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Looking for the magic formula for Roth conversions vs RMDs
Old 01-14-2018, 08:47 PM   #1
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Looking for the magic formula for Roth conversions vs RMDs

I'm new to looking at IRA RMD numbers. I see lots of web pages that suggest doing Roth conversions on one's IRA assets to avoid RMDs. I'm only age 55 so I have quite a few years between now and RMDs, but it seems like one cannot start planning too soon since it could take a number of years to implement a gradual conversion strategy to avoid RMDs.

The Roth conversion strategy sounds nice, but when I start thinking about the details, it seems very complicated to decide how much to convert each year. If I do a Roth conversion, that increases my taxes now; but if I don't, that increases my taxes at age 70.5. It's similar (but not identical) to the question of contributing to a Roth vs a traditional IRA to begin with.

Am I missing some way of looking at this which makes it a lot simpler than I am making it out to be?

Complications:

- I'm not sure what my goal should be. Should I try to Roth-convert 100% of my IRA assets by age 70.5 so that my RMDs will be 0 at that point? It seems like a more balanced approach may be in order. I.e., converting only part of my assets by 70.5, which will lower my current taxes each year (compared to what they would be if I were aiming at 100% conversion by 70.5), thus aiming at having some RMDs but hopefully a low amount, at least lower than if I didn't convert anything. But I don't know what final percentage I should aim for to be converted.

- I don't know how much my IRA assets will be worth at (& above) age 70.5. The focus on the 3 vs 3.5 vs 4 % withdrawal rate debates is how to avoid running out of money in the worst case of the stock market. But the focus on RMDs is that if it is *not* the worst case for the market, in some markets, my money could double or triple or quadruple in the next 10-20 years. Depending on how that works out, I don't know whether I will have (for example) $2 million or $8 million at age 70.5.

- RMDs vary by age. RMD at 70.5 is only 3.65%, and if I only live to be 82, my max RMD is 5.5%. But by age 86, it's up to 7.09% and if I live into my 90s, it gets to 9, 10, 11%, and higher. Depending on the size of my investments, withdrawing 3 to 5% will likely leave me in a different tax bracket than withdrawing 7 to 10%. If I do live to be 95, perhaps by then I will be so senile that I don't know or care what an RMD is. (Just kidding - if anyone reading this board is in their 90s, I don't mean to offend you!) But ideally I would like for my heirs to retain as much of my estate as possible, which means paying as little taxes as possible in general from now until I die - I just don't know how long that will be.

- Even in retirement, I will have other income - may range from interest/dividents to rental houses to Social Security. That could vary from year to year. That affects Roth conversions which would be added to my current income in each given year to determine my final tax amount.

So I'm aiming for this target which is moving in 4 different directions at the same time.

Someone should come up with a calculator where you can plug in various current ages & investment values, % growth of assets, and Roth conversion amounts until age 70.5, to compute estimated taxes both before and after age 70.5. I have seen simple RMD calculators, but I haven't seen anything that includes all these other factors into the calculations. Does anyone know of a calculator like that?

Or like I asked above, am I making all this way too complicated?

If it is as complicated as it seems, what are other people doing about this who are closer than I am to age 70.5?
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Old 01-14-2018, 09:01 PM   #2
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Are you familiar with iORP? An acronym for Optimal Retirement Planner, this program seeks to optimize your retirement cashflows. One of the parameters it uses is Roth conversions to minimize taxes on RMDs. While not a perfect solution, it does provide some very useful data for consideration. Check it out at
https://www.i-orp.com/GOPtax/index.html
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Old 01-14-2018, 09:09 PM   #3
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I agree that it can be complicated; there are a lot of variables. There are many members here who analyze this in much greater detail than I do, and who likely understand the nuances better. Iím sure theyíll come along shortly with suggestions.

My approach is pretty simple and, while probably not optimum, I think it provides a good approach to minimize overall taxes. Iíd also say that, given all the variables & unknowns, this is an area where ďcloseĒ is good enough.

My Approach:

1. I input my numbers into i-ORP, which will suggest an Ďoptimizedí w/d source by year (taxable, tax deferred, tax free). It also estimates yearly RMDs.
2. I compare the the RMDs to what Iíd need for income anyway, to ensure those numbers are close. [Note: if they are close, I think Iím near optimum.]
3. Separately, I evaluate whether to capture CG to fill up the Zero CG bucket, and do so if itís beneficial. [Note: I have a lot of CG in our taxable account, which is >25% of NW.]
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Old 01-14-2018, 09:34 PM   #4
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I'll explain what I have been doing and why.

The why first. I retired at 56 and have been living principally from taxable account savings. After our SS starts I expect we will be in the 25% tax bracket (22% under the new law) or perhaps even higher. Before our SS starts, we would not pay taxes as deductions/exemptions exceed our interest and my small pension and our qualified dividends and long-term capital gains are not subject to tax. So, I have a window of time from when I ERd until our SS starts that I can do Roth conversions and pay little in tax.

With that background, you'll read that many of us are doing Roth conversions to the top of the 15% tax bracket (12% under the new tax law). Since your OP said "I" rather than "we", I'll go through the calculations for a single for 2018 under the new tax law.

The top of the 12% tax bracket for a single person in 2018 is $38,700. The total income to get 0% capital gains is $38,600. It is stoopid that these numbers are different, but it is what it is.... I'll chose the lower of the two... $38,600. The standard deduction is $12,000. The sum of these two is $50,600. So if you had no other income, you could have $50,600 of Roth conversions and would pay $4,441.50 in tax... 8.8% of the Roth conversion... most likely a lot lower than the tax you avoided by deferring that income while you were working and also lower than what you would later pay if you took that money later once SS starts as a withdrawal, RMD or Roth conversion.

So in my case where I expect to pay 22% later, I'm saving 13.2%.. pretty substantial.

Now in reality, interest income, dividends, pension income etc effectively reduce the amount that you can convert and remain in the 12% tax bracket. So if you had $10,000 of income from other sources, you could only convert $40,600.

Over the last 5 years, I have converted almost 25% of my tax-deferred balances on the day that I retired and paid about 7.4% of the amount converted in federal tax. that's the good news.... the bad news is that because of growth my tIRA balance today is still a lot higher than when I retired despite converting that 25%... sort of a nice problem to have. Be aware, if you live in a state that has a state income tax then there will likely be state income tax on conversions too.

P.S. If your income includes qualified dividends or long-term capital gains then you will not want to exceed $50,600 because for each $100 the increase in tax is $27... a 27% incremental tax rate... this is because $100 of ordinary income is taxed at 12% but it pushes $100 of qualified income above the limit and that $100 of qualified income is taxed at 15% (for a total of 27%).
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Old 01-14-2018, 10:58 PM   #5
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I'm starting to work through similar questions.

Here's my answers, although I'll preface them by saying that I think pb4uski's answer above is the correct one - it's all about managing marginal rates:

My goal is to have my top marginal rate remain consistent over my lifetime. So I'll convert up to the top of the X% bracket in order to keep my RMD's and other retirement income at around the X% bracket when I get to that point. X% could be 12%, 22%, 24%, 32%. But the goal for me would be to avoid converting to the top of the 32% bracket today to end up in the 24% bracket when I'm 70.5, or conversely converting to the top of the 12% bracket only to end up in the 32% bracket at age 70.5. I don't know if that's mathematically the best, but it makes intuitive sense to me.

I project my accounts to grow at an expected long term rate of return, and I project the tax brackets to grow at the chained CPI. Reality will turn out differently, of course, but it's the most reasonable prediction I can make. I built a little spreadsheet that does this for the next 21 years for me, and I can plug in simple conversions to see what a typical conversion does to my year 70.5 tax rate to answer the X% in my previous paragraph.

I only look at my age 70.5 RMD and tax rate now. RMD's are required, so it sounds like your third paragraph to me is just a restatement of the first paragraph - what is the optimal way to minimize lifetime federal taxes paid.

As far as other sources of income, the way I look at it is to figure out each year what my X% bracket as already described above, then add up my other sources of income and use Roth conversions to "top off" to the top of the X% bracket or whatever other target AGI I might have for whatever reason.

Overall I also think I have some flexibility because I have 21 years to work my plan. I can already sort of see that there will be variations over time...I have FAFSAs to deal with for the next five years or so, so I'll probably convert less during that time and maybe up the conversion amounts for the next 16 years after that.

You're right, there are lots of moving parts, and it's hard, if not impossible, to optimize everything. Make a plan, make sure it's reasonable and fits your goals, then iterate. I think that's the best you can do, because even if you consider everything and do the math correctly, external events (such as changes to federal tax laws) will happen that will make your plan obsolete. It's still good to have a plan I think.
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Old 01-14-2018, 11:02 PM   #6
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You can't convert an inherited IRA can you? I'm thinking the answer is no...
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Old 01-15-2018, 06:09 AM   #7
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If you are retired now, and I don't think you said whether you are, the difference between now and when you would have to take RMDs is social security income. For me, that, along with a small pension, will put me in a higher bracket, so I'd rather convert now. Possibly I could also reduce the amount of SS that is taxed.


The flip side is that now I'm managing income to qualify for an ACA subsidy, so I'm very limited in how much I can convert.


If you have other earned income that you won't have in retirement, it probably isn't time to convert as you're probably in the same or higher bracket now, though the 2018 tax law changes may make a difference.
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Old 01-15-2018, 06:42 AM   #8
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I find this calculator useful to get a feel for what my future RMD's might be.

https://www.schwab.com/public/schwab...alculators/rmd
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Old 01-15-2018, 06:53 AM   #9
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Quote:
Originally Posted by Yarnstormer View Post
You can't convert an inherited IRA can you? I'm thinking the answer is no...
You are correct... but new to me, you can convert an inherited 401k.

Quote:
You are a non-spouse beneficiary and you've inherited an IRA or employer plan assets. Can you convert those assets to a Roth IRA? The answer is yes and no.

Yes
Inherited employer plan assets (401(k), etc.) can be directly transferred to a properly titled, inherited Roth IRA. Income tax will be due on the amount converted and must be paid by the beneficiary doing the conversion. Since the funds are in an inherited Roth IRA, required distributions to the beneficiary begin in the year after the plan participant's death. For 2009, the employer plan is not required to offer this option. In 2010 it will become mandatory for the plan to allow a transfer to an inherited IRA or Roth IRA.

No
Inherited IRAs, on the other hand, cannot be converted to inherited Roth IRAs. Only the IRA owner (the person who made the IRA contributions) can do the conversion.

Spouses
A spouse can always move the funds inherited from the deceased spouse to his or her own IRA and then do a conversion to a Roth IRA.
https://www.irahelp.com/slottreport/...ssets-roth-ira
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Old 01-15-2018, 09:20 AM   #10
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Thanks to those who have answered my OP so far.

To give a couple comments and answers to questions:

I am not familiar with iORP, but it sounds very useful. Thanks Curmudgeon for the suggestion. I will check it out!

RunningBum, to answer your question, I'm probably going to retire this year. If not this year, I might work part time for another year or two. Either way, this year, I will likely have too much income to do any useful Roth conversion. But starting next year, it's a possibility; so I'm going ahead and looking at what my strategy will be.

pb4uski, yes, it is "I" not "we". When I do retire, my situation will be very similar to yours - I will be living off non-retirement assets for a few years with little earned income. Eventually I will have to dip into retirement funds, and when I reach full SS age, I will have income from that. But I will have several years to do conversions and stay in a low tax bracket. Your strategy looks good. But like SecondCor521 said, I may not want to just go to the top of the 12% bracket but it depends on what I think the brackets will look like overall for me. Depending (like I said initially) on how my investments do from now to 70.5 (and a few years beyond) - If I believe I will likely get to the 24% bracket, then I might rather do Roth conversions into the 22% bracket now, instead of only to the top of the 12% bracket, to avoid the higher bracket later on. Of course, 22% and 24% are not that different. But if I think there is a good possibility I might reach the 32% bracket from RMDs (which could happen if I live long enough, since RMDs keep progressing higher), it would almost certainly behoove me to go from the 12% to the 22% bracket now to avoid the 32% bracket later.
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Old 01-15-2018, 11:58 AM   #11
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ilikestartrek,

I've been searching for a similar magic calculator recently.

Like you, I'm single. This limits my options as to deductions and moves me into higher tax brackets sooner.

I've used i-orp over the years. 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."

Although, when I look into the future I'm staring squarely at the tax torpedo....plus that will throw me into Medicaare IRMAA (= increased Medicare Plan B premiums simply for having higher MAGI). So, I'm trying to optimize income, net worth, Roth conversions, minimize taxes paid, little/no IRMAA, when to take SS.

Poking around online I ran across ESPlanner and incomesolver.com.

Incomesolver is $450/3mos.

I just wrote to the ESPlanner folks and they suggested a less-expensive calculator of theirs called MaxiFi ($99).

Their site has both calculators listed...I'm still sorting out what the differences are and if MaxiFi will work for my needs. https://economicsecurityplanning.com/

HTH,
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Old 01-15-2018, 12:21 PM   #12
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Quote:
With that background, you'll read that many of us are doing Roth conversions to the top of the 15% tax bracket (12% under the new tax law).
This is the no brainer part to me, it’s anything above that where it’s more complicated.

We’re slightly over the 15% bracket without conversions. From there it depends on predicting future tax rates, RMDs, future value of IRA (if they decline, I’m paying taxes on higher value now) and the SS tax torpedo. Every time we’ve tried to do calcs, it’s about a push and hinges on assumption, even according to i-ORP. I’m open to being proven wrong, I’d start conversions if it was clearly an advantage.
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Old 01-15-2018, 12:33 PM   #13
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Great detailed answer pb4uski (I always do btw! lol). Another question on the same topic, HOW do you do the conversion? sell your investment (say VTSAX etc) in your IRA, transfer the cash to ROTH? or is there a way to do the conversion without selling your investment?
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Old 01-15-2018, 12:37 PM   #14
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At Vanguard, at least, you can just transfer the funds from an IRA to a Roth. I'd guess most places are like that.
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Old 01-15-2018, 12:48 PM   #15
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^ perfect thanks RunningBum - good info for when I'm ready to do this, some 8yrs or so down the road
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Old 01-15-2018, 12:54 PM   #16
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Quote:
Originally Posted by dvalley View Post
Great detailed answer pb4uski (I always do btw! lol). Another question on the same topic, HOW do you do the conversion? sell your investment (say VTSAX etc) in your IRA, transfer the cash to ROTH? or is there a way to do the conversion without selling your investment?
With Vanguard, there is a specific transaction for conversion from tIRA to Roth... I suspect that under the covers it is a sale of the tIRA asset and a purchase in the Roth.... in my case I sell Total Stock in my tIRA and buy Total Stock in my Roth so my AA isn't impacted.

It doesn't matter to me if it is a sale because in a tax-deferred account there are no tax implications from the sale, just from the conversion.
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Old 01-15-2018, 01:39 PM   #17
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Originally Posted by pb4uski View Post
With Vanguard, there is a specific transaction for conversion from tIRA to Roth... I suspect that under the covers it is a sale of the tIRA asset and a purchase in the Roth.... in my case I sell Total Stock in my tIRA and buy Total Stock in my Roth so my AA isn't impacted.

It doesn't matter to me if it is a sale because in a tax-deferred account there are no tax implications from the sale, just from the conversion.
That makes sense but what if the market suddenly rises after you sell in your tIRA account?
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Old 01-15-2018, 01:56 PM   #18
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With a conversion the "sell" and "buy" execute and settle at the same time so you are never out of the market... at least IME.
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Old 01-15-2018, 02:00 PM   #19
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^ As far as anyone can tell, the transaction (at least at Vanguard) is instantaneous. How they actually do things under the hood I have no idea, but I'm sure they operate in a way that they're not exposed to market fluctuations.

Whoops, crossposted with pb4uski.
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Old 01-15-2018, 02:15 PM   #20
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Originally Posted by Midpack View Post
This is the no brainer part to me, itís anything above that where itís more complicated.

Weíre slightly over the 15% bracket without conversions. From there it depends on predicting future tax rates, RMDs, future value of IRA (if they decline, Iím paying taxes on higher value now) and the SS tax torpedo. Every time weíve tried to do calcs, itís about a push and hinges on assumption, even according to i-ORP. Iím open to being proven wrong, Iíd start conversions if it was clearly an advantage.
+1

Beyond the top of the 15% bracket (now 12%), there's not a compelling advantage rate-wise, even if you believe rates revert to current law. Assuming no reversion, we'll likely stay in the 22% or 24% bracket even with RMDs and SS. And the cost to convert is actually higher than 22% due to the 27% incremental rate on QDs and LTCGs.

But the other aspect I've been studying lately is the effect of tax-free growth. Most people here just talk about rate differentials. I don't see much discussion or attempts to quantify this other aspect. We've got 14 years to go. Odds are the market will grow during that time. To the extent that growth occurs in the Roth, it escapes taxation forever. To the extent it occurs in the tIRA, it just makes the problem bigger. I suspect this may be part of the reason i-ORP is so aggressive about fast and furious upfront conversions. Anyway, my thinking is that it could help offset some of the less-than-compelling rate-related arguments for converting into the 22% bracket.
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