Thursday, July 5, 2007

Roth IRA Conversions as a Tax Timing Tool

"Observe due measure, for right timing is
in all things the most important factor."


- Hesiod


Nigel from Retire To India recently wrote a good article entitled Roth IRA Conversion During Early Retirement. The article describes the Roth IRA conversion process and explains the possible positive implications of conversions for early retirees. The article also links to the relevant portion of the Fairmark tax guide website, which is a great site for learning about most anything related to taxes on investments. For general background on conversions, I would refer you to the above article and to the Fairmark site. There is also a reasonably informative Wikipedia article on Roth IRAs.

While there are numerous articles on Roth IRA conversions, most of the writing tends to focus on the mechanics of the process, the specific tax guidelines involved, and the tradeoffs between a traditional and Roth IRA. Nigel's article is one of the few I have seen that explores how the timing of the conversion can benefit people in specific situations.

I would like to generalize upon Nigel's article by suggesting that Roth IRA conversions are an extraordinary powerful timing tool for taxes. While I'm not a tax professional, it occurs to me that most legal methods for reducing taxes mainly involve timing - shifting when the tax is imposed. While this doesn't sound as glamorous as some dubious scheme to create a big deduction, proper tax timing can actually make a fairly big difference in your net worth over time.

In order to understand why timing is important, it is necessary to recognize two basic things about the U.S. personal income tax code: (1) it is progressive; and (2) it is calculated on a periodic basis, generally a calendar year. Those with a quantitative background will immediately recognize that to minimize your total taxes - not just for a particular year, but for your whole life - you should time your income such that you are being taxed in the lower brackets as much as possible.

For those that are not so mathematically inclined, let me illustrate it visually, which is actually the way I think about it. Imagine that there are a large number of empty water glasses sitting on your desk. Each glass is labeled with a different year - 2007, 2008, 2009, etc. You have a large pitcher of water which represents your total income over your whole life. You pour water into each yearly glass representing when the income is recognized by the IRS. The size of each glass represents the amount of money you can earn that year before you start actually paying taxes at all (or alternatively, before you are in a higher tax bracket). The glasses are all different sizes because some years you have more deductions and credits than others. When you pour more water into a glass than it holds, the water spills onto the table, representing taxes you had to pay.

Your task is straightforward: Empty as much water from the pitcher into the glasses without spilling any on the table. (Translation: Time as much income as possible into lower brackets and against available deductions and credits without paying the higher rates.) As you visualize it, the idea should become clear: Never leave any glass unfilled if you can avoid it!

Unfortunately, income is usually not so easy to time because the general rule is that tax is due in the year that you worked for the income. For example, you can't simply wait until next year to cash your paycheck and defer the income that way. You also can't defer income by asking your employer to pay you next January for the work you did today. IRA and 401(k) plans are actually one of the few options that common workers have to legally shift the timing of when your income is taxed.

By making a pretax contribution to a 401(k) or IRA, you are choosing to pay taxes on the contribution when you later withdraw the money. By making a post-tax contribution to a Roth 401(k) or Roth IRA, you are choosing to pay taxes on the contribution now, in exchange for not paying any taxes on the future investment earnings of that contribution (so long as it stays in the account according to certain rules).

The general timing approach that a lot of people seem to take is to try to always defer whatever taxes they can. Intuitively this sounds appealing because you can pay later. However, this is not always the best idea. If you are in a higher bracket later, you could wind up paying more.

Conversely, you can't assume that a Roth is always the best deal either. As an extreme example, suppose you save ALL your money in Roth IRA and Roth 401(k) accounts. When you retire and start withdrawing money, you won't be taxed on any of the withdrawals, so you might think this was clearly the best choice. However, all those water glasses valued at $20K or $30K are sitting around unused. You've essentially wasted the tax credits and deductions for those years because you had no taxable income. This means you overpaid on your taxes - you could have paid less by originally contributing some to a traditional IRA or 401(k) and then withdrawing it during those retirement years that you otherwise would have had no income. In the end, your net worth would have been higher because you would end up not paying tax at contribution time (because it is deductible) and not paying taxes at withdrawal time (if your withdrawal income is fully covered by your tax deductions and credits).

This all brings us to what I consider one of the best tools for income timing: Roth IRA conversions. When you elect to make a conversion, you convert your IRA from traditional to Roth and the conversion amount is considered taxable in the year in which you make the conversion. Compared to the rest of the tax code, conversions are extraordinarily flexible, since you essentially get to pick the year you want the income to be taxed.

So what does all this mean to early retirees? It means a lot! The typical early retiree has a lot of flexibility and is probably more likely than average to:
  • Have accumulated a significant amount of tax deferred income (which can probably be timed with conversions)
  • Have accumulated a significant amount of money in taxable accounts (which can even out any cash flow issues with the conversions)
  • Own a home (which generates property tax deductions)
  • Potentially still have children living at home (which generates child credits)
  • Consider moving (to/from states with higher or lower tax rates)
  • Work for brief periods of time (i.e. second career, entrepreneurship, etc)
  • Have considerable flexibility and discretion with cash flow

An early retiree has a lot of years left to exploit conversions to minimize overall taxes. Each individual situation will be different, but here are a couple of scenarios that are likely to be common:

  • Lots of deductions. We own a house and have children. We also make substantial charitable contributions. Thus, we have a lot of deductions and credits. I calculate that we would pay no taxes at all on roughly the first $40,000 of income each year. After I stop working, this means it would be possible to very gradually convert all my 401(k) and IRA accounts to Roth by converting $40K each year. I might not end up paying any tax on all that income I saved in retirement accounts during my working years.
  • Moving to another state. If you've already decided you are going to make a conversion and you're also planning on moving to another state, then performing the conversion while you are in the lower tax state could save you a lot on state income taxes. For example, if you live in New York and are planning on moving to Florida, you would pay a hefty New York state income tax if you converted before you moved. If you waited until after the move, you wouldn't pay anything in state income taxes. (Florida has no state income tax.)
  • Working again for a brief time. If you decide to go back to work for a year, that would probably not be the best time for the conversion. In other words, if you're planning on not working the next year, waiting until next year for the conversion would likely make more sense.
  • Going back to school. If you are going back to school for a few years before starting a second career, you are likely to have no income for several years, followed by a lot of income again from your second pursuit. Don't let those empty water glasses go to waste during your school years! You might be able to convert tens of thousands of dollars each year without paying anything because your conversion income will be entirely offset by deductions and credits.
  • A severe market downturn. This idea is probably more controversial, but it could be useful in some limited circumstances. I don't advocate jumping in and out of the market, but attempting to time a Roth IRA conversion to the bottom of a market cycle is less dangerous than general market timing because you don't have to buy or sell anything - you just choose the tax year. The idea here is that if your IRA goes down sharply in a general downturn, you could benefit from converting when the amount is low and then letting it rise back up with the market tax-free in a Roth account. During the market meltdown of 2001-2002, I actually converted one of my IRA accounts that contained nothing but the Vanguard European Stock Index fund. (I balance my portfolio across all accounts.) I converted when the value was temporarily depressed and never sold anything. I paid far less in taxes than what I would have to pay now to convert, as the index has more than doubled since then.