically (I own shares of PM) or if there is any risk involved in terms of stock movement. I am asking if this would be legal and penalty free.

Well, this message is a mouthful!


Edyboom
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2009 contribution - 5,000
2010 contribution - 5,000
2011 contribution - 5,000
[all excess]

If I understand this correctly, I can withdraw my 2011 contribution with no penalty.

I can withdraw my 2010 contribution with no penalty as long as I withdraw it by October 15, 2011 - 6 months after the April 15.


Correct on both counts, except that you must also withdraw the earnings on the excess contributions. See page 49 of Pub 590. You include positive earnings on your return for the contribution year (you may have to amend 2010), and they are subject to the 10% premature distribution penalty.

I will have to pay a penalty of $600 (6% * $5,000 * 2 years)...or will it count as $900 for 3 years on my 2009 contribution?

Actually, as long as you fix it by 10/15/2011 you'll owe the 6% penalty for only 2009. Again, the earnings have to come with it, and you'll need to amend your 2009 return.

What would you recommend?

Definitely fix it by 10/15/2011.

Also, is there any way that I can contribute to any kind of tax sheltered account while in Korea? Is it possible for me to contribute to an HSA? I don't think I can since I've read that you need a high deductible health plan to contribute to one of those, and I don't have one.

Correct about the HSA. There's no US retirement account you can contribute to. You should check the treaty to see if there are some options available to you there.

THEORETICALLY speaking, check out this future scenario:

It is January 1, 2012. I am in Korea, and I see an explosive stock idea with a severely undervalued stock. I contribute $5,000 to my Roth when I shouldn't. I buy $5,000 in that stock, and I just wait. Before October 15 of 2013, I sell the stock and withdraw $5,000 from my Roth.


By this point in our conversation you realize that this won't work since you must also withdraw the earnings on the conribution to avoid a penalty.

Phil
Rule Your Retirement Home Fool
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Phil,

Thanks again for all of your help! I'll be in the US for 6 weeks, so I should be able to get it all done. I recommended your response to me. I figured that's an extra way of saying thank you. Keep up the great work!


Edyboom
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I do have 1 more nagging question.

"If I understand this correctly, I can withdraw my 2011 contribution with no penalty.

I can withdraw my 2010 contribution with no penalty as long as I withdraw it by October 15, 2011 - 6 months after the April 15.

Correct on both counts, except that you must also withdraw the earnings on the excess contributions. See page 49 of Pub 590. You include positive earnings on your return for the contribution year (you may have to amend 2010), and they are subject to the 10% premature distribution penalty."

I contributed to the Roth for 6 years. 3 were good, and 3 were bad. I must withdraw the earnings on the excess contributions.

Well, will that mean I have to withdraw all earnings for 2009, 2010, and 2011?

How are these "earnings" determined. I contributed $14,000 legally before I contributed the $15,000 in excess. Who is to say that my increase in stock value is from the 15k and not the 14k. Obviously, any earnings would come from all 29k in contributions. I am just wondering if all of my earnings will have to be withdrawn from certain years or just part of the earnings. To me, only part of the earnings should need to be withdrawn since I also have legitimate money growing in the account as well. Agh! :) Perhaps I have to withdraw all of the earnings and that's my punishment!

It's starting to look like I'll have way more money than I need for today :), but less money than I want for the future :(. I'll restart the Roth when I am in the States for good in 2-3 more years!

Edyboom
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How are these "earnings" determined.

There's a prescribed formula. It doesn't track specific investments; it's based on percentages of the account at various points in time. Your custodian will do the calculations, but if you want to see how it works it's explained in Pub 590. You do not have to withdraw earnings attributable to your legal contributions.

BTW, there's nothing stopping you from investing what you have to withdraw.

Phil
Rule Your Retirement Home Fool
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edyboom,

i'd just like to point out that nothing forces you to exclude 100% of your foreign earned income. when i was in a situation similar to yours, i used to exclude all but a few thousand dollars of my income, in order to have enough income to be eligible for roth contributions.

i still didn't owe any US taxes, but i filed my tax returns anyway, just to be sure i had a paper trail demonstrating the legitimacy of the tax position i was taking... but i'm not sure i even needed to file those returns if i didn't want to.

so, with all due respect to pmarti, it's not clear to me that you have made any excess contributions at all. can't you just take the same tax position that i did? what would be the problem with that?

trp
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Hey TRP,

Honestly, I wish I could do this! If I am earning about $30,000, I would love to not exclude $5,000 in order to max out my Roth! If I have to pay tax on the $5,000 in order to do so, I would gladly do it. A little bit of pain now for a lot of happiness later would completely be worth it.

I do file my taxes every year. I believe that you have to. While the earnings don't add value to my future SS or medicare (to my knowledge), I was told that the years of work will count.

Phil, is it possible to choose not to exclude $5,000 of my income in order to legally contribute to a Roth?


Edyboom
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Hey TRP and Phil,

Honestly, I wish I could do this! If I am earning about $30,000, I would love to not exclude $5,000 in order to max out my Roth! If I have to pay tax on the $5,000 in order to do so, I would gladly do it. A little bit of pain now for a lot of happiness later would completely be worth it.

I do file my taxes every year. I believe that you have to. While the earnings don't add value to my future SS or medicare (to my knowledge), I was told that the years of work will count.

Phil, is it possible to choose not to exclude $5,000 of my income in order to legally contribute to a Roth?


Edyboom
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Phil, is it possible to choose not to exclude $5,000 of my income in order to legally contribute to a Roth?

IIRC, no. I'm far from an expert in this area, but I've seen discussions, both here and elsewhere, which concluded that if you elect the exclusion you can't restrict it to less than the full amount allowable.

Pros?

Phil
Rule Your Retirement Home Fool
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Phil, is it possible to choose not to exclude $5,000 of my income in order to legally contribute to a Roth?

IIRC, no. I'm far from an expert in this area, but I've seen discussions, both here and elsewhere, which concluded that if you elect the exclusion you can't restrict it to less than the full amount allowable.

Pros?


I've seen the same discussions, but it's an area where I have absolutely no experience.

Ira
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I was rummaging around on misc.taxes.moderated to see if I could find one of the discussions I recall and was reminded of something else that might work in your situation. If you are paying Korean tax on your earnings you could take the foreign tax credit rather than electing the foreign earned income exclusion. This would leave your wages available as "taxable compensation" for IRA purposes. You'd have to run the numbers to see if it would be worthwhile.

Lots of information in Pub 54.

Phil
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IIRC, no. I'm far from an expert in this area, but I've seen discussions, both here and elsewhere, which concluded that if you elect the exclusion you can't restrict it to less than the full amount allowable.

phil, i am not a pro, and i am operating on recollections from years ago, but i looked at this fairly carefully when i was doing it.

congress has not drafted the tax law in this area to OBLIGE you to minimize your taxable income, merely given you the RIGHT to avoid double-taxation up to a certain limit. that was my reading of the IRC at the time.

from a mechanical reporting standpoint - the way i put this down on the forms was to choose the "physical presence" test rather than the "bona fide resident" test. then i figured out how many days out of 365 would pro-rate my income to the desired amount, and then i wrote that number down in the box for "physically present" on the relevant form. hey presto.

edyboom - if you read the beginning of the instructions for f1040, you'll see that if you don't owe any US taxes, and you haven't owed any for several years (which is usually the case for expat english teachers), then you don't even need to file a return.

in this case, if you filed returns for prior years wherein you excluded 100% of your income while simultaneously making IRA contributions, then you are likely going to need to go back and amend those prior year tax returns on f1040-X in order to exclude less income, in order to avoid the penalties for excess contributions.

usual disclaimers apply, IANAL etc. etc., just trying to help 'cause i've been there before.

trp
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If you are paying Korean tax on your earnings you could take the foreign tax credit rather than electing the foreign earned income exclusion. This would leave your wages available as "taxable compensation" for IRA purposes. You'd have to run the numbers to see if it would be worthwhile.

good idea! except i rather suspect that the korean rate structure is more favorable than US rates, so there's likely to be a cost to that. but OP said he's only got $30K income, so it might be OK. indeed, have to run the numbers on that one.

trp
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edyboom223 writes:

Here's my situation:

I am 27.

I have a Traditional IRA with about $3,000.

I have a Roth IRA with about $42,000.

I have read that it's good to have tax diversification, and this makes me think it's safe to have 2 accounts. However, I believe the Roth is superior to the Traditional IRA, so I feel that I should convert. What do you think? Thanks in advance for any feedback.


I reply:

I'd convert. Here's why.

I'm assuming that current law will remain more or less the same. If so, there will probably come a day when your income means you can no longer make contributions to a Roth IRA. But you'll always be able to make contributions to a traditional IRA and then convert them to a Roth. If the traditional IRA is empty at the time you begin this process, the next tax effect is essentially the same as contributing to a Roth.

But if there's more money in the traditional IRA than your basis there, that won't necessarily be the case. That's particularly true if you are covered by a retirement plan at work -- then you'll have a basis in the traditional IRA because your contributions won't be deductible (once your income is sufficiently high). --Bob
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edyboom223 writes (in part):

To correct an excess contribution, an individual must remove the excess amount and any applicable income from the IRA by the owner's tax-filing deadline, which is generally April 15. But if you miss the April 15 deadline, you may still be able to make the correction, as individuals who file tax returns by April 15 receive an automatic six-month extension on the deadline for removing the excess amount. An excess contribution that is not removed by the deadline accrues a 6% penalty for every year it remains in the IRA.

I reply:

Can the problem be fixed by amending the prior year returns to forego use of the foreign earned income exclusion? Based on a $30,000 per year income, I'm not even sure there'd be any tax liability. --Bob
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