Looking for the magic formula for Roth conversions vs RMDs

[Curmudgeon]

Quote:

Originally Posted by omni550 ilikestartrek, My tax guy strongly advised against the huge Roth conversions suggested by i-orp. His comment being, "My philosophy has always been don't pay taxes any sooner than you need to."

Are the people that say this dumber than us, or smarter? Serious question. Of course all things being equal I'd rather defer; but if I'm pretty sure it's a choice of 15% of X now, or 25% of X (in constant dollars) later, the former is going to be better. Does the tax guy see something we're missing, like a good chance that taxes (or the taxable amount!) will go away? What is the logical basis for such a statement?

(My gut agrees with him - I hate to intentionally pay extra taxes now by doing conversions, but this is one of those cases where my brain is saying "Don't listen to your gut!")

[omni550]

Quote:

Originally Posted by Curmudgeon Are the people that say this dumber than us, or smarter? Serious question. Of course all things being equal I'd rather defer; but if I'm pretty sure it's a choice of 15% of X now, or 25% of X (in constant dollars) later, the former is going to be better. Does the tax guy see something we're missing, like a good chance that taxes (or the taxable amount!) will go away? What is the logical basis for such a statement? (My gut agrees with him - I hate to intentionally pay extra taxes now by doing conversions, but this is one of those cases where my brain is saying "Don't listen to your gut!")

I have no idea if folks like that are smarter or dumber. He's a baby boomer and is still working...we're not.

There used to be a local fee-only financial guy who had a weekly column in the newspaper as well as a weekly radio show. He used to say something like, "don't let the tax issue wag the dog" and "if i'm paying a lot in taxes that must mean I've made a lot of money."

Nonetheless I prefer to minimize taxes paid if possible.

---

The i-orp calculation with unlimited Roth conversions was giving me heartburn due to the huge-to-me income taxes involved. And there's no guarantee that somehow Roths won't be means-tested down the road.

omni

[pb4uski]

Quote:

Originally Posted by Curmudgeon Are the people that say this dumber than us, or smarter? Serious question. Of course all things being equal I'd rather defer; but if I'm pretty sure it's a choice of 15% of X now, or 25% of X (in constant dollars) later, the former is going to be better. Does the tax guy see something we're missing, like a good chance that taxes (or the taxable amount!) will go away? What is the logical basis for such a statement? (My gut agrees with him - I hate to intentionally pay extra taxes now by doing conversions, but this is one of those cases where my brain is saying "Don't listen to your gut!")

It depends. If I explained that I can pay 10% now on Roth conversions or 22% in 8 years and he still says it is better to pay 22% later then IMO he is dumber than a rock.

[CRLLS]

There are a lot of moving pcs and a lot of guesses that have to be made. Estimating investment earnings, ACA subsidies, IRMAA, and more. Not the least is: what happens in 2026 with tax rates. It is enough to cause analysis paralysis.

It is similar, in some manners to the question of when to take SS. You can come up with a definitive answer but once reality deviates from the assumptions, all bets are off.

In the end, I think most will take a leap of faith and go with their gut feel.

We were in the same boat and felt we needed professional help. We paid to have a 20 year financial plan created for us by a FP. In the end it was clear that despite the fact there was less taxes being paid with a Roth conversion, there was more money in our accounts if we didn't convert. I asked if the taxes for the conversion was simply added vs looking at the time value which he said that was a good question and he should add that to his evaluation. This would, in my estimation, show less of a benefit in the taxes-paid comparison.

Everyone's situation is different their financial starting point, their goals, and their comfort level. Good luck in your quest.

[Scuba]

Quote:

Originally Posted by Curmudgeon Are the people that say this dumber than us, or smarter? Serious question. Of course all things being equal I'd rather defer; but if I'm pretty sure it's a choice of 15% of X now, or 25% of X (in constant dollars) later, the former is going to be better. Does the tax guy see something we're missing, like a good chance that taxes (or the taxable amount!) will go away? What is the logical basis for such a statement? (My gut agrees with him - I hate to intentionally pay extra taxes now by doing conversions, but this is one of those cases where my brain is saying "Don't listen to your gut!")

I was thinking about this and there is definitely time value of money to be considered. Paying a lot of taxes now to avoid potential taxes later may not pay off in the long run. Depends on the opportunity cost of how much return you’re giving up by paying taxes now that you otherwise wouldn’t have to pay for many years.

I share the OP’s interest in finding a tool that will help us optimize all of the various factors. Tried i-Orp but didn’t yet get it to process our input. Going back and forth on email with them to try to resolve the issues. Apparently we have some unusual sources of inflows that their model doesn’t typically accommodate.

The good news is that we have a lot of options on what to rely on for cash flow at what point in time. The bad news is these options create a lot of complexity and make it difficult to select what is truly the most optimal solution that should maximize the value of our portfolio over our lifetimes net of tax, Medicare costs, etc.

As a practical matter, we haven’t had to worry about it yet because our tax bracket has still been relatively high so it hasn’t made sense to convert. That may change in 2018. May be time to get a pro to help us model this.

[Human]

I agree with @Scuba that one has to factor in the loss of growth on the dollars that would be used to pay taxes due to the conversion.

Anyway, I’ve spoken with CFPs and CPAs in the past about conversions. I’d go in excited and leave having learned that the factors are complicated, so much is unknown (what will the future tax laws be, for example), and/or conversations wouldn’t benefit me.

Still, every year I still consider a Roth conversion as part of my end of year process...and every year I kick the can down the road.

[growing_older]

Quote:

Are the people that say this dumber than us, or smarter? Serious question. Of course all things being equal I'd rather defer; but if I'm pretty sure it's a choice of 15% of X now, or 25% of X (in constant dollars) later, the former is going to be better.

If you expect to have any IRA assets in your estate, there is an additional complication of tax rates for your heirs. Roth IRA assets are tax free to heirs but Trad IRA assets are taxed at the heir's tax rate, possibly requiring RMDs on their own accelerated schedule. If your heirs are in their peak earning years, this could be their highest tax rate.

[RunningBum]

You don't have to guess on the effect of growth and taxes, you can use math and assumptions to figure it out.


It's been years since I've done it but run a spreadsheet of $10K in a tIRA, and $10K in a Roth with taxes from the conversion paid from outside the Roth. Figure in a growth rate for both accounts, and also for the money from outside that would keep growing in the non-conversion case. Then figure taxes on liquidation of the tIRA, and on the growth in the outside account that you didn't have to use to pay taxes. There will be no taxes on liquidation of the Roth for the conversion case.


Assuming the conversion and liquidation tax rates are the same, or higher on the liquidation, and you use the same return on investment on the accounts, the Roth conversion will come out ahead. If the tax rate on the liquidation is lower, it's likely that you shouldn't convert.

[CardsFan]

Quote:

Originally Posted by RunningBum You don't have to guess on the effect of growth and taxes, you can use math and assumptions to figure it out.

Isn't an assumption the same as a guess?

[pb4uski]

Quote:

Originally Posted by Scuba I was thinking about this and there is definitely time value of money to be considered. Paying a lot of taxes now to avoid potential taxes later may not pay off in the long run. Depends on the opportunity cost of how much return you’re giving up by paying taxes now that you otherwise wouldn’t have to pay for many years. ....

Not really.... it is differences in tax rates that is the more important determinant.

An example if the tax rate is the same with the time value of money. Let's say someone has $100k and is subject to a 15% tax rate now and later and the assumed investment earnings rate is 7% and time horizon is 10 year.

If they convert now, they start with $85k in their Roth after paying taxes and in 10 years that $85k grows to $167k.

If they don't convert now, their $100k tIRA grows in 10 years to $197k.... if they withdraw it an pay they tax they have $167k.

If you run the same scenario but starting with a $100k tIRA and $15k in after tax funds to pay the taxes, the convert scenario ends with a value of $197k and the not convert scenario ends with $194k... with the slight difference due not to the time value of money but due to taxes on the taxable account earnings (the $15k in taxable funds grows to $27k at the after-tax earnings rate of 5.95% [7%*(1-15%)].

[Cobra9777]

Quote:

Originally Posted by pb4uski Not really.... it is differences in tax rates that is the more important determinant. An example if the tax rate is the same with the time value of money. Let's say someone has $100k and is subject to a 15% tax rate now and later and the assumed investment earnings rate is 7% and time horizon is 10 year. If they convert now, they start with $85k in their Roth after paying taxes and in 10 years that $85k grows to $167k. If they don't convert now, their $100k tIRA grows in 10 years to $197k.... if they withdraw it an pay they tax they have $167k. If you run the same scenario but starting with a $100k tIRA and $15k in after tax funds to pay the taxes, the convert scenario ends with a value of $197k and the not convert scenario ends with $194k... with the slight difference due not to the time value of money but due to taxes on the taxable account earnings (the $15k in taxable funds grows to $27k at the after-tax earnings rate of 5.95% [7%*(1-15%)].

+1

That's a good example. But conceptually, here's how I think about it... Embedded in your tax-deferred account is a tax liability that grows in lock-step with the taxable funds that could be used to pay tax in a conversion. IOW, when you continue to defer, the tax liability continues to grow by the same amount as your would-be tax dollars on a conversion. When you convert, it's really just like paying off a liability early in the hope that the liability will be less today than in the future (due to tax rates).

[redduck]

Would it be worthwhile for a 40-something who is still working and making $400,000 a year to start making these Roth IRA conversions? (We have a lot of these guys in the neighborhood).

[CRLLS]

Quote:

Originally Posted by pb4uski Not really.... it is differences in tax rates that is the more important determinant. An example if the tax rate is the same with the time value of money. Let's say someone has $100k and is subject to a 15% tax rate now and later and the assumed investment earnings rate is 7% and time horizon is 10 year. If they convert now, they start with $85k in their Roth after paying taxes and in 10 years that $85k grows to $167k. If they don't convert now, their $100k tIRA grows in 10 years to $197k.... if they withdraw it an pay they tax they have $167k. If you run the same scenario but starting with a $100k tIRA and $15k in after tax funds to pay the taxes, the convert scenario ends with a value of $197k and the not convert scenario ends with $194k... with the slight difference due not to the time value of money but due to taxes on the taxable account earnings (the $15k in taxable funds grows to $27k at the after-tax earnings rate of 5.95% [7%*(1-15%)].

I got it. It makes sense. But now change the starting value from 100K to say 500 or 750K. And the starting age at, or near age 65. The conversion will possibly affect ACA subsidies, kick in IRMAA, and in some cases, Social Security tax torpedo. Doesn't that skew the benefit towards not converting?

For those who are planning on leaving a legacy, there may be reasons to make the conversion. But here is where I draw the line. 1st, our money is for DW and my benefit. Anything left over, and most likely, there will be a fair amount, whether it is taxable or not is a problem they will have to deal with.

[Huston55]

Quote:

Originally Posted by pb4uski Not really.... it is differences in tax rates that is the more important determinant. An example if the tax rate is the same with the time value of money. Let's say someone has $100k and is subject to a 15% tax rate now and later and the assumed investment earnings rate is 7% and time horizon is 10 year. If they convert now, they start with $85k in their Roth after paying taxes and in 10 years that $85k grows to $167k. If they don't convert now, their $100k tIRA grows in 10 years to $197k.... if they withdraw it an pay they tax they have $167k. If you run the same scenario but starting with a $100k tIRA and $15k in after tax funds to pay the taxes, the convert scenario ends with a value of $197k and the not convert scenario ends with $194k... with the slight difference due not to the time value of money but due to taxes on the taxable account earnings (the $15k in taxable funds grows to $27k at the after-tax earnings rate of 5.95% [7%*(1-15%)].

You will find that Kitces says the same thing; more specifically, it’s “marginal” tax rates that make the difference. It took a while for me to get this into my head but, it is what it is.

https://www.kitces.com/blog/why-a-ro...in-the-future/

[misanman]

The general online procedure at Fidelity is:

- Create the Roth
- You will be asked how it is to be funded
- You will indicate a conversion of an existing Fidelity IRA
- You can also indicate whether or not it is a complete or partial conversion
- If a partial, then a list of securities are displayed and you can pick which ones are to be converted.
- Conversion is immediate

I would say the whole process is "easy peasy"

[RunningBum]

Quote:

Originally Posted by CardsFan Isn't an assumption the same as a guess?

Yeah, I had that coming!

What I meant was, no reason to just wonder about you when you can actually do some math.

[RunningBum]

Quote:

Originally Posted by redduck Would it be worthwhile for a 40-something who is still working and making $400,000 a year to start making these Roth IRA conversions? (We have a lot of these guys in the neighborhood).

Probably not, but we don't know the other side of the equation, what tax rate they will have in retirement. It's probably lower, so the answer would be No, but they could have a massive pension or large income from rentals or something like that.

[RunningBum]

Quote:

Originally Posted by CRLLS I got it. It makes sense. But now change the starting value from 100K to say 500 or 750K. And the starting age at, or near age 65. The conversion will possibly affect ACA subsidies, kick in IRMAA, and in some cases, Social Security tax torpedo. Doesn't that skew the benefit towards not converting? For those who are planning on leaving a legacy, there may be reasons to make the conversion. But here is where I draw the line. 1st, our money is for DW and my benefit. Anything left over, and most likely, there will be a fair amount, whether it is taxable or not is a problem they will have to deal with.

ACA subsidies could be a factor at any age before medicare, but if they are at 65, it's no longer a factor, right?

IRMAA, yes, a factor, but it will be a factor with MRDs too, right?

Likewise the SS tax torpedo. Around 65 you don't have to be taking SS, so maybe those 5 years are a good time to convert before you start adding SS income, if you have deferred.

The IRMAA and SS factors favor levelling out income over your remaining years, which would usually mean taking partial conversions, but perhaps leaving some for MRDs. I doubt that skipping conversion and taking larger MRDs will work better. There may be some individual factors, so it's worth working out the various ways with a spreadsheet or tax program.

[CardsFan]

Quote:

Originally Posted by RunningBum Yeah, I had that coming! What I meant was, no reason to just wonder about you when you can actually do some math.

Sorry, couldn't resist.

But you have a good point that you can get an idea of the benefit of conversions by running different scenarios. At least then you are making an educated guess.

[CRLLS]

Quote:

Originally Posted by RunningBum ACA subsidies could be a factor at any age before medicare, but if they are at 65, it's no longer a factor, right? IRMAA, yes, a factor, but it will be a factor with MRDs too, right? Likewise the SS tax torpedo. Around 65 you don't have to be taking SS, so maybe those 5 years are a good time to convert before you start adding SS income, if you have deferred. The IRMAA and SS factors favor levelling out income over your remaining years, which would usually mean taking partial conversions, but perhaps leaving some for MRDs. I doubt that skipping conversion and taking larger MRDs will work better. There may be some individual factors, so it's worth working out the various ways with a spreadsheet or tax program.

My gut feeling is that it greatly depends on the income/expense levels required for living. If you are close to ACA or IRMAA triggers with normal required income/expenses, then there is virtually no or little benefit to converting at all. It is an individual situation for sure. Even if one converts a small amount over several years, with a larger IRA/401K, the net benefit may be too small to really matter in the big picture.

In our picture, ACA subsidy was a consideration for the last few years. Now we are on Medicare, IRMAA is in play. I was bring this up in light of the fungible calcs that pb4uski presented. If one was near those triggers, then the tie goes to non-convert team. (I think).