I’ve decided on a Roth conversion schedule.
$250,000, $250,000, $250,000, $250,000 for a total of 1M over 4 years. I’m in process now and I have till Dec 31 to get the first conversion done. This process has turned out to be more complicated than I thought but once understood very do-able. This schedule does not eliminate some of the cliffs of conversion like excess medicare costs but minimizes them over 4 years.
The considerations are
- Volatility of tax law. Since the present tax law expires and the politicos seem hell bent on changing the law again it’s time to make hay while the sun shines. This is why the first conversion are $250K. No matter what that much will be converted and likely no matter what $750K will be converted before anything could legislatively be done to ruin the plan. What could ruin the plan you ask? They could eliminate the ability to convert. Hopefully gridlock will protect me on all 4 conversions. By sticking to $250K, as a couple we avoid the extra 3.8% medicare surcharge, but still get 1M converted in 4 years.
- My wife and I both own IRA’s which were funded with post tax dollars. It turns out the government only expects you to pay once, so a % of the Roth conversion will be tax free and the rest will be taxed as ordinary income. I’ve dutifully saved the 8606 IRS forms each year so I have an accurate legal basis. Something to consider is each spouses IRA gets treated separately since Roth conversions are per spouse. My IRA is large. My earliest IRA contributions were only 2000/yr which was the max contribution till about the year 2000. The IRS has a formula by which you determine a percentage of already tax paid money which you can subtract from the gross conversion to give you net taxable money. The formula (from investopedia) :
“John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2018, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.
Here’s how it works:
Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount) = $100,000 ÷ ($200,000 + $100,000) = $100,000 ÷ $300,000
Tax-Free amount of Conversion = 33.3% (or $33,333)Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate”
That percentage is set each year based on contribution amount, total IRA size and total amount of non deductible assets in the IRA, for each spouse, once IRA conversion commences. Because my early IRA contribution was small when I started my percentage is small, about 2%. When I started the IRS only allowed 2K per year per spouse. So I will have to pay on 98%. 2% off works for me! My wife however worked a shorter time and raised our kids as a SAHM so her IRA is much smaller so her % tax relief is much larger, about 9% meaning on every dollar converted she pays, only 91 cents are taxed. Such a deal! The 1M conversion is not just my conversion it is OUR conversion but the IRA belong to each of us separately so sequencing the conversions into each spouses Roth accounts matters. It turns out by converting her entire IRA and by back-filling the remaining from my IRA to reach $250K total we save an additional $4000 in taxes. So my sequence becomes: convert all of hers then begin to convert mine for a $4000 maximized savings on this years conversion. I will recalculate next year on a conversion based on my IRA alone.
3. What you convert matters. You want to convert your highest risk assets first and of those high risk assets convert the ones that are down first. My TIRA’s are at Fido and Vanguard as are my wife’s and our Roth’s are there as well. Fido and Vanguard will transfer assets from a IRA to a Roth without a conversion to cash step as long as both IRA and Roth are at their brokerage. So the funds are transferred and a tax bill generated, slick! This year Emerging markets and Foreign are down 11% and 9% so these are my first equity’s to convert. Stocks are property and by transferring the least appreciated highest risk property first you can transfer the most property for the least tax bite. My conversion order will then be remaining stock, then alternatives, then REIT, then commodities, and finally bonds. My goal is to end up with most of my bonds still in the TIRA and not in the Roth. This minimizes the tax bill. A Roth’s greatest advantage is sheltering capital appreciation as in stocks. It’s less effective in sheltering assets that don’t appreciate much as in bonds. The trade off is pay the government now or pay the government later. Assets with large appreciation potential should be in the Roth ASAP so they can compound over years tax free. Something like bonds which don’t appreciate much can be RMD’d as an interest bearing annuity, and pay those taxes over time. BIG NOTE the RMD is still subject to whatever percentage you determine yearly from the non deductible portion when you started conversion so in my case if I RMD $30K I pay on only $29,400 since my percentage is reduced by 2% or so (variable each year). I’ll take $600 tax free, so it gives me a little Roth like relief even while being a TIRA. By splitting my assets into TIRA and Roth based on capital appreciation I split my tax bill between paying some now on the aggressive earners with no further tax consequence, and paying some in the future on smaller less aggressive earners as opposed to paying it all at once. This reduces sequence of return risk early in retirement to some extent. I am paying my taxes from my post tax account so by having a smaller tax bill for conversion that extra tax money I would pay by converting everything continues to grow in the post tax account. My goal at RMD is to live on SS + a small RMD which gives me room to grow for quite a while before a jump to a new tax bracket, supplement my income as needed from small donations from my taxable account and let the Roth grow unmolested forever.
4. By cleaning appreciation out of the IRA you have the ability to control tax brackets for a longer time. My SS will be about $43K and my wife’s will be about $10K for a total of $53K. Taxes are paid on 85% of the $53K or $45K. The top of the 12% bracket including deductions for age 65+ is 104,000 (26,600 deduction plus 77,400 (top end 12% bracket), so I have $59K of RMD money I can use to fill to the top of the 12% bracket. If I RMD say $25K my taxable is 45K + 25K or 70K and I have $34K of growth before I hit the next tax bracket. That probably is 12-15 years of retirement. Because of the .85% break on SS my spendable income will be 53K+25K or $78K. I’ll fill in my remaining needs from selling post tax stock or from post tax dividends. Since I’m in the 12% bracket cap gains are 0%. A masterpiece in optimization! (I think). I’ve run it by my professional adviser and he thinks so also.
Just a snapshot of what post retirement granularity including Roth conversion looks like. So much for 4% x25, get drunk on the beach.