My Mega Roth Conversion: a $212,000 mistake?

Prior to 2010, Roth conversions were off limits to most physicians or anyone else with six-figure income. In 2010, the rules changed and the $100,000 AGI limit was eliminated.

The prevailing thought was that there would be a one-year window in which high earners could legally do a Roth conversion. From one of the many articles on the subject from back then:

 

“2010 is the only year that this exception is allowed. Starting in 2011 (unless congress changes it), it reverts back to the original way where all the tax is owed in that year.”

 

My Mega Roth Conversion: a $212,000 mistake?

 

Guess what? Our federal government liked the tax revenue from all the 2010 conversions so much that the AGI limit was lifted permanently (for conversions only).Fox & Company CPA

Of course, I didn’t know that was going to happen. I will also admit to being a personal finance novice at the time. I knew that Roth money was good money and I wanted more Roth money. So I filled out some paperwork and converted our traditional IRAs and my SEP IRA. I wasn’t going to let that one year window pass me by!

Let’s talk numbers. My wife and I had traditional IRAs worth a combined $36,000 ($30,000 of which was tax deferred, with $6,000 in non-deductible contributions). The SEP IRA, after 5 years of tax-deferred contributions of $25,000, $45,000, $45,000, $49,000, and $49,000 had grown to $242,000.

To convert the whole lot to Roth, I had to pay income taxes on $272,000. There was a provision (which no longer exists) to spread the tax pain over the following 2 tax years, so we took advantage of those interest-free loans. The conversion was made in 2010, but the taxes were paid in 2012 (2011 return) and 2013 (2012 return).

In 2012, with the addition of $136,000 of “income” from half of the conversion, we paid an extra $53,557 in federal and state income tax. If that $53,557 had remained invested in an S&P 500 fund, we would have seen a 114.2% return from April, 2012 to January, 2018 according to the S&P 500 Dividends Reinvested Price Calculator. That money with four years of 12.2% annualized returns would be worth $113,000.

In 2013, we similarly added $136,000 to our taxable income on the 1040. The $53,577 we paid in 2013 would have grown 85.1% in three years, a 14.1% annualized return. Had we not paid the tax, we would now have $99,000. Thank you, bull market!

 

In summary, our calculated net worth would be $113,000 + $99,000 = $212,000 higher today if I hadn’t made the Roth conversion in 2010.

 

big chainsaw bear

i don’t often enjoy bear markets, but when i do…

 

Have I made a huge mistake?

 

This is not a simple question to answer. Yes, our net worth would be a larger number if I hadn’t made the conversion. But now I’ve got a lot more of that good Roth money that will (presumably) never be taxed again. More than five years have passed, which means I can withdraw the entire $278,000 penalty-free and tax-free. Not that I would, but I could.

 

What would it cost to convert today?

 

In the 7-plus years since making the conversion in October of 2010, the S&P 500 is up 161%. The $272,000 invested in the S&P 500 would have grown to $709,000 (not precisely because my Roth holds different asset classes including REIT, small cap value, and emerging markets).

Let’s call it $700,000 today. If it were still in the tax deferred IRAs, to convert it all, I’d be paying the tax bill in one year rather than two. Converting $700,000 at once with a high-income in a high tax state would create a tax bill well over $300,000. Ouch!

 

 

Is there a better way to make Roth Conversions?

 

Yes! Wait until you’re retired (particularly if you plan to retire early). You can convert smaller chunks one year at a time when you are in lower income brackets. A good strategy is to fill the 12% bracket, and perhaps the 24% bracket with Roth conversions. Play around with tax software and see what works in your situation.

Making annual conversions to Roth will build a so-called Roth ladder, which is a great strategy to access your 401(k) / IRA money prior to age 59.5. Converted assets can be accessed tax and penalty-free after it has seasoned in the Roth for 5 years (technically January 1st of the year 5 years later, so closer to four years if you convert late in the year).

gob and his huge mistakes

So, did I make a huge mistake?

 

We make the best decisions we can with the knowledge we have at the moment. When I was 35, the thought of an early retirement hadn’t crossed my mind. I thought 2010 would be my only opportunity to get my hands on more Roth money, before going back to many years of adding $50,000 a year in tax deferred retirement savings.

Knowing what I know now, having my eye on an early retirement, if I could fire up the flux capacitor and go back in time, I would advise my younger self not to make those conversions. “There will be time to make those conversions in a lower tax bracket when you’re early retired”, I would say. While in hindsight, it was probably not the best decision, I did the best I could with the information I had at the time.

 

back to the future delorean

doc, could i borrow your ride?

 

The good news is I’ve since become an employee, and have been building up some tax deferred retirement savings. The 457(b) will be part of our drawdown strategy to help fund our monthly expenses in early retirement. The 401(k) will be rolled over to a traditional IRA, and year by year, slowly converted to Roth. I’ll still be able to take advantage of those Roth conversions in much lower tax brackets down the line. Unless the rules change. Again.

[note: this post was originally published in 2016, but updated in January, 2018]

 

Did you take advantage of the “one-time opportunity” in 2010? What would you have done in my situation? Would you say I made a huge mistake?

 

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36 comments

  • Anonymous

    You made the right choice…bill at that tax bill at that time would have given me an AMI! I pondered this question with a traditional IRA I have from an old 403b. That’s great advice to wait. Your info is awesome, Thank you,

    • I’m glad you think it was the right choice. I think it was at least a reasonable choice, and not necessarily a huge mistake. I did when the Pease provision had been phased out, and before the ACA taxes kicked in. Taxes were high, but they would be even higher today. Of course, as I’ve said, they will be lower in early retirement. Thanks for your thoughts!

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  • The Green Swan

    I would have only been about 24 at that time so no, I didn’t take advantage of it but I specifically remember my Dad doing so. At the time nobody would have risked not taking advantage of the conversion. You didn’t make a bad choice, hindsight is 20/20 and it’s just one of those things out of your control. Thanks for the post PoF!

    The Green Swan

    • Thank you, Green Swan. As you say, hindsight is 20/20, which is why I don’t beat myself up over this or for not buying Apple or Microsoft when they were just getting started (or any individual stock since I don’t own any). It’s easy to pick the winners and make the right call when looking backwards. Looking forward, it’s not that easy, unless you’re Biff with Marty McFly’s Sports Almanac.

      Cheers!
      -PoF

  • I think the key to your post is when you said:

    “We make the best decisions we can with the knowledge we have at the moment.”

    That’s all we can do. The good news is that your money will now be tax free when you take it out, so that will be one less thing to have to even think about down the line.

    — Jim

  • Sergey

    Without doing the conversion of trad. IRA, backdoor Roth IRA would be out of the question- or else would be taxed on the converted amts. Also, from what I remember, 2010 was not a particularly onerous year for taxes(certainly there was not added Obamacare tax)

    • True and true. The Pease provision wasn’t in effect in 2010, nor was the ACA tax, plus I lived in a lower tax state than I do now.

      I was able to circumvent the pro-rata rule when I became an employed physician by rolling several years worth of post-2010 SEP-IRA money into my employer’s 401(k). So I’m once again eligible to do the Backdoor Roth.

      Thanks for the input, Sergey!

  • Yeah, I did this too, although with smaller numbers. Taxes the next two years were painful indeed! Knowing my plans now I think it was probably a mistake but hindsight is always 20/20 😉

  • gxa

    I did the same as you did, with about the same amount. My post conversion funds have grown as yours have, and I have also built up a significant amount in a new 401k since then, so will be able to take advantage of maxing out the lower tax rates with future conversions.
    Converting when the Dow was down has allowed all of that to grow without having to be taxed again. And adding that income without the Pease provision was important for us as we had a big property tax bill that year (long story). The other huge benefit is the lack of RMD on the Roth accounts.
    Still happy I did it.

    • Glad it worked out for you. I should have plenty of tax deferred dollars built up again by the time I retire, even if that is as soon as 5 years from now at age 45.

      I’m not entirely convinced it was the right thing for me to do, but most opinions are that it was, and I’ve not harboring any regrets.

      Best,
      PoF

  • I contemplated the same for my IRA but decided not to. We pay about 45% in combined marginal taxes today and plan to pay only 15% federal and no state taxes in retirement due to move to zero-income state once we retire. We invested the money we would have spent on the tax bill in equities and that amount has grown to an amount multiple times over what we will pay in taxes once we take RMD.
    I am also worried about politicians finding a way to tax Roths in the future. You never know.

    • Indeed. Every year, there are rumors and proposals for changes to Roth accounts that never get off the ground.

      I don’t fault you for making the informed choice that you did. I might choose differently if I had a flux capacitor.

      Cheers!
      -PoF

      • Of course there’s also the risk that marginal taxes go through the roof and nothing is changed with the Roth so everybody who did the conversion is looking golden. Who knows?
        Definitely what helps you is that you got an interest free loan to pay the taxes due with a delay and the market did pretty well during that time. So doing the conversion back then and having the peace of mind of no taxes might have been worth it.

        Nice blog! Found you through Mr and Mrs Pie’s blog!

  • Slightly off topic, but maybe of interest to you and some readers: What to do if you like to contribute more to a Roth out of your taxable account wealth but you can’t because you max out the $5,500 ($11,000 for married) every year already? Create a synthetic Roth in a taxable account:
    https://earlyretirementnow.com/2016/06/07/synthetic-roth-ira/

  • PoF asked me to post a recent email I sent to him on this blog post:

    >>I believe you made an incredibly good decision, not the (possibly) huge mistake you wrote about.

    Here’s what I see:
    • You paid $107,114 in taxes on the conversion. Your Roth IRA (at time of post) was up 91%. The net effect was that the government allowed you to “convert” $107,114 from a taxable account to a Roth account.
    • Given that, you “invested” $278,000 + $107,114 = $387,114. Your balance at time of writing was $532,000, or up 37% (actually higher because the tax payments were made 2 & 3 years later).
    • In addition, all of the growth on the tax payments that w/h/b taxable gain is tax free and you would owe taxes on all gains in the taxable account. All growth is now utterly tax free.
    • Of course, that’s assuming you had actually invested the money in your taxable account rather than doing something else with it (as most people would have done), including letting it sit there.
    • Sure your heirs would have gotten a stepped-up basis at your death if you had left the account to grow, but you’ve permanently stepped up your basis with the conversion.

    How could that be a mistake? I think there is no question that you made the correct decision. There is also no question, in my mind, that the stars aligned for all equity investors who converted to Roth IRAs in 2010, right after the bear market of 2008-2009. I can tell you that we have some very happy clients!

    Must heartily disagree with your recommendation under “Is there a better way to make Roth Conversions?” No better time to convert than during a bear market, no matter your age.<<

    Thanks for asking me to post this – here's to creative planning!

    • PhysicianOnFIRE

      Thank you for the in-depth analysis, Johanna.

      That’s the best part about airing my soiled laundry on the internet; I get great feedback like this. It’s looking more and more like I made a good call with the Mega Roth conversion.

      Cheers!
      -PoF


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  • chau

    should my husband do the roth ira backdoor since he doesn’t have an existing IRA but I do? And avoid the mega roth conversion?

  • Kevin Pritchard

    Thanks for a great article! My wife and I are entertaining the thought of a similar move and wanted to get your thoughts on it.

    My wife recently retired so she could spend more time with our young children. She has a traditional 401k of about $250000. We are leaning towards just leaving it with the current company MassMutual. There is an annual asset charge of 0.15%. The money is divided amongst various Vanguard funds so the expense ratios are fairly minimal (0.04% – 0.08%)

    The vast majority of our net worth is in taxable accounts through Vanguard. We both also have backdoor Roth IRAs at Vanguard. We were contemplating a Mega Roth conversion like you did as an alternative to keeping the money at Mass Mutual.

    Reasons we are leaning towards NOT doing the Roth conversion:
    1) My income still puts us in the highest tax bracket
    2) I don’t plan on retiring early, I enjoy my job and hope to work into my 60s (and if I’m healthy and happy enough), perhaps into my 70s

    Would you also recommend foregoing the conversion? Thanks!

    • The only reason to convert to Roth when you’re currently in the highest tax bracket is if you think you’ll be in an even higher tax bracket when you are forced to take RMDs. If the vast majority of your net worth is in taxable, I doubt your RMDs will put you in the same tax bracket, and a higher one doesn’t exist, at least not yet. I don’t know your entire financial picture, but based on what you’ve told me, I’d be comfortable leaving the money in the low-fee 401(k) for now.

      Best,
      -PoF

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  • I don’t consider this a mistake, PoF. You made a calculated decision which you now are concerned might not generate the absolute maximum value. Stop it!

    That is as crazy as trying to time a market top! The tax law changed; it will change again. Back then I recommended clients bifurcate their choice because insiders strongly suspected this might become permanent. No matter what happened I was half right, but only half right. (Is 50% a passing grade now?)

    I don’t like paying tax up front, but the younger you are (the longer the money stays invested) the more time the tax free growth will mitigate the effects of the up front tax bill.

    Also, you mentioned the easier access to the money now. Hard to put a value on this, but it is valuable if the need for funds ever arises.

    I like what you did here, PoF. You made your readers think about a serious tax issue. A lot of money is/was involved and you made a decision. Every reader you have should learn from your lesson.

    Back to your regular programming.

    • Thank you for taking the Twitter-bait and weighing in, Keith!

      It seemed like the right choice at the time, and has left me in an enviable position with a large Roth stash that has more than doubled in the interim. It’s tough to complain about that, but with the benefit of hindsight, OK, OK… I’ll stop now.

      I like how you approached it. I often suggest a similar strategy for windfall recipients wondering if they should lump sum invest or dollar cost average their pile of cash. It’s such a common question on forums and I like to point out that it’s not a binary question. You can do both — invest half now and DCA the rest over 6 to 12 months. Hedging that bet gives you a hybrid between the two potential outcomes. Just like your recommendation. Great minds…

      Cheers!
      -PoF

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  • Gasem

    You didn’t plan out the end game or you would be clear you made the right decision.

    Put the presumed value of your IRA into this calculator

    https://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/ira_calculators/rmd

    You will get a pretty clear estimate of what your RMD is going to be. SS is taxed at 80%. So RMD + .8*SS Is what your going to be taxed. My taxable SS is $33,600 at age 70. If I had a $2,000,000 tIRA/401K at RMD I would start withdrawing $73,000 for a taxable income of $106,600 which is already into the 22% bracket. Notice this is your minimum taxable income. It is the income you HAVE to take and be taxed on. In 10 years your RMD would be $120,000 and your taxable SS would be $41,000 (at 2% growth) for a taxable income of $161,000 barely on the limit of the 22% tax bracket. The next year you will be in the 24% bracket at $168,000. Your married filing jointly tax bill is $23,000. Now a spouse dies. The next year the required income is $180,000 BUT the tax explodes into the 32% bracket at $35,000 REQUIRED to be paid to the feds. This analysis only looks at one SS income and one RMD so it stays apples to apples. What this analysis says YOU MUST Roth convert if you don’t want your life’s work to unduly enrich the government. The government is hoping to cash in on your miracle of compounding. I have nothing against paying my taxes but by Roth converting you are limiting the amount of compounded taxes you pay. I made a spread sheet and calculated it takes about 10 years for the up front Roth tax bite to pay for itself once RMD kicks in, and it’s MUCH sooner if one of the spouses dies. If you are used to a say $10,000 a month lifestyle the loss of one spouse does not contract into a $5,000 a month lifestyle, maybe more like $8,000, but the taxes go up dramatically bringing you to approaching a $10,000 lifestyle. The government becomes your new spouse.

    I’m trying to decide how much of my tIRA to unload right now and what would be the most efficient way. My solution is to sell some post tax stock and mix it with some LTcap loss for a 0% tax bill to raise the tax. During the next 4 years I’m going to Roth convert about $1,360,000 (341,000/yr) which will take me to the top of the 24% bracket for an effective tax rate of 18% on my converted money. The Roth grows to $1,900,000 during the conversion and continues o.n tax free from there. There will still be some money in the tIRA that will be liable to RMD but it will be taxed at a far lower rate likely only 8% effective including SS.

    So your Roth conversion will eventually pay off but you won’t realize the payoff till after you RMD or somebody dies.

    • All true, but if I had known I would be in a position to retire early and that the tax brackets would be lowered, I’d be able to make those Roth conversions over a number of years. Of course, I couldn’t have predicted those things back in 2010.

      I will have some 401(k) money to rollover into an IRA and convert to Roth over the years, though.

      Best,
      -PoF

  • Gasem

    I’m mostly saying that there is a significant kind of “hidden cost” to not converting due to bracket creep besides doing a simple future value calculation and comparing state 1 to state 2. I wanted to try and demonstrate that. I think this is an important FIRE topic and thought this something to add.

    Certainly there are many paths that smooth the conversion and it depends on how you intend to spend/not spend the Roth. It’s like doing a Riemann sum with smaller and smaller overshoot. Unfortunately my N=4. I didn’t do it sooner because my effective tax rate was closer to 30 cents on the dollar for conversion. That pushes the break even to over 20 years. My original calculation was to spend down the IRA so it threw off an amount keeping me roughly in the 12% bracket but I did the (married /single) calc and it became clear it was a better idea to just convert the majority as efficiently as possible before RMD. The other thing I like about a Roth is it’s indifferent to dividends whereas I’ve always constrained my taxable money to being tax efficient.

      • mrhouseholdcfo

        Gasem,

        Do you have a spreadsheet that you used for this analysis? I’d love to see it if possible and dig in more.

        I also did this conversion like PofF. I think it was the right call, although I was also surprised when the conversion door wasn’t closed after the 1 year reprieve.

        I’m still struggling with why the FIRE community seems to hate the Roth. I have been using my Roth 401K option as a way to build up more Roth dollars and have been debating whether I should do conversions of my non-deductible IRAs (they have a mix of appreciation, non-deductible contributions in them). The advantage of avoiding RMD, passing on to next generation, and being able to fund a much higher annual lifestyle while keeping the tax chunk of retirement expenses at a lower level seems appealing to me despite the fact that my tax bracket will probably be lower in retirement (but not as low as many in the FIRE community) are aiming. But I’d love to analyze it more rigorously.

  • Ryan

    I also completed a Roth conversion of an old 401k that I rolled to an IRA in 2010, and spread the taxes out over 2011-12. It was for less money ($75k) but my time horizon is also long (completed it when I was 30yo), I am expecting to accumulate several million in nest egg and will have significant RMDs, and hope to retire early and so can appreciate the additional flexibility of Roth for early withdrawal or estate purposes. I still think it was the right decision, even if the timing has proven to be not so once-in-a-lifetime. Appreciate the discussion here, but not losing sleep over how the math works out…

  • mrhouseholdcfo

    The bigger question that all this is starting to raise for me is whether doing a non-deductible IRA is worth it if you are not converting regularly to a Roth through a ladder? I had not previously focused on the fact that the gains are taxed at ordinary income. For certain professionals, I wonder if a capital gains, tax efficient taxable portfolio actually is more attractive vehicle (no RMDs, taxed at long term capital gains rates, allows for tax harvesting, can access any time without penalty, etc.) versus putting it into a non-deductible IRA, where there’s no upfront tax benefit. Has anyone analyzed where the break-even is on that? Also, has anyone played with the Roth conversion ladder but not one that assumes the zero tax game (i.e., balances to convert more substantial, no head room in lower tax bracket rates for those conversion dollars because of higher annual expenses to fund in retirement, other income sources, etc.)?

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  • Raj

    I think I have the same problem you did (though not those amounts thank god!). I currently have ~10K in my employer 401K (all pre-tax) and ~50K (all pre-tax) in a IRRA (rollover retirement account; this is like a traditonal IRA but has money from previous employer 401Ks in it). Now say I start contributing to my current 401K and by the end of the year I have ~25K in it (10K current pretax + 10K future pretax + 5k aftertax); in short 80% pretax and 20% after-tax money in the 401K and 93.33% pre-tax and 6.67% after-tax money if I include my IRRA as well.
    Now if I decide to do a 25K rollover on 01/01/2019 from my 401K:
    1. can I transfer 80% of it to my existing IRRA and 20% to a new Roth IRA without tax consequences (assume no gains)? or do I have to transfer the money from the 401K and the current IRRA into a new IRRA and a new Roth IRA in the same proportion?
    2. If the latter, would I violate the one-rollover-per-year rule?

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