Client Specific Roth Conversion Question

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Dec 28, 2009 3:17 pm

Client of mine rolled in a portion of his ESOP plan, and I'm thinking of suggesting a Roth conversion for a piece of it.


Client is widowed, 58, and retiring at 59 later in 2010.  Has total net worth of about $1.75 million, of which only $200,000 is non-qualified.  So there are a lot of future tax liabilities with his qualified money.  He has no debt and owns the house outright.  He plans on needing about $5,000/month gross.
 
So, I am considering recommending converting $100,000 to a Roth IRA, waiting at least 5 years to take income from it, and using $25,000 from the NQ account to pay the taxes in 2011 and 2012.
 
Would you guys make a similar recommendation given that he is within a year of retiring?  The taxes shouldn't change his tax bracket level.
 
I am having a tough time finding a calculator that includes withdrawals to present to the client. 
 
Any thoughts are appreciated, just want to make sure I'm not way off base here.
 
 
Dec 28, 2009 3:40 pm

Does he care about leaving money behind at death?

Does he have long term care insurance?
Dec 28, 2009 3:42 pm
anonymous:

Does he care about leaving money behind at death? Yes, if possible.

Does he have long term care insurance?  No.
Dec 28, 2009 9:27 pm

Snags, I'm having trouble understanding how his tax bracket won't change.  What is his current income?

Dec 28, 2009 11:29 pm
anonymous:

Snags, I'm having trouble understanding how his tax bracket won't change.  What is his current income?

 
Current income is around $70k filing as a single person.  At worst, he'll be bumped up from 25% to 28% if too much is converted.
 
But, he will be in the same tax bracket in retirement as he needs pretty close to his current income in retirement.
 
Also, not to say anyone can predict the future, but the Federal Income Tax Rate relief passed by the 2001 Congress is set to expire at the end of 2010.  I figure it will be easier for the gov't to just let it expire and implicitly raise tax rates than explicitly do so at this time.  So if he's at 25% now, he'll be at 28% anyways after 2010.
 
I guess I could also position it as a way to leave money to his children, or grandchildren if that happens. 
 
Just for the info, we put about $650k into various annuities with living benefits.  The idea is that in about 7 years from now, he'll have income from the annuities and SS to last the rest of his life, without taking money from other accounts to let it grow for his kids or whoever.
Dec 29, 2009 9:29 am
Bio, if I'm not mistaken, you have a tax background, so I'll assume that your tax knowledge is greater than mine.  Please explain how tax bracket is irrelevant.  I'm missing the irrelevance.
 
Ex.  Joe makes $350,000 a year.  He has $100,000 in a traditional IRA and is 30 years old.  He is thinking of coverting this to a Roth.  He is taking a year off of work in 2011 to travel the world. 
 
Isn't he much better off converting the IRA in 2011 than in 2010?
Dec 29, 2009 9:41 am
anonymous:
Bio, if I'm not mistaken, you have a tax background, so I'll assume that your tax knowledge is greater than mine.  Please explain how tax bracket is irrelevant.  I'm missing the irrelevance.
 
Ex.  Joe makes $350,000 a year.  He has $100,000 in a traditional IRA and is 30 years old.  He is thinking of coverting this to a Roth.  He is taking a year off of work in 2011 to travel the world. 
 
Isn't he much better off converting the IRA in 2011 than in 2010?



I think the rule is that you can spread the gain over three years if you convert in 2010.  Not sure.

Dec 29, 2009 9:50 am

It can be spread over two years 2011 and 2012.  Regardless, the point I'm trying to make/ the question that I'm trying to ask is that it sure seems like tax brackets do matter because the year in which one makes a conversion can have an impact on one's taxes especially if there is a great disparity in income between one year and the next.

Dec 29, 2009 12:57 pm
iceco1d:

Snags,

When you say "total net worth is about 1.75mm" do you mean he has investable assets of 1.75mm?  Or just his total net worth is that much (house, cars, etc.)?

 
Investable net worth (i.e. money I manage, which is everything).
Dec 29, 2009 1:03 pm
BioFreeze:

The tax bracket is irrelevant. Jumping to a higher tax bracket only taxes the amount that is in that bracket. I hope you guys aren't giving advice to real people. 

 
I understand the progressive system, which is I said that the tax bracket shouldn't be a problem.
 
It can be a problem for someone whose income is just under the 28% tax bracket meaning their full conversion will be in the 28% bracket and not the 25% one.  But, I don't really believe that 3% will stop the presses when considering a lifetime (and possible future lifetimes) of tax-free income.
 
And you need not worry, I only give advice to fake people, not the real ones...still can't figure out why my close rate is not 100%...
Dec 29, 2009 1:19 pm

Snags, based upon what you have posted, it appears to not be a good idea. 



If he converts, he'll be paying taxes of 25% on some of the money and 28% on some of it.  I agree that the extra 3% isn't huge.   What happens if he doesn't convert?
 
I think that you said that he needs $60,000/year.  Based upon the 2010 tax brackets and assuming that he has $0 in deductions and assuming that his NQ money will mainly get capital gains, he should use $34,000 from his IRA every year and $26,000 of his NQ money. 
 
The IRA money will only be taxed at about 11% (0% on the first $8375 and 15% on the amount between $8375 and $34,000).  If he has more deductions, he can use more of his IRA money.
 
There isn't a big difference between 25% and 28%, but there is a big difference between 11% and 28%.
Dec 29, 2009 1:42 pm

anon - you're assuming no social security (only 85% of which will be taxable) The guy has probably maxed out SS and will likely be drawing two grand a month in the very near future reducing the amount he must w/d from investments(ignoring inflation). In the end, I think it still makes sense to have a bucket of money to draw on tax free to prevent crossing into some future tax bracket yet seen.



I wish all my clients had such moderate expectations of income.

Dec 29, 2009 1:54 pm
Incredible Hulk:

anon - you're assuming no social security (only 85% of which will be taxable) The guy has probably maxed out SS and will likely be drawing two grand a month in the very near future reducing the amount he must w/d from investments(ignoring inflation). In the end, I think it still makes sense to have a bucket of money to draw on tax free to prevent crossing into some future tax bracket yet seen.

I wish all my clients had such moderate expectations of income.

 
Yeah, you're right Hulk.  When he's 60, he'll be eligible for his deceased spouse's SS, which will be close to $2k/month.  So really, ignoring taxes, we'll only have to withdrawal about $36k/year.  Eventually at some point he'll be able to switch over to his own SS.
 
I wish all clients were like this, but bottom line, he was a good saver with a modest lifestyle.
Dec 29, 2009 2:16 pm

I am assuming lots of things.  The point that I'm trying to make is that to whatever extent that he can use his IRA and still have it be in a 15% bracket, it's better than converting it and paying 25-28%.

 
Snags, if he's healthy, you've got a big life insurance case staring at you.
Dec 29, 2009 2:42 pm
anonymous:
 
Snags, if he's healthy, you've got a big life insurance case staring at you.
 
Seeing how I don't have a background in LI, what would you recommend, generally speaking of course, in a situation similar to this?  I'm just curious.
Dec 29, 2009 3:04 pm

There's not enough info to really answer your question, but I'll take a guess.  Based upon what you have posted, his #1 goal is to live comfortably for the rest of his life.  His 2nd goal is to leave money behind if it doesn't impact his first goal.

 
He has enough money without social security to accomplish his first goal.  He could take some of his social security money and purchase a life insurance policy.  A $1,000,000 GUL policy would probably cost in the neighborhood of $15,000/year.  This would mean that even if he spends all of his money, he'll still be leaving a $1,000,000 income tax free legacy. 
 
Doing this will also allow him in the future to purchase a SPIA that is only based upon his life expectancy.  This will give him a greater income than he can safely take out of an investment.  It won't matter that the insurance company keeps the money if he dies the next day, because his beneficiaries are still getting the $1,000,000.
Dec 29, 2009 3:15 pm

Here's another life insurance tact.   Go with a WL policy and do it as a 10 pay.  He can do it with a $2,000 month premium that he'll get from SS.  It will be about $350,000.  If he dies soon, his beneficiaries will get all of his money plus the SS.  After 10 years, the death benefit should be above $400,000, but there would be no more premiums, so he can spend the SS money.  In 20 years, the death benefit should be over $600,000.  At age 90, if he has run out of money, his insurance policy should have over $750,000 in cash if he needs it.

 
The insurance policy structured in this manner will allow him to leave more money behind at death while ultimately having no negative impact to him.
Dec 31, 2009 7:00 pm

Don't forget the nice aspect of the Roth: no forced w/drawals RMD. I think the idea has merit due to low NQ %