Roth Conversions - Conventional Wisdom

[Independent]

When I retired, we had enough money in taxable investments to cover expenses for a few years. We spent that money first, and that put us in the 15% marginal tax bracket.

Since I figured we'd be in the 25% bracket eventually, I converted some traditional IRA to Roth IRA, roughly up to the top of the 15% bracket. (I wasn't worried about going a little over since I figured that 25% now was no worse than 25% later.)

I think that's the "conventional wisdom" on tIRA => Roth IRA conversions.

But, now I'm thinking I should have filled up the 25% bracket as well.

When RMDs hit, we'll be in the 25% bracket. So we'll spend the 25% on FIT, then put any money we don't spend into taxable accounts.
It seems like I should try to get it out of the tIRA sooner. Sure, we'll spend the 25% on FIT in order to roll to the Roth. But, once it's there, it will be in a tax free account.

Right now, this seems like "duh, why didn't I see that sooner". Have I been missing something that everyone else around here knows? Or, maybe I'm missing the downside of conversions?

 

[MBAustin]

I am doing Roth conversions each year into the 25% bracket because like you, our RMDs will put us there anyway. I haven't maxed out the bracket yet, but I may get a little more aggressive as DH gets closer to 70. We still have a few years.

 

[N02L84ER]

The catch when you have regular taxable investments when doing Roth conversions in the 15% tax bracket is that the LT cap gains and qualified dividends on the regular taxable investments are 0% but if you go into the 25% tax bracket those gains and dividends are taxed at 15%. It sounds like you no longer have regular taxable investments, so filling up the 25% bracket makes more sense in your situation now than it did earlier.

 

[Animorph]

Roth conversions early on can be beneficial, even if the tax rate is the same now as it would be at age 70. You are taking out $100 from the tIRA, paying $25 in taxes, placing the remaining $75 into the Roth, and adding $25 from your taxable account to your Roth to fill out the $100 you are allowed. You have the same $75 after-tax value you used to have in the tIRA before the conversion, plus an extra $25 that used to be taxable and is now tax free. Every year you can keep that $25 growing in the Roth adds to the advantage you see from the conversion. So, the earlier the better.

Per my calculations, I'm converting as much as possible as long as the current marginal tax rate is less than or equal to my anticipated age 70 marginal tax rate. In a few years that will slow down and I'll be able to stay within the 15% tax bracket with Roth conversions and then with RMD's. That maximizes the time my money stays in the Roth accounts.

 

[GrayHare]

Two downsides about converting are 1) it's a guess about future tax rates, and 2) you lose the opportunity to deduct against that income. For example, medical expenses are likely to rise as we age, but if we have little-to-no taxable income, their deductability may be wasted.

 

[MichaelB]

Right now, this seems like "duh, why didn't I see that sooner". Have I been missing something that everyone else around here knows? Or, maybe I'm missing the downside of conversions?

It's a lot easier to see the average tax rate when looking back at the past. I think we have an aversion to paying taxes and naturally try to minimize our current tax burden by deferring until we no longer can. The option to pay more tax earlier is one that is most evident when it is no longer available.

 

[hnzw_rui]

Two downsides about converting are 1) it's a guess about future tax rates, and 2) you lose the opportunity to deduct against that income. For example, medical expenses are likely to rise as we age, but if we have little-to-no taxable income, their deductability may be wasted.

Alas this. It's a bit of a balancing act. Still, I figure if my problem when I turn 70 1/2 is high RMDs, then I'm ahead of the game.

 

[Rothman]

Independent, I think your realization is right on track. All the extra years of growth after conversion compound the benefit. ACA subsidies are the only thing that complicates the answer, as that may make lower conversions beneficial until you have Medicare, then go heavy to 70.


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[pb4uski]

Roth conversions early on can be beneficial, even if the tax rate is the same now as it would be at age 70. You are taking out $100 from the tIRA, paying $25 in taxes, placing the remaining $75 into the Roth, and adding $25 from your taxable account to your Roth to fill out the $100 you are allowed. You have the same $75 after-tax value you used to have in the tIRA before the conversion, plus an extra $25 that used to be taxable and is now tax free. Every year you can keep that $25 growing in the Roth adds to the advantage you see from the conversion. So, the earlier the better.

Per my calculations, I'm converting as much as possible as long as the current marginal tax rate is less than or equal to my anticipated age 70 marginal tax rate. In a few years that will slow down and I'll be able to stay within the 15% tax bracket with Roth conversions and then with RMD's. That maximizes the time my money stays in the Roth accounts.

I'm not sure if it makes much of a difference.

Let's say I have $25 in taxable and $100 in tax deferred and my current and later tax rates are 25%.

If decide not to convert at a 7% annual return, the $100 will grow to be $197 in 10 years and the $25 will grow to be $49 in 10 years. If I then withdraw that $197 and pay the 25% tax of $49, I have $197 left to spend.

Alternatively, if I convert the $100 and pay $25 in tax so the taxable account is gone and I have $100 in the tax-free Roth and the roth grows at 7% for 10 years I have $197 to spend.

Same thing.

 

[pb4uski]

There are some downsides to the 25% bracket that cause it to be more than 25%, especially if you have tax preferenced income.

For example, tax a 60 yo married couple with standard deductions and $30k of qualified dividends and LTCG. Their tax is zero.

If they convert $65,500 then their TI is $74,900 (the top of the 15% tax bracket) and their tax is $5,816.

If they convert $141,800 then their TI is $151,200 (the top of the 25% tax bracket) and their tax is $26,388.

So the tax on the $76,300 extra conversion income from the top of the 15% tax bracket to the top of the 25% tax bracket is 27% ($26,388-$5,816)/($141,800-$65,500).

All per Taxcaster (2015).

 

[Independent]

Thanks for all the responses. So far, I have these cautions regarding going beyond the 15% bracket, or "filling up" the 25% bracket with conversions:

1) Getting into the 25% bracket increases taxes on qualified dividends and capital gains.

2) Conversions get into the MAGI that is used for ACA subsidies.

3) Congress could change the law and our future tax rates may be less than expected.

4) We could get big enough tax-deductible medical expenses after age 70 to push us down into the 15% bracket.

In our case, we didn't/don't have taxable dividends or cap gains to worry about.
We were born too early for ACA.
I'm going to give (3) a near-zero probability.

But (4) is interesting. Certainly, our "worst case" future involves large nursing home expenses. I figured a long term stay would eventually become tax deductible. I'll have to look at some numbers on that.

Animorph, I get the idea of using conversions to convert taxable assets into Roth assets. But, we were using the taxable assets for living expenses. If we had put them into the Roth, we would have increased our tIRA withdrawals.

 

[Animorph]

I'm not sure if it makes much of a difference.

Let's say I have $25 in taxable and $100 in tax deferred and my current and later tax rates are 25%.

If decide not to convert at a 7% annual return, the $100 will grow to be $197 in 10 years and the $25 will grow to be $49 in 10 years. If I then withdraw that $197 and pay the 25% tax of $49, I have $197 left to spend.

Alternatively, if I convert the $100 and pay $25 in tax so the taxable account is gone and I have $100 in the tax-free Roth and the roth grows at 7% for 10 years I have $197 to spend.

Same thing.

If you don't convert, and you are in the 15% CG tax range then your tax is $49 on the $197 tIRA withdrawal plus $3.60 in CG tax. Net is $193.40

If you do convert, you do have $197 tax free. That's an extra 1.86% to spend after just 10 years.

Not life changing, but not the same thing.

 

[Rothman]

I'm not sure if it makes much of a difference.



Let's say I have $25 in taxable and $100 in tax deferred and my current and later tax rates are 25%.



If decide not to convert at a 7% annual return, the $100 will grow to be $197 in 10 years and the $25 will grow to be $49 in 10 years. If I then withdraw that $197 and pay the 25% tax of $49, I have $197 left to spend.



Alternatively, if I convert the $100 and pay $25 in tax so the taxable account is gone and I have $100 in the tax-free Roth and the roth grows at 7% for 10 years I have $197 to spend.



Same thing.

Your neutral view assumes the conversion is available at the later date, I understood the OP to say because he didn't convert earlier he is now taking more RMD than needed to live and it's going to taxable account. In that scenario he is paying taxes on its growth. Why not convert to the top of the bracket you will be in retirement, unless you have expectations taxes will be lower in the future at your bracket?


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[pb4uski]

Your neutral view assumes the conversion is available at the later date, I understood the OP to say because he didn't convert earlier he is now taking more RMD than needed to live and it's going to taxable account. In that scenario he is paying taxes on its growth. Why not convert to the top of the bracket you will be in retirement, unless you have expectations taxes will be lower in the future at your bracket?

I agree with the idea of converting to the top of the tax bracket that you expect to be in retirement, what I'm objecting to is the notion that Animorph suggested that Roth conversions can be beneficial even if your current rate is the same as your tax rate in retirement. If the rate is the same it is not beneficial.

 

[pb4uski]

If you don't convert, and you are in the 15% CG tax range then your tax is $49 on the $197 tIRA withdrawal plus $3.60 in CG tax. Net is $193.40

If you do convert, you do have $197 tax free. That's an extra 1.86% to spend after just 10 years.

Not life changing, but not the same thing.

Good point, but that $3.60 tax is easily avoided if the growth is the result of qualified dividends or if you do gains trading of the taxable account while in the 15% tax bracket so the actual 15% CG tax would probably be more like 35 cents. Hardly beneficial.

 

[Animorph]

Good point, but that $3.60 tax is easily avoided if the growth is the result of qualified dividends or if you do gains trading of the taxable account while in the 15% tax bracket so the actual 15% CG tax would probably be more like 35 cents. Hardly beneficial.

Depends on your specific taxes. If you can hold the $100 in a taxable account and never pay taxes on dividends or capital gains then a tIRA or a Roth does nothing for you.

 

[Dog]

Is there a limit to how much you can add to a Roth once you are retired? Are there any special rules or gotchas other than staying within 15% or 25% tax rate? I seem to recall someone telling me I could not use my 72t distributions from a tIRA to fund a Roth.
I apologize if this has been answered before and would appreciate the link to prior discussion. Thank you!

 

[Independent]

Your neutral view assumes the conversion is available at the later date, I understood the OP to say because he didn't convert earlier he is now taking more RMD than needed to live and it's going to taxable account. In that scenario he is paying taxes on its growth. Why not convert to the top of the bracket you will be in retirement, unless you have expectations taxes will be lower in the future at your bracket?

Actually, I still have a couple years before RMDs. But I do wish I had asked this question sooner.

 

[pb4uski]

Depends on your specific taxes. If you can hold the $100 in a taxable account and never pay taxes on dividends or capital gains then a tIRA or a Roth does nothing for you.

True, but the Roth allows you to invest in corporate bonds and have the interest income be tax-free and you can't do that in a taxable account unless you invest in munis.

 

[LOL!]

The catch when you have regular taxable investments when doing Roth conversions in the 15% tax bracket is that the LT cap gains and qualified dividends on the regular taxable investments are 0% but if you go into the 25% tax bracket those gains and dividends are taxed at 15%. It sounds like you no longer have regular taxable investments, so filling up the 25% bracket makes more sense in your situation now than it did earlier.

Yep and 15% + 15% is 30%. I noticed this by using TurboTax. I will be in the 15% tax bracket this year if I [-]work[/-] play my cards right. However, if i go over, all that extra income will be taxed at 30% because of the above.

I need to have less dividend income so that I can convert more. Since I have lots of carryover losses to offset capital gains, I am going to think about selling just before dividends are paid and buy back the next day in order to avoid getting the dividends. I bet dividend investors will think I am crazy.

 

[mathjak107]

I'm not sure if it makes much of a difference.

Let's say I have $25 in taxable and $100 in tax deferred and my current and later tax rates are 25%.

If decide not to convert at a 7% annual return, the $100 will grow to be $197 in 10 years and the $25 will grow to be $49 in 10 years. If I then withdraw that $197 and pay the 25% tax of $49, I have $197 left to spend.

Alternatively, if I convert the $100 and pay $25 in tax so the taxable account is gone and I have $100 in the tax-free Roth and the roth grows at 7% for 10 years I have $197 to spend.

Same thing.

you are correct. the flaw in most calculations is folks use outside money to pay the taxes on the roth up front but then want to figure paying the taxes on the traditional not from outside money like the roth but pulling it from within the traditional balance .


the advantage of the roth is in other areas.

mostly the fact that our final years income is not what counts when comparing tax rates to retirement. for most of us 40 years of rampping up will have our long term tax bracket average inflation adjusted at a much lower rate than our retirement one which is usually based within spitting distance of our final earning years.

unless you had a career that started you off in the higher tax rates or had a dead end job odds are a roth will leave you with more spending dollars since odds are you retirement tax braccket will typically be higher than your career one.

he other is the fact you will be taxed on any rmd money reinvested forever. the roth stays untaxed.

whether or not you get a medical subsidy or your ss taxed are two other concerns.

all of the above have little to do with whether taxes go up or not.

 

[ziggy29]

Is there a limit to how much you can add to a Roth once you are retired? Are there any special rules or gotchas other than staying within 15% or 25% tax rate? I seem to recall someone telling me I could not use my 72t distributions from a tIRA to fund a Roth.

There is no limit to direct Roth *conversions*, nor are there income limits for Roth conversions since they were repealed a few years back.

However, other than a direct conversion you can only *contribute* to a Roth with *earned* income, and a 72t distribution is not earned income. You can only directly convert from the tIRA to a Roth, and that could reduce the required amount of 72t income in future years.

 

[pb4uski]

Yep and 15% + 15% is 30%. I noticed this by using TurboTax. I will be in the 15% tax bracket this year if I [-]work[/-] play my cards right. However, if i go over, all that extra income will be taxed at 30% because of the above.....

I ran into this last year. I had overconverted by a small amount and was looking at 30% on the amount overconverted but was able to avoid it by recharacterizing the excess so the taxable income on my tax return was exactly the top of the 15% tax bracket.

 

[Dog]

Thanks Ziggy. We have two more years to contribute via earned income. I will need to research the direct conversion to Roth. I do have a 401k that I could look at until the 5 year clock runs out on 72t from my tIRA.


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[pixelville]

Another reason to convert in the early years, especially if you retired early with decades before RMD, is that typically your IRA/401k will grow at a rate much higher than inflation, and with compounding over decades, RMDs will likely push you into higher tax brackets than you thought you would be (since tax-brackets are only inflation-adjusted). Of course, there are a lot of assumptions here.
Maybe mathjak107 was saying the same thing about inflation & tax brackets?

Also, sooner or later, one spouse passes away and the surviving spouse files as Single resulting in higher taxation with same income. If this money was in Roth, that would not be a concern.