In a previous article I wrote with Jussi Askola, one commenter requested an article on smart strategies for Roth conversions of 401(k) funds. Such an account (401(k)) is one type of traditional individual retirement account ("TIRA"). There are quite a few others, such as 403(b) accounts. Here we refer to them all as TIRAs.
Articles about such topics are challenging to write, because of the diversity of individual circumstances and the complexity of some of the relevant rules. I am neither a tax attorney nor any sort of certified financial professional. The downside of this is that I might make mistakes herein. The upside is that I am not locked into any traditional viewpoint.
My motivations for having engaged this topic in the first place are personal. These questions matter, substantially, to me and to my retirement. My goal in writing the article is to learn further by explaining, and through good explanations of good thought to be helpful.
That said, this article is not a substitute for doing your own thinking and your own consultation with your own experts. I hope it might help you be more effective in your thinking and in your choice and use of experts.
It takes a lot of words to set the stage here, in the next few sections. But for any individual, the stage matters.
First, know yourself
This is the hardest part of effectively utilizing TIRA funds. Here we discuss some of the issues and questions. Most of the value to be found in good financial advisors is not that they magically make your rich. It is that they force you to come to terms with knowing yourself.
Ask what kind of retiree you want to be: One can find standard advice that you need some fraction, often 70%, of your pre-retirement income to support you in retirement. Ignore these numbers. Throw away any article giving such advice.
Figure 1. Are you a foodie who loves high-end travel? If so, your spending may increase in retirement. Source.
Studies that have looked more deeply have found a range of patterns. Retirees who enjoy high-end travel and food often spend more early in retirement than they did before retirement. (Figure 1) In contrast, those who sell their big house, move out to the sticks, and spend their time fishing often spend much less. (Figure 2)
In my own case, with retirement a few months away, my best guess is that my spending rate won’t change much. In your case, I hope you have been tracking your expenses. If not, start now and also try to at least look back and see how much you have spent annually for the last few years.
Figure 2. If you are headed to a small house where you will spend your days fishing, retirement might not be so expensive. Source
Project your expenses forward for 30 years with your best estimate of the kind of retiree you will be. Include taxes in the projection. This corresponds to spending the money directly from TIRAs.
Everyone should consider assuring that they have a level of secure income sufficient to survive on. If you do not have a pension, and social security is not adequate, then consider purchasing single-premium lifetime annuities.
During a market crash, it would be an emotional strain beyond most people’s tolerance to have a market recovery be the only thing standing between you and abject poverty. This is (part of) why most individual investors rack up abysmal returns. (Figure 3)
Figure 3. If you are the typical investor who panics during a market crash, you may not want your own finger on the “Sell” button. Source.
Ask if your goals are realistic: Determine what fraction of your remaining assets you would like to spend each year, after allowing for any pension or annuity income.
If this fraction is 3% or less, then you have no need to be clever with investments. You don’t need to worry about moving money around, unless you want to for other reasons. You will be just fine with a diverse selection of index investments within the TIRA.
If the fraction is 10% or more, then you need to either accept flexibility or change your goals. By various routes, the odds are reasonable of doing well while spending at a 10% rate.
Two examples are to just buy an ETF such as (NOBL) holding the Dividend Aristocrats or to buy a fund holding large-cap equity REITs such as (VNQ), as I discuss here. Or you may do better making your own choices. But with the 10% spending rate, the chances that you will be forced to cut back spending at some point are not negligible.
Ask what kind of investor and spender you are: Some investors need certainty. Others are comfortable watching an investment they just made drop a factor of two in value before it finally begins to recover, two years later.
Quoting Warren Buffet :
Unless you can watch your stock holding decline by 50 percent without becoming panic-stricken, you should not be in the stock market."
The track record is clear, most individual investors buy high and sell low. If this is you, then you have no business trying to spend at a 6% rate, let alone 10%. You need to be in the hands of an advisor, or perhaps in index funds that you rebalance annually. (Figure 3)
The Promise and Peril of Roth Accounts
Now we turn to pulling money from a TIRA to put into a Roth, perhaps keeping some in cash.
The important element, for tax effectiveness, is that any funds converted to Roth funds are taxed, in the year of the conversion, at ordinary income tax rates. This makes it disadvantageous to convert all your TIRA funds in one year.
In many circumstances, individuals have a choice of whether to place (or leave) funds in TIRAs vs. Roths. A major aspect of this decision is that it represents an arbitrage on tax rates.
The Roth is designed so that pre-tax money invested identically in a TIRA or in a Roth, and left there for a few years or more, will provide the exact same after tax income when spent, if your tax rates do not change. I discuss some aspects of this here.
The standard expectation that your tax rates will go down in retirement is not guaranteed. If your money is all in TIRAs, and you are go-go traveling foodies, you may spend more and end up with a higher tax rate. Such individuals should maximize their investment of funds in Roth accounts before retirement.
In addition, suppose the present is an era of historically low tax rates. It certainly seems to me that this is likely. Suppose some future congress substantially raises tax rates. You might end up spending more in taxes later to get money out of the TIRA than you would spend to get it out now. If you share this viewpoint, you should consider moving funds to Roth accounts sooner rather than later.
In the present era of low inflation, the difference in yield needed to make up for taxability is not large, especially in tax advantaged investments such as Master Limited Partnerships and (for very high-tax investors) municipal bonds.
The Context for Roth Conversions
Some individuals are able establish and fund their Roth accounts while working. Our primary focus here is on the opportunities to move larger amounts of money into Roth accounts via conversions.
One way this happens is if and when one changes jobs. One has the option of rolling any amount of funds from a TIRA with one’s prior employer into a Roth, and paying the associated taxes. Timing and process matter. If this applies to you, look into it.
Another source of Roth conversions, and our focus here, is when one gains control of TIRA funds at 59 1/2 or retirement. At this point one can convert any amount of funds. I have heard this from readers and have done it myself. (Before recently I had no Roth accounts.)
With Fidelity, and likely with most custodians, one can have the taxes withheld at the time of conversion. This is convenient. I personally established my first Roth account this year, as part of establishing checkbook control of some of my funds.
Whether you are allowed to convert the TIRA funds depends upon the details of the employer retirement account. I know this because I ended up with accounts of both types in my early 60s, while still employed.
My Best Understanding of the Roth Rules
Here follows my best understanding of the Roth Rules. There is a lot of information out there that I believe to be incomplete or wrong.
Under the recent tax law, one can now convert any amount of TIRA funds to Roth funds by doing a “Roth Conversion”. One can do this at any time. One owes regular income taxes on the TIRA funds when one makes the conversion.
Repeating some material from a previous article, with one expansion in italics.
Withdrawals from the Roth account are more complex. I believe the H&R Block website has this right, and also expresses things unambiguously. The relevant parts are here:
Roth IRA Withdrawal Rules
Because your Roth IRA contributions are made with after-tax dollars, you can withdraw your regular contributions (not the earnings) at any time and at any age with no penalty or tax. After you withdraw an amount equal to all of your regular contributions, the earnings will be taxable only if the distribution isn’t a qualified distribution. If the distribution is qualified, then none of your distribution will be taxed. In an employer Roth plan, this may not be allowed before retirement or separation.
All of your Roth IRAs are treated as one for the purposes of withdrawal rules. It doesn’t matter how many Roth IRA accounts you have.
Distribution Ordering Rules for Roth IRAs
If the money you withdraw from a Roth IRA isn’t a qualified distribution, part of it might be taxable. Your money comes out of a Roth IRA in this order:
- Regular contributions — always tax- and penalty-free
- Conversion contributions — which come out on a first-in, first-out basis. So conversions from the earliest year come out first.
- Earnings on contributions
Roth IRA Earnings & Withdrawal Rules
Your earnings are tax-free if both of these are true:
- You’ve had the Roth IRA for at least five years.
- You’re age 59 1/2 or older when you withdraw the money.
Not mentioned by H&R Block is that each Roth conversion starts its own 5-year clock for withdrawing earnings. This will be a non-issue if you put enough into the Roth the first year that you don’t withdraw all the contributions within five years.
As I read the explanatory IRS document, after age 59 1/2, one can withdraw Roth contributions from Roth conversions without penalty. It appears that there is a tax penalty for doing so at younger ages.
To check on this, I asked my tax attorney, who is also a CPA, about my own case. His position is that I can withdraw Roth conversions, like other contributions (his words), at any time without penalty.
I even asked him twice, in different ways. He was adamant. But he knows I am in my 60s, and I did not ask about younger individuals. And maybe he is wrong. I have not tested this yet in practice, and may or may not do so.
A Rant on Roth Rules and Random Readers
This section is a rant, skip it if you like. It provides the reasons why I will not participate in any discussion of Roth rules in the comments.
First I offer a brief note on writing for Seeking Alpha (“SA”). Most writers, including me, write from a desire to help and a love of writing. I do let SA pay me, but pity the writers who try to make real money solely from writing articles.
At my present publishing rate, the money this hobby produces from SA does not cover my coffee budget. My affiliation with Jussi Askola and High Yield Landlord pays a bit more. It covers the coffee budget but is far short of the wine budget.
The point is that advice on SA may well be worth what you pay for it, or less. But it is most often offered by intelligent, literate people who are motivated to try to be helpful. Between that and the comment strings, which are often very useful, I have gained a lot from reading SA.
My observation is that comment strings on Roth rules always turn into a ragged mess. The fundamental reason is that Congress made the rules a complex mess and the IRS produced a very opaque document discussing them. (Neither surprises me.) The environment of brief comments is abysmally suited to discussing such matters.
Another aspect of the comment strings on Roths is this: different readers read the relevant IRS document and come to very firmly held, and utterly contradictory, conclusions. Moreover, they are so sure they are right that pointing this out has no effect on their certainty. Some of these readers have behaved very unpleasantly as well.
Being abused is not worth it. You’ve got my best effort above. I put in the disclaimers. Use it as you will but don’t expect responses from me about the Roth rules.
Seeking Tax Efficient Roth Withdrawals
This section considers tactics that apply if you have a lot of money in TIRAs, compared to your spending needs. The most valuable principle is to manage your tax brackets.
Table 1 shows the taxes and rates for 2019 income, for married couples filing jointly. We will consider how to exploit this table.
Table 1. Source.
Filing status: Married filing jointly and surviving spouse
Income tax due
10% of taxable income
$1,940 + 12% of TI over $19,400
$9,086 + 22% of TI over $78,950
$28,765 + 24% of TI over $168,400
$65,497 + 32% of TI over $321,450
$93,257 + 35% of TI over $408,200
$612,351 and more
$164,709.50 + 37% of TI over $612,350
Tax bracket management: The first principle of tax effectiveness, if seeking to pull funds out of a TIRA, is to set your net taxable income (after deductions) at the upper end of a tax bracket. Thus, you want that number to be $78k, $168k, $320k, $408k, or $612k for 2019.
Your spending puts you in some tax bracket. You can’t escape this, in the short run. So you have no choice but to take money out of the TIRA, if you choose to do so, at that tax rate or a higher one.
Table 2 shows how this works out. The first column shows the taxable income needed for spending. You need to figure this out by subtracting any non-taxable income from your anticipated spending and allowing for taxes of the taxable income.
The second column shows the deductions, taken here to be the $24k standard deduction for 2019 income for married filing jointly. There may be opportunities to be clever by clustering deductions into certain years. The third column is the adjusted gross taxable income, set at a tax bracket boundary.
Table 2. Examples of TIRA withdrawals that respect tax-bracket boundaries. Source: Author calculations.
The fourth and fifth columns are the implied additional and total withdrawals from the TIRA. The total tax owed is column 6.
Columns 7 and 8 then show the part of the tax that is owed because of the additional TIRA withdrawals, and the net tax rate for these additional withdrawals. Column shows the net cash generated that can go into a Roth or a taxable account.
You can use this table, or a similar one you create, to consider how much you want to withdraw from the TIRA in a given year. This is a personal decision where the tradeoff is paying less vs getting funds out sooner.
For example, if your taxable income needed for spending is $125k, there is not much barrier to withdrawing another $200k, which creates a 1% average increase in the tax rate. Withdrawing an additional $100k beyond that is more expensive, but the average tax rate only goes up 4%.
If you are over 70, you will be required to withdraw enough funds to equal your Required Minimum Distribution, even if this pushes you into a higher tax bracket.
Exploit cash once you have it: Once you have significant funds in Roth or taxable accounts, or if you have any kind of big nontaxable windfall, you have the option of taking a tax vacation.
You could take a true tax vacation and live for a year with no income taxes.
Alternatively, you could spend nontaxable income and divert more TIRA funds into Roth or taxable accounts, with no additional taxes. This drives down the average tax rate on the funds withdrawn.
The top section of Table 2 is relevant to this case. If, for example, you withdraw $344k, the average tax rate drops by up to 5% using this strategy.
Implications for Investors
You need to decide the mix you desire of TIRA, Roth, and taxable funds. This is a portfolio construction choice, and not the focus of the present article.
Some investors are also concerned with being sued. In some states, 401(k) funds are more strongly protected than IRA or Roth funds.
You may or may not want to focus on this in structuring your portfolio. On my own part, my career has not been the sort that tends to lead to lawsuits, I carry a large umbrella policy, and I am not worried about this issue.
You may want to pull quite a bit of money out of your TIRA accounts. This is certainly my case.
You can save a lot in taxes paid by keeping taxable income within chosen tax brackets, relative to just pulling all the funds out in one year. You can also save a few percent by using after-tax funds for some or all spending, once you can.
One can look at this two ways. You can gain a few percent by some manipulations. Hooray! Alternatively, the time spent on figuring these things out might produce a gain much larger than 5%, if instead you used the time for effective investing.
That said, it would seem a bit extreme for someone whose spending puts them in the 22% tax bracket to take all their money out in a single year, paying taxes at 37% on most of it.
It would be useful for readers to hear, in the comments, of actual experiences people have had with Roth conversions and subsequent withdrawals of the associated funds.
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