Roth Conversions - Much Ado About Little?

[samclem]

Quote:

Originally Posted by harley 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]

Quote:

Originally Posted by 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, 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]

Quote:

Originally Posted by pb4uski 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]

Quote:

Originally Posted by Cobra9777 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]

Quote:

Originally Posted by pb4uski 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

[RunningBum]

Right, gains will never be taxed in a Roth.

[pb4uski]

Yes, we are living from our taxable accounts. If we did no Roth conversions we would pay no tax because our ordinary income is well below the combination of our itemized deductions and exemptions and our other income is qualified dividends and long-term capital gains (both of which are tax-free as long as our total income stays within the 15% tax bracket).

So our Roth conversions to the top of the 15% tax bracket get taxed at 0% to the extent of our unutilized itemized deductions and exemptions, then at 10% and then at 15% and it all averages out to ~7%.

The difference between what we are doing and drawing from our tIRA for living expenses is that we get to put the money into a Roth which is tax-free for the rest of time and can be inherited tax-free by our kids.

So since we are fortunate enough to have taxable funds we can live on for now, we are using Roth conversions to take the best advantage of our current low tax situation. I can't imagine that we will ever be in a position where we can extract funds from our tax-deferred accounts for ~7% so we are taking full advantage of it while we can.

[BBQ-Nut]

Quote:

Originally Posted by pb4uski Yes, we are living from our taxable accounts. If we did no Roth conversions we would pay no tax because our ordinary income is well below the combination of our itemized deductions and exemptions and our other income is qualified dividends and long-term capital gains (both of which are tax-free as long as our total income stays within the 15% tax bracket). So our Roth conversions to the top of the 15% tax bracket get taxed at 0% to the extent of our unutilized itemized deductions and exemptions, then at 10% and then at 15% and it all averages out to ~7%. The difference between what we are doing and drawing from our tIRA for living expenses is that we get to put the money into a Roth which is tax-free for the rest of time and can be inherited tax-free by our kids. So since we are fortunate enough to have taxable funds we can live on for now, we are using Roth conversions to take the best advantage of our current low tax situation. I can't imagine that we will ever be in a position where we can extract funds from our tax-deferred accounts for ~7% so we are taking full advantage of it while we can.

Just a question though - will you need the Roth accounts 'later' or are you doing the conversions cuz you can?

If you don't need the Roth money later, and given your current tax situation, couldn't you also just withdraw the deferred dollars and up your WR for 'better quality of life'?

[pb4uski]

I guess it depends on how you define "need" but we are not lacking in lifestyle right now but I'll concede we are intrinsically frugal and probably don't spend as much as we can.

The way I'm looking at it is that that money will get taxed at some point, either as RMDs or when my kids inherit it and draw on it and it is very unlikely that it will be taxed at less than the 7% that I am paying now while doing Roth conversions and very likely that it will be taxed at much more. I expect my tax rate will be higher later on once my pension and SS start and my kid's tax rate will be higher because they will be working when they inherit it.

So I guess more cuz I can.

[harley]

Quote:

Originally Posted by pb4uski I guess it depends on how you define "need" but we are not lacking in lifestyle right now but I'll concede we are intrinsically frugal and probably don't spend as much as we can. The way I'm looking at it is that that money will get taxed at some point, either as RMDs or when my kids inherit it and draw on it and it is very unlikely that it will be taxed at less than the 7% that I am paying now while doing Roth conversions and very likely that it will be taxed at much more. I expect my tax rate will be higher later on once my pension and SS start and my kid's tax rate will be higher because they will be working when they inherit it. So I guess more cuz I can.

I'm right there with you. We have a similar situation, although I do have some taxable income so I lose the very bottom bracket for my Roth conversions. However, we mostly live on after tax cash. I put the money into the 401(k) while I was in a high (25+%) bracket. I can convert it in a much lower bracket. Right there I'm saving money. Plus I don't intend to ever need the money in the Roth, so it will be growing tax free for my daughter/grandkids to inherit some day. I really don't need to do the conversions, but it saves me money in taxes, and I get a big warm and fuzzy feeling when that happens.

[Animorph]

The net effect of a Roth conversion is that you get to move some of your taxable account money into a tax-free account. Not a wash over a full retirement period, providing you pay taxes, just a wash when you first do it.

Example:

Start:
$100 taxable ($20 untaxed capital gain at 15%), $100 tIRA (25% tax bracket), $0 Roth, NW after taxes = $100 - $20*15% + $100 - $100*25% + $0 = $172

Roth convert $20 of tIRA, pay taxes with taxable account so all $20 goes into the Roth:
Taxes paid = $20*25% = $5 conversion income,
$1 capital gain on average CG tax = $0.15
$94.85 taxable ($18.97 untaxed capital gain), $80 tIRA, $20 Roth,
NW after taxes = $100 - $5.15 - $18.97*15% + $100 - $20 - $80*25% + $20 = $172

So a wash for immediate after-tax net worth, $172 either way. But now you have the $15 after-tax value you moved from the tIRA to the Roth, and you have "moved" $5 of your taxable account into your tax-free Roth account. The benefit is that you avoid all taxes on that $5 in the future, capital gains or dividends or interest. But you only see that over time.

Strictly a way to minimize taxes. You must have enough money in a taxable account to live off of, and to pay the conversion taxes. You must have money in a tIRA to convert. You must have a tax rate for your taxable account that is greater than 0% so that you do actually save taxes by moving that money into a tax-free account.

As far as spending, if you spend from the tIRA instead of the taxable account, you don't get to move that $5 from the taxable account to the Roth account. You withdraw $20 from the tIRA, pay $5 of it in taxes, and spend $15. Your taxable account stays unchanged. If you spend $15 from the taxable account instead, while doing the Roth conversion, you have another $15 gone from the taxable account. Again, the after-tax NW is the same for either case. But with the Roth conversion you now have about $20 less in your taxable account and $20 more in your Roth account. That will lead to less taxes paid in future years. Same net worth now, less taxes due in the future.

I've assumed the tax rate remains the same from now until the tIRA is emptied. If you can get more money Roth converted now at a lower tax rate than your RMD's will have in the future that's an added bonus. If your tax rate is higher now than it will be during RMD's, you may not want to Roth convert.

As a tax reduction plan, Roth conversions are never going to double your yearly spending. At the very best it moves all of your taxable account into a Roth account and you no longer have to pay taxes on that money. Depending on the sizes of your taxable and tIRA accounts and your living expenses, you may be able to move all of your taxable account or only a fraction of it into the Roth. Depending on your tax rates, that may save you nothing or a significant amount.

[user5027]

Quote:

Originally Posted by Animorph The net effect of a Roth conversion is that you get to move some of your taxable account money into a tax-free account.

Thank you for providing the example. I've one comment...

A Roth conversion moves TAX DEFERRED (tIRA) money into a tax-free account.

A taxable account is money invested that was already taxed and tax is paid on the gains, dividends and interest earned.

[pb4uski]

Quote:

Originally Posted by Animorph The net effect of a Roth conversion is that you get to move some of your taxable account money into a tax-free account. Not a wash over a full retirement period, providing you pay taxes, just a wash when you first do it.....

Agreed, I misinterpreted your earlier post as being a wash in the long run. It would be a wash in the long run if the effective tax rate at conversion and when the money would otherwise be used (by you or an heir) are the same.

I'll admit that I this ER to pension/SS period where we can convert at very low effective tax rates was a pleasant surprise.

[Animorph]

Quote:

Originally Posted by user5027 Thank you for providing the example. I've one comment... A Roth conversion moves TAX DEFERRED (tIRA) money into a tax-free account. A taxable account is money invested that was already taxed and tax is paid on the gains, dividends and interest earned.

Yes, of course, but the net effect is a reduction of your taxable account. Just as if you took $20 from the tIRA, paid $5 of that in taxes, added back $5 from your taxable account, and then placed the $20 into your Roth. That makes the value proposition easier (for me anyway) to see.

[Animorph]

Quote:

Originally Posted by pb4uski Agreed, I misinterpreted your earlier post as being a wash in the long run. It would be a wash in the long run if the effective tax rate at conversion and when the money would otherwise be used (by you or an heir) are the same. I'll admit that I this ER to pension/SS period where we can convert at very low effective tax rates was a pleasant surprise.

Wait a minute, it's not necessarily a wash in the long run if the tax rates now and in the future are the same, though it could be if you don't owe any taxes on your taxable account throughout retirement. That's what my example showed, shifting taxable funds into the Roth account. The Vanguard Roth conversion calculator used to show that benefit as well. I assume it still does.

Luckily for me all this stuff came up on the forum in time for me to incorporate it into my plans. When I first started it was all 4% SWR discussions, then we gradually branched out to other useful ideas.