Roth Conversion Newbie with a question on taxes

[Zona]

I have a question on how the federal taxes will work on a Roth Conversion if we are retired and living off of only dividends (mostly qualified) and capital gains for the first few years. (We're not quite FIRE'd yet, but hope to be soon and want to understand how Roth Conversions are taxed in this situation.) I'm hoping someone who understands taxes better than I do (or who has done similar conversions) can give me some guidance.

Let's say I have three buckets: one Roth IRA (that has existed for > 5 years), one Traditional IRA, and my taxable brokerage.

So hypothetically let's say I am fully retired on Jan 1, 2020. I'll get around $18K in dividends from my taxable brokerage, of which $17K are qualified ($1K ordinary divs). I also sell stock from the taxable brokerage that results in $45K of capital gains. We have no other ordinary income for the year, and the MFJ standard deduction for 2020 is $24,800.

I have built a spreadsheet that mimics the "Tax Projection Worksheet - Tax Using Capital Gains Rates" from the 1040. (Or at least I *think* it mimics it, but I'm trying to confirm if I set it up correctly). Given the income numbers above, my spreadsheet says that I can convert $43K from my Traditional IRA to my Roth IRA and only end up paying $2,125.00 in Federal Taxes. Does this sound right?

It just seems like a very small amount to be paying in taxes to convert that much. Thanks in advance for any guidance!

 

[pb4uski]

You're on the right track, but you want to focus on the top of the 0% preferenced tax bracket rather than the top of the 12% tax bracket.... so for 2020:

Top of 0% preferenced income tax bracket..... $80,000
plus standard deduction..................................24,800
income.......................................................104,800
dividends....................................................(18,000)
capital gains................................................(45,000)

Head room available for Roth conversion.........$41,800

Preferenced income..($17,000 QDiv + $45,000 LTCG)........$62,000... $0 tax

Ordinary income..($1,000 Div + $41,800 Roth conv - $24,800 std dedn)
...................................................................................$18,000... 10%... $1,800 in tax

Welcome to the wonderful world of Roth conversions! Your tax on the conversion is:

$23,800 at 0% + $18,000 at 10% = $1,800 on $41,800 conversions.

However, let's say you do $100 more.... the ordinary tax is 10% but it pushed $100 of preferenced income in the 15% tax bracket... so your tax on that additional $100 of roth conversion is $25 or 25% (10% + 15%).

 

[RunningBum]

Try TaxCaster https://turbotax.intuit.com/tax-tools/calculators/taxcaster/ or whatever tax program you use. It sounds reasonable to me. Probably most or all of the LTCGs or QDivs are taxed at 0%. That would keep your overall rate low.

Assuming you aren't trying to manage income to qualify for an ACA subsidy, the next step many people here do is keep those QDivs and LTCGs from being taxed. The marginal rate on your conversions is almost certainly 12%. What you want to do is make sure you aren't converting to much such that you aren't pushing Qdivs/LTCGs into being taxed for another 15%, for a 27% marginal tax rate.

Assuming you are married, for 2019 you would want to keep all income (conversions, dividends, cap gains, etc) less deductions (probably the $24K standard deduction) and less anything else like HSA contributions under $78,750. The ideal if you have a large amount in your tIRA is to convert right up to this point, if you don't have the ACA subsidy to deal with.

ETA: I didn't verify the exact numbers, but everything pb4 said too. I intended to say the same thing. He's probably right that you're in the 10% regular income bracket, not 12%.

 

[Zona]

Thank you so much for your explanation PB4USKI -- when you explain it as "preferenced income" and "ordinary income" it all starts to make more sense.

On the plus side, when I enter the numbers in my spreadsheet just as you specify I get the same $1800 in total tax, so at least I know I got the formulas right.

And I can see now if I tweak those numbers just a little bit on my spreadsheet (adding more "preferenced income" capital gains without reducing the conversion amount, wow the taxes start to pile up fast. It definitely helps to understand that there is a sweet spot depending on how much of each type of income you have. Thank you!

 

[Zona]

Assuming you are married, for 2019 you would want to keep all income (conversions, dividends, cap gains, etc) less deductions (probably the $24K standard deduction) and less anything else like HSA contributions under $78,750. The ideal if you have a large amount in your tIRA is to convert right up to this point, if you don't have the ACA subsidy to deal with.

Thanks, RunningBum. We do each have a large tIRA balance and my focus for the early years of retirement will be to convert as much as we can out of those as long as we can keep taxes on the conversions low.

We pay out of pocket for a grandfathered BCBS insurance plan that we've had for many years and that all our current doctors accept, so we don't deal with the ACA subsidy threshhold.

 

[RunningBum]

Great strategy. I've been doing that as much as I can too, and hope to have my tIRA fully converted by 70.

 

[pb4uski]

Thank you so much for your explanation PB4USKI -- when you explain it as "preferenced income" and "ordinary income" it all starts to make more sense.

On the plus side, when I enter the numbers in my spreadsheet just as you specify I get the same $1800 in total tax, so at least I know I got the formulas right.

And I can see now if I tweak those numbers just a little bit on my spreadsheet (adding more "preferenced income" capital gains without reducing the conversion amount, wow the taxes start to pile up fast. It definitely helps to understand that there is a sweet spot depending on how much of each type of income you have. Thank you!

However, if you have penalty free access to tax-deferred withdrawals because you are over 59 1/2 or because the money is in a 401k and you left service in the year your turned 55 or later.... and if you have a lot of money in tax-deferred accounts (which is common) you might be better off to do tax-deferred withdrawals for the money you need for spending and Roth conversions to the top of the 0% preferenced bracket.

So for example, if the $45k of LTCG were instead $45k of tax-deferred withdrawals while you would pay more tax because you would have $63k of ordinary income rather than $18k of ordinary income, you would also reduce your tax-deferred balance by $63k rather than $18k.... reducing RMDs later in life... and the taxable account will still be there and potentially eligible for a stepped-up basis to survivors or heirs so those embedded gains never get taxed.

Your tax on $63k of ordinary income would still be a very reasonable $7,165 or 11.4%... likely much lower than when you deferred that income and lower than what you would pay on withdrawals once SS has started.

Depending on your circumstances it might be a better strategy.... another way to think about it is that every $1 of capital gains means $1 that you can't do in tax-deferred withdrawals or Roth conversions.

 

[SevenUp]

I have built a spreadsheet that mimics the "Tax Projection Worksheet - Tax Using Capital Gains Rates" from the 1040. (Or at least I *think* it mimics it, but I'm trying to confirm if I set it up correctly).

Yes, $1800 on $41800 conversion appears correct.

I took the latest version of the case study spreadsheet (see that thread for the link) and overwrote its 2019 numbers with 2020 values.

Appears you pay ~4% for the first $40K, then ~26.4% on the next $64K, but if you convert another $147K instead of $64K (for a total of $187K) it's ~24% marginal on that $137K.

Above numbers assume neither of you will be 63 or older in 2020. If that is not a good assumption, then IRMAA tiers would come into play, starting at $170K AGI.

 

[corn18]

I ran the numbers for my taxes from 55 to dead. This interesting chart popped out:

That tail at the 80%-90% conversion rate caught my eye. That's due to the SS hump which is where I end up if I just have my pension + SS @ age 70. But I did find my optimum plan which is to convert 60% to 70% from 55 to 69. That could all change over the next 17 years, but I like data.

 

[RunningBum]

That tail at the 80%-90% conversion rate caught my eye. That's due to the SS hump which is where I end up if I just have my pension + SS @ age 70. But I did find my optimum plan which is to convert 60% to 70% from 55 to 69. That could all change over the next 17 years, but I like data.

I don't see how you avoid the SS hump if you leave 30-40% of your tIRA for RMDs, but hit it if you only have pension + SS. You still have the SS hump with more income (RMDs), it's just that you push beyond it. The marginal rate drops, but you're still paying more in taxes.

I suspect the reason for that tail is that to convert 100% before age 70 puts you in a higher tax bracket early, compared to what you pay at 70+ for the remaining amount taken out with RMDs.

I could be wrong. I'd be curious to understand it better if I am.

 

[pb4uski]

^^^ I had the same reaction at first but I think it is a matter of interpreting the graph... the vertical axis is total taxes paid from 55 to 89... the horizontal axis is the percentage of tax-deferred accounts converted from 55 to 70 (I think).... so the tail is the result of converting more from 55 to 70 and the additional taxes paid as a result of such conversions.... I suspect because one is covnverting at a marginal tax bracket higher than their ultimate marginal tax bracket... like converting into the 24% bracket where your ultimate marginal tax bracket with pensions and SS is only 22%.

 

[corn18]

I don't see how you avoid the SS hump if you leave 30-40% of your tIRA for RMDs, but hit it if you only have pension + SS. You still have the SS hump with more income (RMDs), it's just that you push beyond it. The marginal rate drops, but you're still paying more in taxes.

I suspect the reason for that tail is that to convert 100% before age 70 puts you in a higher tax bracket early, compared to what you pay at 70+ for the remaining amount taken out with RMDs.

I could be wrong. I'd be curious to understand it better if I am.

I think you are right. There are a lot of moving parts, but from what I can tell from my model, it does have to do with paying higher taxes if I convert more than 70% early.

 

[gwraigty]

However, if you have penalty free access to tax-deferred withdrawals because you are over 59 1/2 or because the money is in a 401k and you left service in the year your turned 55 or later.... and if you have a lot of money in tax-deferred accounts (which is common) you might be better off to do tax-deferred withdrawals for the money you need for spending and Roth conversions to the top of the 0% preferenced bracket.

So for example, if the $45k of LTCG were instead $45k of tax-deferred withdrawals while you would pay more tax because you would have $63k of ordinary income rather than $18k of ordinary income, you would also reduce your tax-deferred balance by $63k rather than $18k.... reducing RMDs later in life... and the taxable account will still be there and potentially eligible for a stepped-up basis to survivors or heirs so those embedded gains never get taxed.

Your tax on $63k of ordinary income would still be a very reasonable $7,165 or 11.4%... likely much lower than when you deferred that income and lower than what you would pay on withdrawals once SS has started.

Depending on your circumstances it might be a better strategy.... another way to think about it is that every $1 of capital gains means $1 that you can't do in tax-deferred withdrawals or Roth conversions.

+1

OP, choosing to realize LTCG's are optional. Eventual RMD's are not.

 

[RunningBum]

I think you are right. There are a lot of moving parts, but from what I can tell from my model, it does have to do with paying higher taxes if I convert more than 70% early.

Graphing it out like you did does seem like an effective way to determine how much to convert, even if there is some question why.

Curious how/if you factored in growth of your tax deferred account? If you only make small conversions, the growth of the account can make the progress even slower.

 

[corn18]

Graphing it out like you did does seem like an effective way to determine how much to convert, even if there is some question why.

Curious how/if you factored in growth of your tax deferred account? If you only make small conversions, the growth of the account can make the progress even slower.

My tax model is independent of the size of the 401k over time. It just assumes I will convert the max amount each year (or a percentage of the max amount). The conversion rate is not a percentage of my portfolio, it is a percentage of the maximum I can convert to the top of the 12%/15% tax bracket.

As it looks right now, I can convert 100% of my projected 401k balance and cap gains in my taxable account @ retirement age in 2 years. My 401k is 70% bonds so it isn't growing much. I'll take a closer look at growth when I retire to see if there is a more optimal strategy than the 60%-70% conversion.

 

[Zona]

+1

OP, choosing to realize LTCG's are optional. Eventual RMD's are not.

Yes, I think pb4uski's advice here is great, in terms of getting money out of our tIRA's and SEPs before RMD's hit. Unfortunately, neither of us is 59 1/2 (DH is 48 and I'm 44), so if we did FIRE soon, we would need to realize some LTCG for living expenses from the brokerage account while we convert what we can into Roth. But once we can pull from tax-deferred without penalty, we will begin doing so.

Boy am I learning a lot from this thread, thanks so much everyone for your replies!

 

[ERD50]

Bit of a side-line, but I'll also add something for those of us likely to leave an inheritance (which is probably most of the conservative ones among us, unless you are covered by SS/pension/annuities):

For the above case, Roth conversions probably beat LTCG harvesting. If you think you can hold the LTCG until your demise, the gains pass tax-free to heirs (step up basis).

In my case, RMDs, SS and pension will more than cover expected expenses @ age 70.5, so I plan to hold onto as much of my taxable investments that have gains for my heirs. I will sell only as much as I need to meet expenses from now until 70.5, and of course, harvest any losses along the way.

-ERD50

 

[SecondCor521]

Yes, I think pb4uski's advice here is great, in terms of getting money out of our tIRA's and SEPs before RMD's hit. Unfortunately, neither of us is 59 1/2 (DH is 48 and I'm 44), so if we did FIRE soon, we would need to realize some LTCG for living expenses from the brokerage account while we convert what we can into Roth. But once we can pull from tax-deferred without penalty, we will begin doing so.

Boy am I learning a lot from this thread, thanks so much everyone for your replies!

One additional strategy I'm considering strongly, which may benefit you as well since you're in a roughly similar situation: Split your tIRA in two around age 55, do Roth conversions as desired from one, and do an SEPP from the other between 55 and 60. This will help reduce the size of the tIRA for purposes of the tax torpedo, and help preserve the brokerage account. (At age 60, just stop the SEPP and recombine the two tIRA portions back into one.)

In your case, I'm pretty sure you could have your husband do one and you could do one also - depending on who's name is on the tIRA and how big the relevant accounts are.

SEPPs have to last at least 5 years or until 59.5, whichever is later, but a 5 year SEPP starting at 55, with conservatively chosen parameters, could reasonably give you approximately half your living expenses.

 

[pb4uski]

A SEPP is a great idea in such situations.... as is splitting the tIRA to achieve the desired SEPP amount... you could back into how much to transfer to the IRA that will be used for SEPP based on what you want to get out of it for spending.

 

[Zona]

A SEPP is a great idea in such situations.... as is splitting the tIRA to achieve the desired SEPP amount... you could back into how much to transfer to the IRA that will be used for SEPP based on what you want to get out of it for spending.

This would probably help us quickly reduce the balance in our tax-deferred accounts. I worry that if we don't do something early on in FIRE we will have very large tax hits when DH turns 70 1/2. Our SEP IRAs total 1.4M (we were self-employed for many years) and our tIRAs are 185K. Splitting some of that off into separate tIRAs to do a SEPP/72t would probably be a good idea. I will need to start working on yet another spreadsheet to optimize how much we would need to transfer for income and to minimize taxes (and still find a way do some Roth conversions).

It sounds like many of you are advocating preserving the funds in the brokerage for as long as possible -- is this just because having a sizeable amount there will give more flexibility to minimize taxes in withdrawals later on? Or would having lots of funds in the Roth also do that? (Current Roth balances are 350K, so any conversions would add to that). I'm just trying to understand whether it would make more sense at first to prioritize Roth Conversions (while living on stock sales/LTCG) or do a SEPP/72t to move a larger chunk of the deferred money out. We have no children, so are not looking to leave large legacies.

Again, thanks for the ideas and the discussion!

 

[SecondCor521]

A SEPP is a great idea in such situations.... as is splitting the tIRA to achieve the desired SEPP amount... you could back into how much to transfer to the IRA that will be used for SEPP based on what you want to get out of it for spending.

Exactly. Splitting the tIRA and backing into the total via reversing the SEPP calculations is my plan.

The other part of it is that you can't do Roth conversions and SEPPs from the same tIRA, because that would bust the SEPP. So that's a second reason you need to split the account.

(If you want to get super fancy, you can split the tIRA into N+1 parts and do N different SEPPs plus Roth conversions. The SEPPs can all have their own schedule and method. I doubt anyone gets that complex.)

 

[pb4uski]

It isn't so much about preserving taxable account money, but more because the use of taxable account money (other than cash like items) uses up headroom that could otherwise be used to reduce tax-deferred amounts (through either withdrawal or Roth conversion).

In your situation, I would focus first on using a SEPP to generate spending money rather than using taxable account money. and then once you have what you need for spending then use Roth conversions for any headroom left in the 0% preferenced income tax bracket.

BTW, if you go above the 0% preferenced rate tax bracket with additional ordinary income, your marginal rate will be the ordinary marginal rate plus 15% to the extent of your preferenced income, and then drop down to the marginal tax bracket rate once ordinary income exceeds the 0% preferenced income bracket ($80k in 2020). So in your case it would be 25% (10% + 15%), then 27% (12% + 15%) and then drop down to 22%.

 

[SecondCor521]

It isn't so much about preserving taxable account money, but more because the use of taxable account money (other than cash like items) uses up headroom that could otherwise be used to reduce tax-deferred amounts (through either withdrawal or Roth conversion).

In your situation, I would focus first on using a SEPP to generate spending money rather than using taxable account money. and then once you have what you need for spending then use Roth conversions for any headroom left in the 0% preferenced income tax bracket.

BTW, if you go above the 0% preferenced rate tax bracket with additional ordinary income, your marginal rate will be the ordinary marginal rate plus 15% to the extent of your preferenced income, and then drop down to the marginal tax bracket rate once ordinary income exceeds the 0% preferenced income bracket ($80k in 2020). So in your case it would be 25% (10% + 15%), then 27% (12% + 15%) and then drop down to 22%.

I'm 50, so I'm currently doing taxable for now for the following reasons:

1. I don't want to do a 10 year SEPP. Just don't like being locked in long term like that.

2. I want more flexibility over my AGI and want to avoid installing an SEPP "floor" during the next few years while my kids are in college and I need to manage AGI for both that and ACA.

3. As years pass, I think the SEPP math might get easier/more attractive because my age goes up and the IRS interest rate may go up, which I think would result in a smaller "SEPP tIRA" given the same target income to be generated.

It just occurred to me, but I could do a smaller SEPP starting now (say 1/4 of my income needs) rather than a larger SEPP (I was thinking about 1/2 my income needs) when I'm 55. That would address most of the concerns above.

 

[NgineER]

You could also look into a Roth rollover ladder to live off of instead of the SEPP. You can withdraw contributions and conversions tax free after five years. You must have some contributions inside your Roth as you have $350k I. It.
You are pretty young and this is a common strategy.

 

[Zona]

You could also look into a Roth rollover ladder to live off of instead of the SEPP. You can withdraw contributions and conversions tax free after five years. You must have some contributions inside your Roth as you have $350k I. It.
You are pretty young and this is a common strategy.

Thanks for this idea, NgineER - I will have to review my contributions and do some research on what is considered a "contribution". Back in 2010 I think the IRS offered a one-time chance to spread taxes on any conversions over two years, so I converted the entire amount of an old IRA at that time. I will be honest and say I didn't really understand what I was doing at the time -- probably it was a bad choice, but it's water under the bridge now. Not sure if that conversion amount counts as a "contribution" that can be withdrawn. If so, your idea could help, although the total amount of contributions into that account would not be enough to cover all our expenses without either doing some kind of SEPP or selling stock from the brokerage.

Definitely something to think about!