El Lobo:

You state:

Circumstances where there would be an advantage:

1. If your IRA is large enough such that RMDs kick you into a higher tax bracket. For example, if you can convert, today, at zero or 15%, but your RMDs will be taxed at 25%.

That’s true, but doesn’t apply in my case. My IRA is smallish and the RMDs are highly unlikely to be large enough to push me into another bracket. I have no idea if my tax rates will go up or down. It’s entirely a crap shoot and speculation and I don’t want to make a bet on it.

 

1. If the same amount of money ends up in either a taxable account (for an RMD) or a Roth (for a conversion), there is an advantage in that FUTURE earnings are not taxed in the later, but are taxed in the former.

I realize that all growth and withdrawals from a Roth are never taxed, but I had to pay tax on the money before putting it in the Roth. A thousand dollars of gross income only results in a $750 contribution to a Roth, assuming the 25% bracket. A thousand dollars in gross income results in a $1000 contribution to an IRA, as far as I know. Maybe I have been misinformed.

"If the same amount of money ends up in either a taxable account (for an RMD) or a Roth (for a conversion), there is an advantage in that FUTURE earnings are not taxed in the later, but are taxed in the former." 

"Maybe I have been misinformed."

I think you are confused.  The $1000 that I was talking about was in your traditional IRA, and you are deciding (we are talking about) the advantages of converting that $1000 to a Roth, or withdrawing it (RMD or voluntary) to a taxable account.

Whether to do one, or the other (withdraw or convert), depends on your particular tax situation.  My point was that, if there are no advantages one way or another (tax wise), you are better off to convert, since future earnings are not taxed.

"Turns out I am in the 25% bracket and don’t expect to move out of it unless I lose my job. I don’t expect to retire voluntarily. If I lost the job, I would be in the 15% bracket."

I thought you were close to retirement (voluntary).

"I guess I don’t follow that. If my income were to drop to 20k, my tax rate is 15%. Any RMD that didn’t push me above 32,550 would be taxed at 15%. If I convert, I would pay a 15% tax on the amount converted. How am I better off?"

In general, people are in a higher tax bracket, while working, then whenever they stop working.  While working, you 'saved' 25% on taxes for all monies put into a tax deferred account.  Whenever you retire (voluntary or otherwise), and you withdraw/convert that money back out of the traditional IRA, if you are paying taxes at the 15% rate, you are gaining 10% (the difference in tax rates).

"What are those limits?"

I don't know.  I do my taxes with TurboTax, and I know I don't bump up against those limits.  Roberta probably knows.

"I guess I don’t follow that either. As far as I know, RMDs end up in a taxable account, period. How do you propose to put RMDs in a Roth? If you are referring to AVOIDING an RMD by converting X amount to a Roth, you still must pay the tax on the conversion, and that may or may not be advantageous, depending on the tax rates in place at the time of the conversion. Is that not true?"

You do follow it.  It's just terminology.

"The above passage has me confused. What does the first sentence have to do with the second sentence? The first sentence has the RMD going to a taxable account. The second sentence speaks of money going to a Roth. Conversions and RMDs are separate processes, are they not?

I realize you can buy anything you want with an RMD. I assume you are referring to a Roth conversion that has nothing to do with an RMD—in which case you have to pay the tax on the conversion. Can you clarify what you mean?"

I didn't read your first posts in much detail, but I thought I read where you, or someone else, implied that RMDs had to be spent and/or had to be used to pay taxes.  I think of an RMD as being a certain sum of money that is being moved from a traditional IRA to a taxable account.  That same sum of money, if moved to a Roth, has been converted, not distributed/withdrawn.  Again, terminology.

Anyhow, my only point was that, rather then telling Vanguard to move a certain sum of money from my traditional IRA, I tell them to move a certain number of shares, which happen to be worth something on the day of movement.  That is, I don't have to first sell fund shares, move the proceeds, and repurchase shares (whenever I convert or withdraw).

Imagine this situation:

Suppose 2 people have 10k in a traditional IRA and both will always be in the 25% bracket.

One converts the entire account to a Roth and the other doesn’t.

The Roth account then has a balance of 7.5k (10k minus 2.5k tax on the conversion). The traditional IRA still has a balance of 10k.

Assume both accounts have the same later rate of return and double in 10 years.

The traditional IRA grows from 10k to 20k before taxes and has an after tax value of 15k. The Roth grows from 7.5k to 15k and is not taxed.

How does that square with the statement:

"Whether to do one, or the other (withdraw or convert), depends on your particular tax situation. My point was that, if there are no advantages one way or another (tax wise), you are better off to convert, since future earnings are not taxed".

Where is the advantage of the "future earnings" not being taxed? Both accounts have identical after tax values. How are you better off to convert?

I hope someone can show the errors in the above arithmetic.

Ignatz,

You can't discern how I feel about the IRA dilemma b/c I haven't figured it out and thus cannot convey an opinion only data.  The back of my brain kinda, sorta thinks that if that money wasn't segregated in retirement accounts it might have been used for college tuition, travel, cars, etc.  There's something about the forced savings of a retirement account plus their relative inaccessibility that does it's job of forcing retirement savings.

To the best of my knowledge there are no dollar limits on conversion amounts. The big limiting factor is the size of the tax bill.   Income has to be below 100k to be eligible to do a conversion. That does not include the amount of the conversion.   That limit will be lifted for one year in 2008 or 2010 and the subsequent tax bill can be paid over a two year period.

You are correct in your analysis of the tax neutral effect of whether money is in an IRA or Roth.  When that is the only aspect evaluated, there is no difference.  There are big differences in terms of estate planning issues, which don't apply to you, and the impacts of RMD's, which is where the real number crunching and issues are located.

When you retire, the amounts that had been withdrawn and placed in retirement accounts such as IRA's and 401k's is no longer being withdrawn from your SS and/or pension.  The AGI for a 25k salary with those deductions is quite different from the AGI on a 25k retirement income "salary" dependent on income sources.

Simplifying tremendously.  If you need your RMD's for survival, you're probably better off with an IRA.  If you're transfering your RMD's to your taxable account for investment, you need to evaluate Roths in your situation..

Roberta 

Roberta:

Thanks for the clarification.

It looks like in my case, the verdict is tipping away from conversion and in favor of standard IRAs.

If I lost my job, SS could become a major part of my income and I might have to spend any RMD.

Given my status, would you contribute the 6k annual IRA money to the Roth or to an IRA?

Do you have any offhand opinion on whether or not I should keep any investable assets in a taxable account or should I try to get EVERYTHING under some type of IRA if possible?

My taxable account is 27% of total portfolio now and relatively tax efficient. I could move the one tax-inefficient fund in it to my Rollover, in which case the taxable account would generate virtually no taxable income.

What are the reasons to keep some investments in a taxable account, assuming it is highly tax efficient?

Issue number one in thinking about this is future tax rates both for us as an individual and as a country.  I always figure they're going to be higher.  I have been rudely disproved about lower tax bills in retirement and I think a lot of those people who carefully saved and planned and underlived our incomes are now paying taxes at 25 and 28% rates that we avoided 15% rates on.  The other issue that has to be figured into this is the growth of the money over the years and its compounding.

The answer you'll get from me is akin to the one about whether I'm sorry I did it that way.  It's not really a rational, logical decision but has a lot of emotional overtones and a lot dependent on the individual. i.e.  are you disciplined enough to save the money in the taxable account or will the forced savings in the 401k before you see the money work better for you?  What about the accessibility of the money and the temptations to use it?

Someone I've "known" for a lot of years on other boards always preaches the 3 legged stool of retirement - taxable, SS and sheltered.  And the more legs you can put on the stool, the better off you'll be.  I never, ever expected my SS to be taxed.  I can't reconcile your estimate of about 1k/month SS income with your tax bracket and ability to shelter 26k/year.

I think Roths are the best thing since sliced bread but have only been able to get a small proportion of assets in them.  Aside from the estate planning issues, the fact that I am not forced to take money from it but can at my will if I want and that there are no tax issues when I do are very desirable characteristics.  It is another leg on my stool.

My taxable is another leg of the stool.  I, currently reinvest all income and capital gains so that when I sell to fund something or otherwise use the money, I've been able to use the IRS tax laws and sell at a "loss".  I, of course, have been paying the taxes along the way but using other money and thereby increasing my investment rate w/o feeling the pinch as savings but rather as taxes and that works for me.  I can take the money from that to spend on travel and extra's and not feel I'm going to be eating alpo at 85 b/c I'm depleting my retirement resources.

Money, investing and saving and spending has a great deal of emotional components which are very real and not well understood.  No investment plan, no matter how good or reasonable or realistic is going to work if the individual involved has not had their emotional or behavioral needs met.  The trick is figuring out what works best for you and your needs that balances both sides of the brain.

The other issue to be considered in the taxable is the opposite of the Roth.  Any money going into IRA's will come out and be taxed as income while taxable spending will mostly generate capital gains and possibly, as I mentioned, tax losses.

All of this is predicated and planned on who knows what future congresses and politicians will do with tax rates and rules about sheltered income which is a completely different cr*p shoot.

Roberta 

ignatz:

 I don’t see "high" RMDs as much of an issue and am therefore contemplating putting as much as possible in IRA and Roth, and getting taxable even lower than the current 27%.

Do you see any particular problems with that per se?

Agree with the above strategy.  However, would not convert nor contribute to Roth and would concentrate on building up your traditional IRA. The main reason is that If you lost your job, having an TIRA as opposed to a Roth, would let you take funds from your TIRA (or take RMDs) and pay a lower tax than you would pay if you contributed to, or converted to, a Roth at your present tax rate.

One way of looking at this is suppose you have a 400K TIRA and are in the 25% tax bracket,  Then the government "owns" 100K of that account and you "own" 300k.  If you lose you job, and drop to a 10% tax rate, then the government "owns" only 40K of the account and you now "own" 360K.

Its somewhat similar to owning a 400K home with a 100K mortgage loan on it.  And if you lost your job, the government will reduce the loan to 40K.  This would help soften the blow of a job loss.

Thus, a strategy of building up your TIRA (increasing the size of the government loan) has a sort of insurance aspect to it.  Most would try to build up their Roth, but you are in the position where your tax rate will not go up in retirement, even with RMDs, and you are relying more than others on being able to work after retirement age.

Dick