Roth Conversion Taxes - Perspective (I Needed)

[RetireBy90]

I’ve been following these threads for couple months now and I’m following midpack’s course. Funny strange that I started thinking on this problem as the threads started. Made an initial conversion last year and looks like it worked like I expected, except I paid too much in estimated taxes.
This year I was looking at Boeing stick that has declined in value, and managed to convert the shares while under $320. That should be most of my conversions for 2020. The one thing I haven’t seen discussed is looking at my TIRA and converting those assets that have had the poorest performance. It also reminded me to look at the individual stocks and assess if they still belong in our portfolio.
Have to agree that the single tax filing rates and potential for higher effective rates are two good reasons to convert. Some of my conversions will be taxed at 24%. We also have the situation where the retirement income we planned for is starting to come in, DW SS in 2019, our rental property is paid off and we have a check from that each month. In a few years I’ll start SS and that will kick up our taxable income. So, taking conversion hits now seems to be a no brainer.

Most importantly, these decisions are unique to each situation. I’ve spent lots of time running different plans and will continue to revisit with each year’s income and tax situation.

 

[Corporateburnout]

Does iOrp currently offer conversion recommendations.

Extended ORP gives you the options under retirement plans to select from 0 conversions to unlimited.

 

[sengsational]

Unlimited will give you the "optimal" plan (in quotes because all models have limitations). But you can run with various levels of limitations on conversions to see how much the earlier conversions are gaining you. So this 'sensitivity analysis' might away you from unlimited if the extra savings are not large enough to justify having a bird in the hand.


And my standard warning is to put the same value (your average equity % allocation) in all three tax buckets, that way taxes drive the model, not expected ROR.

 

[bingybear]

It looks like IORP won't process the secure act 10 year window on non-spousal inherited IRAs

 

[Corporateburnout]

And my standard warning is to put the same value (your average equity % allocation) in all three tax buckets, that way taxes drive the model, not expected ROR.

I input my exact equity allocation % per account (taxable, tax deferred and tax free) to get the tool's optimum analysis.

 

[atmsmshr]

One Tax strategy with Capital Gains and Roth

After reading Midpack’s threads, other blogs, IRS publications (snore) and time with lookups and spreadsheats, I developed a personal strategy to fit Roth Conversion with LTCG. All of our cases are unique, but I think there are some elements that apply to most of us doing a Roth conversion, MFJ, and having income streams that can be ‘turned on’, while optimizing Long Term Capital Gains. These may seem obvious to those of you with experience, but the fog only started clearing for me recently. Please critique or add your thoughts.

· Overall strategy is to pay the lowest allowed taxes over a retirement income and maximize assets. Generally, this means converting now to a Roth account at a marginal rate less than or equal to what is otherwise expected for the future desired income level, and letting the Roth grow tax free. Future tax rates are likely to be higher than present. Duh. My preliminary optimization outcome is to convert 40% of my IRA to Roth. That gives me a 17% tax rate during Roth conversions, 4% effective tax rate during LTCG conversion, and 8% effective rate until the bitter end.
· iORP does not model the connection between your capital gains tax rate and your personal income tax to compute your capital gains tax rate! Proves the point to understand the model and tax code; however you can artificially add a tax rate. Additionally, iORP harvests LTCGs at the same time of Roth conversions, which is tax inefficient – these activities should be sequential not concurrent. The IRA is also spent early with no reserves for later. Plus side: iORP does have the utility of ‘is your spreadsheet in the ballpark?’, it shows the time value of money, and SS scenarios.
· Ordinary income includes: pension, wages, SS, SSDI, 401k and IRA withdrawls. Up to the standard deduction of $24,800 this year is taxed at 0%. Therefore, it is desirable to fill up the remaining (if any) shelf space in the standard deduction with IRA withdrawls.
· LTCG ‘floats’ on top of ordinary income. It is tax inefficient to fill any remaining standard deduction shelf space with LTCG since ordinary income can be used at the 0% rate and the $24,800 in LTCG can otherwise be applied to a future tax year (stretching out the LTCG 0% tax rate harvest). IRA withdrawls to the standard deduction amount coupled with LTCG harvesting results in the first $104,000 being tax free (an incredible deal). Therefore, it is not be advantageous to convert all of an IRA to Roth.
· Consider leaving some of the IRA intact for a catastrophic shock medical issues that can be deducted from income at a later at the 0% tax rate. If you convert to Roth prematurely, you may have 22% less resources for the emergency.
· Converting an IRA to a Roth during a year harvesting LTCG is tax inefficient if income exceeds the standard deduction. Every IRA dollar is taxed at ordinary income rates, and above $24,800 pushes a LTCG dollar out of the 0% tax bracket and into the 15% bracket. Every IRA dollar converted above the standard deduction therefore has an effective tax rate of 25, 27 or even 37%. To get full advantage of the LTCG tax rate of 0%, ordinary income must not exceed the standard deduction in that tax year.
· For the same reason, other income streams such as pensions, social security and wages that are collectively more than the standard deduction will result in pushing up the effective tax on LTCG harvesting to 25, 27 or even 37%. The intentional delay of pensions and Social Security that push above standard deduction will optimize the tax utility of LTCG harvesting, potentially increase mortality credits in a pension, and optimize SS income (and reducing future income taxes since SS is taxed at 85%).

 

[atmsmshr]

Some other random thoughts, facts, oddball insights

· TheIRS indicates that NUA (Net Unrealized Appreciation) treated gains do not trigger NIIT. I would imagine the stock gain after NUA conversion date is another matter.
· It is risky to maintain a highly appreciated stock position, but the tax benefits of such a brokerage account for tax treatment bears consideration.
· IRMAA for Medicare lookback starts at the year you turn 63; the penalty begins at $174,000. It is advantageous to complete Roth conversions before this age, otherwise risk a premium Medicare charge.
· The 32% income tax bracket starts at $326,600 – which is pretty much the highest conversion point for us mortals. Alternate Minimum Income tax is about that same level of the stratosphere. I wish I had this problem, but sadly no.
· Going from the 22 to 24% tax bracket for conversions may be considered efficient when considering the tax free compounding of the Roth in addition to speculating on future tax rates.
· I ran spreadsheets to look at outcomes for: converting Roth first 2-3 years, harvesting LTCG until 70, finishing off LTCG after mandatory start of SS, Roth withdrawls with SS and IRA withdrawls, death of a spouse at 80 years old.
· The key optimizing trick for me was guestimating my marginal tax rates in my 70’s, to help understand how much IRA to covert to Roth, which turned out to be only 40%.
· Just for fun later on a rainy day, I will see if accelerating LTCG harvest produces better tax harvesting.

Caveat - I don’t have a cited source to tie these elements of a strategy together (have not even seen this all in one sock before), and I am not a CPA. I have not even slept in a Holiday Inn recently.



Great thread Midpack – really got me going on developing a personal strategy for Roth conversions starting next year. I will have to run the recommended pay software to check my spreadsheets and assumptions.

 

[pb4uski]

The other factor to consider is that upon your demise taxable accounts will likely get a stepped up basis and all unrealized gains are effectively untaxed, making any use of the 0% LTCG rate as wasted.

 

[sengsational]

I input my exact equity allocation % per account (taxable, tax deferred and tax free) to get the tool's optimum analysis.

And that's fine if what you actually will do (in "real life") what the i-orp model is doing when it has those inputs.

The problem that I perceive is that many people won't end up doing what the model does (if they set the model inputs to have different equity percentages in each tax category).

If you periodically rebalance to your target asset allocation across all tax categories, then you're not doing what the model is doing. Since many of us rebalance across all tax categories, the option I always recommend is to take away any "incentive" the model has to spend at a higher rate out of a tax bucket with a lower expected return (generally, the one with the lowest equity allocation), thus leaving only the 'lever' (the one of taxes) for the optimization to work on.

Maybe you have three different sets of asset allocation targets (one set of targets for each one (taxable, tax deferred and tax free), and you periodically rebalance back to those. Then you're doing what the model is doing and your solution is good (reality matching model). But in all of the asset allocation talk here, I don't recall seeing any people reporting that's what they do.

 

[MasterBlaster]

For those of you doing Roth conversions...


Where do you take the money from to pay the conversion tax. Is it from cash you had sitting around ? Or do you take money out of other investments, pay the tax due on the money you took out, and then use what's left to pay the Roth conversion taxes.


What's the scheme you all use ?

 

[pb4uski]

For those of you doing Roth conversions...


Where do you take the money from to pay the conversion tax. Is it from cash you had sitting around ? Or do you take money out of other investments, pay the tax due on the money you took out, and then use what's left to pay the Roth conversion taxes.


What's the scheme you all use ?

Through 2019 I carried a 5% allocation to cash in an online savings account so it wasn't of a consideration. At the end of 2019 I used that cash allocation to pay off our mortgage and small auto loan.

For 2020 it'll probably come from cash just sitting around or perhaps from tIRA withdrawals with 100% withholding that I do in lieu of paying estimated taxes. Since money is fungible it's not a big worry.

 

[Gumby]

For those of you doing Roth conversions...


Where do you take the money from to pay the conversion tax. Is it from cash you had sitting around ? Or do you take money out of other investments, pay the tax due on the money you took out, and then use what's left to pay the Roth conversion taxes.


What's the scheme you all use ?

I have not yet started conversions, but this is my plan:

1. Decide how much I can convert (i.e - to keep AGI under the IRMAA Level 1 Surcharge level). For the sake of this exercise, assume that is $75k.

2. Calculate the taxes on that amount of conversion. In my case, 22% federal and 6% state. Using the assumption of $75k conversion, that is $21k in taxes (16.5 fed, 4.5 state).

3. Direct Vanguard to convert $54k directly from tIRA to Roth.

4. Direct Vanguard to distribute from tIRA $21k, and withhold $16.5k to the feds and 4.5k to the state. i.e. - All withheld; I get no cash in hand.

 

[bingybear]

For those of you doing Roth conversions...


Where do you take the money from to pay the conversion tax. Is it from cash you had sitting around ? Or do you take money out of other investments, pay the tax due on the money you took out, and then use what's left to pay the Roth conversion taxes.


What's the scheme you all use ?

taxable account.. much of it is from distributions that I don't reinvest

 

[RunningBum]

It's part of cash flow planning. Just like I have to have cash available to pay for groceries, gas, utilities, etc, I know this is coming and make a plan to have cash for that. In the past I've sold investments in advance to make sure I'd have cash when the tax bill came. Now I've got a pretty good stash available in MMs and a CD ladder that I should be able to go a few years without selling more investments.

 

[Rdub]

I held off on any Cap Gains/rebalancing in 2019 and then rolled a chunk of my 401k in December to fill up the 24% tax bracket. I am at the top of my asset allocation threshold right now, so I will hold off till later in the year to figure out how much I will need to rebalance and/or roll over from my 401k to the Roth.

 

[RetireBy90]

For a source of funds for taxes, (and I’m only 2nd year into doing conversions) I’ve been using after tax funds. I have some CDs that were in case I messed up my budget and needed more income that I’ve been using.

 

[Gumby]

The reason I am taking a simultaneous tIRA withdrawal to pay the conversion taxes is because a withholding is considered to occur throughout the year, so I won't have to pay estimated taxes in advance of my end of year Roth conversion.

 

[MasterBlaster]

I have not yet started conversions, but this is my plan:

3. Direct Vanguard to convert $54k directly from tIRA to Roth.

4. Direct Vanguard to distribute from tIRA $21k, and withhold $16.5k to the feds and 4.5k to the state. i.e. - All withheld; I get no cash in hand.

Are you sure that taking money out of a taxable IRA to pay conversion to a Roth is a step ahead. You are then paying taxes at the highest marginal rate.

I suppose you lock in the 22% federal tax rate. That could be a good thing. Or not.

The way I look at it, is that when I take taxable IRA money out it (what I take out plus SS) gets taxed at an average rate that is likely far less that your now marginal rate.

Good luck predicting future marginal and average tax rates though. The trend isn't looking so good considering all that debt and unfunded obligations. Still I'm betting that my future average tax rates will be less than current marginal rates.

 

[thefist]

Are you sure that taking money out of a taxable IRA to pay conversion to a Roth is a step ahead. You are then paying taxes at the highest marginal rate.

I suppose you lock in the 22% federal tax rate. That could be a good thing. Or not.

The way I look at it, is that when I take taxable IRA money out it (what I take out plus SS) gets taxed at an average rate that is likely far less that your now marginal rate.

Good luck predicting future marginal and average tax rates though. The trend isn't looking so good considering all that debt and unfunded obligations. Still I'm betting that my future average tax rates will be less than current marginal rates.

This certainly illustrates the thought process of an early retiree living solely off of assets with no pension/SS. It's a bit of a mental exercise to come to grips that everything you buy is price + (income tax). The tough one is when it's Tax + Tax, even though you are making a trade off of 15% vs 22% or higher.

 

[Gumby]

Are you sure that taking money out of a taxable IRA to pay conversion to a Roth is a step ahead. You are then paying taxes at the highest marginal rate.

I suppose you lock in the 22% federal tax rate. That could be a good thing. Or not.

The way I look at it, is that when I take taxable IRA money out it (what I take out plus SS) gets taxed at an average rate that is likely far less that your now marginal rate.

Good luck predicting future marginal and average tax rates though. The trend isn't looking so good considering all that debt and unfunded obligations. Still I'm betting that my future average tax rates will be less than current marginal rates.

Our marginal rate will never, ever be less than 22%.

 

[pb4uski]

I have not yet started conversions, but this is my plan:

1. Decide how much I can convert (i.e - to keep AGI under the IRMAA Level 1 Surcharge level). For the sake of this exercise, assume that is $75k.

2. Calculate the taxes on that amount of conversion. In my case, 22% federal and 6% state. Using the assumption of $75k conversion, that is $21k in taxes (16.6 fed, 4.5 state).

3. Direct Vanguard to convert $54k directly from tIRA to Roth.

4. Direct Vanguard to distribute from tIRA $21k, and withhold $16.5k to the feds and 4.5k to the state. i.e. - All withheld; I get no cash in hand.

+1 but you said it clearer.

No doubt that we will be paying 22% or more once SS and RMDs start... so I don't mind paying 22% but even with withdrawals to the top of the 22% bracket our effective rate on conversions/withdrawals is ony 17% (a blend of 0%-covered by standard deduction, 10%, 12% and 22%). [Before withdrawals/conversions our ordinary income is my small pension and is well below the standard deduction].

What I have done is limit myself to 12% as long as we have state income tax (about 5% for us) is at play... after that goes away in 2020 I'll increase to the top of the 22% bracket... and if it looks like rates will revert to 2017 levels I may even goose it to the top of the 24% bracket.

 

[tenant13]

While everyone's plans are totally viable I decided not to give a **** about conversions - and taxes in general. I already know that however I spend my money I won't have an issue with hitting my budget AND paying taxes. So I stopped caring. No heirs to worry about so whatever happens 30 years from now is of no relevance. Given how random US laws can be when relating to retirement funds I think we should just live in the moment instead of worrying about future tax rates.

 

[pb4uski]

While everyone's plans are totally viable I decided not to give a **** about conversions - and taxes in general. .... Given how random US laws can be when relating to retirement funds I think we should just live in the moment instead of worrying about future tax rates.

Spoken by someone who has no heirs to plan for.... just sayin'

 

[Out-to-Lunch]

For those of you doing Roth conversions...


Where do you take the money from to pay the conversion tax. Is it from cash you had sitting around ? Or do you take money out of other investments, pay the tax due on the money you took out, and then use what's left to pay the Roth conversion taxes.


What's the scheme you all use ?

If you have money in taxable accounts, you should use those funds to pay the tax on conversion. It is effectively moving more money into the Roth. There is no down side to this.

If you do NOT have cash to spare, you must pay for the taxes out of the converted money. Mathematically (assuming no changes in marginal tax bracket), this is a wash. However, if your marginal rate changes, either from changes in law or filing status or other reasons, it can matter.

Personally, I am planning to convert (~aggressively but not tooo aggressively) on the assumption that DW will be filing as a single taxpayer some day.

 

[Hermit]

As a single person, I am at the top of the 22% bracket with pension and SS starting next month. In prior years I took out enough from TIRA to put me at the top of 22%. IRMAA starts at about the same point as the top of 22% bracket. No Roth conversions for me. I will be doing QCDs starting this year for several years which will lower eventual RMDs. I don't think there is much more I can do.