Roth Conversions/Puzzlement

[OldShooter]

I have always felt that Roth conversions were basically tax rate arbitrage with future tax rates unknown. IOW we win if the future tax rates are [-]lower[/-]higher, we don't-care if they are the same, and we [-]lose[/-]win if they are higher. My personal ability to predict the behavior of federal and state governments is poor, so I just sit on my hands.

Hence, I am puzzled by all the excitement for conversions that seems to exist here.

Here is a simple little example I just cooked up to reflect what has been in my head:

​

It seems that this may be best case because the $100K taken from an IRA may drive the taxpayer into higher income taxes on SS or lower ACA subsidy.

Am I missing something?

 

[davebarnes]

Do you have heirs?
If you have children/grandchildren who will inherit your money, then Roth is much better.
This is the driving factor for us.

Do you think tax rates will go lower, stay the same, go higher?
If higher, then Roth is better.

 

[RunningBum]

Pay the tax from taxable and you will see the difference. Add $25k to a taxable account in both cases. In the IRA case, you keep 25K in taxable that grows to 37.5K, then the 12.5K is taxed at LTCG rate, so you end up with 112.5K in the IRA, and 31.875K in taxable, or 144.375K total. In the Roth case, you use the $25K in taxable for the conversion tax, and have the full 100K in the Roth, growing tax free to $150K.

Plus you better avoid the SS tax torpedo as you mentioned, and you lock in on the current tax rate if you think as many do that taxes will have to go up in the future.

 

[pb4uski]

Yes, you pretty much have it right... it is mainly a tax rate arbitrage play.... but I think you worded it backwards (or I read it backwards). If future marginal rates are higher than today's rates then you win with Roth conversions... if they are lower then you lose and if they are the same then you are indifferent.

However, in many cases there is a period of time from ER until pensions and SS start that one's marginal tax bracket is lower and it is clear that your marginal tax bracket once pensions and SS start will be higher and that is an ideal time to do Roth conversons.

For example, since we ERed 8 years ago our marginal tax bracket has been 0%... deductions exceed our income... so we can do Roth conversions at a blended rate of about 8-9% (a blend of 0%, 10% and 12%). Once SS starts, our taxable SS on top of our taxable account income and my pension will put us near the top of the 12% tax bracket.. so any RMDs will be some at 12% and most at 22%... let's say 20% for discussion purposes... so we save 11-12%... not life-altering but not chump change either.

In addition, if the taxes are paid from taxable funds rather than tax-deferred funds as in your numerical example, there is a beneficial second order effect of not paying tax on taxable account fund earnings.... I think a few thousand in your example... but the real benefit is the tax rate difference.

On the second order effect, let's say that the 50% increase is over 5 years... that would be an annual return of 8.45%... so at a 25% tax rate the second order effect would be the difference between 1*(1+8.45%)^5 and 1*(1+(8.45%*(1-25%)))^5... or 14% or about $3,500 on $25,000 paid in tax.

Another important reason for doing it early is that if you are a couple and one of you die then your marginal tax rate and tax-cost of RMDs increases dramatically.

 

[OldShooter]

Do you have heirs?
If you have children/grandchildren who will inherit your money, then Roth is much better.
This is the driving factor for us. ...

Yes. It was for us when I did some Roth conversions a number of years ago. It's my dim understanding, though, that the rules on withdrawals have changed a couple of times since then and the advantage is no longer the case. Our attorney is reviewing our plan right now to update for latest rule changes. We'll hear for her I'm sure.

Do you think tax rates will go lower, stay the same, go higher?
If higher, then Roth is better.

Yes. My point exactly. It is tax rate arbitrage where future tax rates are driven by unknown future events like tax law changes and RMDs.

... I think you worded it backwards (or I read it backwards). If future marginal rates are higher than today's rates then you win with Roth conversions... if they are lower then you lose and if they are the same then you are indifferent. ...

Yes, thanks for the correction.

... if the taxes are paid from taxable funds rather than tax-deferred funds as in your numerical example, there is a beneficial second order effect of not paying tax on taxable account fund earnings.... I think a few thousand n your example...

Yes, actually when we did our conversions we did it up to the point where we ran our taxable accounts to zero. But isn't it true that you could take the conversions out of the picture and just take the dollars you would pay in taxes and instead put that amount into a Roth? I have not done the numbers but it seems to be a similar situation.

But in any case if you use taxable funds you are effectively increasing the amount in your retirement accounts, so -- guess what? -- there is more money in your retirement accounts.

 

[kaneohe]

Perhaps the excitement is temporary caused by a number of factors:
1)RMDs are suspended for this yr which reduces income significantly so that
Roth conversions which would normally be done at 24% could be done in a lower bracket (12%)
2) With the market down, "more" can be squeezed into the available space
and still remain in the lower bracket.

 

[RetireBy90]

I Have converted into 24% bracket last year and this year, and plan to continue for several years for reasons below. If you only look at one number you could conclude that it is only pay taxes now or same rate later. Even if the income tax brackets stay the same as they are today I think we will still be in a better place having done conversions. Some reasons to convert:
1) current tax rates are set to expire end of 2025 and revert to previous (higher) rates.
2) if you are filing as married joint, when first one dies survivor will be subject to higher rates for single tax payers.
3) RMDs will be required once principal account owner turns 72. This will cause my rates to increase if I still have funds in my TIRA on top of other income sources. My income will increase when I turn 70 and continue till the end.
4) several programs are based on your AGI. ACA, SS that is taxed, rental real estate tax benefits, long term cap gains tax rates, and others. Those that affect you should also be considered. I would rather bite this bullet today than sometime in the future when rules on any of these can be changed.
5) I can take from my Roth anytime I want and as much or little as I want without having to consider the tax implications. If I want to pay cash for a beach house, I can draw total price from my Roth.
6) I can afford to pay the taxes on conversions from after tax accounts. I would rather pay taxes today and be free of unknown liability sometime in future. In other words, I’ll pay a bit more today to have future taxes paid and done with.

These are my reasons for acting and apply to my situation. They may be similar to others situation or may not. I would only suggest that anyone run specific numbers before doing significant conversions. The conversions seem to have caught me in that AGI for 2019 and 2020 will both include conversions that seem to have made us ineligible for a virus stimulus check.

 

[pb4uski]

....But isn't it true that you could take the conversions out of the picture and just take the dollars you would pay in taxes and instead put that amount into a Roth? ...

No... you have to have earned income to put taxable account money into a Roth.. in that case it would be a Roth contribution rather than a conversion. We don't have earned income so a Roth contribution isn't possible for us... and I suspect for you as well.

....But in any case if you use taxable funds you are effectively increasing the amount in your retirement accounts, so -- guess what? -- there is more money in your retirement accounts.

True that you have more money in retirement accounts, but money in a Roth is better than money in other retirement accounts like a tIRA or 401k... no RMDs irrespective of age and tax-free withdrawals!

 

[OldShooter]

Perhaps the excitement is temporary caused by a number of factors:
1)RMDs are suspended for this yr which reduces income significantly so that
Roth conversions which would normally be done at 24% could be done in a lower bracket (12%)
2) With the market down, "more" can be squeezed into the available space
and still remain in the lower bracket.

Interesting points. Effectively arguments that your tax rate will be higher in the future, hence the arbitrage probably makes sense. "Probably" only because the future rate is not guaranteed. Thanks.

No... you have to have earned income to put taxable account money into a Roth.. in that case it would be a Roth contribution rather than a conversion. We don't have earned income so a Roth contribution isn't possible for us... and I suspect for you as well.

Pesky details ...

True that you have more money in retirement accounts, but money in a Roth is better than money in other retirement accounts like a tIRA or 401k... no RMDs irrespective of age and tax-free withdrawals!

Oh, I agree. I have an inherited Roth and a Roth conversion account. The latter was created ages ago under different tax laws and, as I said, I drained the taxable accounts to pay the taxes.

 

[pb4uski]

Is your marginal tax rate now lower than your marginal tax rate once RMDs start?

 

[OldShooter]

Is your marginal tax rate now lower than your marginal tax rate once RMDs start?

We're 72, so already there. Speaking roughly because I'm too lazy to look up the numbers, the amount we've drawn from IRAs pre 70 1/2 has not been wildly different than the RMD requirements anyway.

 

[pb4uski]

I sort of thought you were there already... but you might want to look at what your marginal tax rate would be if one of you were to die... I'm guessing that if the surviving spouse was the beneficiary of the tIRAs then while your RMDs might not be all so different that the surviving spouse's marginal tax rate would spike due to using single rates rather than married rates... so if that is the case then there is a credible argument to do Roth conversions to avoid those much higher tax rates. If it jumps the surviving spouse from the 22% tax bracket to the 24% tax bracket that isn't so bad... but if it jumps the surviving spouse from the 24% tax bracket to the 32% tax bracket then that is more painful. YMMV.

 

[RenoJay]

I have always felt that Roth conversions were basically tax rate arbitrage with future tax rates unknown. IOW we win if the future tax rates are [-]lower[/-]higher, we don't-care if they are the same, and we [-]lose[/-]win if they are higher. My personal ability to predict the behavior of federal and state governments is poor, so I just sit on my hands.

Hence, I am puzzled by all the excitement for conversions that seems to exist here.

Here is a simple little example I just cooked up to reflect what has been in my head:

​

It seems that this may be best case because the $100K taken from an IRA may drive the taxpayer into higher income taxes on SS or lower ACA subsidy.

Am I missing something?

Your equation is right. I think the reason some people are converting now is a) a bet that tax rates are more likely to rise than fall over the next few decades based on debt/deficits, b) a bet that the assets we are converting are depressed currently which lowers the current tax bill. Furthermore, if this ends up being a low earning year for some (due to lay-off, furlough, reduced dividends or offsetting losses in taxable account) then the conversion tax could end up lower due to a temporarily lower tax bracket vs a “normal” year. No one has a crystal ball, so it’s mostly a bet people are making.

 

[Animorph]

Pay the tax from taxable and you will see the difference. Add $25k to a taxable account in both cases. In the IRA case, you keep 25K in taxable that grows to 37.5K, then the 12.5K is taxed at LTCG rate, so you end up with 112.5K in the IRA, and 31.875K in taxable, or 144.375K total. In the Roth case, you use the $25K in taxable for the conversion tax, and have the full 100K in the Roth, growing tax free to $150K.

Plus you better avoid the SS tax torpedo as you mentioned, and you lock in on the current tax rate if you think as many do that taxes will have to go up in the future.

This is my answer!

It keeps my tax rates from jumping into a higher tax bracket when RMD's hit.
It effectively hides some of my currently taxable funds in a Roth account (that $25k in the example). That's tax-free growth until I start Roth withdrawals. That may be worthless if you are in the 0% capital gains brackets (and stay there), or do not have taxable accounts/excess income. But over 10 years it's a worthwhile savings for me.
My calculations tell me that the taxable account-to-Roth savings are outweighed by the 0% capital gains rate when you get close enough to withdrawing from your Roth (about 10 years?). 2020 is our last big conversion year. In 2021 we'll be maxing out 0% capital gains.
Currently we have no income other than taxable dividends and capital gains so we take advantage of the low tax rates now.
Some of this is low-hanging fruit. Some is small potatoes. And all of it depends on your personal tax situation from now until you no longer need income.

 

[VanWinkle]

I have been able to do 4 years of conversions with 0 tax due prior to taking Social Security. They were small conversions, but likely saved me 2200 per year in future taxes. I will continue to convert up to the 12% brkt limit as I believe the rate will never be lower. If it stays the same, I have gained the ability to control income in the future with more monies in my tax free account.

VW

 

[LRDave]

^^^^^ It has to be very close to a no-brainer to convert at least to 12% bracket.

 

[Montecfo]

Montecfo

Another important reason for doing it early is that if you are a couple and one of you die then your marginal tax rate and tax-cost of RMDs increases dramatically.

I find this to be the most compelling reason to do Roth conversions because 1) virtually all married taxpayers will face it and 2) it requires no speculation about law changes.

 

[OldShooter]

^^^^^ It has to be very close to a no-brainer to convert at least to 12% bracket.

Yes, makes sense. I can only dream about our taxes being that low, so the arbitrage opportunity doesn't shine so brightly for us.

I sort of thought you were there already... but you might want to look at what your marginal tax rate would be if one of you were to die... I'm guessing that if the surviving spouse was the beneficiary of the tIRAs then while your RMDs might not be all so different that the surviving spouse's marginal tax rate would spike due to using single rates rather than married rates... so if that is the case then there is a credible argument to do Roth conversions to avoid those much higher tax rates. If it jumps the surviving spouse from the 22% tax bracket to the 24% tax bracket that isn't so bad... but if it jumps the surviving spouse from the 24% tax bracket to the 32% tax bracket then that is more painful. YMMV.

Thanks. I had not come upon the surviving spouse issue. & we are, IIRC, already at 24%.

I'll be lazy/avoid some research: Is there an annual maximum $$ limit on conversions? I get it that I want to watch marginal tax rate but is there an external/gummint limit?

 

[RunningBum]

No limit on Roth conversions.

 

[Time2]

A few points, with this spending on the Covid 19, it has me thinking even more that taxes will increase in the future.


My plan is to only convert up to the 12% bracket, over the next 7 years.
(I have LTCGs I can take advantage of in a taxable account.)



When I turn 70, I'll start SS and at 72-1/2 RMDs, so I will be in a higher tax bracket.


I think Roths are a real winner for me and my heirs.

 

[OldShooter]

Thanks, all. This has been a pretty educational thread for me, particularly concerning the complexity of the tax rate arbitrage game. And no thread drift!

Hopefully, Search will bring this thread up to help others with similar questions.

 

[pb4uski]

... Thanks. I had not come upon the surviving spouse issue. & we are, IIRC, already at 24%.

I'll be lazy/avoid some research: Is there an annual maximum $$ limit on conversions? I get it that I want to watch marginal tax rate but is there an external/gummint limit?

As RB said no limit... you can convert the whole shooting match as long as you're willing to pay the tax.

I would think that it might make sense for you to look at converting to the top of the 24%... presumably the surviving spouse would be in that tax bracket or higher so better to pay 24% now rather than more than 24% later.

 

[thepalmersinking]

I might be looking at this wrong but I loaded our Roth’s way back when I could still put money in them. My theory was regardless of the tax conversion example used. I liked the thought of aggressive investing and covered calls. 500k later in investing in things like V, PYPL, SQ and a few biomedicals, I can move some to dividend and fixed if I chose. I really love selling way out of the money calls and know that I can take the cash tax free in additions to DIV income. Maybe the wrong way to loom at Roth’s but it is working even in this downturn.