US tax Roth IRA ladder conversion/recharacterization questions
May 28, 2016 8:35 AM   Subscribe

I'm looking into using a "Roth conversion ladder" to periodically convert some of my money from a traditional IRA to a Roth IRA, which I can then withdraw five years later in a tax-advantaged manner, despite being younger than the typical age to withdraw funds from IRAs. I have several questions about this.

As I understand it, if I have a traditional IRA, I can convert any amount of money from it to be part of a Roth IRA instead. The amount is considered taxable income for the year in which the conversion is done. Moreover, I can rollback ("recharacterize") some or all of such a conversion up until October of the year following the conversion, so that the money is back in my traditional IRA and it doesn't count as taxable income. Finally, for any such amount that I do not rollback, I can withdraw that amount from my Roth without any tax liability, as long as I do so five or more years after the conversion, even if I'm not of the "normal" age to make withdraws. I have several questions about all of this:

(1) Right?

(2) Let's say I want to be in at most the 15% tax bracket for tax year 2016, so as to take advantage of reduced capital gains taxes. The cutoff for the 15% bracket is something like $37,000, so I want $37,000 or less in taxable income. A conversion like this for 2016 must be done in 2016, so at some point in 2016 I convert $37,000 or less.

But I don't know how much less it should be until I actually do my 2016 taxes, which will be in 2017 (so that I can take into account other income and stuff like that). So at the time I have to make the conversion, I don't know how much I should convert. But -- and this is what I want to make sure of here -- I think that's where the recharacterization comes in? Specifically:

It seems like I can just not worry about figuring out an exact conversion amount at the time of the conversion. I can instead just convert some ridiculous amount, let's say $1 bazillion, from traditional to Roth at some point in 2016. Then when figuring out my 2016 taxes in 2017, I now have precisely enough information to figure out what the conversion amount should have been in order to get me into the desired tax bracket. I can then recharacterize the vast majority of the 2016 $1 bazillion in April 2017, so that most of it is back in my traditional and only (say) $34,225.39 is in the Roth, thus keeping my 2016 taxable income in the 15% bracket but as close to the next higher bracket as possible. And now, come 2021, I have the ability to take out $34,225.39 from my Roth, without any tax liability, even if I'm younger than the normal Roth withdrawal age.

I guess my question here is: Really? I can do that?

(3) I can do this every year? I see that there are time limits for when you can convert from a IRA that you recharacterized back into, but if I'm reading it correctly, I can do it the year after the conversion, as opposed to the year after the recharacterization. So I can convert in 2016, recharacterize some of that in 2017, and convert in 2017 even though I recharacterized in 2017?

(4) What happens to gains or losses that happen in the Roth between the time of the conversion and the time of the recharacterization? I understand that gains don't count towards what I can withdraw tax-free five years later, but I mean if I convert $50,000, which grows in the Roth to $52,000, and I then want to recharacterize it so that it counts as $20,000 for taxable income purposes, do I do so by moving $30,000 from my Roth to my traditional? $32,000? Some prorated amount in between?
posted by Sock McPuppet, Jr. to Work & Money (10 answers total) 6 users marked this as a favorite
I understand that gains don't count towards what I can withdraw tax-free five years later...

I think you have this bit right, but to clarify -- gains in your Roth IRA are taxable, only the initially deposited amount upon which you already paid taxes may be withdrawn tax free. And I know because I had a 2,000 Roth that was really old and when I cashed it out many years later I did own taxes on the 3,000 gain.
posted by puddledork at 8:40 AM on May 28, 2016

This is a popular topic among the early retirement crowd, so you might get some help from The Mad FIentist or Go Curry Cracker. Barring that, post your question at the Mr. Money Mustache Forums and someone will surely have all the answers.
posted by jabes at 12:43 PM on May 28, 2016

A friend who is quite financially savvy and very smart fucked up his back door Roth last year and it became a huge hassle he eventually had to pay to make go away. As i understand it the issue is the cost base of the money in the trad ira you convert. Really get an accountant.

But most of what you say sounds right-ish. Which is of course the most dangerous kind.
posted by JPD at 1:52 PM on May 28, 2016

You have the general rules correct.

You can recharacterize up until October of the following year. However some things to keep in mind.

You may have to pay estimated taxes in January to cover your conversion tax bill in April. If you have too little payroll withholding and estimated taxes paid in January, you may be subject to an underpayment penalty.

If you recharacterize in October, you may have to file an amended tax return to get the overpayment of taxes back that you paid in April. The usual recommendation is that you just automatically file for an extension in April, but regardless, in April you must pay the full amount of expected taxes (which would be the worst case assuming no recharacterization) or else risk an underpayment penalty.

Regarding recharacterization of gains or losses, they must be pro-rated. This can get complicated so it is recommended to open an new, separate Roth IRA for each year's conversion so they aren't mixed with previous contributions or conversions. In the $50,000 example you gave, the net gain for the $30,000 recharacterization would be (52K - 50K)/50K * 30K = 1.2K. So you would have to recharacterize 31.2K.

Yes, you can do this each year, but you have to be careful. You can't convert the same money you recharacterized until the next year (which is okay if you recharacterized in the following October) and you cannot convert the same money within 30 days of recharacterization. So if you recharacterize 2016 in October 2017, you can convert again in November 2017. Or you can convert money from a different IRA.

That all said, is this all really worth it? Note that you have to pre-pay estimated taxes. You have to pre-pay April taxes. You may have to file an amended return to get a tax refund. You will have to do keep accurate Form 8606 and 1099-R.

I find that I can compute my taxes quite accurately in December. I know my ordinary income. I can closely estimate end of year taxable dividends and interest. So I can also estimate Roth conversions quite accurately. If you go over or under the 15% bracket a little it is of little consequence.

Note that capital gains income is stacked on top of ordinary and Roth conversion income. So if you fill up the 15% bracket with Roth conversion income first, all your your capital gains income will be taxable. You would need to keep the sum of ordinary and capital gain income below the 15% limit. But pushing it a little over 15% is of minor consequence. You will only owe an extra 15% on the amount of capital gains that is above the 15% bracket. So if you convert $1000 too much, it will cost you $150 of extra tax. How much is your time worth to avoid $150 of tax?
posted by JackFlash at 1:56 PM on May 28, 2016

Thanks. JackFlash, I just want to make sure I understand what you mean by "this all" in "is this all really worth it?". If I understand you correctly, you're suggesting that I consider:

(1) Sure, use Roth conversion, but

(2) This whole "overconvert then recharacterize" brings a lot more complication for little benefit, so it might be better to just convert a vaguely appropriate amount, as best as I can, at the end of any given tax year. And then not need to worry about recharacterizing part of it in the next calendar year.

Is that right? I just want to be sure that I'm not misreading you, like perhaps by "Is this all really worth it" you mean Roth conversion in general.
posted by Sock McPuppet, Jr. at 2:45 PM on May 28, 2016

Yes, you understood me correctly. Roth conversions are a good thing to do if you are in a lower tax bracket and have enough spare cash to cover the extra taxes.

And I'm not saying that recharacterizations should be avoided. Recharacterizations are always a good idea if there is a big market value decline shortly after conversion. Just that you should be aware of the complications and only you can decide if it is worth over-converting to fine tune the strategy as you suggest. Some people really like doing that stuff and don't mind the paperwork.

Another thing I didn't mention before is a possible interaction with health insurance if you are getting it through the ACA exchange with a subsidy. You have to work the numbers but in many cases you come out better by reducing conversion income to increase the amount of insurance subsidy. Some people use conversions to tune their income so that they are just above the Medicaid limit but still get the maximum subsidy and cost sharing reductions.
posted by JackFlash at 3:13 PM on May 28, 2016

gains in your Roth IRA are taxable,

They're not. The whole point of a Roth is that it's never taxable.
posted by jpe at 4:45 PM on May 28, 2016 [1 favorite]

(I think that's only true if you wait until retirement age?)
posted by nobody at 4:52 PM on May 28, 2016

The whole point of a Roth is that it's never taxable.

The context of the question here is non-qualified withdrawals (generally before age 59 1/2). In that case, gains are taxed as ordinary income plus a 10% penalty (with a few exceptions).
posted by JackFlash at 5:17 PM on May 28, 2016

So in other words, be careful you only withdraw contributions, not gains before age 59 1/2. (There are some exceptions).
posted by JackFlash at 5:19 PM on May 28, 2016 [1 favorite]

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