Roth conversions beyond the 15% bracket

[Cobra9777]

We convert to the top of the 15% bracket. But it's a fairly small number due to rental income and 2 pensions. Our tax-deferred balances are quite large, so I've thought about converting into the 25% bracket. But it just doesn't seem to make sense for us.

I've modeled our future tax situation as thoroughly as I know how. There's no reasonable downside scenario under which RMDs will totally escape the 25% bracket. So converting what we can at 15% makes sense. But the probability of RMDs getting even partially taxed at 28% is sufficiently low that I see no compelling case to convert at 25%. Especially since the immediate impact is actually greater than 25% due to the impact on qualified dividends and capital gains. As we get closer to 70, we can certainly adapt as needed.

If I'm wrong, it will be due to very favorable market performance. So paying a couple percentage points of incremental tax will be no burden. Then again, if OP's CPA is correct about future tax rate increases, the impact could be quite a bit larger. My planning is always based on current tax law and reasonable estimates of indexed brackets, etc. If and when there are actual changes, I'll adapt the plan accordingly. I could easily envision flat/lower income tax rates plus new VAT. So I'm not inclined to change direction based on one CPA's opinion.

Early death of one spouse does change the analysis quite a bit. But we are both in reasonably good health. So the baseline plan assumes a reasonable life expectancy for both. Again, if our health status changes, we can adjust the plan at that time.

I've thought about CG harvesting instead of Roth conversions to fill out the 15% bracket. But since our expenses are mostly covered by pensions, rentals, and dividends, we simply don't sell much, if at all. When SS starts, we definitely won't be selling. RMDs, on the other hand, are inevitable. So converting is the current strategy, but definitely not beyond the 15% bracket.

 

[Animorph]

I have been converting to either the AMT threshold, the 250k AGI threshold, and maybe into the 28% bracket once (whichever is lower), for the past 3 years and will continue roughly the same for the next 6 or so years. This will get me almost out of the 25% bracket when RMD's hit along with SS benefits and a small pension at age 70. I have a very detailed program to calculate future withdrawals, taxes (federal and state), and portfolio values.

The value of Roth converting when the current tax rate will be the same as the future tax rate is that you are effectively moving a little of your taxable account value (an amount equal to taxes paid on the conversion) into the nontaxable Roth account. Numbers-wise, that's it. You save whatever taxes you would have paid had that money remained in a taxable account. So it's not as compelling as converting at 15% taxes now to avoid 25% taxes later.

For this (conversion into the 25% bracket) to make any sense, you need to have a large 401k/tIRA balance (large RMD's coming taxed at 25%), and a large taxable account balance (to live off of and pay Roth conversion taxes for the years it takes). So it certainly won't be beneficial to everyone.

As far as tax laws, all we an do is assume current laws will continue into the future. I do inflate tax brackets along with my portfolio and withdrawals and SS benefits. Beyond that, I'll wait until any changes are more certain before I modify anything. If anything, I lean towards expecting higher tax rates. I don't think Roth and tIRA accounts will be taxed wildly differently in the future (as in a tax that applies to Roth withdrawals only). As already mentioned, the survivor of a couple will see higher single tax rates. So I'm willing to push Roth conversions now.

I'll still have a substantial tIRA after all Roth conversions, sufficient to fill in the current 15% bracket for a long time after age 70. I'm not going to pay 25% taxes now when I could be paying 15% later! Plus I'll be out of taxable money before the tIRA is empty. So I'll have some flexibility still if tax laws change.

 

[Done]

Married couples may also want to consider the implications to a surviving spouse when deciding whether (today) to convert tIRA monies to a Roth or reduce basis in taxable accounts by taking advantage of the 0% LTCG rate. If a surviving spouse winds up in the 25% bracket (very easy given the loss of deductions and reduced brackets), then any remaining cap gains would be taxed at 15% instead of 0%. The tax rate for tIRA funds would go from 15% to 25%. A 15% difference in tax rate is more than a 10% difference, so it favors harvesting those LTCGs rather than using up "headroom" in the 15% bracket to convert to Roth.

Another consideration applies if you live in a community property state. Assets held as community property receive a full (not just half) step-up in basis upon the death of the first spouse. The surviving spouse would reset basis on all taxable accounts and real estate if properly held, as if he/she had just inherited all of those assets. We hold all assets in a trust that defines held assets as community property for this reason. Based on our circumstances, it makes better sense to avoid harvesting capital gains and instead continue with annual Roth conversions to fill the 15% bracket.

Bogleheads article on the step-up in basis:
https://www.bogleheads.org/wiki/Step-up_in_basis

Which states?
https://en.m.wikipedia.org/wiki/Community_property

 

[pb4uski]

I do both. I have gains traded in the past but at this point I expect to exhaust our taxable funds while I am still in the 15% tax bracket so I do see much sense to accelerating that benefit.

....I have no idea how your CPA has any clue what tax rates are going to do... that's a SWAG I wouldn't put any stock in. JMO.

+1 tax rates have actually fallen over time but who knows what will happen... to think they will increase is pure conjecture on his part.

ORP would have me converting a lot more than the top of the 15% tax bracket. If I went from the top of the 15% bracket to the top of the 25% bracket with Roth conversion my federal tax would be $20,131 (26%) of the $76,300 additional conversion. Too much for me since the tax on my Roth conversion to the top of the 15% tax bracket is only 9.7%. I'm loathe to pay that 26% even though I know that in the long run it may be a wise move.

 

[audreyh1]

Another consideration applies if you live in a community property state. Assets held as community property receive a full (not just half) step-up in basis upon the death of the first spouse. The surviving spouse would reset basis on all taxable accounts and real estate if properly held, as if he/she had just inherited all of those assets. We hold all assets in a trust that defines held assets as community property for this reason. Based on our circumstances, it makes better sense to avoid harvesting capital gains and instead continue with annual Roth conversions to fill the 15% bracket.

Bogleheads article on the step-up in basis:
https://www.bogleheads.org/wiki/Step-up_in_basis

Which states?
https://en.m.wikipedia.org/wiki/Community_property

Wow - incredibly good point. I shall have to look into this.

 

[samclem]

Assets held as community property receive a full (not just half) step-up in basis upon the death of the first spouse. The surviving spouse would reset basis on all taxable accounts and real estate if properly held, as if he/she had just inherited all of those assets.

Very helpful, thanks!

 

[audreyh1]

Another consideration applies if you live in a community property state. Assets held as community property receive a full (not just half) step-up in basis upon the death of the first spouse. The surviving spouse would reset basis on all taxable accounts and real estate if properly held, as if he/she had just inherited all of those assets. We hold all assets in a trust that defines held assets as community property for this reason. Based on our circumstances, it makes better sense to avoid harvesting capital gains and instead continue with annual Roth conversions to fill the 15% bracket.

Bogleheads article on the step-up in basis:
https://www.bogleheads.org/wiki/Step-up_in_basis

Which states?
https://en.m.wikipedia.org/wiki/Community_property

Wow - even though I've lived all my adult life in a community property state, I did not know this. I hadn't really thought much about the basis of investments in brokerage accounts after one spouse passes.

I knew a US citizen surviving spouse could inherit with no estate taxes, and figured a 50% step up in basis, but didn't know about the 100% step up in JTWROS accounts or jointly owned property like a house. Better make sure all the titles are correctly titled.

 

[nubill]

I use the variable amount slider on the Fidelity Roth conversion evaluator. Based on my inputs and state taxes, I can vary where it shows optimum amount to convert. I have never exceeded the 15% bracket, but may by just a little when it comes to transferring Vanguard Admiral minimums. I know it's silly talking about a few basis points but I am wired that way.

There is a radio show in Pittsburg called The Lange Money hour where they have back episodes where you can download. He has mentioned this topic before with well know IRA experts.

The Lange Money Hour: Where Smart Money Talks - Radio Show with James Lange, CPA/Attorney

edit formatting and clarity

 

[kaneohe]

.......................

It's actually worse - we aren't really in the 15% tax bracket on ordinary income. We're in the 26% tax bracket (our capital gains income triggers AMT on our ordinary income) and sometimes NIIT, add another 3.8%. Any Roth conversions would likely be taxed at a 29.8% rate as well as eliminating our 0% cap gains "bracket". Suddenly not so appealing to convert.

.......................................................................

Might be even worse.....if you're in AMT land, the exemption phases out w/
increasing income in some range so that it's 26% + 25%(26%) = 32.5%
+ NIIT. You can put numbers in Taxcaster to verify.

 

[fh2000]

Another consideration applies if you live in a community property state. Assets held as community property receive a full (not just half) step-up in basis upon the death of the first spouse. The surviving spouse would reset basis on all taxable accounts and real estate if properly held, as if he/she had just inherited all of those assets. We hold all assets in a trust that defines held assets as community property for this reason. Based on our circumstances, it makes better sense to avoid harvesting capital gains and instead continue with annual Roth conversions to fill the 15% bracket.

Bogleheads article on the step-up in basis:
https://www.bogleheads.org/wiki/Step-up_in_basis

Which states?
https://en.m.wikipedia.org/wiki/Community_property

Thank you for such a good information that I never knew.

I live in one of the community property states, California. We have some stocks acquired thru ESPP. When we sell, we will pay the 15% discount as ordinary income. The gain above that as short/long term capital gain.

If one of us passes, will the surviving spouse move the new step-up basis in full, or the 15% ordinary income still owed by the time when surviving spouse eventually sells it?

 

[Done]

I knew a US citizen surviving spouse could inherit with no estate taxes, and figured a 50% step up in basis, but didn't know about the 100% step up in JTWROS accounts or jointly owned property like a house. Better make sure all the titles are correctly titled.

Be careful.... Property held in Joint Tenancy only gets a 50% step-up in basis. It has to be held as Community Property (in a community property state) to get a 100% step up. Here's a California attorney's explanation.
http://www.blog.chubblawfirm.com/20...y-property-for-married-couples-in-california/

Nolo article on how property title should read:
http://www.nolo.com/legal-encyclopedia/free-books/avoid-probate-book/chapter6-5.html

To be safe, we hold everything in a revocable trust that defines ownership as community property, and the trust provides other benefits as well.

 

[Done]

Thank you for such a good information that I never knew.



I live in one of the community property states, California. We have some stocks acquired thru ESPP. When we sell, we will pay the 15% discount as ordinary income. The gain above that as short/long term capital gain.



If one of us passes, will the surviving spouse move the new step-up basis in full, or the 15% ordinary income still owed by the time when surviving spouse eventually sells it?

I'm not an attorney or tax advisor, but my understanding is that for a qualified ESPP if the employee dies, income on the original purchase discount is reportable to the decedent in the tax year of death. If the spouse dies first, the income portion is not yet taxed. The tax basis is stepped up according to how the stock was held (separate property, joint tenancy or community property).

The tax code has a host of examples at the end of this excerpt: https://www.law.cornell.edu/cfr/text/26/1.423-2

 

[Markola]

I generally find Roth conversions difficult to justify at any tax bracket.

+1. I just generally like the idea of letting maximum money compound longer and then managing taxes vs. paying some tax but but reducing the eventual nest egg. Maybe I'll be sorry but here is a solid article on the topic that influenced my thinking:

http://www.caniretireyet.com/roth-iras-roth-conversions-needs/

 

[RunningBum]

+1. I just generally like the idea of letting maximum money compound longer and then managing taxes vs. paying some tax but but reducing the eventual nest egg. Maybe I'll be sorry but here is a solid article on the topic that influenced my thinking:

Roth IRAs and Roth Conversions: Who Needs Them? - Can I Retire Yet?

Here's the catch I find in the logic from that article:

Suppose you’re in the 15% tax bracket and you have $5,000 to put to work in a retirement account. In a Traditional IRA account that gives you a starting balance of exactly $5,000, because the contribution is before taxes. But in the Roth account, which is after taxes, you’d have just $4,250, after paying your 15% taxes first from the initial sum.

Don't pay your taxes out of the conversion. Instead, pay it from a taxable account. That way you'll have $5,000 is the Roth, forever growing tax free.

Assume you’re getting about a 7% return. Ten years go by, and your investments have doubled in value. Now you have $10,000 in your Traditional account and $8,500 in the Roth.

Now it’s time to withdraw and use the money. (We’ll ignore various time limits and penalties which are irrelevant for this example.) The Traditional account is taxable, so when you pull out the $10,000, you must pay your 15% tax, leaving you with $8,500. The Roth however is tax free, so when you pull out the balance, you get to keep the full amount. You wind up with $8,500, just like the Traditional.

By paying out of pocket, you now have $10K in your Roth, compared to $8500 after taxes in the tIRA. You have $750 less in your taxable, which would've also doubled to $1500, but you would pay cap gains tax on that $750, or $112.50.

The net is, on a $5000 Roth conversion you came out $112.50 ahead. Not a huge amount, but it is over 2%, and of course we usually are talking about having a lot more in an IRA. I'll take any advantage I can get.

 

[pb4uski]

Yeah, but all that ignores the real reason to do Roth conversions... you are temporarily in a lower tax bracket... the last 3 years I've paid about 10% on my Roth conversions... I'm sure that my tax bracket once pensions and SS are online will be 25%... it certainly will not be less than 15%.. so the real kick is the lower tax rate.

 

[ABQ2015]

I'm slightly in the 28% tax bracket and expect to be in the 25% tax bracket in retirement. I'm single and my retirement income will come from a pension, Social Security, and a tax deferred 401k in that order. I also have a small Roth IRA. RMDs are not an issue. Due to my concern for the potential to means test Social Security and to increase the current means testing of Medicare Part B premiums, I'm considering contributing to a Roth 401k for the next two years and making small Roth conversions in retirement.

Another option might be to defer Social Security and spend down my deferred investments. Regardless, I-ORP calculations recommend the Roth conversions up to the top of the 25% tax bracket and these result in a small increase in after tax spending level of about $1K vs no conversions. Any thoughts would be appreciated.

 

[orplanner]

I'm slightly in the 28% tax bracket and expect to be in the 25% tax bracket in retirement. I'm single and my retirement income will come from a pension, Social Security, and a tax deferred 401k in that order. I also have a small Roth IRA. RMDs are not an issue. Due to my concern for the potential to means test Social Security and to increase the current means testing of Medicare Part B premiums, I'm considering contributing to a Roth 401k for the next two years and making small Roth conversions in retirement.

Another option might be to defer Social Security and spend down my deferred investments. Regardless, I-ORP calculations recommend the Roth conversions up to the top of the 25% tax bracket and these result in a small increase in after tax spending level of about $1K vs no conversions. Any thoughts would be appreciated.

If you compare ORP's spending plans for the IRA to Roth conversion scenario to the non conversion scenario you will see that conversions move tax payments up front in the plan but pay considerably less total tax. A Social Security means test is a tax increase and conversions are prudent in the face of higher taxes later in retirement. You have your finger right on it. The question is what will this anticipated means test look like? The Heritage Foundation proposes that benefits would be reduced by 25 cents of each dollar of income (excluding Soc Sec) beyond $55K with benefits disappearing at $110K income.

 

[samclem]

The question is what will this anticipated means test look like? The Heritage Foundation proposes that benefits would be reduced by 25 cents of each dollar of income (excluding Soc Sec) beyond $55K with benefits disappearing at $110K income.

To expand: That appears to be from the "Saving the American Dream" Heritage Foundation proposal of 2011 (here), and the numbers are for single filers. For married couples, the phaseout of SS benefits would begin with $110K of non SS income, with no SS above $165K of non SS income. A couple of questions I would have:
- Why is this proposal commonly called a "means test" if it still based on income and not "means?"
- If this proposal, or one like it, came into effect, would Roth withdrawals count as income? Just Roth gains, or Roth contributions, too? How about withdrawals of the principal (not gains) in after-tax accounts?

 

[orplanner]

To expand: That appears to be from the "Saving the American Dream" Heritage Foundation proposal of 2011 (here), and the numbers are for single filers. For married couples, the phaseout of SS benefits would begin with $110K of non SS income, with no SS above $165K of non SS income. A couple of questions I would have:
- Why is this proposal commonly called a "means test" if it still based on income and not "means?"
- If this proposal, or one like it, came into effect, would Roth withdrawals count as income? Just Roth gains, or Roth contributions, too? How about withdrawals of the principal (not gains) in after-tax accounts?

You make a good point. Congress is totally unconstrained in how they define "income". It can include or exclude anything.

 

[pb4uski]

To expand: That appears to be from the "Saving the American Dream" Heritage Foundation proposal of 2011 (here), and the numbers are for single filers. For married couples, the phaseout of SS benefits would begin with $110K of non SS income, with no SS above $165K of non SS income. A couple of questions I would have:
- Why is this proposal commonly called a "means test" if it still based on income and not "means?"
- If this proposal, or one like it, came into effect, would Roth withdrawals count as income? Just Roth gains, or Roth contributions, too? How about withdrawals of the principal (not gains) in after-tax accounts?

IF, and notice that "IF" is capitalized, they stay with the traditional definition of income then obviously Roth withdrawals and after-tax principal would not be income though they could slide slippery into some scheme to bifurcate Roth withdrawals between principal and gains and include the gains in income. I doubt that they would ever slide to the point of considering principal as income for that purpose but you never know the extent of politicians greed.

I suspect that they call the proposal a means test even though it is based on income in that income is the result of capital aka means... and defined broadly that would include pensions and tax-deferred accounts.

In a way it would make tax-deferred accounts much less desirable because the in retirement tax rate on an economic basis would be higher because it would be composed of income tax (as it is today) and loss of SS retirement benefits (sort of like in some ER cases the economic tax is a combination of taxes and loss of Obamacare subsidies) so it might generate more tax revenue in the long run since people would be less inclined to do tax-deferred savings.

 

[harley]

Gain Harvesting
As long as you stay within the 15% tax bracket all capital gains and qualified dividends are taxed at a rate of 0%.

So if I'm in the 15% tax bracket and I have a $200 investment that I bought for $100 I can sell it and immediately repurchase it tax free. I step up my basis from $100 to $200. I never have to pay taxes on that $100 gain. Any future gains or losses may be taxable or tax deductible.

I'm curious. Do you invest in individual equities? Or mutual funds/ETFs? I can see doing the harvesting with the individual stocks, but never really thought about harvesting gains in funds. I'll have to give this some thought.

At the same time, tax laws change and not always in the way we expect. The imposition of a VAT or carbon tax would mean that your Roth conversion gets taxed twice. It's not a certainty that future tax changes will benefit Roth accounts.

But wouldn't a withdrawal from a tIRA also be taxed twice, with the withdrawal taxed at the higher level we would like to avoid while in the 15% bracket, then again when you buy something with it? In other words, I convert $10K now and pay $1.5K tax, then later withdraw it and buy something paying the whatever VAT. Or I don't convert, withdraw later from the tIRA paying 25% (because I'm now in a higher bracket due to RMDs) totaling $2.5K, then buy something with it and pay the VAT. Seems like I still pay higher taxes if I don't do the conversion.

This disregards the harvesting aspect. I'm just curious if my thinking about the conversion with VAT is right.

 

[Gone4Good]

I'm curious. Do you invest in individual equities? Or mutual funds/ETFs? I can see doing the harvesting with the individual stocks, but never really thought about harvesting gains in funds. I'll have to give this some thought.

Funds get the same tax treatment as individual stocks for this purpose. You can use the "Individual Sale" method of cost basis accounting for funds just like with stocks. But even if you're using the weighted average cost method gain harvesting still raises your basis and lessens future gains.

But wouldn't a withdrawal from a tIRA also be taxed twice [with the imposition of a VAT], with the withdrawal taxed at the higher level we would like to avoid while in the 15% bracket, then again when you buy something with it?

Yes, but as with most things it also depends on the specifics.

If a VAT reduces or eliminates the income tax than a tIRA would fare better than a ROTH.

It's worth noting that one of the final four candidates for president of the U.S. put forward such a proposal as his tax plan this election cycle.

More generally, for those who support VAT type taxes it is usually for the reason that taxing consumption is more economically efficient (less distorting) than taxing income. So if something like a VAT ever gets passed, it probably only happens if it also reduces income taxes.

The same is true for something like a carbon tax, which might be more likely in the coming decades than is currently appreciated.