Please confirm I understand Roth conversion modeling

[Delawaredave5]

So when you do tIRA to Roth conversions, the converted amount is treated as income on your tax return, correct ?

Friend of mine is retired, gets about $10,000 in SS payments, and draws RMD of about $5,000 from tIRA.

So the RMD and SS go into AGI - so the person has $15,000 in income. Any Roth conversions are "extra income".

2014 tax tables show 15% tax on additional income up to $36,900.

So this person surely wants to Roth convert $21,900 to get to $36,900, right ?

Thanks !!!

 

[gauss]

If all of the tIRA funds were not pretax (ie if non-deductible contributions are present) then there may be some basis in the tIRA that would lessen the tax hit.

Also and perhaps more important, not all SS payments are taxable especially if he is fairly low income.

There would be a personal exemption also.

Might want to create a pro forma 1040 (with your favorite tax software) in order to model the actual amounts.

-gauss

 

[Senator]

Do not forget, you get a standard deduction of at least $5K too. So it is not exactly $10,000 SS + $5,000 RMD.

 

[walkinwood]

I think you understand the basics, but there are some many complications in the tax law that it is best to use a tax program to determine exactly how much you can convert & still stay in the 15% bracket.

 

[Animorph]

If he or she is already paying 15% taxes on the RMD I think there's no rush to take more out at the same 15% tax rate. With deductions, they may be paying only 10% taxes on some or all of the RMD, which would be much better than taking out more at 15%. I'm through with Roth conversions once RMD's hit.

 

[Sunset]

You need to use tax software, even last years version would give a very close answer. I say this because SS is not taxable for such low amounts (unless there is more info).

.5 of 10K + 5K RMD = 10K , that is less than base amount 25K so SS is not taxable.

So your friend could convert $14,999 and he would pay NOT pay tax on the SS amt, just the 5K + 14,999 which is roughly $19,999 total
It would be wasteful to convert more as he would then pay tax on part of the SS.
If he converts more, he then is taxed on 50% of his SS, even if off by $1, and it could even go up to 85% of his SS if he converted a lot.

 

[kaneohe]

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So your friend could convert $14,999 and he would pay NOT pay tax on the SS amt, just the 5K + 14,999 which is roughly $19,999 total
It would be wasteful to convert more as he would then pay tax on part of the SS.
If he converts more, he then is taxed on 50% of his SS, even if off by $1, and it could even go up to 85% of his SS if he converted a lot.

I agree w/ everything (almost) you said here but you seem to suggest that a $1 increase in income will cause a step function jump in the amount of SS taxed and therefore a similar step function jump in AGI, taxable income , and taxes.
In fact, a $1 increase in income will cause a $0.50 increase in the amount of taxable SS so there is a smooth increase in income and taxes, not a step function jump.

 

[kaneohe]

2014 tax tables show 15% tax on additional income up to $36,900.

So this person surely wants to Roth convert $21,900 to get to $36,900, right ?

Thanks !!!

You might want to check this out for a lesson in SS taxation
Taxation of Social Security benefits - Bogleheads

At a threshold point, each increase of $1 in income causes $0.50 in SS to be taxed so even though though you may be in the 15% bracket, your marginal tax rate can be 50% higher (e.g. 22.5% vs the nominal 15%).

 

[karluk]

So when you do tIRA to Roth conversions, the converted amount is treated as income on your tax return, correct ?

Friend of mine is retired, gets about $10,000 in SS payments, and draws RMD of about $5,000 from tIRA.

So the RMD and SS go into AGI - so the person has $15,000 in income. Any Roth conversions are "extra income".

2014 tax tables show 15% tax on additional income up to $36,900.

So this person surely wants to Roth convert $21,900 to get to $36,900, right ?

Thanks !!!

If you are accurately reporting your friend's situation, it would be a really terrible idea for him or her to make such a large Roth conversion. The underlying problem is that your friend is currently in the 0% tax bracket and should owe no Federal income tax whatsoever. It's quite counterproductive to voluntarily pay 15% tax on a Roth conversion when the tax on the annual RMD is 0%.

For 2014, the standard deduction for single taxpayers is $6,200 and one personal exemption is worth $3,950. That's a total of $10,150. Your friend is well under this limit, since SS benefits aren't taxed all when a person's total income is only $15,000. So your friend's adjusted gross income is only the $5,000 from the RMD - only about half of the $10,150 in income that would be taxed at 0%.

If your friend wants to make Roth conversions this year, the right strategy is to convert only up to the top of the current tax bracket, namely $10,150 - $5,000 = $5,150. Your friend can Roth convert roughly $5,150 from the traditional IRA and still have no federal tax liability at all.

 

[Delawaredave5]

If you are accurately reporting your friend's situation, it would be a really terrible idea for him or her to make such a large Roth conversion. The underlying problem is that your friend is currently in the 0% tax bracket and should owe no Federal income tax whatsoever. It's quite counterproductive to voluntarily pay 15% tax on a Roth conversion when the tax on the annual RMD is 0%.

She won't spend it all and will leave chunk to children. Isn't it more advantageous to pass a Roth IRA to heirs than tIRA ?

That's was their rationale for converting at 15%; her heirs are at 25+% converting under her at 15% beats converting later at kids 25+%.

Correct ? Thanks !!!

 

[karluk]

She won't spend it all and will leave chunk to children. Isn't it more advantageous to pass a Roth IRA to heirs than tIRA ?

That's was their rationale for converting at 15%; her heirs are at 25+% converting under her at 15% beats converting later at kids 25+%.

Correct ? Thanks !!!

Wow, all I can say is that her children had better be giving her a gift equal to the extra taxes she is willing to pay. Having a retiree living in near poverty making financial sacrifices for children with income in the 25% bracket in my book is excessively generous on the mother's part. The children are the ones who should be helping her, not the other way around.

If she's not suffering from any life-threatening illness that might limit her time to make the conversions, I stand by my original advice. $5,150 per year adds up fast on what must be a rather small IRA.

 

[Delawaredave5]

Wow, all I can say is that her children had better be giving her a gift equal to the extra taxes she is willing to pay. Having a retiree living in near poverty making financial sacrifices for children with income in the 25% bracket in my book is excessively generous on the mother's part. The children are the ones who should be helping her, not the other way around.

Thanks and agree. I don't know any of the amounts or "family drama".

I was just interested in helping confirm "conversion mechanics".

Have a great day !

 

[kaneohe]

She won't spend it all and will leave chunk to children. Isn't it more advantageous to pass a Roth IRA to heirs than tIRA ?

That's was their rationale for converting at 15%; her heirs are at 25+% converting under her at 15% beats converting later at kids 25+%.

Correct ? Thanks !!!

Her marginal tax rate could be as high as 22.5% . This is because her SS is not taxed now but part of it will be if she converts enough (but stays within the 15% bracket). You could argue that 22.5% is still less than 25% , just that the benefit is less than you might think. Try this in a tax calculator like Taxcaster or the HR Block tax calculator.

 

[Delawaredave5]

I made a quickie TT model: using $5k (RMD), $25k (RMD +$20k conversion), $35k, and $45k distributions.

Tax due came out $0, $2.1k, $4.5k, $6.7k, respectively.
This is (as % of conversion amount): 0%, 11%,15%, 17%, respectively.

The last couple cases had increasing proportions of the SS benefit taxable (last one had 80% taxable)

So you are right - the marginal tax rate comes up quickly. Seems like conversion to stay in bottom bracket make sense, above that, not.

 

[karluk]

I was just interested in helping confirm "conversion mechanics".

Have a great day !

As several other posters have already pointed out, there are a number of mistakes in your conversion mechanics. At her current income level, none of her SS is included in AGI. This changes starting with about $15,000 in Roth conversions. At that point, RMD + Roth conversions + 1/2 SS adds up to $25,000, which is the trigger point for beginning to include SS benefits in AGI.

You are also mistaken in equating AGI with taxable income. You get taxable income after subtracting deductions and exemptions from AGI. Since she is old enough to be subject to RMDs, her deductions will be larger than the standard deduction of $6,150. In 2013 she probably had one box checked on form 1040, line 39a, and got a $7,600 deduction. I'm not sure what she'll get this year, but $7,600 should be close.

So if she converts $15,000 to a Roth IRA, she'll have taxable income of approximately $5,000 + 15,000 - $7,600 - $3,950 = $8,450. Conveniently enough, this happens to fall completely into the 10% tax bracket, which covers the first $9,075 of taxable income. Her Federal tax due will be about $845. Not too bad. If she's willing to pay taxes on part of her SS and venture into the 15% tax bracket, she could convert even more, but of course this is all subject to the law of diminishing returns - a lot more tax for her in exchange for some dubious future benefits to her children.

 

[Delawaredave5]

Thanks. Went back to quickie model and entered what you have above ($5 + $15). Yes, standard deduction is around 7,600 and tax due is around $800 (5% or so of converted).

Thanks for your help - I forwarded input and learned a lot myself. Have a great day !

 

[Sunset]

Karluk has explained so well, and seen the bigger issue within the question.
My thoughts are:
1) Those children should be helping out their poor mother.
2) Those children can inherit the IRA, no conversion is needed, so forget about the wasteful Roth conversion.
In fact inherited IRA's by children can be a wonderful gift to the children (even grandchildren indirectly).
Check out some reading Like:
http://online.wsj.com/articles/SB10001424052702304587704577335751592771924

 

[rodi]

Is your friend age 70 or older? If not, it's just regular withdrawals from SS, not an RMD.

 

[jebmke]

The only way to model this is with tax software. For people with significant dividends, additional income can be taxed at 30% which isn't even a bracket. Brackets do not necessarily equate marginal rate.