Gyroscopic Investing

I'd appreciate tapping into a bit of wisdom from some of the more tax planning and accounting-savvy folks here.

Let's say I have a 401k or IRA, I'm 60 years old, and I take distributions. I understand that these distributions are taxed at your income tax rate, but how is this income tax rate determined? What if you've stopped working and you have no taxable wage income? Does the money from the distribution count as taxable income for the purposes of determining what rate it's taxed at? Or is your tax rate automatically the lowest one? And does your state income tax apply to this too?

Next, what about if you do a roll-over into a Roth IRA? Is 100% of the rolled-over money taxed? And is that rate determined in the same way as for distributions?

Basically, I'm trying to figure out if I can get a huge tax savings by doing a rollover at a time when I have no taxable income. Right now I'm avoiding a ?35% tax rate by contributing to tax-deferred accounts. If I can roll this over into a Roth IRA at a much lower tax rate (maybe even 10%; the lowest federal rate) by doing it when I have no income and maybe even am living in a state with no income tax, I would be a happy man. 

Pointedstick wrote: Let's say I have a 401k or IRA, I'm 60 years old, and I take distributions. I understand that these distributions are taxed at your income tax rate, but how is this income tax rate determined? What if you've stopped working and you have no taxable wage income? Does the money from the distribution count as taxable income for the purposes of determining what rate it's taxed at? Or is your tax rate automatically the lowest one? And does your state income tax apply to this too?

It's treated as income to determine your tax rate.  So if I have zero income elsewhere, I can distribute (or convert to a Roth) income at an abnormally low tax rate, maybe even zero... but don't convert the whole damn thing, because you'll push yourself into higher brackets.

So you are very right, except you have to be careful.  It's a moving target! I'm definitely a fan of doing conversions in low-tax-rate years (I'm actually in one now, and am doing a modest conversion), but you can't just do massive ones... they actually affect the bracket you're in if they're too big.

Thanks a lot, moda. How do you do a partial conversion? Is it as simple as just transferring a bit of 401k/IRA income into an existing Roth IRA? Do you have to sell assets and move the cash, or are the assets themselves transferred into the Roth IRA?

And is this all taxable at the state level too?

This is all still taxable at the state level same as federal.

401(k)'s can be difficult. You'll want to contact your plan provider.  Usually I sell the assets and THEN do the conversion.  The other way involves more paperwork.

For 401k to Roth IRA, my understanding is you do a rollover from the 401k to a rollover IRA at no tax penalty other than gains. Then you could rollover smaller portions from your IRA to a Roth whenever you want, paying the full tax penalty.

Note that this is a loophole that lets high earners get into a Roth and at amounts well in excess of $5000. I fully expect this to be fixed. The Beast is ever hungry and huge sums of money is being locked away out of reach. Simply look at HSA's for an example of how much the government cares to let even small amounts of money escape taxation. 

It's not a loophole.  Roth conversions are simply trading tax shelter A (pretax) for tax shelter B (post-tax).

Rich people can contribute $17k per year to Roth 401(k)'s.  It's not really a loophole that they can sneak money in by converting their 401(k).

It is a loophole because high wage earners aren't supposed to have access to "tax shelter B."  Federal law specifically prohibits high wage earners from contributing to Roth IRA's.  The fact that they can get around this by daisy-chaining rollovers is a blatant loophole.  If this weren't a loophole, there would be no prohibitions against making the same measly $5,000 per year Roth IRA contribution as those of us in the poor house.

Don't get me wrong, I don't think they should be prohibited from utilizing Roth IRA's in the first place.  But I expect this particular method to be closed, at least for high wage earners.

Well the rules are so different for each type of account that I  don't think you an really call it a loophole.  If congress really cared about people being phased out of the Roth, they would t allow Roth 401k's.  Further, the phase-outs for traditional IRA's are even lower than Roth's, so one could say that "tax shelter A" is actually even more prohibited.  Where I think the loophole comes in is that the IRS is trying to limit people to only the $17k 401k space, and the Ira accounts, whether traditional or Roth, are effectively increasing the size of that shelter by about 30%.

So it's more about the size than the type of shelter... IMO.... But then we have SEP's with $50k limits so there really is not enough consistency to identify where a loophole even is.