Roth Conversion - More Than Just the Tax on the Conversion

[RobertTN]

Trying to understand a little more/better the tax consequences of a Roth conversion.

The conversion itself is easy, it is all ordinary income in that tax year, and you will pay whatever marginal tax rate that conversion income pushes you into. However, I believe, especially for people who have significant taxable brokerage accounts with 50/50 stock/bond allocations, that the Roth conversion adds even more tax consequences that I do not see discussed.

For example, if you ONLY have $200,000 of qualified dividends as income (and for ease let's say all your bonds are Muni bonds and you live in a state that does not have an income tax) and are MFJ, I believe you will pay $0 in taxes on the first $89,251, and then 15% on the remainder amount for a total tax of $16,612. I know there will be deductions, credits, etc. but assume none of that for this 'simple' example.

If in the same above scenario, you do a $100,000 Roth conversion the same year, not only would you pay the tax on the Roth conversion, but then that $89K of qualified dividends that were in essence tax free now becomes taxable at the 15% qualified dividend rate and I believe the Obamacare investment tax of 3.8% would kick in (because now your MAGI is above $250,000). So, the total tax on the Roth conversion is much more than just the tax liability on the $100,000 that I convert, it pushes some qualified dividends into high brackets and kicks in the 3.8% tax on ALL of the investment income.

Am I correct, or am I completely missing the boat here? Thanks.

 

[street]

Interesting!!! I will be following this thread. I have a friend that says ROTH aren't all what they are cracked up to be. I'm sure there is a downside to a ROTH somewhere or somehow.

Also, he said if you wait and do RMD and reinvest that money verses doing Roth now. In the end would be a ~ a wash in taxes and your portfolio at the end. I have no idea just his study he did on it.

Tax changes can happen, up and down in investment from year to year, death and so many things can change the final comparison of Roth or no Roth.

 

[Winemaker]

Roth conversions are nothing but tax arbitrage maneuvers. Yes, in your example, your tax assumptions are correct. But if you do not convert now before you take SS and RMDs at 72 the tax would bemuch more obscene.


I am trying to sort out a plan for my single sister, who has a nice nest egg, and a pension. While we are thankful for our many blessings, initial plans of doing nothing, show her writing $45,000 checks to the IRS.

 

[jebmke]

You have discovered the marginal tax rates that are not in the tax brackets. This is one of the reasons why it is critical to use tax software to simulate the effect of marginal income when making specific decisions that will result in more or less income. The tax brackets are only part of the story. For years we lived in the hidden 27% bracket (and earlier flavors prior to TCJA).

 

[pb4uski]

Yes OP, the best way to assess the tax cost of Roth conversions caused by the change in tax with and without the Roth conversion.

But... you then need to compare that with the tax that you will pay on an RMD if you don't do the Roth conversion or that your heirs will pay if you don't do the Roth conversion and they inherit your taxable IRA. Or even worse, the tax on the RMD a surviving spouse will pay if you or your DW die and the surviving spouse are launched into even higher tax brackets.

 

[FloridaWizard]

Trying to understand a little more/better the tax consequences of a Roth conversion.

The conversion itself is easy, it is all ordinary income in that tax year, and you will pay whatever marginal tax rate that conversion income pushes you into. However, I believe, especially for people who have significant taxable brokerage accounts with 50/50 stock/bond allocations, that the Roth conversion adds even more tax consequences that I do not see discussed.

For example, if you ONLY have $200,000 of qualified dividends as income (and for ease let's say all your bonds are Muni bonds and you live in a state that does not have an income tax) and are MFJ, I believe you will pay $0 in taxes on the first $89,251, and then 15% on the remainder amount for a total tax of $16,612. I know there will be deductions, credits, etc. but assume none of that for this 'simple' example.

If in the same above scenario, you do a $100,000 Roth conversion the same year, not only would you pay the tax on the Roth conversion, but then that $89K of qualified dividends that were in essence tax free now becomes taxable at the 15% qualified dividend rate and I believe the Obamacare investment tax of 3.8% would kick in (because now your MAGI is above $250,000). So, the total tax on the Roth conversion is much more than just the tax liability on the $100,000 that I convert, it pushes some qualified dividends into high brackets and kicks in the 3.8% tax on ALL of the investment income.

Am I correct, or am I completely missing the boat here? Thanks.

You are correct. There are lots of things to consider with Roth conversions - you mention two of the big ones. If you are on ACA this could affect your subsidy. If you are close to retirement, you need to consider Social Security taxation and IRMAA surcharges as well.

 

[RobertTN]

I appreciate everyone's responses. A few have pointed out the tax on the RMDs which I did not consider and the tax on death. Wish life, and especially taxes, were easier!

 

[MarieIG]

It appears that interest income is also subject to NIIT - something to consider when choosing investments.

 

[TheWizard]

You need to be aware of your own tax situation as regards Roth conversions, correct.
In my case, 85% of my SS is taxable and I already pay some Medicare IRMAA.
So my criteria for last year's Roth conversion was twofold:
1) stay in the 24% Federal tax bracket, don't get into the 32% bracket.
2) keep MAGI below next higher IRMAA tier threshold.

And since I do RMDs now, my allowable Roth conversion is lots smaller than it was before RMDs...

 

[Dash man]

It’s important to map out your income, taxes and RMDs as best as you can well into your 80s. Your 80s is when the RMDs become onerous tax liabilities. At least in our case. We’ve done large Roth conversions the past few years and are starting to dial them back a little this year to reduce our future IRMAA taxes. We’re planning to stop the conversions after 2025 and let qualified charitable contributions help us keep our income lower when we hit 70 1/2 in 2027. Then it’ll be no more IRMAA and no more NIIT if our plan works out.

 

[RunningBum]

I appreciate everyone's responses. A few have pointed out the tax on the RMDs which I did not consider and the tax on death. Wish life, and especially taxes, were easier!

It is complicated. But usually those complexities are to our benefit.

They could be taxing the first dollar of your qualified dividends.

They could be taxing qualified dividends at regular income rates.

Roth conversions could be disallowed, with no way to access deferred income before 59.5 without penalty, and no tax free growth when the converted money is in a Roth.

If deferring income had never been an option, that income would have been taxed at our (probable) higher tax rate while working.

Just trying to add some perspective. You can make it a little easier on yourself by running your numbers through a tax program or estimator, and adding Roth conversions in increments to see the marginal rate of conversions.

What's more complicated is to compare that with the future marginal rate of RMDs. I just use the same calculator, and figure that since most of these tax brackets and limits are inflation indexed it will match up with my growing deferred account causing larger RMDs. Be sure to include other things such as ACA subsidies and IRMAA.

Another guideline I use is that what I can clearly convert now at a better rate is an easy decision to convert, for a relatively large benefit. If conversion is clearly at a higher rate than I'd pay later, that's another easy decision, to not convert at this point.

Where the conversion rate seems to be about the same rate as taking RMDs later, there's relatively little gain or loss by converting, so it hardly matters what to do. I tend to convert at the known rate today, rather than have more income later when I can't be sure what rates will be. Married people may also use the tie breaker to convert now in case a lone survivor is filing single for many years later. Planning to move to a lower taxed state later is a tie breaker for not converting. Heirs income rates are another factor.

 

[dmpi]

What the OP says is 100% true. You have to be extremely careful which years and how much you convert for Roth. I had to wait for my wife to retire and then I had to stop when I hit 63 and IRMAA starts up. This gave me a window of just five years of which I hit it real hard and converted 45% of our 401K. Now I can still do some, but only a tiny bit before I hit some tax threshold.

 

[street]

One question on Roth. Can you still do Roth after the RMD age (73)? When you take your RMD and pay taxes on that can you still put that money into the Roth?

 

[cathy63]

One question on Roth. Can you still do Roth after the RMD age (73)? When you take your RMD and pay taxes on that can you still put that money into the Roth?

You can contribute funds to a Roth IRA if you have earned income, and you can do a Roth conversion in addition to your RMD, but you cannot do a Roth conversion of your RMD.

 

[Venturer]

Interesting!!! I will be following this thread. I have a friend that says ROTH aren't all what they are cracked up to be. I'm sure there is a downside to a ROTH somewhere or somehow.

Also, he said if you wait and do RMD and reinvest that money verses doing Roth now. In the end would be a ~ a wash in taxes and your portfolio at the end. I have no idea just his study he did on it.

Tax changes can happen, up and down in investment from year to year, death and so many things can change the final comparison of Roth or no Roth.

I'd say we may or may not have messed up,but we only have IRA's in Fidelity,savings & checking accounts locally and stocks in TD Ameritrade--soon to be merged with Schwab. No Roths and mabey too late to do any converting since I'm 71 and wife is 70. Never thought about Roths till I joined here so I guess we'll just do what we have to and pay up.

 

[SecondCor521]

Yes, you have to consider all of the tax effects, both good and bad.

On the "bad" side is ACA effects (which are larger than most people expect because of the way the math works), NIIT, SS taxation, the 27% shadow bracket, etc.

On the "good" side, and this benefited me in 2022, are tax credits like AOTC and CTC. I had two dependents in college last year and took full advantage of AOTC on both of them. This created a pretty sizeable 0% shadow bracket. I used tax software to dial in my Roth conversion up to the top of that 0% shadow bracket. Early retirees with several kids getting CTC would see a similar effect.

(I actually went a few hundred dollars over and will dial it in exactly with an HSA contribution once I do my taxes in the next week or so. Like IRA contributions, HSA contributions can be made for the prior year up to the filing deadline.)

 

[AmigaDude]

I'd say we may or may not have messed up,but we only have IRA's in Fidelity,savings & checking accounts locally and stocks in TD Ameritrade--soon to be merged with Schwab. No Roths and mabey too late to do any converting since I'm 71 and wife is 70. Never thought about Roths till I joined here so I guess we'll just do what we have to and pay up.

Just and opinion, but "I" do not think you have messed up. Having any IRA is a great thing, assuming it did well over the years that you paid zero taxes on that income.

Of course we can play that game of paying more taxes now (Roth) so that we owe less in the future. For me, I'll stick to the plan and just pay taxes as the RMD(s) demand.

 

[Which Roger]

Yet another variable: Some people won't need their RMDs when they kick in, and may use QCDs and the like to donate a big chunk of the RMDs. That significantly reduces the tax torpedo and tips the equation, making Roth conversions much less desirable. DW and I fall into this category.

 

[street]

You can contribute funds to a Roth IRA if you have earned income, and you can do a Roth conversion in addition to your RMD, but you cannot do a Roth conversion of your RMD.

Cathy63, so if I do a RMD and I get check for that year, I then can put that money in a Roth account, correct? If I put that money in a Roth, I just paid taxes on from the RMD, do I pay taxes on that money going into that Roth account again?

Thank you, for your knowledgeable/expertise help I see you give so often here on this site.

Very much appreciated!!

 

[braumeister]

Cathy63, so if I do a RMD and I get check for that year, I then can put that money in a Roth account, correct? If I put that money in a Roth, I just paid taxes on from the RMD, do I pay taxes on that money going into that Roth account again?

The RMD amount cannot go into a Roth, period.
If you decide to take the money, you'll have to pay taxes on it, of course. The other alternative would be to do it as a QCD, in which case no tax would be due.

But you can convert any amount over and above the RMD amount into a Roth, paying taxes on that amount when you do.

 

[Dash man]

The RMD amount cannot go into a Roth, period.

If you decide to take the money, you'll have to pay taxes on it, of course. The other alternative would be to do it as a QCD, in which case no tax would be due.



But you can convert any amount over and above the RMD amount into a Roth, paying taxes on that amount when you do.

While RMD money cannot go into a Roth, it can be used to pay the taxes on any additional Roth conversions after the RMD.

 

[cathy63]

Cathy63, so if I do a RMD and I get check for that year, I then can put that money in a Roth account, correct?

No! You can't put the RMD in a Roth. It has to be money over and above the RMD or else it has to be money you earned that year.

 

[Romer]

As stated, just emphasizing it. One big benefit of doing Roths is ensuring your surviving spouse doesn't end up with huge tax bills when transitioning to single tax rates vs married. That and converting before Tax rates go up in 2026 are my primary drivers right now

 

[Exchme]

Roth Conversions mix all the complexity of the tax code with the uncertainty of market growth, longevity and more. Often overlooked is folks have to decide on their goals, fears and general life circumstances before working on the economics of Roth Conversions.

-The charitably inclined may do QCDs with some/all of the RMDs and avoid the big run up in tax rates or intend to give their IRA to charity when they pass, so the effective tax rate on the IRA left in their estate would be zero.

-Folks with heirs in high tax brackets may want to be more aggressive doing conversions so that the government ends up with less of the estate. Remember your heirs may be in their peak earning years or ready to do their own Roth Conversions when they instead have to do the inherited IRA withdrawals.

-Folks with concerns about long term care may want to leave a chunk in the IRA in case there is a need as those costs are mostly tax deductible.

-Folks with age or health disparities between spouses may want to be more aggressive to minimize taxes for the surviving spouse.

-As mentioned by others, many need ACA and the Premium Tax Credit phase-out is another incremental cost to doing Roth Conversions.

-Folks that may move to a state with different tax rates need to consider that as well.

Then comes your economic and tax forecasts.

-TCJA expires after 2025, so tax brackets are scheduled to go up about 3 points, so conversions now can hopefully give you an advantage.

-The TCJA expiration in 2026 also is scheduled to cut the estate exemption in half, so some of the well-heeled folks here might eventually pass with enough to have estate taxes due, they would wish they had aggressively Roth converted as the estate tax is blind to the type of holding.

-If we get happy market results, folks may end up in higher brackets someday causing second guessing for not doing more conversions previously. The inverse is also true, a prolonged downturn could turn the regrets the other way.

So no one will get these predictions "right". But most of the benefit can be had by getting the big ones sort of close.

 

[Midpack]

That’s why I’ve said since 2019 you have to project out actual taxes with and without taxes to know if Roth conversions makes sense for your situation. I used Income Strategy** for $20 (one month subscription) to do just that at convert to 12%, 22%, 24% and 32% - made it easy to see lifetime taxes with all the various and portfolio residual. Also easy to look at effects on IRMAA etc. Of course you have to make some assumptions about longevity, future tax code, AA, returns, heirs, etc. - but then you have to do so with almost all financial planning. Glad I did so in 2019, will save me almost $400K in lifetime Fed and State taxes.

** While Income Strategy showed all the work in 2019, it’s now more of a black box. Still serves its purpose but I don’t necessarily recommend it any more.