Skip Roth IRA conversion?

[Global1]

I was using i-orp to assess the income impact of converting an IRA to a Roth IRA. I kept current tax rate and investment rate assumptions consistent with future rates.

These numbers are simplified but reflect our situation:

DW and I are both 60. Recently retired. Current income is $50k from dividends. We were planning to take care of our additional income needs by selling equity/bonds in after tax account. Future income from non-cola pension ($18k @ 65) and Social Security ($50k @ 67).

Current savings. Overall asset allocation is 50% equity/bond:
$2.5 million in after tax funds. 70% equity/30% bonds.
$1 million in IRA funds. 100% bonds.

Assuming we live until 90, i-orp shows that we would maximize income by withdrawing the funds from the IRA directly as income in equal amounts over the next 5 years rather than converting to a Roth IRA and withdrawing Roth IRA funds later.

I had planned on converting to a Roth IRA up to the 22% (or maybe 24%) marginal tax rate each year until SS starts. However, the i-orp result calls this strategy into question.

The plan was to sell equity (taxed at capital gains rate) and bonds from the after tax account for added income needs above the $50k in dividends. This would make it relatively easy to manage the asset allocation to remain at 50%. If I follow this new strategy and take out bonds from the IRA for added income instead. However, I would have to also sell, at least, some equity in my after tax account to keep my asset allocation at 50%.

I would very much like to hear what others think.

Thanks
Global1

[RunningBum]

Ignore spending for the moment. You are given the choice of converting an IRA to a Roth vs. putting it in taxable. In the initial transaction it's a wash because you pay taxes on the conversion or withdrawal either way. But in the conversion, your future gains will be tax free forever. In the withdrawal, the gains are subject to tax.

Seems like a no-brainer to convert rather than withdraw. I'm not sure the right amount to convert is, but about the only reason I see not to convert is if you have large unrealized capital gains in taxable, and you don't think you'll need to touch them. In that case it might work better to pass them with step-up basis when you go.

Maybe I'm missing something else.

I haven't looked too closely to i-orp, but some of the recommendations I hear sound questionable.

[Global1]

Thanks for your comments. Your thoughts align with my original plan - If I can convert and avoid tax on future gains then I will come out ahead. However, i-orp may be taking something else into consideration that I am not. That is why I included the spending info.

[Scuba]

James Welch of I-Orp wrote a paper about the benefits of Roth conversions and concluded that on average, there is only about a 1% difference in lifetime cash flow with or without a Roth conversion. In our case, this is what the model suggested and it indicated that we’d be slightly better off not doing the conversions. Our tax CPA had told us the same thing.

Perhaps you could have a CPA look at your unique situation and advise appropriately.

[Koolau]

My understanding is that the best way to "win" at Roth conversions is to pay the conversion taxes with already-taxed money. In effect, this increases the amount of Roth money working for you tax free in the future. I don't have a reference, but it's been discussed here IIRC (or see the Fairmark website).

I think the other reason to covert (assuming taxes being equal) is the favorable inheritance rules for Roths when you leave this mortal plane. YMMV

[pb4uski]

Quote:

Originally Posted by Global1 ...... Assuming we live until 90, i-orp shows that we would maximize income by withdrawing the funds from the IRA directly as income in equal amounts over the next 5 years rather than converting to a Roth IRA and withdrawing Roth IRA funds later. I had planned on converting to a Roth IRA up to the 22% (or maybe 24%) marginal tax rate each year until SS starts. However, the i-orp result calls this strategy into question.....

I don't see much of a difference between Roth conversions or spending from the tIRA... I give a slight preference to Roth conversions because that money, which we'll probably never spend, will grow tax-free whereas money in taxable account wil be taxed. Assuming that the withdrawals from the tIRA will be the same and it is a matter of whether all or some of that money is spent or rolled into a Roth then RMDs won't be any different.

I'll continue converting to the top of the 12% tax bracket since I expect to be in the 22% tax bracket once SS starts and the 10% difference makes it worth converting... but given my small pension and dividend/LTCG the amounts that I'll be able to convert will likely be less than the growth in the tIRA so it will have little impact on RMDs.

If we redomesticate to Florida once we are 65 and on Medicare and state income tax considerations go away, I may step up Roth conversions into the 22% tax bracket for a few years and then start SS.

[gauss]

I-Orp doesn't model the case where you are married (filing MFJ) now and for whatever reason (ie death divorce etc) are filing Single in the future.

In this scenario it definitely pays more than 1% to convert now.

FWIW I am trying to convert enough so that I have 50% in Roth and 50% in trad IRA/401k. My reasons are

#1) tax diversification - ie having different pots of money with different rules applying to adapt to future law changes and opportunities that may arise.

#2) most of our heirs will be charities. No taxes are due when trad IRA /401k are inherited by a charity after your death.

-gauss

[RunningBum]

Quote:

Originally Posted by gauss #2) most of our heirs will be charities. No taxes are due when trad IRA /401k are inherited by a charity after your death. -gauss

That's a good point. If you think you will be leaving behind significant money, it can change the picture of whether you convert, and where you spend from.

My take is, and please correct me if I'm off:

If you're leaving money to people, assets with high unrealized gains are best to leave, because they get a step up basis and no one pays taxes on the gains. Spend down other accounts first. It also works best to use SpecId on mutual funds so you can spend the shares with smaller gains and leave behind the larger gains. A caveat is that if you can take the gains at 0%, you should be doing so every year you can.

If the heirs are low income, leaving behind a tIRA might work better, as long as they stretch the IRA distributions rather than taking lump sum. This is if they are in a lower bracket than you would be for conversion or withdrawal. Of course with MRDs you are withdrawing a lot if you live long.

If they are at your income level or higher, and you don't have large unrealized gains, leaving a Roth seems best as the heir can leave it in a Roth (taking MRDs on schedule) and let it grow for them tax-free.

If you're leaving it to charities, leave what you can in the tIRA since they don't pay taxes on it. I have not verified this but a couple of people here have said it.

The latter two situations would probably say not to do Roth conversions, unless your own MRDs cause tax issues that you can avoid with conversions.

[Lawrencewendall]

I-ORP tells me to max out the 22% bracket with conversions from 57-59 then not touch tIRA till 70 and RMDs. I can't figure out why since distributions/converting to the top of the 12% will still pay the bills and the plan was to do that from 57-70 then start RMDs.

[Global1]

Thanks for the discussion. There are some very good insights for me to consider. I do have a DD to consider for inheritance. I will discuss scenarios with my CPA to incorporate some of the thoughts brought up here. My guess is that it is not a slam dunk either way.

[Winemaker]

I-orp suggests I withdraw 100% of my 7 figure tIRA over the next 10 years before I turn 70, spending only a portion to supplement our pensions and rents. The objective of I-orp is to make income tax efficient, that is, pay the least amount of tax. I understand the idea, but it's hard for me to wrap my head around paying all that tax up front. A blessed curse, I guess.

[walkinwood]

i-orp does not model qualified distributions from mutual funds or qualified stock dividends. It assumes that your stock allocation does not generate any dividends & all proceeds are from sales. Be aware of this and how it might affect your modeling.


I created a spreadsheet that I keep refining to account for the tax treatment (current law) of qualified dividends & cap gains and HSA contributions. I found that over my lifetime (assuming another 32 years), there are savings from doing ROTH conversion (to the top of the 22% bracket), but they are in the order of one year's spending budget.

[pb4uski]

Quote:

Originally Posted by Winemaker I-orp suggests I withdraw 100% of my 7 figure tIRA over the next 10 years before I turn 70, spending only a portion to supplement our pensions and rents. The objective of I-orp is to make income tax efficient, that is, pay the least amount of tax. I understand the idea, but it's hard for me to wrap my head around paying all that tax up front. A blessed curse, I guess.

I-orp made similar recommendations for me.... and when I run more aggressive Roth conversions through my long-term Excel model it does result in higher residual values in 30-40 years. Like you, while the numbers suggest that path I just can't stomach the idea of writing out big checks to Uncle Sam and the state. However, if we move to a no tax state in a few years when we are 65, I might do Roth conversions to the top of the 22% tax bracket instead of the 12% tax bracket... that will add $87,600 a year to Roth conversions.

[ERD50]

Quote:

Originally Posted by Scuba James Welch of I-Orp wrote a paper about the benefits of Roth conversions and concluded that on average, there is only about a 1% difference in lifetime cash flow with or without a Roth conversion. ... .

Quote:

Originally Posted by gauss I-Orp doesn't model the case where you are married (filing MFJ) now and for whatever reason (ie death divorce etc) are filing Single in the future. In this scenario it definitely pays more than 1% to convert now. ... -gauss

Interesting that it is only 1% difference on average. But I suspect my case is far from 'average', yet similar to some/many on this forum. I should be able to keep my taxable income to the 12% bracket until age 70 (age 63 now), allowing room for conversions. But then a higher delayed SS, and large RMDs (I will still have ~ 1/2 my portfolio in a tIRA) will push me to a higher bracket (I need to test with the new tax regs).

So I suspect that for me, conversions will be much more than a 1% benefit.

And good point on a surviving spouse being in the higher single tax bracket.

-ERD50

[Scuba]

Quote:

Originally Posted by ERD50 Interesting that it is only 1% difference on average. But I suspect my case is far from 'average', yet similar to some/many on this forum. I should be able to keep my taxable income to the 12% bracket until age 70 (age 63 now), allowing room for conversions. But then a higher delayed SS, and large RMDs (I will still have ~ 1/2 my portfolio in a tIRA) will push me to a higher bracket (I need to test with the new tax regs). So I suspect that for me, conversions will be much more than a 1% benefit. And good point on a surviving spouse being in the higher single tax bracket. -ERD50

Yes, I was surprised that on average, the difference is so small. Many on this forum apparently believe the benefit is much bigger for them.

I am going to ask our CPA about the surviving spouse issue and whether that should change any of our plans. However so far, our CPA and two FA’s told us Roth conversions are unlikely to be beneficial for us. I thought maybe we were really unique until I explored it for myself in i-Orp and saw those projections, and then found out that on average, the benefit is relatively small.

[RunningBum]

"On average" would seem to be the key word. "On average", people don't have ~5-20 years to do Roth conversions before pensions and SS kick in like many of us early retirees have. That's a long window to improve the benefit. Most of the population goes directly from working to collecting SS benefits, and don't really have favorable times to do conversions. I don't make personal financial decisions based on how it would affect the average person, I make them for me.

What does 1% on the "lifetime cash flow" mean? 1% on everything, or just the IRA/Roth money? If it's everything, for someone spending $50K/yr in retirement, that's $500 every year. Basically free money by shuffling funds between accounts. Not game changing, but I'll still take it.

For me it's a no-brainer. When I start getting SS and my small pension, it's going to at least kick a lot of my QDivs into being taxed. If I had to take RMDs later it'd likely push my income into the next tax bracket too. Anything I convert now that doesn't make Divs taxable saves me at least that 15% on much of the converted amount, maybe more. In the scheme of overall cash flow, maybe it is just 1%. I'm not going to bother calculating that. Doing things like this that make small changes can add up to a big difference.

For others, if you really can't see how conversions would change your tax picture, maybe it's not worthwhile.

[pb4uski]

+1 for me, no brainer given 10% difference in tax rates between current and what I'll be paying once SS starts, not to mention 15% difference on preferenced income.

[cathy63]

I can convert $24K tax free every year. We don't have any ordinary income and we don't have more than $77.2K of LTCGs and QDivs, so the $24K standard deduction (or maybe more if we find ourselves itemizing again) is going to sit there unused unless I fill that bucket with a Roth conversion. If I wait until I'm collecting SS, that RMD is going to be taxed at least 10%, so the tax-free conversion now is saving me $2.4K each year, and potentially a lot more since the growth will be tax free as well.

It's true that $2400 is a drop in the bucket for most people here and it might not show up in i-orp as a big deal over the long run; but there are also an awful lot of threads here about how to save on cell phone service, cable cutting, travel, etc, and most of those take a lot more time and effort for less savings.

[Sunset]

Quote:

Originally Posted by cathy63 I can convert $24K tax free every year. We don't have any ordinary income and we don't have more than $77.2K of LTCGs and QDivs, so the $24K standard deduction (or maybe more if we find ourselves itemizing again) is going to sit there unused unless I fill that bucket with a Roth conversion. If I wait until I'm collecting SS, that RMD is going to be taxed at least 10%, so the tax-free conversion now is saving me $2.4K each year, and potentially a lot more since the growth will be tax free as well. It's true that $2400 is a drop in the bucket for most people here and it might not show up in i-orp as a big deal over the long run; but there are also an awful lot of threads here about how to save on cell phone service, cable cutting, travel, etc, and most of those take a lot more time and effort for less savings.

Sweet..... I'd do that conversion in a heartbeat.

That $2.4K will also grow tax free.

The question is should you be converting even more, before you get to RMD + SS as income ?

[cathy63]

Quote:

Originally Posted by Sunset Sweet..... I'd do that conversion in a heartbeat. That $2.4K will also grow tax free. The question is should you be converting even more, before you get to RMD + SS as income ?

Yeah, I probably will convert more in most years. Last year was our first opportunity to do a conversion and we sold some ex-employer stock that brought us almost to the max of the 0% bracket for LTCGs. As a result, it turned out that our marginal tax rate went from 0% to 40%* when I tried converting more than our itemized deductions+exemptions, so I didn't think it was worth it.

This year, we won't itemize and there are no exemptions, but we also won't have as much in LTCGs, and depending on the market performance for the last half of the year we might even have some losses. That would open up the 10% and 12% brackets for conversions and I will fill those if I can.

* The increase in income from conversions reduced our Sch A deductions as well as our allowed losses on Sch E, so each $100 converted above the $0 tax level added $162 to our taxable income at 10% and also caused $162 of LTCGs to be taxed at 15%, which comes out to $40 in tax.