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.
halo said:
#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.
halo said:
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.
halo said:
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.
halo said:
#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.
halo said:
#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.
halo said:
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.