Dave on the Roth Conversion

by Joe on July 16, 2013

The question seemed simple enough. A reader asked The David if after paying off all non-mortgage debt, and having the suggested 3-6 month emergency fund, a Roth conversion of his $100K IRA made sense.

Dave answers, warning that the conversion will cost about $25K in tax and this money should be available, not taken from the IRA itself.

The problem here is that an edited question like this misses far more details than it gives, and even if the advice is right for the person who submitted the question, it’s probably bad advice for 90% of those reading the paper or site it appeared in. Let’s do a bit of detective work here. The OP (Original Poster or person asking the question) only mentions the IRA, so we might assume this is his entire retirement savings. Working backwards, knowing that IRA limits were far lower each year, it would have taken nearly 20 years to accumulate this $100K. The next 20 years might produce a savings of $200K-$300K. This is enough to withdraw no more than $12,000 per year, and virtually no tax at all would be due.

2013taxrates

Next, from my friends at Fairmark, we’ll look at the 2013 tax rates. Say the OP is single and would have a taxable income of $35,000. He’s been putting money aside in a pretax IRA over the years and doing so while in the 15% bracket. Now, Dave gives him the green light for a wholesale conversion, but do you see what I see? $135K is well within the 28% bracket.  It makes no sense for someone with this situation to convert any amount that would put them into the next bracket. Someone hugging the 15%/25% line can choose between Pretax IRA and Roth IRA to get their taxable income to exactly $36,250 (if single) and stay right at the 15% bracket. If the OP has a taxable $30K, then converting $6250, just enough to ‘top off’ that bracket is a great idea, but converting it all? Bad idea in most situations.

Keep in mind, the OP just finished paying off debt, and only has a mortgage. Great progress for someone who appears to be about 40 years old, but this isn’t someone who should be throwing $25K in liquid cash at a Roth conversion. At the very least, Dave should have warned about understanding and looking at current tax bracket. In this case, the advice can be very costly, first, a tax on the conversion, and then the missed opportunity to have retirement income at the 10% and 15% brackets.

{ 2 comments… read them below or add one }

Honolulu Aunty July 16, 2013 at 2:16 pm

Aloha Joe,

The OP looks to be in great shape – and if he is only 40, WOW!

Whenever I am facing a big tax liability, I try to find ways to offset the hit with deductions. In this young man’s case, if he was planning on continuously funding a pretax IRA and convert to a Roth each year, his taxable income would be offset by the current year’s pretax IRA contribution, making that portion a wash.

Just last year, I had my husband convert his $100K IRA into a Roth. We will be paying additional taxes because of it, but still have some wiggle room because we filed for an extension and plan to contribute as much as we can to the company plan. It is a defined contribution company plan for the employees which I am finding to be a bear with very high fees and strict rules. I really want to return to the simpler SEP IRA plans that we used to have. Calls to our agent have been unanswered – not sure what is going on over there.

If we can start up the SEP IRAs again, we will do so and fund to the maximum that we can afford, convert to Roths on and on each year as long as we are working (not too much longer I hope).

The reason we are doing this is because I love the Roth IRA for the reason of tax free income upon distribution. To me, having tax free income is like having a rental property cash flowing without any mortgage. The ideal situation would be having cash flowing mortgage free rental property in the Roth IRA!

Mahalo for your insights. Always great food for thought.

Aunty

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Joe July 18, 2013 at 9:04 pm

Good to hear from you, Aunty! Unfortunately, we know nothing about the guy that wrote to Dave, and I’d bet neither did Dave. One size doesn’t fit all. Three sets of people might be in completely different situations – one has a year till retiring, and why convert while having a full income, another, with room to spare to fill his 15% bracket and should do so each year, and perhaps another, with such a great pension, he should convert before starting to collect it. With no detail, chances are the answer given is going to be less than ideal.

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