Roth IRA Conversion Laddering

Yes, you can increase returns this way, but it’s important to note that the reason is because you’re taking more risk, not because of some special feature of traditional vs Roth IRAs. Let’s say for simplicity your bonds earn nothing and your stocks will either double or half over some holding period and you hold $100 in each initially:

Case 1: low risk in traditional
tIRA: bonds, final value $100
Roth: stocks, final value $200 (or $50 if unlucky)
Total after tax value (30% tax rate)
1a) up market = $100*(1-30%)+$200 = $270
1b) down market = $100*(1-30%) + $50 = $120

Case 2: high risk in traditional
tIRA: stocks, final value $200 (or $50 if unlucky)
Roth: bonds, final value $100
Total after tax value (30% tax rate)
1a) up market = $200*(1-30%)+$100 = $240
1b) down market = $50*(1-30%) + $100 = $135

As you can see, if the market is up, you end up with more money putting the stocks in the Roth (case 1, $270 vs $240), while if the market is down you’ll end up with a more money if you put stocks in the traditional (case 2, $135 vs $120). You took more risk by putting stocks in your Roth, and it either pays off or it doesn’t. That’s not very helpful though, since if you knew which way the market was going, you’d have everything in stocks (or bonds).

Said another way, the difference in risk here is coming from the fact that the asset allocations are not the same in the two cases. With a 30% tax rate, you should think of $100 in a Traditional as only being worth $70, while a $100 Roth is worth the full $100. This is obvious when it comes to withdrawing the money, but people often forget when they’re doing their AA, which is sometimes called tax-adjusted asset allocation and is more correct IMO.

The Roth is “bigger” than a Traditional of the same nominal dollar amount, and so if you put all stocks there, you’re really taking a more risky, stock-heavy AA than if you put them in the traditional (where the Feds will share 30% of the gains or losses), so the returns in the good scenario are just from this mismatch in risk. Explicitly, the $100 starting point of the above example has the following allocations:

Case 1: bonds in Traditional
$100 bonds, worth $70
$100 stocks, worth $100.
59% stocks / 41% bonds, after tax adjusting (out of $170 post tax total)

Case 2: stocks in Traditional
$100 stocks, worth $70
$100 bonds, worth $100
41% stocks / 59% bonds, after adjusting.

So of course Case 1 pays off more in an up market, because it took 20% more stock risk (60/40 vs 40/60). If you tax adjust your AA, you’ll find it doesn’t matter at all what you put where between Roth vs Tradtional.

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Anyone know if the five year clock on conversions goes by the exact date of the transfer or by the tax year? I.e.- is a Jan 1,2000 conversion five years old on Jan 1, 2005? Or does it go by the tax return dates? If it’s the former, I need to keep better records than just the returns.

Good question.

According to this article: What Is the Roth IRA 5-Year Rule? Withdrawals, Conversions, and Beneficiaries, the 5 year rule on contribuions (the first of the three 5 year rules) starts on Jan 1st for the tax year of your first contribution. I know you’re asking about conversions though (second 5 year rule) and I am having trouble finding any specifics. I think it’d be safe to assume that uses the same timing rules as the contribution rule. The IRS would be really dirty if they used different timings to apply to different rules. They’re nit picky but usually don’t play that dirty.

Excerpt from the article:
The use of the term “tax years” above with regard to 5 year rules means that the clock starts ticking January 1 of the tax year when the first contribution was made. For example, a Roth IRA contribution made on April 15, 2018 counts as if it were made on Jan. 1, 2017. In this case, you could begin withdrawing funds without penalty on Jan. 1, 2022—not April 15, 2023.

Update Correction: A conversion must be done during the calendar year and not the filing deadline. Thus, the clock starts Jan 1st of the calendar year in which the conversion is done.

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Per Motley Fool, it’s the tax year. Jan. 1 of the year you converted starts the clock.

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There are lots of complex timing rules and rules about recharacterizations and reconversions, transactions spanning across years, etc. but for the most part, the timing rule is the same: it counts as converted or contributed on January 1 of the year the conversion or contribution applies to. Of course, conversions can only be made in the calendar year of the year they apply to, so based on that rule, the example wouldn’t apply to conversions (a conversion on 4/15/18 could only apply to 2018, so it would count as contributed 1/1/18, not 1/1/17).

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OK, thanks for that clarification. That’s an important point I was missing. A conversion must be done during the calendar year and is applied to that calendar year, however a conversion reversal or recharacterization can be done before the filing deadline or extension for that tax year.

Thus, a conversion timeline rule applies to Jan 1st of the calendar year that conversion is done. I’ve edited my previous post.

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I hope I am not hijacking this thread, but I have a specific application of this strategy which I would like to get your opinion on. If this is too far off topic, please feel free to move it to its own thread.

Let’s take the case of a person over 50 whose expenses and income are such that by maximizing their 401k withholding, it’s possible to live within the 15% tax bracket. Let’s say this person is holding a significant amount of an under-performing stock in that account. If it were possible to remain in the 15% bracket after paying taxes on an additional 10-30k of income, would it be possible to move some portion of the 401k to a Roth IRA to avoid paying taxes on the appreciation of the under-performing stock?

I’m a little confused by your question, but, maybe this answers it - the amount you convert is, for the most part, the fair market value at the time of conversion.

[stike]Also, you can’t convert directly from a 401k to a Roth IRA.[/strike]

You have two options -

  1. you can try to do a rollover from the 401k to an IRA (Roth or otherwise), or
  2. you can try to do an in-plan 401k conversion.

Either way will be some paperwork and probably working your way through some confusion with the HR and 401k administrator.

Issues with #1 are that you need to be eligible to remove the funds from the 401k plan to do it, and generally speaking elective deferrals (the most common type of 401k contribution) are not possible to be removed from the plan until either you leave your job or until you’re old enough to take the withdrawals penalty free. If you meet those requirements, you can either do a rollover to a traditional IRA (and then convert the desired amount each year based on your tax situation) or do a simultaneous rollover and Roth conversion straight into a Roth IRA. I would suggest the former since dealing with your own IRA is a lot easier and faster than dealing with a company 401k plan, especially if you’re going to do it more than once, and because it will be much easier to recharacterize the Roth conversion back to your Traditional IRA if your “undervalued” stock continues to get even more undervalued after you convert it.

Issues with #2 are that your employer has to both offer a Roth 401k option to hold the converted funds, and they have to allow the in-plan 401k Roth conversion as an option. Both are allowed, but older 401k plans might not have chosen to implement these features and they aren’t required to. Also, in-plan 401k conversions can’t be undone the way a Roth IRA conversion can be recharacterized, so you lose the option to reduce your tax cost via recharacterization in years when your investment goes down. More on #2 generally here:

http://archive.is/cH33G

Lastly, and more generally, you might consider separating your two financial decisions:

  • if you expect 15% is a low tax bracket for your situation and you have extra room in the 15% bracket, converting some of your pretax retirement accounts to Roth makes sense if you can afford the tax bill.

  • Separately, if you think your favorite stock is cheap, you may want to buy more of it. you can do that in your taxable account to get more exposure to its upside in the same way converting a pretax holding to Roth essentially increases your exposure by the 15% tax bill you pay. You can’t take the losses already incurred no matter what.

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It used to be that way years ago, but now you can do it directly if you want.

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Thank you for your responses. Let me be more specific.

I work for General Electric. I have a 401k which is invested in GE stock. Due to a number of life changes, my cost of living has plummeted this year. I live in New Hampshire which has no income tax on wages and work in Massachusetts, which does. I save as much as I can in the 401k and take the dividends as regular income to avoid Massachusetts income tax.

I have maxed out my 401k withholding. I have a Roth which I am depositing this excess income into.

We do have Roth option in our Retire Savings Plan, but I assume the contributions would be subjected to Massachusetts income tax.

This is something I plan to take up with Fidelity (who manages the Retirement Savings Plan), but I was hoping this discussion would give me something to look into until I can chat with a Fidelity CSR. The In-Plan 401(k) Roth Conversion is exactly what I was looking for. Thanks for the link.

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Not sure what you mean by this, but probably something due to goofy tax laws in Mass.

My advise would be to never use any Roth IRA/401k. Put everything into tax-deferred Traditional IRA and standard 401k. If you really wanted Roth money, then do an immediate conversion. In theory (I Am Not Your Accountant), the 401k/IRA will let you “defer” Massachusetts state income tax on contributions. And when you do the conversion, you do have to pay state income tax, but to NH, which has none, so it’s not state taxable.

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Besides the 10k Roth conversion, you can also take ~27k in capital gains from your taxable account tax free (up to the 15% bracket). The 27k is just the capital appreciation, so if you are realizing the gains on those lots with the smallest appreciation that you had for 1+ years, this could be 100’s of thousands to draw from every year.

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Agree w/ xerty above…you can take out original contributions anytime w/o tax or penalty. No 5 yr rule.
True it may not be a qualified distribution but that just sends you to F8606 where you compare you distribution against your original contributions and if you have not exceeded that limit,there is no tax.

Seems like IRS could have made this clearer with just a few words in Pub 590B (maybe they did but I couldn’t find them on a quick check).

was trying to do a quote from a prior reply but didn’t know how…

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