maybe I should go ahead and convert?

[KTP]

I have been giving thought to our 5 year plan and our current retirment contributions.

I am a student, the family income comes from wife. She is maxing out her 401K to $16,500 from her contributions and also has some employer match added in.

In addition, I have created a normal IRA for her for 2009 and 2010 ($5000 each year) and converted them in Jan 2010 into a Roth (no taxes due because the conversion was done just a day after funding the normal IRA.

We are not eligible to contribute to a Roth in the normal fashion because of high MAGI, although I did get $1200 into one for tax year 2009. I do not expect to be able to reduce MAGI enough to get any normal contribution allowance for tax year 2010 unless they greatly raise the Roth income eligibility limit.

I did not do the normal IRA->Roth conversion thing for me as I have around $27K (well actually $31K now since Exxon is way up) in a IRA that started with $1700. Even if I created a separate IRA and put $5000 into it for 2010 and then tried to convert it into my Roth, I would actually have to pay taxes on about 81% of the $5000 because it is all lumped together with my other IRA, and the cost basis of that IRA with a $31K balance is only $1700.

So at 28% I would owe about $1200 on the $5000 conversion for 2010. Not wanting to give our broke government more bailout money they could spend increasing unemployment to 20 years or something, I originally decided not to do this and just put the $5000 in a municipal bond taxable account where it would earn 3.5% or so tax free.

I am having 2nd thoughts now, and thinking maybe I should just bite the bullet and convert the entire $31K to a Roth this year, such that in future years I can do the $5000 IRA->Roth rollover tax free (for as long as they allow this). I would need to pay about $10,000 in taxes (ouch) but I would have $31,000 instantly in a Roth and $5000 more each year going in with no taxes due.

If I am going to do this I would want to do it before the deadline for 2010 IRA contributions so I could get $5000 more ($36000) in it this year.

What do you think? Pay the government $10,000 in taxes now, or just leave my IRA alone and set aside the $5000 a year into a tax friendly investment like municipal bonds?

[jIM_Ohio]

What tax bracket would the taxes paid be at?
How old are you?
How long until retirement?

How much of wife's Roth has been converted already? How much is left to convert?

The first 400k+ in a traditional IRA is not taxed, you do not need all money in a Roth, just "most" of it.

[KTP]

What tax bracket would the taxes paid be at?
How old are you?
How long until retirement?

How much of wife's Roth has been converted already? How much is left to convert?

The first 400k+ in a traditional IRA is not taxed, you do not need all money in a Roth, just "most" of it.

We are going to try and retire early (see other threads).

We are 40,41 and goal is retirement at 45,46. Wife only has 410K and Roth, no other IRA.

I understand that I don't need all money in a Roth. Are you saying perhaps it would be better for me to contribute $5000 a year of after tax money into my traditional IRA (I have no income but I believe I am eligibile to do this off of my wife's income) than to pay the $1200 a year tax on the $5000 of after tax money (so it will really have been taxed twice) and put it into a Roth? If I did this for 5 years I would have $25000 in a Roth and would have paid $6000 spread out over the 5 years vs having $51,000 in the Roth and having paid $10,000 in taxes all at once this year.

Alternativly, keep the $31,000 in the non-deductable traditional IRA and continue to make $5000 contributions to it such that in 5 years I have $51,000 in the traditional IRA and paid no additional taxes.

Per our other discussion, if we do manage to stay in the 15% bracket after we early retire, then maybe having the $51,000 in a tradional IRA isn't really that bad vs a Roth. On the other hand, having $51,000 in a Roth that you *know* will be tax free on withdrawal sounds pretty good too.

argh.

edit: There is one other advantage to moving the funds over to a Roth. Contributions (not earnings) can be withdrawn penalty free, which would make this a decent source for emergency funds. I don't think contributions can be withdrawn penalty free from a traditional IRA, even if you made them with after tax money just like you do in a Roth. Seems weird, but that may be the law. I think there are a few reasons where you *can* withdraw penalty free from a traditional IRA, including using the funds to pay for health insurance if unemployed for longer than 12 weeks (which we would be if we were to retire early at 45). So technically, maybe we would haave some access to the tradional IRA money just like the Roth IRA money before age 59 1/2 if we directed it to be used for health insurance premiums (If we even needed to withdraw from these accounts vs our taxable accounts).

[jIM_Ohio]

We are going to try and retire early (see other threads).

We are 40,41 and goal is retirement at 45,46. Wife only has 410K and Roth, no other IRA.

I understand that I don't need all money in a Roth. Are you saying perhaps it would be better for me to contribute $5000 a year of after tax money into my traditional IRA (I have no income but I believe I am eligibile to do this off of my wife's income) than to pay the $1200 a year tax on the $5000 of after tax money (so it will really have been taxed twice) and put it into a Roth? If I did this for 5 years I would have $25000 in a Roth and would have paid $6000 spread out over the 5 years vs having $51,000 in the Roth and having paid $10,000 in taxes all at once this year.

Alternativly, keep the $31,000 in the non-deductable traditional IRA and continue to make $5000 contributions to it such that in 5 years I have $51,000 in the traditional IRA and paid no additional taxes.

Per our other discussion, if we do manage to stay in the 15% bracket after we early retire, then maybe having the $51,000 in a tradional IRA isn't really that bad vs a Roth. On the other hand, having $51,000 in a Roth that you *know* will be tax free on withdrawal sounds pretty good too.

argh.

edit: There is one other advantage to moving the funds over to a Roth. Contributions (not earnings) can be withdrawn penalty free, which would make this a decent source for emergency funds. I don't think contributions can be withdrawn penalty free from a traditional IRA, even if you made them with after tax money just like you do in a Roth. Seems weird, but that may be the law. I think there are a few reasons where you *can* withdraw penalty free from a traditional IRA, including using the funds to pay for health insurance if unemployed for longer than 12 weeks (which we would be if we were to retire early at 45). So technically, maybe we would haave some access to the tradional IRA money just like the Roth IRA money before age 59 1/2 if we directed it to be used for health insurance premiums (If we even needed to withdraw from these accounts vs our taxable accounts).

At minimum, you want to be contributing $5000 to a traditional (non deductible) IRA. This is because you can convert it later- if that same 5k is in a taxable account, it can NEVER be converted to tax free status.

Whether you convert now or wait depends on many factors

1) current tax bracket
2) probable retirement tax bracket (will it ever be 15%)?
3) income sources in early retirement.
4) can you pay taxes on conversion without lowering conversion amount (pay taxes with other funds- like taxable funds).

I generally don't read 2-3 other threads to answer 1 question, as its tough for me to know if situation changed between those posts and other posts. If other info is relevant, post it here so anyone reading gets a full picture without having to chase various issues down.

The art of financial planning is taking many things which are only moderately related and applying them to a person's specific situation at a given point in time.

I state that because it's not clear to me what you are trying to solve from the post.

I know you are looking to retire early
I know you have around 1.1 M in assets to invest, about 600k taxable and 500k tax deferred/tax free.

I would solve problems like this

1) Build a withdraw strategy for first 10-20 years of retirement. That strategy should have enough detail to provide the following info:
a) expenses (budget) which includes taxes paid (federal and state) each year. Be detailed and use current tax code to determine the taxes paid. Track expenses each year using today's numbers. Don't inflate anything, just assume expenses stay constant and see where it takes you.
b) income (from all sources- including part time employement, retirement accounts and other)
c) how you would change the budget if the income changed (for example if you have 50% equities and the market dropped 50%, what would you do).

2) Build an asset allocation plan which supports the income needs for 1b)
check success rates with a monte carlo

3) Add a Roth conversion into the plan and see if it breaks the success rates or improves them
if success rates change, analyze where the breaking points or success points were- this tells you if its a good strategy or not.

examples-
if you figure out your allocation and its 40-60, and you establish that every other year you withdraw 2X living expenses to cash, and in the years opposite that you have NO INCOME which allows you to fill 80k of tax bracket space with a Roth conversion, then you see the 2) success rates of 80% become 3) success rates of 85%, you are saving yourself money on taxes and that is leading you to why the Roth conversions are good things.


You need to focus on #1 and get a monte carlo done before you look into the Roth conversions. The purpose of the conversions is to preserve MORE capital. The earlier in retirement you convert, the better, but if you lose too much of assets to taxes, it will quickly become a bad idea.

As you get more into Roths, the budget in #1 decreases (less taxes as time goes on). Every situation will have a different tipping point. If you drain too much of your assets paying taxes on conversions too early, you will see lower success rates.

[KTP]

Thanks again for the advice Jim. I had assumed you were familiar with my situation since you have answered a lot of my questions in the past (almost to the point where I should feel guilty about not paying you ) I didn't want to make a super long post re-explaining the nitty gritty of our 5 year plan.

I searched around a bit on the Monte Carlo simulators, but they don't really allow for great customization, or take into account situations such as ours. Most of them assume you will be retiring at an age where you will be withdrawing from your retirement accounts and collecting SS. If we go foward, we will be 20 years before we collect from SS (assuming there is anything left of SS to collect from).

The worry for not converting to the Roth now and instead of making $5000 IRA/Roth rollovers for the next 5 years just putting the money in my nondeductable IRA is if our plans change and we decide to keep working for whatever reason. This would mean we lived quite better in our retirement, but also would probably be in the 25% or higher tax bracket making the $100,000 or more Roth balance much more attractive than the $100,000 traditional IRA balance. I don't *expect* to delay retiring much past 46 or 47 if we don't at 45, but you never know.

[jIM_Ohio]

Thanks again for the advice Jim. I had assumed you were familiar with my situation since you have answered a lot of my questions in the past (almost to the point where I should feel guilty about not paying you ) I didn't want to make a super long post re-explaining the nitty gritty of our 5 year plan.

I searched around a bit on the Monte Carlo simulators, but they don't really allow for great customization, or take into account situations such as ours. Most of them assume you will be retiring at an age where you will be withdrawing from your retirement accounts and collecting SS. If we go foward, we will be 20 years before we collect from SS (assuming there is anything left of SS to collect from).

The worry for not converting to the Roth now and instead of making $5000 IRA/Roth rollovers for the next 5 years just putting the money in my nondeductable IRA is if our plans change and we decide to keep working for whatever reason. This would mean we lived quite better in our retirement, but also would probably be in the 25% or higher tax bracket making the $100,000 or more Roth balance much more attractive than the $100,000 traditional IRA balance. I don't *expect* to delay retiring much past 46 or 47 if we don't at 45, but you never know.

Try this one, if it does not work, you probably do need to hire someone

Flexible Retirement Planner

As far as planning

if A implies B
and B implies do C
and C implies do D

and then you look at D and decide that's not the result, or you change your mind, think if you did D what is the "worst case" or "biggest inconvenience"?

Here is my thoughts

1) You have income and an IRA you are not contributiing to, so you should strongly consider funding a traditional IRA
2) The IRAs imply you are planning for retirement.
3) You are contributing to the traditional with intention of converting it
4) Once retired, you should strongly consider converting to a Roth.

If you look at that progression, then say "I might not retire early" or "instead of retiring in 5 years, I retire in 10 years" what is the worst case or biggest inconvenience?

You have lots of money in a traditional IRA- some of which you paid taxes on and some which might have no basis. If you had the deductable rollover IRA at Vanguard, and the non deductable IRA at Fidelity, I can show you a way to convert only the part with basis first, to give you time to spend the zero basis IRA and convert the part with basis.

If you see a bigger inconvenience- tell me what it is.

[KTP]

Thank you for the link. I played around with that simulator some, but really need to dig into it more to make sense of the results. Sometimes it would give a 90% success rate when you chose moderate risk, and have your final withdrawal to be $80,000/yr, other times it would give 92% success rate when you lowered the risk a bit, but the final withdrawal was only $58,000/yr. I guess the higher risk run indicated that 90% of the time you would have more money to spend throughout your retirement, but 10% of the time you didn't make it until the end. The lower risk showed that 92% of the time you would have somewhat less money that the higher risk run and only 8% of the time not making it to the end. Ok, I guess this makes sense now that I explained it to myself. Both simulations started with an income need in retirement of $40K/yr.

Many variables that I can't really put into the simulator. For example, what will be the value we sell our house for in 5 years? How much will we make off of this in profit? What will the tax rates be like in 5 years? How much can we expect in SS payments at age 65? Perhaps these questions cannot really be simulated easily.

Just analyzing the IRA situation:

Current IRA balance of $31,000 with zero basis
Have not made any contribution for 2010 to either Roth (ineligible) or this IRA
Tax bracket is at least 28% (MAGI greater than $180K)

If I convert this year, I pay, say $10,000 in tax from my other funds (checking account). I then have $31,000 in a new Roth. I can then in december (or now I guess) start a new IRA with $5000 and immediately convert it to the Roth with no taxes due. I do the same thing in 2011,2012,2013,2014, and 2015 while our MAGI remains above the normal Roth eligibility limits. I then have $61,000 in the Roth plus anything it made, so probably something like $80,000 in the Roth in 2015.

If I leave the $31,000 in the IRA and make after tax contributions of $5000 to it each year until 2015, I have $61,000 in the traditional IRA, which would be the same $80,000 after gains, with a basis of $30,000 (the contributions for 6 years).

If I am able to completely convert the traditional IRA into a Roth in 2016 because our income went to zero (we probably will not work anywhere for the first 6 months at least) I would owe 15% on the $49,000 of gains, or $7350 in taxes. Well, this is if the tax rate for $51,000 worth of rollover income is 15%, married, filing jointly, standard deductions. In addition, the $10,000 of taxes I *didn't* pay the government out of my checking account in 2010 could at least be worth $12000 if stuck in a municipal bond fund for the 5 years at 3.5% return.

So by not converting to a Roth I would save about $4650 in taxes by doing the whole lump sum rollover in 2016 when we do the early retirement. The only *bad* case is if the IRA makes huge gains and is worth something like $150,000 in 2016 with $119,000 of that taxable. Trying to roll that much over in 1 year would probably put us in the 20% or 25% tax bracket and make me wish I had just paid $10,000 in 2010.

I still haven't made up my mind the right thing to do

[jIM_Ohio]

Many variables that I can't really put into the simulator. For example, what will be the value we sell our house for in 5 years? How much will we make off of this in profit? What will the tax rates be like in 5 years? How much can we expect in SS payments at age 65? Perhaps these questions cannot really be simulated easily.

You missed the additional options tab or other option... that simulator can do it, just keep looking. Both SS and adding a lump sum to portfolio.

Just analyzing the IRA situation:

Current IRA balance of $31,000 with zero basis
Have not made any contribution for 2010 to either Roth (ineligible) or this IRA
Tax bracket is at least 28% (MAGI greater than $180K)

If I convert this year, I pay, say $10,000 in tax from my other funds (checking account). I then have $31,000 in a new Roth. I can then in december (or now I guess) start a new IRA with $5000 and immediately convert it to the Roth with no taxes due. I do the same thing in 2011,2012,2013,2014, and 2015 while our MAGI remains above the normal Roth eligibility limits. I then have $61,000 in the Roth plus anything it made, so probably something like $80,000 in the Roth in 2015.

If I leave the $31,000 in the IRA and make after tax contributions of $5000 to it each year until 2015, I have $61,000 in the traditional IRA, which would be the same $80,000 after gains, with a basis of $30,000 (the contributions for 6 years).

If I am able to completely convert the traditional IRA into a Roth in 2016 because our income went to zero (we probably will not work anywhere for the first 6 months at least) I would owe 15% on the $49,000 of gains, or $7350 in taxes. Well, this is if the tax rate for $51,000 worth of rollover income is 15%, married, filing jointly, standard deductions. In addition, the $10,000 of taxes I *didn't* pay the government out of my checking account in 2010 could at least be worth $12000 if stuck in a municipal bond fund for the 5 years at 3.5% return.

So by not converting to a Roth I would save about $4650 in taxes by doing the whole lump sum rollover in 2016 when we do the early retirement. The only *bad* case is if the IRA makes huge gains and is worth something like $150,000 in 2016 with $119,000 of that taxable. Trying to roll that much over in 1 year would probably put us in the 20% or 25% tax bracket and make me wish I had just paid $10,000 in 2010.

I still haven't made up my mind the right thing to do

I would not convert at 28% because you project lower income 5-10 years into the future. I would contribute and immediately convert as that is $0 tax due.

If your account with basis is at Fidelity, open a new account at T Rowe for the new $5000 contribution and only convert the T Rowe account, leave the 31k with basis at its current custodian.

[KTP]

I would not convert at 28% because you project lower income 5-10 years into the future. I would contribute and immediately convert as that is $0 tax due.

If your account with basis is at Fidelity, open a new account at T Rowe for the new $5000 contribution and only convert the T Rowe account, leave the 31k with basis at its current custodian.

Woah! Jim, I think we need MonkeyMama or another tax guru to step in here.

It is my understanding that the IRS forces you to consider all IRA monies (both traditional IRA and deductable IRA) as one lump sum when determining taxes on a conversion, even a partial conversion. It doesn't matter if you have one account with Vanguard, another with Fidelity, and the third with Joe Bob's Chicken Wings and Investments, they will find them all and force you to pay taxes on the partial or full amount you are converting based on the combined balances and cost basis of all your IRA accounts.

An example. I do like you say and fund another IRA today with $5000, then convert it tommorow to a Roth. I would owe tax on (31,000/36,000)*5000, or about 86% of the $5000. At 28% it means I would immediately owe a tax of $1200 on the $5000 I converted to the Roth.

[jIM_Ohio]

Woah! Jim, I think we need MonkeyMama or another tax guru to step in here.

It is my understanding that the IRS forces you to consider all IRA monies (both traditional IRA and deductable IRA) as one lump sum when determining taxes on a conversion, even a partial conversion. It doesn't matter if you have one account with Vanguard, another with Fidelity, and the third with Joe Bob's Chicken Wings and Investments, they will find them all and force you to pay taxes on the partial or full amount you are converting based on the combined balances and cost basis of all your IRA accounts.

An example. I do like you say and fund another IRA today with $5000, then convert it tommorow to a Roth. I would owe tax on (31,000/36,000)*5000, or about 86% of the $5000. At 28% it means I would immediately owe a tax of $1200 on the $5000 I converted to the Roth.

I agree you want a second opinion on that.
But how would that work because Fidelity is not responsible for knowing what is at T Rowe, and if you make the conversions in kind, it can be really clear which funds were converted.

I like thinking out of the box, as long as its not outside of the legal box.