My wife and I have been converting some of our IRAs into Roths, now we are retired and in lower income brackets, until we have to take RMDs in 3 and 7 years respectively.
This now adds a third type of account besides general taxable vs non-taxable, ie one that while non-taxable will hopefully be available to our heirs.
Any thoughts re
1) best type of assets to put into a Roth?
The typical recommendation for a taxable account is non- dividend paying equity funds and growth stocks as capital gains rates are lower than income tax rates. Qualified dividends also get taxed at capital gains rates.
Whereas investments that throw off cash taxed at income tax rates should be in IRSs etc, as all of the withdrawals will be taxed at those rates, regardless.
Bonds even high yield Bonds while tax free in a Roth, would not seem to have the same prospective rates of returns over decades as Equities. I also want to avoid speculative ideas, as significant capital losses eliminates the advantage that taxes have already been paid on the money.
2) Has anyone found useful calculators or spreadsheets to help determine the tax implications of Roth conversions? Surprisingly, I cannot find anything helpful, other than calculations for the RMD itself.
Comments
Let's assume that the tax rate upon withdrawal is 25%. Let's assume that you've got $4 in a T-IRA and $5 in a Roth. The after-tax value of the T-IRA is $3. The total after-tax value is $8.
Now let's say that you allocate half the money (based on after-tax value) to an investment that quadruples in value, and you allocate the other half to an investment that "merely" doubles.
It doesn't matter how you do the allocation. Two (of many) possibilities:
Roth: $4 to faster growing investment, $1 to slower investment;
T-IRA: $4 ($3 after tax value) to slower investment.
- or -
Roth: $1 to faster growing investment, $4 to slower investment;
T-IRA: $4 ($3 after tax value) to faster investment.
At the time of withdrawal, in the first case:
Roth = 4 x $4 + 2 x $1 = $18
T-IRA = 2 x $4 x 3/4 (remainder after taxes) = $6
Total after tax value = $24
At the time of withdrawal, in the second case:
Roth = 4 x $1 + 2 x $4 = $12
T-IRA = 4 x $4 x 3/4 (remainder after taxes) = $12
Total after tax value = $24
The only trick here is to view everything in terms of after-tax value.
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As to conversions, if one assumes that tax rates won't change upon withdrawal, and that the taxes on conversion are paid from a taxable account, then converting comes out ahead. That's because, by "pre-paying the taxes" (via conversion), you're effectively sheltering the amount of the tax.
For example, say you've got $4 in a T-IRA, $1 in a taxable account, and you're in the 25% bracket. Assume assets double in value between now and when you withdraw from IRA:
Converting (moving the $1of value into a tax-sheltered account):
Taxable account: $0
Roth IRA: $4
At withdrawal, after investments double in value:
Taxable account: $0
Roth IRA: $8
Total after tax value: $8
Instead, if you don't convert, then:
Taxable account $1
T-IRA: $4
At withdrawal, after investments double in value:
Taxable account: $2 minus taxes due on $1 of gain
T-IRA: 2 x $4 x 3/4 = $6 (multiply by 3/4 to account for the 25% in taxes)
Total after tax value: $8 minus taxes due on $1 of gain
You lose here because growth on the $1 remained subject to tax.
Roth conversions are one way to prepay taxes. Another is to pay taxes on accrued interest on savings bonds to date of death. The former must be done before the person dies, the latter is done on the deceased's final tax return.
As sma3 alludes, the best investments after the Roth is established would appear to be the growthier ones - particularly if you have a very long time horizon. Not a done-deal however. If you felt markets were high in terms of valuations, you might want to keep more conservative investments in the Roth for a while. A dollar’s loss in a Roth actually hurts more than loosing a $ in a taxable Traditional IRA. Another way to look at it: If you gamble with a highly speculative investment inside a Traditional IRA, Uncle Sam is party to any loss. But if you gamble inside a Roth and lose money, it’s 100% your own money.
No rigid rule here. But have tried over many years to position my best and most stable funds inside the Roth (those with low fees, long proven track records, highly reputable firms). Newer funds, smaller balances, and the assets I trade in and out of more have ended up in the Traditional. Also - hardly ever keep cash in the Roth.
For example, with a tax rate of 25%, and $1,000 to contribute, assuming the investment doubles (2x) in value:
Traditional: $1000 x 2 x 75% (for taxes) = $1,500 after tax value
Roth: 75% x $1000 (contribution after taxes) x 2 = $1,500 after tax
Likewise it doesn't matter where you keep the faster growing assets, Roth or traditional. Whatever money you keep in a T-IRA, and however you invest it, the 25% share needed to pay the taxes upon withdrawal will keep pace.
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"A dollar’s loss in a Roth actually hurts more than loosing a $ in a taxable Traditional IRA."
True enough as far as it goes. But one's investments drop by percentages, and a 10% drop in a T-IRA hurts the same as a 10% drop in a Roth.
Using the same example as above, except instead of doubling the value, let's say the value drops by 10%:
Traditional: $1000 x 90% (drop of 10%) x 75% (for taxes) = $675 after tax value
Roth: 75% x $1000 (contribution after taxes) x 90% = $675 after tax value
The key is to think in terms of after-tax dollars. That's hard to do when a dollar in a T-IRA looks the same as a dollar in a Roth, even though the former may be worth only 3/4 as much.
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Of course there are other factors to consider. If you have a large T-IRA and a fast rate of growth might kick RMDs into a higher tax bracket, then you will want to constrain T-IRA growth. Of if your heirs are nonresident aliens in a country without a tax treaty (so that they owe 30% on T-IRA proceeds), you'll want to pay taxes now, at a lower rate, to convert that money to a Roth. And so on.
However, your calculations make sense to me if one withdraws TRA-IRA money to pay the taxes due on a conversion. By and large not the route I used. Most of the $$ for taxes came from pension & SS plus some personal savings. ISTM that there was an exemption passed around 2007 or 2008 that allowed the taxes due to be paid over a multi-year span, which helped with the first and largest conversion. But the exemption from RMDs is a nice “plus” - ISTM pretty much a free ride all else being equal. What price flexibility? I value it a lot.
I showed the arithmetic in my Jan 14 post. Basically by pre-paying taxes (via conversion), you're moving tax money from outside into your Roth. So you never again pay taxes on that money's growth. More money sheltered means more money after taxes in the end.
2010 was actually the second time the government allowed the taxes on conversions to be spread over multiple years. You were allowed to declare half of the 2010 conversion amount as part of your 2011 (not 2010) income, and the other half as part of your 2012 income.
https://www.kiplinger.com/article/retirement/t046-c001-s001-faqs-on-the-new-roth-conversion-rules.html
2010 Pub 590 (see p. 2 - What's new for 2010)
The first time the government allowed people to spread taxes on conversions over multiple years was in 1998. Then you were allowed to split the amount converted equally among four years: 1998-2001.
1998 Pub 590 (see p. 39).
My three conversions were all something of an “afterthought” - undertaken only after the overall market (‘07-‘09) became severely depressed or some fund / segment I owned became depressed. Having confidence these would eventually recover, I tried to make lemonade out of lemons.
Never seriously considered doing a conversion “straight-up” by using Trad-IRA funds to cover the taxes. ISTM you’re gaining little if anything doing it that way (and that seems to be the point of a lot of @msf’s math). But, perhaps in small amounts on a recurring annual basis it might make sense to some. Dunno.