Roth Conversion Taxes - Perspective (I Needed)

[Midpack]

A few months ago I went through a deep dive and finally committed to Roth conversions (thread link below). Voluntarily paying taxes up front was always my primary barrier. And simple online Roth conversion calculators always came back close to a wash, so I didn't get serious. When I did...

There's WAY more to it than that, but I won't rehash it all here, it's in the prior thread in too much detail already.

I just finished my 2019 taxes which included my first large Roth conversion. I came up short of maxing out the 22% bracket in 2019, but that's the plan for the next 6-7 years. Without doing any conversions, we'd be in the 22% bracket from age 71 and every year until we go poof. With 22% conversions, we'll be in the 15% bracket from age 71 on. If tax rates stay the same, our residual portfolio won't change much good or bad, though we'll have inheritance/widower benefits. But if future tax rates increase as I believe, we'll come out (much) better.

The bad news is, as expected, our effective income tax rate has tripled over what we paid 2012 thru 2018 - what (shortsightedly) always held me back.

The good news is when I did my annual update of my historical tax spreadsheet, I realized what a dope I've been. I'd FORGOTTEN what it was like to really pay taxes. Though my Roth conversions will be even higher in the next 6-7 years, my effective income tax rate will be about the same as 2019.

Our circumstances are all different, we all have to do our own deep dive. But for those in a similar situation, I thought this could be illuminating - don't be a dope like me.

Too soon old, too late smart...

https://www.early-retirement.org/forums/f28/retirement-tax-planning-income-optimization-99854.html

Chart below is effective federal tax rate % annually.

 

[Philliefan33]

I’ve noodled around a bit with doing the calculations to see if we should be doing Roth conversions, but never really finishes the analysis since DH has a TSP (where until very recently it was not possible to get the money out to do a Roth conversion). Now that I believe we can get money out of his TSP without triggering regular payments from it, I should take a more thorough look. There’s still a high mental hurdle to overcome.

This morning I started refining the spreadsheet I had started, adding some things I didn’t consider before such as IIRMAA.

 

[pb4uski]

I think it is fair to say that my plan has evolved over time. For the first year of retirement I favored 0% LTCG over Roth conversions and for 2013 to 2019 we converted to the top of the 12% (formerly 15%) tax bracket... actually to the top of the 0% capital gains tax bracket which is a couple hundred $$$ less.... and have paid about 8.5% in federal tax.

Unfortunately, even though all my fixed income is in the tIRA and some equities the tax-deferred balance today is 128% of what it was when I retired... despite withdrawing/converting amounts equal to 37% of my retirement day balance over the last 7 years.... like a dog chasing its tail.

I posted a bit on our current plan in a different thread the other day:

Once we have become FL residents and are no longer subject to state income taxes on Roth conversions I'll get real aggressive with Roth conversions for about 5 years..... to the top of the 22% tax bracket. Then once I start SS at 70, I'll back down to about 28% into the 22% tax bracket annually to try to drain my tIRA by the time I'm 90.... from age 72 on it will be a combination of RMDs and Roth conversions..... at age 90 I should be about 17% taxable accounts in equities that will get a stepped-up basis and 83% in tax-free Roths.

In the initial phase I'll be paying about 16-17% of the amount converted and in the second phase I'll be paying 12-15% of the RMD and amount converted. Given that the income was deferred at much higher marginal rates.... 28%+ later in my career... so I'm happy that I decided to defer. The cherry on top is that I avoided ~5% state income tax so the savings have been even better.... in total ~33% when deferred vs 12-17% when converted/withdrawn.

What could disrupt my plan is if investment results exceed my assumptions, but I can then make mid-course adjustments to still have the tIRA drained by the time I'm 90.

And as Mike Tyson said "everyone has a plan until they get punched in the mouth".

FWIW, I tend to focus on the effective rate on withdrawals... tax after withdrawals less tax before withdrawals divided by withdrawals... with in all cases withdrawals and conversions being counted the same. For now, our withdrawals are limited to withdrawals with 100% withholding in lieu of paying estimated taxes... all the rest are Roth conversions.

 

[karen1972]

I'm always waffling whether to tackle Capital gains in my taxable account vs. getting my ROTH converted since 59 1/2 is still 12 years away. I've been biting the tax bullet but splitting it. Tracking it over the last 5 years, the needle doesn't feel like its moved as I started with 65% and still at 65% of the portfolio I still owe taxes on...it keeps growing, I keep trying to empty it, it keeps growing. Almost looking forward to some down years as I feel like its the only way I can make headway.

 

[thefist]

2019 was my first full retirement year, so I'm trying to figure this out too. I filled up the 12% bracket with a small conversion last year. I did have a CFP tell me that they often recommend converting up to 22%, but I've not quite decided yet. My tIRA is only about 20% of net worth, so my RMD's may not be too bad.
I'm 54, so 11 more years to Medicare. The current competition in that low bracket is ACA subsidy vs. zeroCG rate vs. Roth Conversion.

 

[Gumby]

Based on your last thread, I spent the day yesterday building a spreadsheet to model my Roth conversions over the next 11 years, until RMDs kick in, and then 9 years of RMD's.

This year, I am doing no Roth conversion, or maybe $5k at the most, so that I can pay 0% capital gains tax on the shares I just sold in my taxable account. Next year, I will run our conversion up to the top of the 24% bracket. I know I'll be in NIIT surcharge territory, but the conversion itself is not investment earnings for purposes of NIIT and my actual taxable investment earnings will be very small.

After that, my plan is to run Roth conversions up to the first IRMAA surcharge AGI level, beginning in 2022 (2 yrs prior to Medicare.) With the standard deduction, that means we'll be in the 22% marginal bracket.

With this withdrawal schedule, assuming all limits go up together with inflation and assuming a reasonable return on investments, we should stay in the 22% bracket through 7 years of RMDs, but we will breech the IRMAA surcharge AGI after the second year.


ETA: Following pb4uski's lead, I'm also viewing the Roth as a conveyor belt. Conversion dollars go in the top and budget support dollars come out of the bottom. Not all the conversion after tax dollars will be necessary for ordinary budget support, so the Roth should increase in value. There is already enough in the Roth to support 6 years of regular draws, so the conversion 5 year clock is not a problem.

 

[madsquopper]

I'm looking at this now as with my spouse's excellent pension we'll be butting up against the 24% bracket eventually, and probably well past it when I start taking SS in several more years. I'll likely start converting up to the IRMAA level 2 surcharge point and then kind of hope for the best. Worst case is that once RMD's hit, I'll take out money in "reverse order" (from IRA's first instead of taxable).

I'm a bit uncomfortable with not being able to harvest substantial capital gains in the taxable account, but it doesn't look like I can have it both ways.

 

[Dalmore]

I'm looking at this now as with my spouse's excellent pension we'll be butting up against the 24% bracket eventually, and probably well past it when I start taking SS in several more years.

I'm a bit uncomfortable with not being able to harvest substantial capital gains in the taxable account, but it doesn't look like I can have it both ways.

I'm in a similar situation. DW's pension puts us right at the bottom of the 22% bracket and in the middle of my state's 8% bracket. I am thinking we will push it up to the 24% Fed, and 9.3% state. Mentally it is a tough hurdle to get over. It will be a lot of money spent on taxes. The thought of draining my accounts so fast is really scary.

 

[pb4uski]

.... The thought of draining my accounts so fast is really scary.

But you're not really draining it with Roth conversions... from what you wrote the government has a 30% to 33.3% lien on your tIRA as it is.... you are just paying the tax while it is 30% rather than 33.3%.

You might consider relocating to avoid CA's 8.0-9.3% claim.

 

[Dalmore]

But you're not really draining it with Roth conversions... from what you wrote the government has a 30% to 33.3% lien on your tIRA as it is.... you are just paying the tax while it is 30% rather than 33.3%.

That is what I keep telling myself. Like I said it is a mental hurdle I have to get past. <Wow, look at it grow! I can retire! Oh, Sh*! It is shrinking too fast and I'm going to run out of money!>

You might consider relocating to avoid CA's 8.0-9.3% claim.

Unfortunately, two elderly parents (late 80's) within a mile of us will keep us anchored for the foreseeable future.

 

[Scratchy]

For those who are not yet retired and have a solo 401k and business income which is eligible for the 199A deduction, I wanted to mention the opportunity to in effect get a 20 % "discount" on the taxes paid on Roth conversions:

This is because aftertax contributions to a 401k do not reduce QBI which is used to calculate the 199A deduction, whereas pretax contributions do. Therefore, executing the megabackdoor Roth, which comprises an aftertax contribution followed by Roth rollover or conversion has the effect of shifting money from pretax account to Roth account at a 20 % discount on federal income tax owed.

Therefore if one is considering Roth conversions as a strategy to shift pretax retirement accounts to Roth accounts, the right time to effect this may be before retirement, while still earning QBI income, via the megabackdoor Roth.

There are other reasons to do the megabackdoor Roth, mainly related to the fact that some are in the window of business income where employer pretax contributions to a solo 401k are capped but aftertax contributions may still be made up to the retirement plan limits. That's the most common reason and the reason why I did a MBR contribution last year. But I am considering increasing my MBR contribution this year for the reasons above.

 

[pb4uski]

.... [-]Un[/-]fortunately, two elderly parents (late 80's) within a mile of us will keep us anchored for the foreseeable future.

Fixed it for ya!

 

[Dalmore]

Fixed it for ya!

+1 Thanks!

 

[Kwirk]

There is already enough in the Roth to support 6 years of regular draws, so the conversion 5 year clock is not a problem.

Are you not yet 59.5 yo? I've been under the impression that being 59.5 yo is an exception to the conversion 5 year clock. You've raised my anxiety level.

 

[Gumby]

Are you not yet 59.5 yo? I've been under the impression that being 59.5 yo is an exception to the conversion 5 year clock. You've raised my anxiety level.

Sorry about that. You are correct. I never had any reason to look for an exception (like being over 59.5) since there is plenty of old money in mine. Here is an article that makes sense of it.

https://www.doughroller.net/retirement-planning/the-5-year-rule-on-roth-ira-conversions/

 

[RunningBum]

That is what I keep telling myself. Like I said it is a mental hurdle I have to get past. <Wow, look at it grow! I can retire! Oh, Sh*! It is shrinking too fast and I'm going to run out of money!>

Think of it this way. Nobody thinks of their gross pay as what they will be taking home on their paycheck. Similarly, when you defer taxes in a 401K or tIRA, it's not all yours, since you still owe the taxes. You can't even access that money for any spending until you pay those taxes. So you just can't think of your tIRA balance as being all yours.

 

[Ronstar]

Too soon old, too late smart...

That's my problem. I should have been paying more attention to Roth conversions 6 years ago when I retired. Although I had LTCG in almost every retirement year, I could have eeked out something more than my total of $50k converted.

And I got comfortable with the low 12% tax rate too. I didn't dare go over that. But I should have gone up to 22. And will in the future.

I really need to do a thorough roth/rmd/tax analysis. I'm sure I won't like what the tax implications of RMD's are if I don't push roth conversions upward until I'm into the 22% bracket.

But what's up with those brackets anyway? Seem out of whack to me.
12%, then 22%, then 24, then 32.....
Why can't the brackets be more incremental like 12,17,22,27,32....?
The current 10% jump from 12% to 22% makes 12% a mental limit for me, where converting more $ would be more palatable if the next bracket up was 17.

 

[donheff]

With my pension and DW's SS and pension all of our conversions would be at the 24% bracket now. I never gave it much thought in the past since it seemed like it would accelerate the ultimate tax hit and be a negative or, at best, a wash. In retrospect it probably would have merited a closer look years ago. Not a simple analysis. The real gotcha will be if one of us dies and dumps the other into a single filing situation.

 

[Midpack]

That's my problem. I should have been paying more attention to Roth conversions 6 years ago when I retired.

Exactly what I did. I’ll be doing large conversions for 6-7 years, could have started 14 years ago (especially when TCJA was enacted) and been further ahead. I got enamored with paying crazy low effective tax rates in retirement - stupid (OP graph).

With my pension and DW's SS and pension all of our conversions would be at the 24% bracket now. I never gave it much thought in the past since it seemed like it would accelerate the ultimate tax hit and be a negative or, at best, a wash. In retrospect it probably would have merited a closer look years ago. Not a simple analysis. The real gotcha will be if one of us dies and dumps the other into a single filing situation.

+1. After detailed analysis, our choice came down to (assuming 30 year retirement) 7 years at 12% and 23 years at 22% without Roth conversions OR 7 years at 22% and 23 years at 15% with conversions. Sounds like a no brainer, but the difference in ending portfolio value isn’t much, the widow single filer and inheritance benefit is a plus though and it’s unlikely DW and I will leave together. But [-]if[/-] when tax rates become more confiscatory as I firmly expect, we’ll have a higher ending balance too. I don’t believe we’ll tax rates this low ever again in my lifetime.

 

[H2ODude]

With no really clear answer to exactly what we should do, in our case I've been converting about what our MRD will be (which is now 3 years away for us) to ease into paying the tax bill. Puts us just a tad away from 24%. Not sure what I'll do next year as that's when we turn 70 and I'll start my SS, right now DW taking hers and I get half of that. Next year when switch it will about triple the SS income. I find the truly correct course to be undefinable given all the unknown and variable factors. All I'm sure of is it's nice to see the money growing in the Roth, thanks to the markets we really haven't made much of a dent in the tIRA. Hey, it's all good.

Not a market timer, but Friday a week ago when things dove I called FIDO and had them transfer MF shares !from tIRA to Roth, value of about half our annual target. Tried timing decades ago but learned lesson, this just seemed like a no brainer, and it turned out OK. Well, for now anyway.

 

[H2ODude]

Yes, the single filing situation is what tips the conversion for me. It's probably a near certainty that ONE of us will be around without the other for at least one filing year, and that difference is huge. 5-10 years of it could be a real hit. And, in our case it's largely likely the kids will get substantial leftovers and the Roth is a nicer inheritance.

 

[CRLLS]

I feel if I am not converting more than my IRA is earning, I am not getting in front of the issue. The tIRA will still grow faster than I will convert. That said, I did not convert >20% of my tIRA last year. Maybe my rule should be >7-10%, the average(ish) rate of the SP500?

I would like to add that there is nothing preventing Roth conversion wile in RMD time.

 

[Gumby]

I feel if I am not converting more than my IRA is earning, I am not getting in front of the issue. The tIRA will still grow faster than I will convert. That said, I did not convert >20% of my tIRA last year. Maybe my rule should be >7-10%, the average(ish) rate of the SP500?

I would like to add that there is nothing preventing Roth conversion wile in RMD time.

You can't Roth convert an RMD. You can convert an amount over and above your RMD.

 

[pb4uski]

... I would like to add that there is nothing preventing Roth conversion wile in RMD time.

You can't Roth convert an RMD. You can convert an amount over and above your RMD.

I think you are both saying the same thing... even when you are subject to RMDs you can still do Roth conversions... on top of RMDs.

 

[RunningBum]

For people who say they aren't making progress because the tIRA keeps growing, think about how much bigger that tIRA and resulting RMDs would be if you weren't converting at all.

Also, are you keeping most or all of your bonds in the tIRA? The Bogleheads guide says to do this for tax efficiency, and it also slows the growth of your tIRA.