Roth Conversions - Much Ado About Little?

[Independent]

Along the same lines, GrayHare pointed out in another thread that you may incur tax-deductible medical expenses late in life.

For us, the "very bad" scenario is high nursing home expenses. But, under the right conditions, those nh expenses would be tax deductible. We could get IRA money without paying FIT. So:

1) In the good case, we have no nh expenses and the kids inherit money still in traditional IRAs.
2) In the bad case, we have significant nh expenses, but we at least don't have to pay taxes when we hit the IRA to cover them.

 

[harley]

I may being too simplistic, but since I was in the 25-28% tax bracket when I was putting the money into the 401(k) that later got rolled into a t-IRA, and I'm in the 15% bracket when I convert the money to a Roth, I don't see how I'm not saving money. Especially since I'm probably going to be back in the 25-28% bracket someday when SS and RMDs start.

I guess the way I look at it, if I put in $100K while in the 28% bracket I saved $28K in taxes. If it costs me $15K to convert it to a Roth (over a few years), I'm $13K ahead. And that's not counting the tax free money I'll make on it before I die or withdraw it. Am I wrong?

 

[sengsational]

Let's see... you didn't know for sure that you would be ahead or behind when you originally escaped paying 28% on it. You know you're ahead now if you take it out. You don't know you'll be as far ahead in the future. Sounds like a bird in the hand situation.

 

[pb4uski]

I may being too simplistic, but since I was in the 25-28% tax bracket when I was putting the money into the 401(k) that later got rolled into a t-IRA, and I'm in the 15% bracket when I convert the money to a Roth, I don't see how I'm not saving money. Especially since I'm probably going to be back in the 25-28% bracket someday when SS and RMDs start.

I guess the way I look at it, if I put in $100K while in the 28% bracket I saved $28K in taxes. If it costs me $15K to convert it to a Roth (over a few years), I'm $13K ahead. And that's not counting the tax free money I'll make on it before I die or withdraw it. Am I wrong?

No, I agree with you. I have a fairly sophisticated projection of our retirement out to age 100 and while our NW with Roth conversions is not significantly different for 60-70, it takes off after then and is 50% higher with Roth conversions at age 100... I suspect the compounded impact of the lower taxes with Roth conversions vs without.

 

[sengsational]

High level of tax deductible medical costs, utility of the money if the market does one thing or the other...all things that I hadn't thought about that push away from an aggressive conversion strategy. That, coupled with the fact that i-orp tells me my situation is pretty close to a wash (presuming that big 'if' of tax rates staying the same), has me leaning towards a less aggressive conversion strategy.

 

[hnzw_rui]

No, I agree with you. I have a fairly sophisticated projection of our retirement out to age 100 and while our NW with Roth conversions is not significantly different for 60-70, it takes off after then and is 50% higher with Roth conversions at age 100... I suspect the compounded impact of the lower taxes with Roth conversions vs without.

Curious, have you factored in results of reinvesting excess RMD in a taxable account in your NW projections? That's one thing I realized while doing my own projections. Just because you're required to take RMDs does not mean you have to spend all of it.

 

[grasshopper]

I have not seen this addressed before. Scenario you have started SS at 70, starting to take RMDs, you have 200K in LTCG, but you are already butting up against the tax bracket you converted Roths in. While you are more than likely to have boat loads of money with SS and RMDs, what to do about taking gains if you need to.

 

[hnzw_rui]

I have not seen this addressed before. Scenario you have started SS at 70, starting to take RMDs, you have 200K in LTCG, but you are already butting up against the tax bracket you converted Roths in. While you are more than likely to have boat loads of money with SS and RMDs, what to do about taking gains if you need to.

Curious, why would you need to take gains? Given the step up in basis upon death, assuming SS and RMDs cover all your expenses, I'll just leave the taxable account as is.

 

[Options]

It seems to me that future investment performance is >the< biggest unknowable in this "how much should I convert?" situation. It impacts the size of any future RMDs and the taxes to be paid on them. But, I know a few things:
1) If my investments perform poorly compared to my present expectations, I'll need the dollars to meet spending requirements and my marginal tax rate will be the same as my present rate or lower. I will be sorry if I converted too much and gave the dollars to the IRS in my earlier years.
2) If my investments have higher-than-expected returns, then I'll pay extra taxes on funds I didn't convert earlier, but the high returns mean I'll still have more money to spend than I'd planned on, so paying the taxes at this later time is not very painful. And--the uncertainty about portfolio returns and required spending decreases each year (as we approach our appointment with the grim reaper. A 60 year old needs to worry about returns/expenses for long timeline, a 90 year old--less so).

So, given the relative marginal utility of the dollars in each scenario, I bias toward converting less rather than converting more. The expected after-tax values in each case are not of primary importance, it is the expected utility of the remaining funds and the different "pain" of the tax bite. In my case, I will probably convert to the top of the 15% bracket (our present bracket), but not beyond that.

This. Emphasis added.

Same plan of action here to convert to the top of the 15% bracket and not beyond.

 

[RetireBy90]

So if I am psychic and read between the lines correctly, sounds to me like many who have commented on this thread have most of RE assets in IRA, 401K, or taxable account. I have most expenses covered by 2 pensions and SS at age 70. We have retirement savings also, but kinda gives a different start point, my retirement savings will be some for living expenses before 70, then self insured for unknown expenses like LTC, but mostly to pass along to kids. So if they are to pass along does that change your conclusion about to ROT or not?

 

[pb4uski]

Curious, have you factored in results of reinvesting excess RMD in a taxable account in your NW projections? That's one thing I realized while doing my own projections. Just because you're required to take RMDs does not mean you have to spend all of it.

Yes, that is exactly what I do. Spending is based on living expenses, increased each year for inflation and any cash flow in excess of what is spent is invested.

 

[pb4uski]

So if I am psychic and read between the lines correctly, sounds to me like many who have commented on this thread have most of RE assets in IRA, 401K, or taxable account. I have most expenses covered by 2 pensions and SS at age 70. We have retirement savings also, but kinda gives a different start point, my retirement savings will be some for living expenses before 70, then self insured for unknown expenses like LTC, but mostly to pass along to kids. So if they are to pass along does that change your conclusion about to ROT or not?

I think Roth conversions makes more sense in that case (which is similar to ours) in that I'm converting at 15% or less and if I didn't convert and left it to my kids in a tIRA then they woudl pay taxes on it at more than 15%.

 

[grasshopper]

Curious, why would you need to take gains? Given the step up in basis upon death, assuming SS and RMDs cover all your expenses, I'll just leave the taxable account as is.

A round the world trip, I hope to die with $10 in my pocket.

Luxury round-the-world tours on private jets take off - NBC News

 

[Cobra9777]

I have a fairly sophisticated projection of our retirement out to age 100 and while our NW with Roth conversions is not significantly different for 60-70, it takes off after then and is 50% higher with Roth conversions at age 100... I suspect the compounded impact of the lower taxes with Roth conversions vs without.

Just curious if your NW referenced above includes tax-deferred accounts measured net of tax, or pretax? Also, would you mind sharing at what age your NW with conversions exceeds your NW, with no conversions? I assume it takes several years after age 70 (when lower RMD tax kicks in) to recover the upfront tax paid on conversions as well as the foregone growth associated with the upfront tax.

 

[pb4uski]

Pre-tax. I'm 60 now.

NW no Roth conversions compared to NW with Roth conversions after 5, 10, 20, 30, and 40 years is 101%, 105%, 114%, 123%, 139% and 152%, respectively. Taxes on the conversion amounts are relatively modest.... 7% of the conversion amount most years (was 7% in 2014 too), creeping up to 14% at 69 and 70. The taxes saved from 71 to 74 are about equal to the taxes paid from 60 to 70 and there are substantial savings each year thereafter.

My projected tax deferred balances at age 70 are 30% of what they would be if I did no Roth conversions and my Roth balance is 4.5x higher.

 

[samclem]

I guess the way I look at it, if I put in $100K while in the 28% bracket I saved $28K in taxes. If it costs me $15K to convert it to a Roth (over a few years), I'm $13K ahead. And that's not counting the tax free money I'll make on it before I die or withdraw it. Am I wrong?

Given your situation, it sounds like it was definitely a good idea to put the money into a tIRA when you were in the 28% rate. The "it depends" part is whether it makes sense to now convert all or some of it to a Roth IRA. Some of us can't be sure we'll ever be in the 25-28% tax brackets in the future--just a few % change in average returns over the decades can make a very big difference in the size of the portfolio and the RMDs. If there's a chance the portfolio will underperform, I'll be happier to have not converted as much and therefore kept more in the portfolio rather than giving it to the IRS. The stash has to last us for decades, and once it's done its job and has seen us through any market bumps I'll be [-]happy[/-] less unhappy to give it to the IRS.
have more money inthe portfolio for

 

[Cobra9777]

Pre-tax. I'm 60 now.

NW no Roth conversions compared to NW with Roth conversions after 5, 10, 20, 30, and 40 years is 101%, 105%, 114%, 123%, 139% and 152%, respectively. Taxes on the conversion amounts are relatively modest.... 7% of the conversion amount most years, creeping up to 14% at 69 and 70. The taxes saved from 71 to 74 are about equal to the taxes paid from 60 to 70 and there are substantial savings each year thereafter.

My projected tax deferred balances at age 70 are 30% of what they would be if I did no Roth conversions and my Roth balance is 4.5x higher.

I guess I'm a little confused how your tax on conversion is 7%. If you are converting to the top of the 15% bracket, why is the incremental tax not 15%?

You also mention that taxes saved from 71-74 cover the conversion tax. My model is similar for the taxes themselves. However, you don't specifically mention foregone growth on the upfront tax. In my model (conversions starting at age 55), the foregone growth is larger than the tax itself when RMDs start, and that hole in the portfolio never stops growing. The RMD tax savings are substantial indeed, but still don't exceed these two conversion costs until age 86... which for me, seems to validate the thread premise that Roth conversions are "much ado about little." Do you not consider foregone growth to be a conversion cost?

 

[samclem]

NW no Roth conversions compared to NW with Roth conversions after 5, 10, 20, 30, and 40 years is 101%, 105%, 114%, 123%, 139% and 152%, respectively. . . .
My projected tax deferred balances at age 70 are 30% of what they would be if I did no Roth conversions and my Roth balance is 4.5x higher.

I wonder how sensitive the results are to the assumed real growth rates of the investments. A real growth rate difference of 2% higher and 2% lower from the modeled growth might produce some significant differences, and I think that level of uncertainty is reasonable. If the rate is 2% shy of what you modeled, the value of Roth conversions goes down, or could become negative (depending on your initially assumed growth rate and your spending model).

 

[pb4uski]

I guess I'm a little confused how your tax on conversion is 7%. If you are converting to the top of the 15% bracket, why is the incremental tax not 15%?

You also mention that taxes saved from 71-74 cover the conversion tax. My model is similar for the taxes themselves. However, you don't specifically mention foregone growth on the upfront tax. In my model (conversions starting at age 55), the foregone growth is larger than the tax itself when RMDs start, and that hole in the portfolio never stops growing. The RMD tax savings are substantial indeed, but still don't exceed these two conversion costs until age 86... which for me, seems to validate the thread premise that Roth conversions are "much ado about little." Do you not consider foregone growth to be a conversion cost?

The first part is easy and that is the secret sauce. Since we ERed and are living off of taxable investments that are mostly domestic and international equity funds, our income is mostly qualified dividends and LTCG which is 0% tax as long as out TI stays in the 15% tax bracket. On top of that, ordinary income (like the Roth conversion) comes first, so the tax on Roth conversions are a blend of 0% (up to sum of our deductions and exemptions), 10% and 15%. I know the 7% is sensible because that has been our actual incremental tax Roth conversions in 2014 and 2013. YMMV based on your tax situation but you can use Taxcaster to get a reasonable idea of how adding Roth conversions to your current situation impacts you tax-wise.

You are right that if I added growth to the tax it would stretch it out some. If I use 5.5% (which is the rate I use for other purposes) it stretches the payback out until I'm 76-77 (vs 74 with no growth).

 

[Cobra9777]

The first part is easy and that is the secret sauce. Since we ERed and are living off of taxable investments that are mostly domestic and international equity funds, our income is mostly qualified dividends and LTCG which is 0% tax as long as out TI stays in the 15% tax bracket. On top of that, ordinary income (like the Roth conversion) comes first, so the tax on Roth conversions are a blend of 0% (up to sum of our deductions and exemptions), 10% and 15%. I know the 7% is sensible because that has been our actual incremental tax Roth conversions in 2014 and 2013. YMMV based on your tax situation but you can use Taxcaster to get a reasonable idea of how adding Roth conversions to your current situation impacts you tax-wise.

You are right that if I added growth to the tax it would stretch it out some. If I use 5.5% (which is the rate I use for other purposes) it stretches the payback out until I'm 76-77 (vs 74 with no growth).

Thanks. In our case, we have pensions and rentals that ensure any conversions will be taxed at the full 15%. This also severely limits the amount we can convert without going into the 25% bracket, which I'm not willing to do. I suspect the higher upfront tax rate (vs your 7%), plus earlier start age (54-55), explains the longer payback in my case.

Either way, it's still pretty late in life to get your NW back to where it would have been without conversions. I still might do some conversions to create additional withdrawal flexibility. But I highly suspect my kids, not me, will be the main beneficiary of that.

 

[pb4uski]

+1 on the last part if my projections hold true unless I decide to go out and buy a few Lamborghini for fun in my 80s.

 

[Animorph]

If you consider only the after-tax value of your tIRA in your NW then Roth conversions are pretty much a wash for NW, depending on your tax rate assumptions. NW takes a hit if a tIRA flows 100% into NW and then you have to pay taxes to convert, losing some of the tIRA money that was never really going to go to you anyway.

A couple of other things to consider are the loss of the first spouse, resulting in lower single tax brackets and probably increasing the tax rate for tIRA withdrawals, and access to a large chunk of emergency cash without an unexpected tax hit above the normal target tax bracket.

I'll still have a tIRA balance after I hit 70. I'll withdraw enough from it to fill up a tax bracket. Hopefully the RMD's will be small enough to stay within the bracket. That's what all the conversions are for.

 

[Perryinva]

While some are reminding that tax rates are unlikely to decrease, models often overlook that the 15, 25, 28% etc inflection points rise each year. Does the model cover that? Also, if you are still married, and filing jointly. Animorph hit the nail on the head. Spousal protection and flexibility. NW is a wash, disposable income is what matters. My plan is the same as his, and my wife is 6 years older than me, so spousal protection (me) is a real consideration.

 

[pb4uski]

Roth conversions are not a wash for me, definitely better to do now than later since between ER at 56 and age 70 (I'm 60 now) we are living off of taxable accounts so any Roth conversions attract much lower tax now than when I was working or once my pension and our SS starts. We have paid ~7% each of the last two years, vs probably 15% or more if we did no conversions and took the money later as RMDs.

My model does build in annual increases to tax brackets, the standard deduction and exemptions. And it is true that if one of us dies early then the survivor will be in a much higher tax bracket, which makes our Roth conversions between now and age 70 at ~7% even more valuable.

 

[RetireBy90]

pb4uski, please bear with me, you are taking conversions as your taxable income now and drawing from taxable accounts.


I have been rolling over in my mind how that would be different than drawing from the Trad IRA for living expenses ? If I were to say take $25K per year from my TIRA for living expenses, I would add $25K to my taxable income. If I convert $25K the same added to taxable income. I guess the gain is then that the $25K is now sheltered ?


Just asking cause I keep going over this in my mind and can't figure what the factors are that I need to consider.


Thanks