Rule of thumb for ROTH conversion?

[grayparrot]

I have been developing custom spreadsheets to try to determine rules of thumb regarding whether it is advisable to do a ROTH conversion, given certain factors.

I am targeting the same kind of conservative "rule of thumb" as is used for withdrawal rates, i.e., "it generally makes sense to assume conservative starting withdrawal rates of 3.5%..."

The factors for a ROTH conversion rule of thumb would be based on a conservative return assumption as a base...let's say 4% real return. The other factors would include number of years of income available in non-IRA assets, in ADDITION to fund necessary for a ROTH conversion, and the expected tax rates in the years before a ROTH breakeven value with a traditional IRA/tax payment fund.

My goal is specifically to help my parents decide on whether to do a ROTH conversion. More generally, I would like to be able to arrive at a generalized rule that says "If you have X years of projected spending available in non-IRA funds, and in addition you have the necessary conversion funds outside of the IRA as well, and your tax rate will not be more than 3% lower than it is now, and projected portfolio growth is 4% after inflation, then you should convert."

How have others made the determination about whether to convert...your own spreadsheets, or prefab calculators? What growth rates and other assumptions have you made?

I'd be very interested in exchanging ideas with others involved in similar analysis.

 

[donheff]

I saw you parallel post and am interested in the topic. Please post your results when you finish your analysis. I intuitively decided not to convert because I am in to high a bracket to make it seem worthwhile but...

 

[LOL!]

The rule of thumb is to use software such as TurboTax and the calculator found at Optimal Retirement Calculator and Retirement Decision Support System Your parents should probably be paying 0% in income taxes when they do a Roth conversion as shown in this thread:

Bogleheads • View topic - How to pay ZERO taxes in retirement with 6-figure expenses

For some strange reason, people believe that having a Roth is better than paying needlessly 25% or more extra in income taxes. Can anybody explain that?

 

[donheff]

Your parents should probably be paying 0% in income taxes when they do a Roth conversion as shown in this thread:

Bogleheads • View topic - How to pay ZERO taxes in retirement with 6-figure expenses

That only works if the withdrawer can pull almost exclusively from taxed funds for living expenses. If (as is common) you have almost fully taxable pensions that cover most of your expenses then the IRA conversions will start at a high marginal tax rate. Doesn't seem any way out of that.

 

[LOL!]

... Doesn't seem any way out of that.

One possible way is to have high medical expenses. Another is to donate lots of money to charity.

 

[yakers]

For some strange reason, people believe that having a Roth is better than paying needlessly 25% or more extra in income taxes. Can anybody explain that?

AFAIK there are two reasons for a Roth, 1) in inheritance it is tax free, a child inheriting a traditional IRA may have to take withdrawals at their peak earning period and 2) it is very flexible tax wise-one could draw it for an emergency item (car replacement?) without increasing taxes as would a traditional IRA. It could allow one to have an income level without going into a higher tax bracket.
Having taxable, tax deferred and tax free resources leaves the most options but is the most complicated.
DW & I are slowly converting about $5K a year from a traditional IRA to a Roth IRA as these are intended to be our legacy to our two sons. We will have a go at spending the rest down and it is still an emergency fund if we need it.

 

[Animorph]

Two rules of thumb for me.

When deciding between traditional 401k/IRA and Roth contributions it goes into Roth if current marginal taxes are greater than or equal to the future marginal taxes when the money will be used. So if your current top tax rate is 25% and you will have an opportunity to withdraw or convert the funds at 15% during ER then the traditional accounts are best. Otherwise the Roth is probably better. For conversions you also need to be sure you have taxable funds to live on and pay the conversion taxes, so there is a balance between the three types of funds, not just the two.

If you have the opportunity to contribute already taxed funds into a Roth that's pretty much a no brainer. All the growth is then tax free, but your original contribution amount can be withdrawn anytime.

 

[LOL!]

Many folks overestimate drastically the taxes they will pay in retirement.

donheff writes about folks with pensions and they are the exception perhaps. With fewer and fewer folks having pensions that pay more than a token amount, there will be less and less taxes paid by retired folks.

 

[GrayHare]

Like the OP I created my own spreadsheet. If retiree tax minimization is your goal, the spreadsheet said is the rule of thumb is the tax rate now vs. the tax rate later, which is something of a guessing game. However, as others have mentioned, Roths offer additional advantages which may or may not be important depending on each person's situation.

I converted in 2010 because 1) tax on the conversion could be deferred into 2012 and 2013 and thus paid with inflated dollars, 2) a portion of the Traditional IRA was non-deductable and thus tax had already been paid on it, 3) it seems income tax rates will rise in the years ahead, and 4) I like the flexibility of having a source of non-taxable income during FIRE because it allows me some control over the tax bracket I wind up in.

 

[TromboneAl]

When I was working I used one of the many "Should I convert?" online calculators.

Now the answer is always yes, since we are still drawing from already taxed accounts.

This year we'll convert $32K, which will take us to the top of the 10% bracket. We should probably convert more, but a dollar in the hand is worth two in the bush.

Last year: $40K.

 

[73ss454]

I'm with Al, I did 44K this year.

 

[grayparrot]

The rule of thumb is to use software such as TurboTax and the calculator found at Optimal Retirement Calculator and Retirement Decision Support System Your parents should probably be paying 0% in income taxes when they do a Roth conversion as shown in this thread:

For some strange reason, people believe that having a Roth is better than paying needlessly 25% or more extra in income taxes. Can anybody explain that?

Yes, I can explain. There can be a benefit to paying more in taxes now, depending on the period during which the ROTH can grow tax free. If a ROTH could be left to grow tax free for a very long time (such as over the lifespan of a young beneficiary) the value of the tax free growth will eventually make up for and exceed higher taxes now. (Now of course if you have to pay ridiculously high taxes now to do a conversion, then you'd have to wait a very long time for the catch-up. If your tax rates are few percent off, the catch up period is less than 20 years, which can easily be accomplished through the joint life expectancy of both parents and inheriting beneficiaries.

 

[LOL!]

Yes, I can explain. There can be a benefit to paying more in taxes now, depending on the period during which the ROTH can grow tax free. If a ROTH could be left to grow tax free for a very long time (such as over the lifespan of a young beneficiary) the value of the tax free growth will eventually make up for and exceed higher taxes now. (Now of course if you have to pay ridiculously high taxes now to do a conversion, then you'd have to wait a very long time for the catch-up. If your tax rates are few percent off, the catch up period is less than 20 years, which can easily be accomplished through the joint life expectancy of both parents and inheriting beneficiaries.

Sorry I am not buying that explanation because I know the rules of arithmetic. If the tax rate is the same, there is no difference.

I think you are basically making a play on RMDs. Since in the other thread, you mentioned that parents would convert at the highest marginal tax rate, but that means they will never pay higher taxes than now unless tax rates go up. That means they can wait until the last moment to convert. Maybe this is the last moment as their RMD are imminent?

Of course, they will reduce their estate as well. However, does giving 35+% of your estate to the Feds in the form of taxes really count as a reduction?

 

[grayparrot]

Sorry I am not buying that explanation because I know the rules of arithmetic. If the tax rate is the same, there is no difference.

I do appreciate your responses, but with respect, I assure you that your math is incorrect in this case. The actually calculations are significantly more complex than just the basic arithmetic required to calculate differences in tax rates. You have to calculate the exponential growth of various pools of money to get the future values. I provide below a calculated example to illustrate.

Imagine two options for handling a taxable IRA that is eligible for conversion, and for which RMDS will (as you suggest) start immediately. In each case, the IRA is paired with an outside "tax payment fund" so that we can be apples-to-apples fair as you say, and compare the future total value of the ROTH+TAXFUND vs the future value of the REGULAR+TAXFUND at the end of whatever term we are considering. (The assumption here is that the "parents" would have enough other taxable assets, besides the tax fund, to live for a number of years before they needed to tap the ROTH, or leave it to heirs. Same with RMDs from the taxable IRA...they are just added to the tax fund, so all value from each IRA winds up in the eventual apples-to-apples total. Naturally, the value of a ROTH only arises from the ability to pay taxes from outside assets, and leave the full initial value of the ROTH to grow for the specified number of years.)

So our hypothetical 71 year old retiree has two options for his IRA with a starting IRA value of $100,000, and his starting tax fund of $35,000. Let's assume taxes are constant for everything at 30%...tax on growth of taxable assets, income tax to convert now, tax on RMDs, etc. etc. Growth rates are also identical for all asset pools. Here are the two options. Our projected term is 15 years.

1) Regular IRA. RMDs are taken smoothly as required each year, and added to the outside Tax Fund. The Tax Fund assets grow at 8% per year, but also pay the tax on RMDS at 30%. The remaining IRA assets each year of course continue to grow tax-deferred at 8%. At the end of 15 years, the value of the tax fund is $154,000. The value of the IRA (still pre-tax, of course) is $160,000. Total value is $314,000.

2) Roth conversion. 30% tax is paid immediately out of the tax fund to convert the entire IRA balance to a ROTH with a value of $100,000. So the tax fund is now zero. However, the ROTH grows tax free at 8% for 15 years with no RMDs required. At the end of 15 years, the tax fund is still zero, but the ROTH IRA is worth $317,000.

So, after 15 years even the PRE tax value of the IRA, plus the tax fund, is worth less than the completely tax free ROTH. But wait, there's more. Suppose the parents had only enough living assets for 15 years...at the end of the term, they have to pull out all remaining assets from the IRA, pay taxes, and add the funds to their bank account. They could pull $317,000 out of the ROTH on day 1. The money pulled from the IRA would be much less...perhaps the tax would 25% in a lower tax year...so they would have their tax fund of $154,000, but the after-tax value of their withdrawal would only be 75% of $160,000 or $120,000. So they have a total after-tax withdrawal of $154,000 plus $120,000 = $274,000 vs. $317,000 for the ROTH.

So a true after-tax breakeven value comes even EARLIER than 15 years.

Now of course, if we make the ROTH more expensive to convert, all that does is increase the years to breakeven. For example, if we say IRA RMDs and everything else are still taxed at 30%, but a ROTH conversion costs 35% right now, the breakeven value is simply extended to a bit under 18 years. The point is, any difference in taxes can be made up with an extension of the breakeven period.

Moreover, this is just for the parents. Beneficiaries who inherited and stretched the ROTH IRA would remove SIGNIFICANTLY more over their lives than if they inherited even the same value as a taxable IRA...let alone the lower value they'd get if parents survived the breakeven year.

If anybody is interested in the actual calculation formulas so you can build your own spreadsheet, or if it is permitted for me to share/upload/pm or whatever my spreadsheet for the forum's non-commercial use, just tell me how.

Again, I do thank you for your attention to my posts.

 

[kaneohe]

grayparrot.........your analysis is obviously more sophisticated involving a lot of variables. You can also make a simple case (pre-RMD) that if the tax brackets at conversion and distributions are the same, the Roth is at worse equal to the TIRA (only on day 0 of conversion) and then gets progressively better with time (assuming gains, of course).

1) 10 K TIRA. Leave along with side tax fund of 2.5K. After N yrs,
all funds have doubled leaving a 20K TIRA and a side tax fund of 5K.
At a tax rate of 25%, the TIRA is worth 15K and the side tax fund
is worth at most 5K less whatever taxes happened along the way or at the end so total value is 20K minus.

2) 10K TIRA converted to 10K Roth. Tax fund is depleted. After N yrs,
the Roth has doubled leaving a 20K Roth which is worth more than the TIRA by the amount of taxes on the side tax fund.

Even at day 0 after conversion: Roth is no worse than TIRA
1) 10K TIRA is really only worth 7.5K after tax and in combination with side tax fund is worth 10K
2) 10K TIRA converted to 10K Roth. Tax fund is depleted. Value is 10K.

There is some fine print you have to worry about. Tax/penalty on early withdrawals from both TIRA/Roth. At advanced ages, another concern is whether the conversion boosts your income enough that Medicare premiums increase,etc.

 

[LOL!]

I put my entire post from the other thread here as well:

....
Let's assume taxes are constant for everything at 30%...tax on growth of taxable assets, income tax to convert now, tax on RMDs, etc. etc. Growth rates are also identical for all asset pools. Here are the two options. Our projected term is 15 years.
....

This is a totally bogus assumption. The tax on growth of taxable assets could be 0% if they use tax-exempt munis*. If they use tax-efficient passively-managed index funds, then unrealized cap gains are not taxed and qualified dividends are taxed at a a preferred rate. Let's say they get QDI of 2% of assets which is taxed at 15% to 20%, that is like a 0.3% to 0.4% tax on the overall taxable portfolio and nowhere near 30%.

Furthermore, tax-loss harvesting can reduce the taxes on the taxable portfolio even more. So can charitable giving of appreciated shares. LTCG tax rates are not 30% either. And finally, if one parent dies, the entire taxable portfolio will usually get a stepped-up basis for the other parent and heirs.

Thus when RMDs come out of the tax-deferred portion and go into the taxable portion, they get a very very low tax rate thereafter and not 30%.

*Your parents would not use bonds in taxable anyways since they can put bonds in tax-advantaged. They would use tax-efficient index funds of equities in taxable. The taxes on taxable assets really would be under 1%.

Bottom line: Many folks do not realize that investing tax-efficiently in a taxable portfolio can sometimes be as good as a Roth IRA.

 

[GrayHare]

This is a totally bogus assumption. The tax on growth of taxable assets could be 0% if they use tax-exempt munis*.

It's too late for that since the assets in question are already in a TIRA. When they are withdrawn from the TIRA either via RMDs or Roth conversion, their value will be reduced by the 30% of grayparrot's example. After an RMD, yes, the assets could be placed in a tax-advantaged investment like munis, but no such investment is taxed less than the 0% tax rate on the Roth into which they instead could be directly placed via conversion.

grayparrot - the numbers and conclusions in your example closely match those I had calculated some time ago when studying the Roth question.

 

[Alan]

That only works if the withdrawer can pull almost exclusively from taxed funds for living expenses. If (as is common) you have almost fully taxable pensions that cover most of your expenses then the IRA conversions will start at a high marginal tax rate. Doesn't seem any way out of that.

I'm in this situation. I convert some tIRA to ROTH each year to maximize the 15% tax bracket, and it is a little more each year as my pensions are fixed but the tax deductions and bands increase. Of course this will change as the tax code changes.

 

[LOL!]

It's too late for that since the assets in question are already in a TIRA. When they are withdrawn from the TIRA either via RMDs or Roth conversion, their value will be reduced by the 30% of grayparrot's example. After an RMD, yes, the assets could be placed in a tax-advantaged investment like munis, but no such investment is taxed less than the 0% tax rate on the Roth into which they instead could be directly placed via conversion.

Exactly, tax-deferred growth in the tIRA is the same as tax-deferred growth in the Roth IRA: it's not taxed. The conversion to Roth costs the same in taxes as the taxes on an RMD.

Once again with proper tax moves, the taxable account could have much less taxes than has been shown here. For example, tax-loss harvesting with $3000 net loss offsetting ordinary income can be quite helpful. The foreign-tax-credit can be quite helpful. Giving away appreciated stock shares can be quite helpful. Dying and getting the stepped up basis can be quite helpful.

Losses in a Roth are not tax deductible. Losses in a taxable account are tax deductible.

As for "no such investment is taxed less than the 0% tax rate": Foreign stock dividends in a Roth IRA are still taxed by foreign entities and may be at a higher tax rate than in the US. The foreign tax credit can alleviate this.

An inherited Roth has RMDs. An inherited taxable account has no RMDs.

Anyways, yes, I would love to inherit a huge Roth IRA. But my taxes are much much lower than 37%, so I would rather inherit the tIRA before 37% got taken out.

 

[GrayHare]

LOL, I agree with your points as applied to assets outside an IRA, however I do not see their relevancy here since the OPs discussion is about how to handle assets already inside an IRA.

 

[LOL!]

grayparrot brought up "In each case, the IRA is paired with an outside "tax payment fund" so that we can be apples-to-apples fair as you say, ...", then proceeded to handicap the tax payment fund.

Also I think he ignored other aspects of the "pay 37% on conversion" versus "pay much less than 37% if not converting".

Anyways, it's not my money. I hope I have only pointed out some different ways of thinking about taxes, especially ways based on my own personal experiences.

 

[grayparrot]

I put my entire post from the other thread here as well: This is a totally bogus assumption. The tax on growth of taxable assets could be 0% if they use tax-exempt munis*. If they use tax-efficient passively-managed index funds, then unrealized cap gains are not taxed and qualified dividends are taxed at a a preferred rate. Let's say they get QDI of 2% of assets which is taxed at 15% to 20%, that is like a 0.3% to 0.4% tax on the overall taxable portfolio and nowhere near 30%.

I am sorry, but your assumptions are the ones that are incorrect. Average taxes on taxable assets over 15 years will not be close to zero as you imply.

First, if my parents invest in individual munis, holding all of them to maturity, then yes the tax would be zero. However, the long term growth rate would be lower than in my assumptions. You don't get to have your cake and eat it too with munis, enjoying both tax free growth AND appreciation rates equal to the same growth rate assumption of taxable assets including equities, etc.

Second, while you are correct that capital gains tax can be DEFERRED for a long time, you are incorrect in implying that they can somehow magically vanish forever. At the end of the term if my parents need the money from the tax fund that has been growing without any capital gains, then they would have to pay capital gains tax on the entire accumulation at the end of the term, when they sell the assets to use the money. If there are graduated capital gains tax rates, they would get hit with the highest rates on a lumpy withdrawal in the future.

Third, while capital gains tax rates as you say are not 30% now, they have exceeded that in the past, and may well do so again, on a federal+state total basis, when the artificially low Bush tax cuts expire. To assume 15% rates long into the future is wrong now (ignoring state taxes) and mostly likely more wrong in the future.

Fourth, tax-loss harvesting, which you suggest, again can only help defer gains, not eliminate them forever. You may be able to defer for a long time. But, whoever needs to use the assets must sell and pay the tax on all appreciation. The appreciation on a ROTH will be tax free no matter the timing and "lumpiness" of the withdrawal.

Fifth, charitable giving is entirely irrelevant to these calculations. Of course it can save taxes, but it depletes assets at the same time. It has no place in an apples-apples comparison of money that is targeted for use or a family bequest.

Sixth, your assumption that if RMDs come out of a taxable account, those RMDs will get taxed at a low rate is incorrect in my parents' case, based on their base income. Their income will never be below 33% total in any case, unless tax rates are reduced which I think would REALLY be a dangerous assumption.

You are correct about the step-up in basis at death, but if parents are going to be leaving assets, not using them, then leaving as a ROTH is better for the heirs if the heirs plan to adhere to a stretch RMD plan. Stepped-up assets immediately become taxable on any appreciation after death.

Bottom line: Many folks do not realize that investing tax-efficiently in a taxable portfolio can sometimes be as good as a Roth IRA.

"

this is simply wrong. The DEFERRAL of taxes might be similar between a taxable portfolio and a ROTH for quite a long time, but the many other advantages of the ROTH, such as availability at any time (after 5 years) of the assets, completely tax free, in any amount, and tax free availability of 100% of the appreciation, not just deferral of tax on that appreciation, all make ROTH greatly superior over time.

While some of your points are applicable in some cases, they are simply inaccurate in my parents' case and for anybody else with a similar situation. All of my claims have been solely for my parents' situation. Your inclination to generalize has lead you try to globalize assumptions that might be true (i.e, RMDs will be taxed at low rates) for some folks, but not for others.

I have tried to be respectful to your views, but I don't appreciate your use of the term "bogus" in reference to my assumptions. I have nearly 20 years as a professional finance analyst, and over 100 hours invested in carefully developing the assumptions relevant to my parents situation. It is abundantly clear that you have simply not done the math for cases such as my parents', and you are making the tragic error of applying some generalizations that might be true in some cases to a situation where your assertions are just plain wrong. I sincerely hope you do more specific quantitative analysis and homework before offering guidance to people who actually rely on your advice, and I suggest that you be a bit more polite in your discussion with folks interested in a civil discussion.

 

[grayparrot]

There is some fine print you have to worry about. Tax/penalty on early withdrawals from both TIRA/Roth. At advanced ages, another concern is whether the conversion boosts your income enough that Medicare premiums increase,etc.

thanks for your reply. I am with you, and actually have already built that fine print into my models, for example with assumptions for high net worth Medicare penalties, etc. As you astutely indicate, there are just so many factors one must build into these projections!

 

[grayparrot]

grayparrot brought up "In each case, the IRA is paired with an outside "tax payment fund" so that we can be apples-to-apples fair as you say, ...", then proceeded to handicap the tax payment fund.

Also I think he ignored other aspects of the "pay 37% on conversion" versus "pay much less than 37% if not converting"

I do respect your question about whether I have handicapped the tax payment fund. Fair questions to raise. Again, my view is that the correct answer varies from situation to situation. In my parents' case, I have done the math and I feel that the assumptions I have made for the entire 15 year or so term (not to mention the subsequent 30 year term for their heirs) based on my family's tax brackets are entirely reasonable.

The same is true with the conversion tax vs lower conversion. Your implication that everybody will "pay much less than 37% if not converting" is simply inaccurate in my parents' case, though I agree that it will be true for many. To generalize every recommendation and claim you make based on your own or similar-to-your-own case, or even based on typical cases, when somebody is asking about a specific case, such generalizations are unhelpful at best and dangerously misguided at worst.

 

[grayparrot]

Exactly, tax-deferred growth in the tIRA is the same as tax-deferred growth in the Roth IRA: it's not taxed. The conversion to Roth costs the same in taxes as the taxes on an RMD.

Again, this is just plain wrong. Tax deferred growth in the taxable IRA is just that...deferred. Taxes will be paid eventually. "Tax deferred growth in the ROTH" simply doesn't exist. Taxes will NEVER be paid on the growth, so even the term "tax deferred growth in a ROTH" makes no sense at all.