Roth Conversion Tax

[ERD50]

With our government, anything is possible.

Absolutely. I am doing this, but I'm not exactly comfortable doing it. I can understand someone deciding against it.

It's a risk that the feds will mess with it. And I see no way to quantify that risk, so I'm just doing it anyhow. I think it is best to plan based on what you know today, anything can change, so you may end up doing nothing. In some cases, doing nothing ends up being the best thing you could do, but I'm not sure it's a good plan.

The feds are so busy messing things up, they may be too busy to mess this up.

Ask me in thirty years how it went.

-ERD50

 

[ESRBob]

Halo,
if your original question was as much "how do I get this input correctly into FireCalc" as "should taxes paid to convert a Roth be taken out of my annual SWD, or can I 'overspend' to pay those taxes, then I have a strong opinion to add to the thread:

to the latter question, I say, absolutely OK to overspend for the taxes during those years you are converting your Roth. These taxes are actually not your funds, but are the gummint's funds anyway, which you are holding and investing for them until you convert or face RMDs. In that sense they might or might not even belong in your net worth, but we can leave that particular red herring for another thread.

If you have done your own soul-searching and analysis and come up wanting to do a Roth conversion, then simply leave the taxes your pay out of your budget, SWR calcs etc. as a one-time transaction, not as a sign of fiscal profligacy in the years you're converting.

Personally, like Nords, we 'harvest' as much of the 15% bracket as we can with Roth conversion every year. We know the math might look close, but it gets better if you keep the entire amount in the Roth and pay the tax with taxable income. Who knows what the future administrations will do with taxes, means-testing etc, but RMDs get very grim for successful long-term investors, and that is unlikely to improve.

 

[REWahoo]

Personally, like Nords, we 'harvest' as much of the 15% bracket as we can with Roth conversion every year.

Same here. I have no faith that the 15% rate will not increase in the future, so I'm going to pay now in the belief (but not in the certainty) I'll avoid paying more later.

 

[Nords]

I guess my inclination is to never voluntarily pay taxes early. How do you know that Roth's won't be means-tested down the road?

Well, RMDs on a conventional IRA already subject your Social Security to taxation-- sort of a sneaky back-door means test.

We don't know that there won't be means testing-- what a great way to "fix" Social Security! We're not confidently predicting what the govt could do to future tax laws, although I agree with ESRBob & REW that taxes will probably not be going down.

But we know right now that when spouse's pension kicks in if we're taking RMDs we'll be paying 25% tax on them. A Roth conversion is the only way to avoid that certainty.

Good news about the kid's Roth IRA RMDs. That's just like establishing your own trust fund! Of course by our plans she'll be inheriting in her 80s, but again that's her problem.

 

[halo]

Hi ESR Bob

Thanks you for your reply and for sharing your opinions - they really do address my concerns.

One thing you say that is a bit unclear to me is:

"simply leave the taxes your pay out of your budget, SWR calcs etc. as a one-time transaction"

Do mean to not count the yearly conversion tax payment as part of your annual SWR spending amount? And what do you mean when you say to somehow treat it as a "one-time transaction?" I'm planning a partial conversion every year for the next 10 years unti1 I reach age 701/2, so that's a "TEN-time" transaction for me. What am I not understanding ab0ut what your saying here? Could you please clarify it?

Let's say you do count your total TIRA balance as part of your net worth, with the understanding that MRD taxes will have to be paid starting at age 70 1/2. And let's say that you decide to reduce these tax payments by paying a smalller conversion tax every year starting age 60. Woudnt those conversion tax payments have to part of your annual SWR spending under these assumptions?

The good news is that if you ask Firecalc to project a 30-year plan, and include in it a yearly tax payment that stops after the first 10 years (as a "spending increase" for years 1 - 10 and then a "spending decrease" of the same amount for years 11 - 20), the calcuator reduces your annual SWR by an amount that is roughly HALF of the tax payment.

If the effect on annual SWR spending is only about half of the nominal amount, you'd actually have to reduce your annual inflation-adjusted spending by much less (around 1/2) than the actual tax payment. This is because the conversion plan stops 10 years into the 30-year plan. Do I have this right? It makes a significant difference in the conversion tax's effect on your future purchasing power! If 10 years of tax payments only reduces your SWR by 1/2 the annua1 tax payment amount spread over 30 years, that really makes a much stronger case to go forward with this sort of conversion program, doesn't it? I go into this in more detail in this thread:

http://early-retirement.org/forums/index.php?topic=10648.0

Is this a correct use of Firecalc? Thanks for any and all feedback on this Roth Conversion issue and the way I'm using the Fireca1c here.

 

[ESRBob]

Halo,
I'd need to spend some time with your other thread and running some examples in FIRECalc to answer you completely -- maybe someone else here has dug into this already?

My non-technical way of answering is to say that I think a lot of people (I hope I'm wrong?) just ignore future IRA tax payments. They may figure it is too painful to contemplate, that the world will change, or that by the time they start RMDs they'll be old and can afford to make the bigger payments without worrying too much about running out of money. Certainly, older people can take bigger annual withdrawals, even planning to run down assets in a staged manner, which younger ERs can't safely do (imho).

So I am guessing most people look at their IRA assets in their entirety as part of their portfolio, and calculate SWRs during their early retirement years based on the full value of that IRA.

Enter the Roth: people independently come to the conclusion that a Roth is a good idea for them, and decide to take their tax medicine early, leading to your question: should my IRA conversion tax payments be part of my annual spending during those years I am converting?

My gut (and my practice) is to simply pay those taxes ou t of assets, whether as a one-time payment or a ten time payment, and not count it as annual spending, and not consider it in the same way as the income taxes I pay to realize interest and dividend income used for my spending each year.

The reason I am so comfortable with this is that, at least for me, the SWR is really a way of saying, "can I live within my means during ER, and enter traditional retirement with a big enough nest egg to keep body and soul together until I leave this place?". So it is really more about matching SWR to current (and projected) ongoing consumption levels than it is to literally match SWR to every dollar that goes out the door for any reason.

In the same vein, I only count in my budget (and draw against my SWR) the amount of taxes I pay to generate the dollars out of my portfolio that I need to spend each year. That means the direct taxes on the interest, dividends and capgains on whatever amount of appreciated assets I have to sell (during rebalancing usually) to fill up my tank for the year's spending.

If I were to deem it wise to sell and reinvest a major holding in my portfolio, (and not use the proceeds for living expenses/SWR) then I would also not count the capgains taxes on that sale as part of my SWR for the year. The reason? It isn't really spending -- it is a consequence of investment decisions -- sad but true fact of life, paying these taxes -- but I can't do anything about it and it shouldn't arise again. Why reduce consumption this year on account of that one-time tax? Better to simply reduce my overall portfolio value by that one-time tax amount-- it gives me a truer bead on my ongoing financial solvency.

Note that my safe withdrawal amount and spending cap every year thereafter are marginally lower due to that one-time hit to my portfolio value, since I set my withdrawal amount to a percentage (4-4.5%) of my year-end portfolio value. Likewise, each year you lower your portfolio value with another Roth conversion tax payment, you'll be reducing your spending a tiny bit as a result of that smaller asset base. With luck, appreciation will be raising your portfolio value, though, and you won't feel such a pinch.

Make sense? Others may disagree, but this is how I do it personally, and I think it is a responsible and reasonable way to go about things.

 

[Nords]

My gut (and my practice) is to simply pay those taxes ou t of assets, whether as a one-time payment or a ten time payment, and not count it as annual spending, and not consider it in the same way as the income taxes I pay to realize interest and dividend income used for my spending each year.

Paying the taxes out of taxable assets leaves that much more in the Roth to compound tax free...

 

[ESRBob]

Totally agree, Nords -- however you account for it in your own mind/budget, definitely pay the tax to the State and Feds out of taxable funds -- it's effectively like pumping up the value of your IRA by an addiitional 30%.

 

[halo]

Thanks for the thoughtful reply, ESRBob -

I have three broad followup questions:

#1 - Under the way you do things, what happens when the time comes at age 70 1/2 that the gummint forces you to start taking MRD's from your TIRA year after year? Would you treat the tax payments on these MRD's the same way, that is, just deduct them from assets? Or would you reduce your spending for each of those years by the amount of those tax payments on each MRD? And what would the underlying rationale be for doing it either way? By paying the Roth conversion tax early, you are definitely creating future value in 2 ways (by lowering the TIRA MRD tax payments that you will have to pay later and creating open-ended tax-free compounding in the Roth). Therefore, paying the conversion taxes early really is making a true investment decision to create these distinct benefits. However, any tax payments on the TIRA MRD's you are forced to take at age 70 1/2 are most assuredly NOT investment decisions - they are plain old taxes, money gone out the door, not creating any future value whatsoever. So aren't they very different in nature from the conversion taxes? Wouldn't those TIRA MRD taxes HAVE to be deducted from annual spending when they start?

#2 - One of your key criteria seems to be to only deduct from your yearly SWR spending the taxes that you generate to free up your annual 4-4.5% of portfolio spending money, correct? Would you apply this distinction to the taxes paid on TIRA MRD's starting at age 70 1/2? In theory, one could not use the after-tax amount of each yearly MRD to live on and just put it back into the portfolio, and then continue to take your annual SWR withdrawal from your taxable assets, using a total portfolio balance (based on all 3 of your accounts - taxable, TIRA and Roth) that was reduced by the taxes generated to free up that year's spending money out of your taxable account AND reduced again by the tax payment caused by that year's TIRA MRD. In this way, you minimize the impact of all these payments on your annual SWR both before and after age 70 1/2. That would be great, but is it a truly valid way to go about this?

#3 - You don't mention anything about giving yourself an inflation adjustment when you take your annual 4-4.5% SWR withdrawal. Is it possible that any and all of the tactics described above in #1 and #2 are totally dependent on using the 95% Rule? Forgive me if I don't know about your underlying system, which may be to NOT adjust for inflation going forward, but rather to simply take a constant 4-4.5% of whatever the portfolio value happens to be in each year going (while not taking less than 95% of the previous year's withdrawal). The question is: does such a system make not deducting the conversion tax (or the MRD tax) from your annual SWR spending possible to begin with? If so, then that changes everything. This is an important point to clarify, I think.

One of the things that I find most appealing about Firecalc is that it gives you an idea of your SWR on an inflation-adjusted basis. Of course, it is based on inflation models that occurred in the past, like everything else in the calculator is based on what happened in the past. But still, the idea of giving yourself a small inflation-based "raise" each year (based on your portfolio's initial value) seems to me what Firecalc is all about - maintaining purchasing power throughout your entire retirement period. I like to use the Firecalc result of "how much you spend each year" to see the maximum amount I could theoretically safely spend. Then I adjust it for inflation in years past (and going forward too, of course), just to make sure I'm staying well below that maximum amount, always maintaing a good "margin" in this regard.

The question is, would your treatment of Roth conversion taxes (and TIRA MRD taxes starting at age 70 1/2, if you would treat them the same way) still "hold water" if one is taking an inflation-adjusted raise each year based on one's initial portfolio value? Is there any way that could be made to work? Or do both of these treatments (for the Roth Conversion taxes and the TIRA MRD taxes) only work if one is using the 95% Rule Option that Firecalc offers? This really is a key question, here, I think.

Is there any way you can see to treat the Roth conversion taxes (and possibly the TIRA MRD taxes) the same way you are doing if you are using Firecalc in the default mode, which adjusts future withdrawals for inflation? I certainly hope so. It would be interesting if we could get Dory36's opinion on this too at some point . . .

Thanks again,

Halo

P.S. I look forward to seeing what you come up with after working with Firecalc as you said you'd do (when you have the time) regarding this and other matters that I've raised earlier in this thread.

 

[ESRBob]

Anybody else have thoughts on this one?

I confess that all I ever thought about was getting through ER, and by the time we're 70 1/2 and having to deal with RMDs, we'll be 'real-retired', with a higher Safe Withdrawal Rate -- in other words the ability to safely start to draw down assets.

But in answer to some of Halo's specific questions, yes -- my withdrawal method (what I and lots of others here use, and what is in my book), is to withdraw a safe percentage of assets, in effect changing your income yearly to match your portfolio value. This helps preserve real portfolio value over the long run, in our studies, because it is making lots of small micro-responses to actual portfolio performance along the way, as opposed to setting one consumption level and then inflation-adjusting it forever. It also means you can spend more if your portfolio is outperforming, which is always nice! The 95% Rule softens the amount you adjust spending during downcylces in the market. Your inflation adjustment comes from portfolio performance, not a guaranteed raise each year. Part time work or belt tightening can soften the variability in real income.

So the answer to Halo's question about taxes or other one-time expenses-- are they in counted in or outside the Safe Withdrawal for that year or years -- is easy under this system: It doesn't matter. Not to be flip, but if you can afford to pay these taxes and still maintain living standards under your Safe Withdrawal, then great -- do it. If paying these taxes causes you to spend more than your Safe Withdrawal amount, then all that has happened is your spending next year and in subsequent years will be fractionally reduced, since your portfolio is now smaller. In other words, in my system, every year is kind of like "Year 1" -- you take up to 4.3% of your portfolio to spend, but if you need more, then next year's 4.3% will just be smaller. Overspend long enough and you'll plow through your portfolio, have too small a portfolio to support spending, and you'll just need to go back to work or downsize. There's no SWR Cop to stop you, but nor is there any implicit guarantee of maintaining your current living standard into the future. You can maintain a living standard around a 4.3% withdrawal from today's portfolio value, but if you are going to over-withdraw, then you'll be centering tomorrow's living standards around a new lower level.

No doubt IRA Required Minimum Distributions (RMDs) are a big expense, as are Roth Conversion taxes now. My personal practice was to do the Roth Conversions at advantageous tax levels today, pay the taxes by reducing the portfolio (I couldn't have afforded to pay them from my Safe Withdrawal amount) and not worry about RMDs later. I get to spend a little less each year now, but the taxes are paid.

If people keep their traditional IRAs and undergo RMDs later, then my feeling is that they should try to have taxes and living expenses covered under a new larger 75-year-old's SWR, (maybe 5-6%?), since the taxes go on for life and will have to be budgeted somehow each year. They are no longer a one-time expense, but are a real, regular, unavoidable part of your budget from age 70 onwards.

Make sense?

 

[Nords]

In general, by the time we're answering these types of questions, we're way down in the weeds and perhaps over-analyzing the situation. I think "analysis paralysis" is more of a concern than choosing the "correct" IRA conversion option.

Regardless of the answers to the following questions, annual withdrawals have to take out enough to pay the taxes. The good news is that taxes shouldn't be a big part of the annual withdrawal... someone paying all the way to the top of the 25% income-tax bracket is still paying less than 25% of their income on taxes, and their total SWR is probably still less than 5%. Tax payments won't bankrupt the portfolio and no one is going to have to reduce their spending to pay those taxes.

#1 - Under the way you do things, what happens when the time comes at age 70 1/2 that the gummint forces you to start taking MRD's from your TIRA year after year? Would you treat the tax payments on these MRD's the same way, that is, just deduct them from assets? Or would you reduce your spending for each of those years by the amount of those tax payments on each MRD?

Yep, the taxes on RMDs are just another expense and part of the total withdrawal from the assets. I wouldn't reduce "other" spending, I'd withdraw more to cover my "other" expenses as well as to pay the taxes on the RMD. If that drives the total withdrawal above 4% then it's probably OK. (Especially because I'll have been ER'd nearly 20 years by that point and should have a feel for how much we can withdraw.) I doubt SWR would go much above 4% because by that point in most investor's lives they'd theoretically be receiving enough Social Security to reduce the total portfolio withdrawal.

By paying the Roth conversion tax early, you are definitely creating future value in 2 ways (by lowering the TIRA MRD tax payments that you will have to pay later and creating open-ended tax-free compounding in the Roth). Therefore, paying the conversion taxes early really is making a true investment decision to create these distinct benefits.

Not always. Our Roth conversions are based on our knowledge that we'll be in a higher tax bracket when we'd have to take RMDs. So our "decision" was that paying lower taxes earlier beats paying higher taxes later. Creating "distinct benefits" had nothing to do with it but it's a great consequence.

So aren't they very different in nature from the conversion taxes? Wouldn't those TIRA MRD taxes HAVE to be deducted from annual spending when they start?

Nope, they're part of overall spending. You can spend it now (taxes on Roth conversions) or spend it later (taxes on RMDs) but you're gonna spend it one way or another.

The logic behind most Roth conversions is the hope that taxes will be lower now than later. So spending now will be lower than spending later, but the taxes will still be part of the year's expenses.

#2 - One of your key criteria seems to be to only deduct from your yearly SWR spending the taxes that you generate to free up your annual 4-4.5% of portfolio spending money, correct? Would you apply this distinction to the taxes paid on TIRA MRD's starting at age 70 1/2? In theory, one could not use the after-tax amount of each yearly MRD to live on and just put it back into the portfolio, and then continue to take your annual SWR withdrawal from your taxable assets, using a total portfolio balance (based on all 3 of your accounts - taxable, TIRA and Roth) that was reduced by the taxes generated to free up that year's spending money out of your taxable account AND reduced again by the tax payment caused by that year's TIRA MRD. In this way, you minimize the impact of all these payments on your annual SWR both before and after age 70 1/2. That would be great, but is it a truly valid way to go about this?

I give up. (This is way too hard.) Take the RMD, use the leftover money to support that year's SWR (including taxes on the RMD and whatever other taxes are owed), and put whatever's left over back into taxable accounts into whatever asset allocation is appropriate. There's no "valid" or "invalid", just whatever works for each ER.

#3 - You don't mention anything about giving yourself an inflation adjustment when you take your annual 4-4.5% SWR withdrawal. Is it possible that any and all of the tactics described above in #1 and #2 are totally dependent on using the 95% Rule? Forgive me if I don't know about your underlying system, which may be to NOT adjust for inflation going forward, but rather to simply take a constant 4-4.5% of whatever the portfolio value happens to be in each year going (while not taking less than 95% of the previous year's withdrawal). The question is: does such a system make not deducting the conversion tax (or the MRD tax) from your annual SWR spending possible to begin with? If so, then that changes everything. This is an important point to clarify, I think.

The Trinity study, which started most SWR discussions and FIRECalc's design, starts with a 4% withdrawal at the beginning of ER. "4%" is just calcluated that first time and never again... subsequent withdrawals are the previous year's withdrawal boosted by that previous year's inflation rate. It's possible for a 4% SWR system to result in annual withdrawals that are much higher than 4% of the portfolio's current value... or lower.

OTOH the WLLM system withdraws 4% of the portfolio each year or, in some years, kicks in the 95% rule. There's no annual inflation adjustment. Each year starts over with a 4%/95% evaluation.

I still believe that each withdrawal has to include enough money to pay the taxes. There's no spending reduction-- just the sum of "other expenses" and money to pay the taxes-- and not reducing the former by the latter.

I'm not sure that WLLM would benefit from this level of discussion on IRA conversions.

The question is, would your treatment of Roth conversion taxes (and TIRA MRD taxes starting at age 70 1/2, if you would treat them the same way) still "hold water" if one is taking an inflation-adjusted raise each year based on one's initial portfolio value? Is there any way that could be made to work? Or do both of these treatments (for the Roth Conversion taxes and the TIRA MRD taxes) only work if one is using the 95% Rule Option that Firecalc offers? This really is a key question, here, I think.

I think the answer is "Yes". Your ER budget is based on that "other spending" plus the taxes owed, whether that's an earlier Roth conversion or a later RMD. The Roth conversion taxes would be part of the ER spending budget and part of determining whether the portfolio would have a low-enough SWR to support the spending. Or, after RMD, the SWR might have to be boosted to cover the taxes. Considering the ER's age at that point and the probablility of having SS income, boosting the SWR probably won't be a problem.

Again, Halo, I think you're making this way too hard. As part of their ER, people should make a decision about a Roth conversion. They'll decide to do one or the other, for whatever financial or emotional reason they choose. It doesn't have anything to do with FIRECalc runs or "reducing spending" or "valid" tax payments.

Once that conversion decision has been made, they should put together an ER budget to support it. It'll either be additional taxes early on to pay for the Roth conversion or additional income taxes later on the RMDs. That spending (more earlier or more later) can be run in FIRECalc to see how the resulting withdrawals affect the portfolio's survivability. FIRECalc's a pretty good tool but you're trying to use it as a micrometer when your cutting tool is a chainsaw.

If a conversion decision can't be made just by looking at taxes on RMD & SS then there's probably no benefit to running a bunch of FIRECalc data. A Roth conversion has to be decided on pretty compelling information (e.g., 15% tax bracket or 25% tax bracket) or it's not worth the effort.