What do you think of this strategy?


G

Gary

I have, over a lifetime of being a saver, accumulated significant
amounts in IRAs, 401Ks, etc. I am now age 72. Each year the
government requires that I take out, through the minimum required
distribution, certain amounts of money from my IRAs, 401K, etc. I am
fortunate that I do not need this money to live on, so I have opted to
use it to pay the tax on an IRA to Roth conversion. The more I can
convert, the more my children will have "tax-free" when I die.

Each year I calculate how much IRA I can convert to a Roth that will
generate a tax bill equal to the amount I had to take out in the
minimum required distribution. So I can convert IRAs to Roths without
a tax burden that I will feel.

I've done it for two years now and it feels OK as a strategy. Is
there any downsize that I have not seen? For example, how would this
strategy compare to simply gifting my minimum required distribution to
my children?
 
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A

allgyerj

Hi Gary,

I am chuckling to myself over your tactic. I like it. Its creative.
I do have a couple clarifying questions. How much is your minimum
distribution? How many children do you have? What tax bracket are you
in?
 
G

Gary

Why are you asking these questions?

I hope I don't sound too paranoid, but they do seem pretty personal.
If I understood the use of my answers, I might be more inclined to
share this information.

(BTW, I have 3 children).
 
T

Tad Borek

Gary said:
Why are you asking these questions?

I hope I don't sound too paranoid, but they do seem pretty personal.
If I understood the use of my answers, I might be more inclined to
share this information.
Gary-
I didn't post that response but they are key questions. The main benefit
of doing this (using IRA MRD $$ to pay Roth conversion tax) may be
psychological rather than financial, it depends on how much money you're
talking about and the resulting taxes. Whether you're 72 or 42 the same
basic analysis applies when considering a Roth conversion...what is the
tax bill, and considering that you lose the future investment of those
dollars paid to taxes, is there likely to be a net tax benefit?

One thing that raises some questions...if you don't want to take MRD now
is part of the reason the resulting tax bill? Meaning, the tax hit from
the MRD makes you want to leave money in the IRA? If so then realize
that a Roth conversion has the same tax effect. Yes it has an upside to
it (the converted Roth) but your immediate tax bill is higher.

Consider the alternative...let's say you are using $10,000 of MRD to pay
the tax bill on the Roth conversion. If you invested that $10k in a
taxable account in say mutual funds - instead of sending it to the IRS
as a tax payment on a Roth conversion - would you net out ahead? That's
the thing to weight...you get the benefits of the Roth, but the cost is
the dollars lost to taxes "today" that might have been invested and
grown enough to compensate.

This isn't an easy question to answer and at best you can only guess (a
key piece of missing info is "what will tax rates be in the future?").
But if your tax bracket is high now it suggests the Roth might not be
the better alternative. And if your MRD is large and the resulting
conversion distribution is large - ditto - because it's likely a bunch
of that conversion is pushed into a high tax bracket (extreme example -
converting $200k to a Roth on top of what was otherwise $40k in taxable
income). The most obvious cases for a Roth conversion are when there's
little or no tax as a result (because of offsetting deductions), and
the most obvious case against is when you're in the top tax bracket.
Everything in between...it's in part a subjective decision.

-Tad
 
R

Ron Peterson

Gary said:
I've done it for two years now and it feels OK as a strategy. Is
there any downsize that I have not seen? For example, how would this
strategy compare to simply gifting my minimum required distribution to
my children?
The main possible downfall is a possible future reduction on the tax on
the withdrawal from standard IRAs. I don't think it's likely in the
near future.
 
G

gene

I've been pondering your tactic and just couldn't get comfortable with
it, so I ran some calculations and this is what I found:

I started with the following assumptions. These apply to all of my
calculations.
Start with $1,000,000
Rate of Return 8%
Period 10 years

Sceanario 1 - withdraw $125K annually. Use $25K to pay taxes and
convert $100K to a ROTH.
Sceanario 2 - withdraw $25K annually and reinvest it in an after tax
account.

Sceanario 1 plays out like this - The original balance is reduced to
$243,782 and passed on to heirs who pay tax of $60,945 at an assumed
rate of 25%. The $100 annual conversion grows to $1,524.597. So the
combined amount to heirs AFTER TAXES is $1,707,433.

Sceanario 2 plays out like this - the original balance is reduced to
$1,824,465 and passed on to heirs who pay tax of $456,116 at an assumed
rate of 25%. The $25K annual RMD is reinvested and grows to $381,088
and passes to heirs income tax free. So the total combined amount to
heirs AFTER TAXES is $1,749,437.

So if we ignore estate taxes, Sceanario 2 results in $42K more going to
the heirs.

If we assume estate taxes in 10 years will revert to pre 2001 rates,
then Sceanario 1 results in $261K more going to the heirs.

For my money, I'm betting that the estate tax will continue on, but
with increased exclusion amounts. So, I'm betting on Sceanario 2.

I took a client with the following information:
Total income was $31,443 INCLUDING taxable SSA of $4611 and an RMD of
$27,758.
Itemized deductions were $20,013
Exemptions were $6,200
Taxable Income was $5,230
Tax was 491.

And applied your stragety:
I increased IRA withdrawal until the tax liability reached $27,753.
This meant that the IRA withdrawal was $108,820.
Here's the results:
Total income is now $157,951 INCLUDING taxable SSA of $22,299 - an
increase in taxable SSA of $17,688.
Itemized deductions dropped to $16,460 - a loss of $3,553
Exemptions stayed at $6,200
Taxable Income became $135,291 - an increase of 130,061
Tax became $27,753 - an increase of $27,262.

So, increasing the IRA distribution $108,820 actually increased income
$130,061. Most of this was due to the increased amount of taxable SSA,
which wasn't taxable before.

Once again, I'm back to betting on Sceanario 2 - especially considering
this. Let the kids pay the damn tax.

Gene E. Utterback, EA, RFC
 
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G

Gary

I'm very impressed by some of the analyses posted in response to my
strategy of using my MRD money to pay the taxes for IRA to Roth. It's
worth it for me to post numbers closer to my actual situation, in case
they have a substantial effect on the conclusions you have drawn. Here
they are (line numbers are from the 1040 long form):

Income (interest, dividends, capital gains, pension and social
security).................................................68,184
MRD income...........................................25,335
IRA->Roth conversion..............................71,564
............................................................-----------
38. AGI.................................................165,083
40. Itemized deductions............................11,829
.............................................................-----------
41........................................................153,254
42. Exemptions (corrected for income).........2,688
.............................................................----------
43. Taxable income................................150,566

......Tax..................................................34,989
......+New York State Tax...........................7,741

It looks to me as if these numbers basically come to the same
conclusion that I'm reading, that I'm likely to be better off leaving
the IRA intact and investing the MRD money (I am a VERY conservative
investor...almost all S&P500 index funds, large company index funds,
and Total Stock Market Index Fund)?

Thank you for your commentary on my strategy (probably soon to be an
ex-strategy).
 
T

Tad Borek

Gary said:
It looks to me as if these numbers basically come to the same
conclusion that I'm reading, that I'm likely to be better off leaving
the IRA intact and investing the MRD money (I am a VERY conservative
investor...almost all S&P500 index funds, large company index funds,
and Total Stock Market Index Fund)?
Gary,
Your numbers, factoring in as well NY taxes, to me suggest this is in
the high side of that middle area I talked about. The ~$72k in Roth
dollars aren't falling in a low tax bracket really. You'll pay "certain"
current taxes in exchange for a "possible" future benefit. I like Roth
conversions much more when the dollars are taxed at the bottom tax
bracket, or at 0% due to odd circumstances (eg mid-career professional
taking a one-year sabbatical with low/no income).

One thing to consider is that if your intent is to preserve dollars for
heirs, while avoiding income tax on gains (as is the case in a Roth),
the investments you mention at least partially accomplish that. If you
take an $18k MRD and invest it in a mix of equity funds with low annual
turnover, like index funds (instead of using them to convert $72k of IRA
to Roth)....they appreciate in value to, let's say, $40k over the years,
at which point your children inherit. Estate tax issues aside - they
would get the mutual funds at a cost basis of $40k and the $22k in gains
wasn't taxed. At least to the extent of those gains, it's similar to the
Roth (and of course you don't have MRD on a taxable account so that's
also similar). You do pay taxes on dividends and distributions along the
way of course but the unrealized gains might be free from tax.

Important caveat: the "step-up basis" provision of the tax code might go
away as part of estate tax reform. That's one to keep an eye on and
could require a rethinking of many estate plans.

Point being though that instead of doing these Roth conversions you
might deplete your IRA gradually during retirement, with the
distributions being taxed at relatively lower brackets (by doing only
MRD, not the Roth-conversion distributions), and the dollars left in the
IRA still being tax-deferred (as they would be in the Roth). By keeping
the withdrawals to MRD you'll have a bunch of extra dollars to invest
each year, the dollars not paid to those additional resulting taxes. And
if you invest them in a manner that generates mostly unrealized capital
gains...they might be "MRD-free" and income tax free by nature of
inheritance.

Gene can probably quantify this better!

-Tad
 
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G

Gary

Good analysis, Gene and Tad!

But as I considered recharacterizing my IRA->Roth IRA that I did at
the end of December, 2005, I worried that if (1) I did that, and (2)
future taxes went considerably higher [and I'm convinced that's very
likely because of war and other government expenses], that I would
have missed out on this 2005 relatively-low-taxed IRA->Roth IRA
conversion opportunity.
 

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