Changing Roth Strategy

[Sandy & Shirley]

We took advantage of BRexit last June to do a lot of Roth Conversions at the 25% Federal tax bracket. We did a few more early this year in hopes that the market would rise with a businessman in office. The new tax proposal has made us rethink this strategy.

Under the current tax structure the brackets change from 15% to 25% and with the 85% taxability of our future Social Security benefits this results in marginal brackets of 27.75% and 46.25% during retirement.

Doing Roth conversions was and still is a great way to avoid the 46.25% marginal tax bracket. Converting more than is necessary is currently not a “bad” idea because paying 25% or even 28% today to avoid paying 27.75% later is basically a wash.

“If” the new tax proposals become law, the 15% bracket could be eliminated and the standard brackets will then change from 10% to 25%, 18.5% to 46.25% marginal brackets. Doing extra conversions at 25% today is no longer a wash against paying only 18.5% later.

As stated in the first paragraph, we are rethinking Shirley's early retirement planning strategy.

If the current proposal fails, could something like that happen in the future?

If it does pass, even if it does not start until 2018, the change would still be there when we do retire.

 

[joeea]

Under the current tax structure the brackets change from 15% to 25% and with the 85% taxability of our future Social Security benefits this results in marginal brackets of 27.75% and 46.25% during retirement.

I don't understand what you mean here. 46.25%

Converting more than is necessary is currently not a “bad” idea because paying 25% or even 28% today to avoid paying 27.75% later is basically a wash.

How is paying 28% today in order to avoid paying 27.75% later a wash?

If you give me $28,000 today, I promise to pay you $27,750 20 years from now. Deal?

“If” the new tax proposals become law, the 15% bracket could be eliminated and the standard brackets will then change from 10% to 25%, 18.5% to 46.25% marginal brackets. Doing extra conversions at 25% today is no longer a wash against paying only 18.5% later.

Since you don't yet know the income limits for the proposed brackets, you don't have any way to know what the rates will be down the road.

 

[Whisper66]

We had planned on making a large Roth conversion early this year (possibly up to max of 28% bracket). Due to the tax law change discussions, we are waiting until later in the year to see where they go. My guess is that some tax relief will be made law, but probably not until 2018. If that is the case, our 2017 conversion will be smaller than originally planned ... will probably target within the 25% tax bracket limits. Then we'll evaluate the law changes to determine how much to do in 2018.

 

[LOL!]

At this point in time it is a total waste of time speculating about this.

But since you can do all the Roth conversions you want and then recharacterize the portions that you paid too much tax on, there is no need to do any speculation whatsoever.

For more fun, go back and visit the so-called "Fiscal Cliff." Lots of folks speculated on that one, too, and paid a bundle in extra taxes.

 

[Sunset]

The problem with waiting is you lose 1 more year of opportunity to convert.

What will you do if the new tax rates are 10% up to 12K income, and 25% for the rest, then you will have wished you had filled that old 15% bracket.

 

[CRLLS]

While nobody KNOWS what the new tax laws might be, I think discussion along these lines is good. I too am looking at Roth conversions balanced with delayed SS filing and more and how that might minimize my total tax over 5-10 years. I think I've come to terms with just about all the variables. And many of them are indeterminate.

I don't know if my thinking is in the majority. It is sometimes comforting that any choice I might make are not my thoughts alone. Especially here where there are so many good minds. I have nobody in my close circle of friends that can discuss these things intelligently. We all are making financial decisions that have many years of impact on constantly changing regulations. Discussion is good IMO.

 

[Fedup]

This is one reason why I don't go hog wire on Roth Conversion. I did some this year, but regardless of which way the tax swing, I will let it stay in Roth.

 

[Sandy & Shirley]

I don't understand what you mean here. 46.25%

Your Social Security is given to you “tax deferred”. You initially get the entire benefit “tax free”, then as your “income” increases the benefits are slowly taxed in parallel to your income. The 1983 changes to your benefits created a “basis” for taxability as one half of your benefit plus basically all of your other taxable income.

Single: when that “basis” reaches $25,000 each additional dollar of taxable income makes 50 cents of your benefit taxable. The married breakpoint is $32,000.

The 1993 legislation created two additional basis points at $34,000 single and $44,000 married where the taxability becomes 85 cents per additional dollar over those basis points.

These “basis points” are not COLA adjusted, they have not changed since 1983 and 1993.

Back to your question: The 46.25% marginal bracket happens when, for example, you are in the 25% federal tax bracket and the 85 cent per dollar taxability bracket. You withdraw an additional $100 from your IRA, that $100 is taxable so it increases your “basis” by $100 which makes $85 of your previously tax free benefit taxable income so your taxable income increases by a total of $185 and 25% of $185 is $46.25. Your Federal taxes increased by $46.25 because of a $100 additional withdraw from your IRA. A marginal tax rate is the percentage that your taxes increase on the next dollar of income. In this case, $46.25 / $100 equals 46.25%.

If you give me $28,000 today, I promise to pay you $27,750 20 years from now. Deal?

The advantage of a Roth contribution or conversion is based on your tax rate at the time of the conversion vs the rate at the time you use the money. For example:

You earn $6,000 at the 25% tax bracket. You could put that entire $6,000 into an IRA, deduct the contribution, and pay no taxes today. Your second option is to pay your 25%, $1,500, in taxes and put the after tax income of $4,500 into a Roth.

20 years later you are retired and all of your retirement savings have doubled in value. The Roth would be worth $9,000 and the TIRA would be worth $12,000. If you needed $9,000 for a vacation you could take the $9,000 out of the Roth tax free and use the money to pay for the trip. If your “marginal” tax bracket was an identical 25% and you took the $12,000 out of your TIRA you would owe $3,000 in taxes and you would have the same $9,000 after tax to pay for your vacation.

If your marginal bracket was only 20% when you needed the money your taxes due on $12,000 would be only $2,400 so you would get $9,600 after tax to pay for the vacation plus $600 for extra spending money.

If your marginal bracket was 40% your taxes would be $4,800 so your after tax income would only be $7,200 which is not enough to pay for the vacation!

Basically, the advantage or disadvantage of Roth is based on your tax rate when you put money in and your tax rate when you take it back out. When you look at 20 years of inflation and usage you have to look at it from both sides, not just one!

 

[joeea]

Your Social Security is given to you “tax deferred”. You initially get the entire benefit “tax free”, then as your “income” increases the benefits are slowly taxed in parallel to your income.

That's not what "tax deferred" means.

Basically, the advantage or disadvantage of Roth is based on your tax rate when you put money in and your tax rate when you take it back out. When you look at 20 years of inflation and usage you have to look at it from both sides, not just one!

Got it.

So tell me again where paying 28% today to receive 27.75% 20 years later is a good deal?

The new tax proposal has made us rethink this strategy.

Once the impact of any tax law changes becomes clear, it certainly makes sense to reconsider any tax avoidance strategies (since the rules will have changed). Right now, it's too early to know what will change, when it will change, and what those changes might mean for tax strategies.

 

[Sandy & Shirley]

That's not what "tax deferred" means.



Got it.

So tell me again where paying 28% today to receive 27.75% 20 years later is a good deal?

OK, I’m not an accountant or an investment advisor, maybe tax deferred is not the proper accounting term. What is the proper term for getting your social security tax free as long as your income level is low, but as it increases you pay taxes on your benefits at the same time you are paying taxes on your regular income?

Social Security is a lot like Dividend income. It is initially given to you tax free, then as your combined dividend plus other income pushes the dividends into the 25% bracket they are taxed at 15%, “again, in parallel to the income that pushed to dividends into the 25% bracket”.

As for the 28% vs 27.75% difference, you have to consider the growth rate of 20 years on BOTH sides of the equation, not just one side as you keep saying.

If you have $1,000 and pay 28% today you end up with $720 after tax, if the 20 year ROR is 4 times, it will be worth $2,880 in 20 years. If you do not pay the 28% today and let the entire $1,000 grow by the same ROR of 4 times it will be a total of $4,000 and if you then pay 27.75% of that amount you will pay $1,110 and be left with $2,890. The difference is only $10 which I originally stated is pretty much a wash. Naturally if you only consider the 20 year 400% ROR on just one side of the equation all of the numbers a 400% off. That is why you have to consider what happens over a 20 year period on BOTH sides of the equation, not just one!

 

[joeea]

What is the proper term for getting your social security tax free as long as your income level is low, but as it increases you pay taxes on your benefits at the same time you are paying taxes on your regular income?

Perhaps the term you were thinking of was "progressive tax"?
https://en.wikipedia.org/wiki/Progressive_tax

If you have $1,000 and pay 28% today you end up with $720 after tax, if the 20 year ROR is 4 times, it will be worth $2,880 in 20 years. If you do not pay the 28% today and let the entire $1,000 grow by the same ROR of 4 times it will be a total of $4,000 and if you then pay 27.75% of that amount you will pay $1,110 and be left with $2,890. The difference is only $10 which I originally stated is pretty much a wash.

If instead of $1,000 you had a $1,000,000 would it still be a wash?
What if you only started with $10?

Starting with percents and reaching a conclusion using small dollars doesn't make any sense to me.


If you feel that you will be in a higher tax bracket after retirement, then a ROTH account makes sense. If not, then a TRADITIONAL account makes sense.

If you are going to include external effects such as impact on Social Security tax rate, then be sure to include the impact of your starting age for claiming Social Security benefits, ACA subsidies for those who are before the Medicare age, your anticipated longevity, possible inheritances, future healthcare expenditure deductions, and any of the thousands of other factors you can think of.

And keep an eye on changes to tax laws, Social Security rules, Medicare charges, etc. You cannot predict them now (any more than you can predict the age at which you will die), but you can take a guess if you like.

 

[Fedup]

It sounds like tax free income.

 

[Sunset]

.......
Single: when that “basis” reaches $25,000 each additional dollar of taxable income makes 50 cents of your benefit taxable. The married breakpoint is $32,000.

The 1993 legislation created two additional basis points at $34,000 single and $44,000 married where the taxability becomes 85 cents per additional dollar over those basis points.

......
Back to your question: The 46.25% marginal bracket happens when, for example, you are in the 25% federal tax bracket and the 85 cent per dollar taxability bracket. You withdraw an additional $100 from your IRA, that $100 is taxable so it increases your “basis” by $100 which makes $85 of your previously tax free benefit taxable income so your taxable income increases by a total of $185 and 25% of $185 is $46.25. Your Federal taxes increased by $46.25 because of a $100 additional withdraw from your IRA. A marginal tax rate is the percentage that your taxes increase on the next dollar of income. In this case, $46.25 / $100 equals 46.25%.
......

This is true, if you are within certain boundaries, but once you blow past those and take out an additional $100 from IRA, the tax rate on the additional is just 25%.

 

[Sandy & Shirley]

This is true, if you are within certain boundaries, but once you blow past those and take out an additional $100 from IRA, the tax rate on the additional is just 25%.

You are stating the point of diversion exactly. All of my research and advice is designed to help middle to upper middle income retirees to avoid what I have labeled “The Tax Hump”. This is where the parallel taxation of your income plus Social Security plus Qualified Dividends raises your marginal tax rates to 46.25% and even 55.5% under today’s tax laws.

As the chart shows, once your income exceeds a certain level, and 85% of your Social Security benefit has been taxed, then you are “Over The Hump” and back into normal tax brackets. Those who are wealthy enough can look over their shoulders and just say that they got 15% of their Social Security tax free and that the Dividends and LTCGs were taxed at a lower rate.

Those whose income levels place them along the 27.75% marginal tax line who are forced into a situation where they suddenly need an extra 5 grand and are faced with having to withdraw 10 grand to get that amount after tax are also those who do not have millions in their IRAs and consider 10 grand to be a lot of money, not spare change.

It is understandable that many of those who are considered to be “Rich” by those in the middle income categories do not understand the problems that are faced by “us”.

This thread had a lot of back and forth with joeea who just included the line: “If instead of $1,000 you had a $1,000,000 would it still be a wash?” Exactly my point, those in the upper income categories do not understand the problems faced by those in the middle income categories!

 

[joylesshusband]

As the chart shows...

//snip

@ S&S,

The chart shows zilch, as we could only guess what is represented by the X-axis (income?), and whatever it is, it is not measurable due to lack of scale marks.
If you really wanted to demonstrate a point with this chart, you could have made it a bit more illustrative.

Most forum inmates are familiar with the abstract idea you are pontificating, but most of us have figured out individual strategies as necessary to reduce the possible disadvantages within the current income taxation laws, based on our personal situations and income levels.
And we will certainly figure out our strategy adjustments once the new income taxation laws are announced. Until then, we stay the course as speculations don't add any value.

 

[SevenUp]

...taxation of your income plus Social Security plus Qualified Dividends raises your marginal tax rates to 46.25% and even 55.5% under today’s tax laws.

This is also explained in Marginal tax rate - Bogleheads:

For example, with $12,000 in qualified dividends, $27,000 from social security, and $24,000 in IRA distributions, the marginal rate is 55.5%.

 

[joeea]

This is true, if you are within certain boundaries, but once you blow past those and take out an additional $100 from IRA, the tax rate on the additional is just 25%.

Thank you.

 

[pb4uski]

For example, with $12,000 in qualified dividends, $27,000 from social security, and $24,000 in IRA distributions, the marginal rate is 55.5%.

I don't get this or where the 55.5% comes from.

If I take Taxcaster and a single person with $12,000 in qualified dividends and $24,000 from IRA distributions, I get tax of $1,588. If I then add $27,000 of SS income, the tax increases to $5,087.

So initially the taxpayer pays a 4.4% effective rate ($1,588 tax/$36,000 of income). If they add $27,000 of SS then their overall effective rate is 8.1% ($5,087 tax/$63,000 of income). At worst, their marginal rate on the $27,000 of SS income is 13% ($3,499 increase in tax/$27,000 SS income).

What am I missing?

 

[SevenUp]

I don't get this or where the 55.5% comes from.

If I take Taxcaster and a single person with $12,000 in qualified dividends and $24,000 from IRA distributions, I get tax of $1,588. If I then add $27,000 of SS income, the tax increases to $5,087.

So initially the taxpayer pays a 4.4% effective rate ($1,588 tax/$36,000 of income). If they add $27,000 of SS then their overall effective rate is 8.1% ($5,087 tax/$63,000 of income). At worst, their marginal rate on the $27,000 of SS income is 13% ($3,499 increase in tax/$27,000 SS income).

What am I missing?

Yeah, that wiki entry could be clearer.

Seems the marginal rate refers to the "ordinary income" - in other words, the tIRA distributions.

The tax estimation for 2017 I use gives $5024 IRS tax for the income given, and $5079 for $24100 from a tIRA. Close enough to a 55.5% marginal rate.

 

[pb4uski]

Even with the $24,000 tIRA distribution being the last item the tax is $0 before the tIRA distribution and $5,087 after adding the $24,000 tIRA distribution.... so a 21.2% marginal tax on the tIRA distribution.... less than half of the mythical 55.5%.

 

[SevenUp]

Even with the $24,000 tIRA distribution being the last item the tax is $0 before the tIRA distribution and $5,087 after adding the $24,000 tIRA distribution.... so a 21.2% marginal tax on the tIRA distribution.... less than half of the mythical 55.5%.

The tax estimation for 2017 I use gives $5024 IRS tax for the income given, and $5079 for $24100 from a tIRA. Close enough to a 55.5% marginal rate.

(5079 - 5024) / 100 = 55%.

Why "mythical"?

 

[pb4uski]

What do you mean by "income given"?

Mine is this using 2016:

Tax on $12,000 of qualified dividends + $27,000 of SS income (single, standard deduction) = $0

Tax on above plus $24,000 of tIRA distributios = $5,087

Incremental tax of $5,087/incremental income of $24,000 = 13% marginal tax rate

Taxcaster summaries below.

Total Income ? $12,250
Total Deductions ? $6,300
Total Exemptions ? $4,050
Taxable Income ? $1,900
Regular Taxes ? 0
Alt. Minimum Tax ? 0
Additional Taxes ? 0
Tax Credits ? 0
Tax Payments ? 0
Your Refund ?
Marginal Tax Rate ? 10%

Total Income ? $53,675
Total Deductions ? $6,300
Total Exemptions ? $4,050
Taxable Income ? $43,325
Regular Taxes ? $5,087
Alt. Minimum Tax ? 0
Additional Taxes ? 0
Tax Credits ? 0
Tax Payments ? 0
You Owe ? $5,087
Marginal Tax Rate ? 25%

 

[SevenUp]

What do you mean by "income given"?

$12,000 of qualified dividends + $27,000 of SS income (single, standard deduction) + $24,000 of tIRA distributions.

Mine is this using 2016:
Tax on $12,000 of qualified dividends + $27,000 of SS income (single, standard deduction)...plus $24,000 of tIRA distributions = $5,087

What do you get for $12,000 of qualified dividends + $27,000 of SS income (single, standard deduction) plus $24,100 of tIRA distributions?

How much did the tax increase for the extra $100 income, and what is that as a percentage increase?


In graphical form, based on Tools and calculators - Personal_finance_toolbox and the $12,000 of qualified dividends + $27,000 of SS income mentioned above, for 2017 rates we get

 

[Sunset]

You are stating the point of diversion exactly. All of my research and advice is designed to help middle to upper middle income retirees to avoid what I have labeled “The Tax Hump”. This is where the parallel taxation of your income plus Social Security plus Qualified Dividends raises your marginal tax rates to 46.25% and even 55.5% under today’s tax laws.

Those whose income levels place them along the 27.75% marginal tax line who are forced into a situation where they suddenly need an extra 5 grand and are faced with having to withdraw 10 grand to get that amount after tax are also those who do not have millions in their IRAs and consider 10 grand to be a lot of money, not spare change.

It is understandable that many of those who are considered to be “Rich” by those in the middle income categories do not understand the problems that are faced by “us”.

This thread had a lot of back and forth with joeea who just included the line: “If instead of $1,000 you had a $1,000,000 would it still be a wash?” Exactly my point, those in the upper income categories do not understand the problems faced by those in the middle income categories!

Actually, I view it as people in the middle income category have a chance to avoid this problem. The middle income people might fall into this problem for years when they need the extra money.
The suffering "Rich" people are totally screwed and pay the extra every year as there is no way to avoid it.

 

[Fedup]

The truly rich don't give a damn about Roth. I'm sure they have many ways to avoid tax.