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I was cleaning up some newspaper clippings and some of them were recommending doing the Roth conversion of 401K/IRA assets. The whole idea being that you pay for taxes from "after tax money" for the conversion and then it all grows tax free. ssgcinty had posted another link recently on the topic too.

Savers Facing tax bills in retirement due to RMDs

Some of the newspaper clippings were also highlighting stepped up basis. So that triggered a thought of completely different line of thinking which says don't do the ROTH conversion. The core idea would be to take most of your after tax money and only buy ETF's that you plan to hold until you die. You would live off the dividend and cash some ETF's as required. Then if one of spouse were to die early, the other spouse would get the stepped up basis for all the investments - essentially making this all tax free. When the surviving spouse dies, then the kids could use the stepped up basis once more.

The core assumption in Roth conversion was that you had to pay taxes on the appreciation of assets outside the 401/IRA. However, if you defeat that assumption with stepped up basis trick, seems like there is very small or no benefit for early Roth conversion. Am I missing something here?
 

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rated:
PrincipalMember said:   I was cleaning up some newspaper clippings and some of them were recommending doing the Roth conversion of 401K/IRA assets. The whole idea being that you pay for taxes from "after tax money" for the conversion and then it all grows tax free. ssgcinty had posted another link recently on the topic too.

Savers Facing tax bills in retirement due to RMDs 

Some of the newspaper clippings were also highlighting stepped up basis. So that triggered a thought of completely different line of thinking which says don't do the ROTH conversion. The core idea would be to take most of your after tax money and only buy ETF's that you plan to hold until you die. You would live off the dividend and cash some ETF's as required. Then if one of spouse were to die early, the other spouse would get the stepped up basis for all the investments - essentially making this all tax free. When the surviving spouse dies, then the kids could use the stepped up basis once more.

The core assumption in Roth conversion was that you had to pay taxes on the appreciation of assets outside the 401/IRA. However, if you defeat that assumption with stepped up basis trick, seems like there is very small or no benefit for early Roth conversion. Am I missing something here?

  Traditional IRAs and 401Ks, 403Bs and 457s receive no step-up basis at death.

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stanolshefski said:     Traditional IRAs and 401Ks, 403Bs and 457s receive no step-up basis at death.
  
I am talking about stepped up basis for "after-tax" money.

 

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Disclaimer: An "After-Tax 401k" is a real thing, and one of the best "loopholes" in the law; essentially it's treated as a "nondeductible IRA" with a $53,000 annual limit and can be converted to an Roth IRA after only paying the difference in basis. Since "After-Tax 401ks" gains are treated like traditional IRAs, the answer is convert to a Roth ASAP and pay the gains since the account was funded, if that's what we're talking about..

OP, If you're talking about a choosing between holding a traditional 401k, taking a distribution, or Roth conversion, the answer is the tax efficiency of the asset.
- IRA/401k is treated as ordinary income at your tax rate
- Taxable Assets held more then a year get a much better capital gains rate.

So the question is whether you expect to make enough money after Roth conversion to offset the cash flow/capital gains tax rate.

This is really hard to judge, but the conversion option is an excellent option for high risk/high reward asset classes. (Think hard money lending notes/tax lien auctions, etc)
Taxable accounts with stocks/ETFs are essentially tax-deferred except for dividends; as you don't pay tax until you sell and realize the gain, and that's the better route.

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ThomasPaine> An "After-Tax 401k" is a real thing, and one of the best "loopholes" in the law;

Employer has to offer it. At least mine didn't (even though it was a really-really large corporation).

ThomasPaine> Taxable Assets held more then a year get a much better capital gains rate.

I think you are completely missing the point of my question. My point being that taxable assets held until death can completely escape taxation (i.e. even better than capital gains rate). Obviously, somebody can argue - what is the point of funds after death? But I am thinking that the family enjoy the income on those assets and the surviving spouse/kids inherit those tax free. Obviously, if I need the funds while still living, then tap into those at low capital gains rate.
 

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PrincipalMember;19767549 said:
I think you are completely missing the point of my question. My point being that taxable assets held until death can completely escape taxation (i.e. even better than capital gains rate). Obviously, somebody can argue - what is the point of funds after death? But I am thinking that the family enjoy the income on those assets and the surviving spouse/kids inherit those tax free. Obviously, if I need the funds while still living, then tap into those at low capital gains rate.

With the incorrect terminology confusing taxable and after-tax accounts, it's difficult to make sense of your question. The second part of my answer still applies.

The Roth conversion is a better move if you're younger, as:
- After 5 years, the conversion is treated as a contribution, allowing you to take it out without a 10% penalty before 59.5.
- Dollar for Dollar, your heirs would prefer a Inherited Roth IRA that they can stretch over their lifetime, with no penalty to access the money but tax free growth until they take distribution.
(They will not have to pay capital gains tax on the difference between the price on death and when they sell)

Your strategy only breaks even if you're not subject to early withdrawal penalty AND were certain you'd die before selling the ETF, AND ignored taxes on dividends.
The Roth conversion would offer greater tax savings in any other scenario.
Lastly, both conversion and distributions would be more efficient if you took the distribution over a series of years capped to a reasonable bracket instead of taking a lump sum.

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ThomasPaine said:   
Lastly, both conversion and distributions would be more efficient if you took the distribution over a series of years capped to a reasonable bracket instead of taking a lump sum.
 

  
That is the real problem. It doesn't take much to kick into the 25% bracket (75K income for married puts you there). And tax bracket wise, I suspect that I will get a narrow window between age 67 to 70 where I can imagine having no taxable income (assuming social security deferred to age 70). And then at age 70, social security income and minimum distributions will kick me back in higher tax bracket. But I think there is still a minor hope that I could be getting part of the RMD at lower tax rates versus paying full tax rate on conversion today. 




 

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Here's a simple model that hopefully addresses some of the issues here:   (you can tweak the numbers to fit your own situation)
Assume you are in the 25% bracket now and that your heirs will also be in that same bracket.   You have a TIRA worth 100 and a taxable account worth 25.
1) Leave as is so you start w/ TIRA=100 and taxable worth 25.     After some yrs , they both have doubled to TIRA=200 and taxable worth 50.
Now you leave this Earth.   Your heirs inherit the TIRA on which they pay 25% tax of 50 leaving after tax 150.    The after tax account is stepped up
in basis so there is no tax and after sale it is worth 50 for a total after-tax value of  200.
2)Convert to Roth and use the 25 in after tax account to pay the conversion tax.  That leaves you w/ Roth = 100.    After the same some yrs, it has doubled
to 200 and assuming no other complications, there is no tax so it has the same after tax value of 200.

Your point that there is little advantage in converting is generally true.......mostly because the tax rates before and after were the same.  If the later tax rate were lower, your
heirs might even be ahead if you didn't convert.    On the other hand, there is an assumption that the taxable account performed  the same as the Roth.   I don't 
know much about ETFs and how taxes affect them.   However if you had efficient index funds, there still would be dividends paid and a possible tax drag due to
that so the taxable account might not grow as fast as the tax-sheltered IRAs so you could end up a bit behind in not converting because of that.

Also if the later tax rate were higher (perhaps because of the RMDs from TIRA ) , then the Roth conversion would have come out ahead.
The moral of the story is that assumptions affect the end result.

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I know your strategy is ETFs (which I assume some are bonds) all the way, but to avoid "dead money" waiting for distribution, I just wanted to point out one more time that you can segregate asset classes by account type.

Traditional IRAs are best for tax-inefficient assets like bonds ETFs which you have to pay taxes on interest immediately if held in taxable.
Taxable accounts work great for tax-efficient index funds.
Roths are REALLY, REALLY great for the speculative part of the portfolio.

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ThomasPaine - thanks for your patient explanations.

Kaneohe - thanks for laying out the good example.  All else being equal in the case with the same tax brackets, it doesn't make much difference.  However, there are some secondary factors and nearly all of those favor the Roth so in cases where it's "close", you probably would rather convert than leave it as traditional.  These include:

1. Tax drag on the outside taxable assets used to fund the conversion (from dividends, turnover or rebalancing of appreciated holdings, etc).  Converting to Roth essentially moves these assets inside the tax sheltered account, and the sooner that happens the better.  The longer they stay that way, the bigger the compounded advantage.  

2. No RMDs on Roth (for now).  If you're lucky enough to live past 70, you will have to start taking out RMDs from your traditional IRAs/401ks (slight differences for 401ks if you keep working).  This means that despite your goal of having more tax advantaged assets, you will have 5-10% per year coming out and hence you're more likely to leave your heirs a larger amount of taxable cash and a smaller IRA.  All else being equal, your heirs would rather inherit $1 worth of post-tax withdrawable IRA money than $1 in taxable cash since they can keep the tax sheltered money in the IRA if they want to keep it invested.  yes the heirs will have RMDs on the IRA, but those are modest (especially if the heir is not too old) and hence the vast majority of the assets can stay in the inherited IRA and compound tax free, unlike the taxable cash.

3. Estate tax considerations.  I am not an expert on this, but if you're rich enough to be subject to estate tax (which is pretty rich now at a Federal level, but can still catch more modest savers at the state level), the estate with the Roth looks smaller in terms of gross estate assets than the one with the Traditional.  Now there is some deduction you get for the fact that the Traditional has an unrealized tax liability associated with it, but that deduction isn't going to be any better than the Roth case.   As is generally true about tax deductions, they often come with limitations, phase outs, AMT problems, etc, and so it's almost always better to have nothing than to have $1 of income and $1 of deductible items since at best they offset and the best doesn't always work out.

4. Inherited Traditional IRAs cannot be converted to Roth.  If you think your heirs would rather have a Roth, ie they are in a lower bracket now than they are likely to be down the road (perhaps early or middle of their career), you might want to convert their inheritance for them now since they won't be able to after you die.  Remember they won't have the luxury of waiting until retirement, gaming the gaps in delayed SS after retiring a bit earlier than 70 to give them slack years with lower income to convert to Roth, only take out bigger Traditional amounts in low income or high medical expense years, etc.  Inherited IRAs have RMDs from year 1 (at least if you go for the much preferable "stretch" option rather than the 5 year full cashout plan) and so they will be taking out 2-3% each year during much of their working career, and those tax brackets can be much higher than those you typically assume for personal IRAs (ie average tax rate during retirement, rather than the marginal tax rate while working).  

rated:
kaneohe said:   Here's a simple model that hopefully addresses some of the issues here:   (you can tweak the numbers to fit your own situation)
Assume you are in the 25% bracket now and that your heirs will also be in that same bracket.   You have a TIRA worth 100 and a taxable account worth 25.
1) Leave as is so you start w/ TIRA=100 and taxable worth 25.     After some yrs , they both have doubled to TIRA=200 and taxable worth 50.
Now you leave this Earth.   Your heirs inherit the TIRA on which they pay 25% tax of 50 leaving after tax 150.    The after tax account is stepped up
in basis so there is no tax and after sale it is worth 50 for a total after-tax value of  200.
2)Convert to Roth and use the 25 in after tax account to pay the conversion tax.  That leaves you w/ Roth = 100.    After the same some yrs, it has doubled
to 200 and assuming no other complications, there is no tax so it has the same after tax value of 200.

Your point that there is little advantage in converting is generally true.......mostly because the tax rates before and after were the same.  If the later tax rate were lower, your
heirs might even be ahead if you didn't convert.    On the other hand, there is an assumption that the taxable account performed  the same as the Roth.   I don't 
know much about ETFs and how taxes affect them.   However if you had efficient index funds, there still would be dividends paid and a possible tax drag due to
that so the taxable account might not grow as fast as the tax-sheltered IRAs so you could end up a bit behind in not converting because of that.

Also if the later tax rate were higher (perhaps because of the RMDs from TIRA ) , then the Roth conversion would have come out ahead.
The moral of the story is that assumptions affect the end result.

  
Thanks. I did a similar calculation and the numbers came out even.  After reading the link in my original post, I have been digging into this topic. For now, the really hard part is that my tax rate is not low. As you said, the assumptions make a difference and I am hoping that my average tax rate during periods of RMD will be lower than the top tax rate that I would have to pay on conversion today. Once Trump hopefully flattens out the tax structure, may be I should "carefully" move out from CA just for 1 year and do the ROTH conversion that one year. Then I can move back in later. The 10% state tax saved during conversion could completely swing the tax rate advantage in favor of Roth conversion. 

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ThomasPaine said:   I know your strategy is ETFs (which I assume some are bonds) all the way, but to avoid "dead money" waiting for distribution, I just wanted to point out one more time that you can segregate asset classes by account type.

Traditional IRAs are best for tax-inefficient assets like bonds ETFs which you have to pay taxes on interest immediately if held in taxable.
Taxable accounts work great for tax-efficient index funds.
Roths are REALLY, REALLY great for the speculative part of the portfolio.

  
No bonds for now. I did lock in some muni bonds several years ago with 5% interest rate and that was a great move. But right now the interest rate is so crappy, I can't bring myself to buy bond/bond funds. BTW I read a recommendation to buy BRK stock in the taxable account since it has no dividend - i.e. makes it very tax-efficient.

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xerty said:   ThomasPaine - thanks for your patient explanations.

4. Inherited Traditional IRAs cannot be converted to Roth.  If you think your heirs would rather have a Roth, ie they are in a lower bracket now than they are likely to be down the road (perhaps early or middle of their career), you might want to convert their inheritance for them now since they won't be able to after you die.  Remember they won't have the luxury of waiting until retirement, gaming the gaps in delayed SS after retiring a bit earlier than 70 to give them slack years with lower income to convert to Roth, only take out bigger Traditional amounts in low income or high medical expense years, etc.  Inherited IRAs have RMDs from year 1 (at least if you go for the much preferable "stretch" option rather than the 5 year full cashout plan) and so they will be taking out 2-3% each year during much of their working career, and those tax brackets can be much higher than those you typically assume for personal IRAs (ie average tax rate during retirement, rather than the marginal tax rate while working).  

  
Hi Xerty, I've always appreciated the detail in your posts. Getting a complement from you is a high honor.

One quick gotcha on #4: While it's impossible to convert an inherited IRA to a Roth, it IS a little known ability for an inheritor to convert a traditional 401k into a Roth, and pay the taxes based on the inheritor's tax bracket. Also, at the risk of going off topic, a 401k has better protections for bankruptcy, and the penalty for prohibited transactions in a 401k are much less onerous then IRAs.

Lastly the Supreme Court ruled in 2014 that inherited IRAs are not protected from creditors, similar to taxable accounts.
But 401ks are protected under ERISA, so the ruling *might* not apply to them. (This is neither tax/legal advice, see your CPA)

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ThomasPaine said:    a 401k has better protections for bankruptcy, and

When I wanted to transfer my 401K to IRA, the guy at Fidelity mentioned this to me. So I did a bit of research on it. My understanding is that as long as you have clear paper trail showing that the funds in the IRA came from 401K conversion, then it gets the same protection. My brokerage account representative was kind of saying that even co-mingling the funds in existing IRA would be fine since they would have record of what funds came from 401K, I decided not to take that risk and created a separate account. Your earlier comment along the lines of ROTH's being great for speculative part has worked great for me in the IRA too - I put 70% in stocks and put the 30% in call options. And then Trump came along to make my options part of portfolio gain really nicely and no tax obligation for now.
 

rated:
PrincipalMember said:   
ThomasPaine said:    a 401k has better protections for bankruptcy, and

When I wanted to transfer my 401K to IRA, the guy at Fidelity mentioned this to me. So I did a bit of research on it. My understanding is that as long as you have clear paper trail showing that the funds in the IRA came from 401K conversion, then it gets the same protection. My brokerage account representative was kind of saying that even co-mingling the funds in existing IRA would be fine since they would have record of what funds came from 401K, I decided not to take that risk and created a separate account. Your earlier comment along the lines of ROTH's being great for speculative part has worked great for me in the IRA too - I put 70% in stocks and put the 30% in call options. And then Trump came along to make my options part of portfolio gain really nicely and no tax obligation for now.

  I don't think they're the same in theory.    The 401K has unconditional protection except against IRS and irate spouses (QDRO) under ERISA.   The IRA funds get protection under a relatively recent bankruptcy law and you have to file successfully for bankruptcy to be protected.   Whether there is any practical difference.......I'm not sure.    If they can't get your 401K, they go after something else...........you might ask your Fidelity guy about that.    I get the same story from IRA guys trying to get my 401K......kind of funny since it's often the other side of the same fence........401K w/Fidelity and IRA salesman also.......

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I am merely starting to look at the conversion process to help support me in early retirement. I am already at a point where I cannot make TIRA tax-free contributions or RIRA contributions.... they all have to be after-tax TIRA contributions. So, I am considering doing this, fund to the max and then immediately convert. Since it is already after tax money, the conversion create no extra tax if I don't have any gains in between. Since contributions can be withdrawn without penalty, this gives me money that I can withdraw is I retire rather early without having to resort to the equal distributions. I just need to get to the point where I can fund until 59.5 and I can start drawing down off of my traditional funds.

The only other consideration is the estate planning aspect, I suppose. Where a TIRA has the RMDs, and the RIRA does not (is this correct)?

rated:
kaneohe said:   
PrincipalMember said:   
ThomasPaine said:    a 401k has better protections for bankruptcy, and

When I wanted to transfer my 401K to IRA, the guy at Fidelity mentioned this to me. So I did a bit of research on it. My understanding is that as long as you have clear paper trail showing that the funds in the IRA came from 401K conversion, then it gets the same protection. My brokerage account representative was kind of saying that even co-mingling the funds in existing IRA would be fine since they would have record of what funds came from 401K, I decided not to take that risk and created a separate account. Your earlier comment along the lines of ROTH's being great for speculative part has worked great for me in the IRA too - I put 70% in stocks and put the 30% in call options. And then Trump came along to make my options part of portfolio gain really nicely and no tax obligation for now.

  I don't think they're the same in theory.    The 401K has unconditional protection except against IRS and irate spouses (QDRO) under ERISA.   The IRA funds get protection under a relatively recent bankruptcy law and you have to file successfully for bankruptcy to be protected.   Whether there is any practical difference.......I'm not sure.    If they can't get your 401K, they go after something else...........you might ask your Fidelity guy about that.    I get the same story from IRA guys trying to get my 401K......kind of funny since it's often the other side of the same fence........401K w/Fidelity and IRA salesman also.......


I am going to slightly retract my statement. I looked at the issue as I mentioned and since I live in CA, I might have looked at it from CA perspective versus federal perspective. See the link below. The link was also cautious about "mixed funds" - so I kept my funds completely independent.
CALIFORNIA ROLLOVER IRAs CAN RECEIVE ERISA STYLE CREDITOR PROTECTION
 
 

rated:
Re: IRAs and Estate tax. Does anyone know whether the assets inside an IRA (traditional and roth) in determining whether the GROSS estate is above the $5 mil. federal exempt level -- for IRAs with beneficiary designations?

If IRAs are included in computing Gross estate, then who pays the estate tax if the total Gross estate is above $5 mil and the IRA passes directly to the beneficiaries?

TIA

rated:
PrincipalMember said:   
kaneohe said:   
PrincipalMember said:   
ThomasPaine said:    a 401k has better protections for bankruptcy, and

When I wanted to transfer my 401K to IRA, the guy at Fidelity mentioned this to me. So I did a bit of research on it. My understanding is that as long as you have clear paper trail showing that the funds in the IRA came from 401K conversion, then it gets the same protection. My brokerage account representative was kind of saying that even co-mingling the funds in existing IRA would be fine since they would have record of what funds came from 401K, I decided not to take that risk and created a separate account. Your earlier comment along the lines of ROTH's being great for speculative part has worked great for me in the IRA too - I put 70% in stocks and put the 30% in call options. And then Trump came along to make my options part of portfolio gain really nicely and no tax obligation for now.

  I don't think they're the same in theory.    The 401K has unconditional protection except against IRS and irate spouses (QDRO) under ERISA.   The IRA funds get protection under a relatively recent bankruptcy law and you have to file successfully for bankruptcy to be protected.   Whether there is any practical difference.......I'm not sure.    If they can't get your 401K, they go after something else...........you might ask your Fidelity guy about that.    I get the same story from IRA guys trying to get my 401K......kind of funny since it's often the other side of the same fence........401K w/Fidelity and IRA salesman also.......


I am going to slightly retract my statement. I looked at the issue as I mentioned and since I live in CA, I might have looked at it from CA perspective versus federal perspective. See the link below. The link was also cautious about "mixed funds" - so I kept my funds completely independent.
CALIFORNIA ROLLOVER IRAs CAN RECEIVE ERISA STYLE CREDITOR PROTECTION 

  Thanks for the link!   New news for me.........in CA also but I'm going to season this news before   acting on it.
Check this out for more caution:     https://www.irahelp.com/forum-post/17967-creditor-protection-cal...

rated:
confused200 said:   Re: IRAs and Estate tax. Does anyone know whether the assets inside an IRA (traditional and roth) in determining whether the GROSS estate is above the $5 mil. federal exempt level -- for IRAs with beneficiary designations?

If IRAs are included in computing Gross estate, then who pays the estate tax if the total Gross estate is above $5 mil and the IRA passes directly to the beneficiaries?

TIA

  Pretty sure the IRAs are counted in the  gross estate.  Don't know about the estate tax..........assume it would be paid from the non-IRA assets first?

rated:

rated:
confused200 said:   Re: IRAs and Estate tax. Does anyone know whether the assets inside an IRA (traditional and roth) in determining whether the GROSS estate is above the $5 mil. federal exempt level -- for IRAs with beneficiary designations?

If IRAs are included in computing Gross estate, then who pays the estate tax if the total Gross estate is above $5 mil and the IRA passes directly to the beneficiaries?

TIA
 

  
1. BTW the limit is indexed for inflation. For 2017, it is 5.49M.
2. If married, the same limit applies to each spouse - so effectively it is doubled. And if one spouse dies early, a form needs to be filed with IRS for porting over the dead spouse's exclusion amount to the surviving spouse.

rated:
xerty said:   Estate tax on IRAs:

https://www.kitces.com/blog/understanding-the-irc-section-691c-income-in-respect-of-a-decedent-ird-deduction-for-the-beneficiary-of-an-inherited-ira/


My head hurts on reading this. Seriously - you pay estate taxes and then pay income taxes on what remains - wow!  Fortunately, I won't run into that problem with spousal exclusion. Wonder what kind of planning Mitt is doing.

I was going to say - can't wait for Trump to get rid of Estate taxes but looks like Trump is also talking about eliminating the "stepped-up basis" rule - so much for my plan to buy and hold ETF's . It will be an interesting year to see what rules get passed and then we all start working on the loopholes. I did create a living trust for my assets several years ago but it is fast becoming clear to me that I need re-review everything after whatever set of rules that get created by the new administration.

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