Rule of thumb for ROTH conversion?

[LOL!]

So if someone inherits the traditional IRA from your parents, are you saying that the heirs will pay 37% tax or more on their withdrawals from that stretched tIRA?

 

[grayparrot]

So if someone inherits the traditional IRA from your parents, are you saying that the heirs will pay 37% tax or more on their withdrawals from that stretched tIRA?

Yes I'm saying exactly that. Once again, to be clear, I am talking about my parents' specific situation, so that "someone" you refer to is in this case me and my brother. I'm talking about a specific case here, which I've tried my best to be specific about.

If I inherit assets (which I hope will only be the case if my parents have spent ever dollar they possibly care to on a lavish retirement) then here you go:

At minimum, I'll be in the 28% federal marginal tax bracket, and a 9.3% marginal state tax bracket. You said in an earlier post that you know arithmetic, so why don't you go ahead and add those up and see what you get.

(For the detail oriented, yes there is an offset for federal taxes against state taxes, but I may well be in the 33% federal bracket, and that 33% bracket is SCHEDULED to return to 35%. So overall it would be extremely misguided to assume in this case that future tax rates will be meaningfully lower than the cost of conversion now.)

Bottom line: generalizing is dangerous; do the math separately for each individual case.

 

[LOL!]

Let's try this math.

Parents have $100K in trad IRA and $37K invested tax-efficiently in a taxable account.

A. They convert $100K of trad IRA to Roth IRA and use the $37K in taxable to pay the taxes. Roth IRA doubles to $200K. They die and give $200K Roth IRA to heirs. Heirs must take RMDs from Roth IRA, but they stretch it out.

--or--

B. They leave assets alone, tIRA doubles to $200K and taxable account doubles to $74K. Taxes on taxable account are zero since they invested tax-efficiently and unrealized cap gains are not taxed while QDI is offset by tax-loss harvesting and foreign tax credit. They die and give $274K to their heirs. $74K is tax-free and $200K is tax-deferred. Heirs use the $74K to pay the 37% tax on the $200K withdrawal. Net result is that heirs get $200K, same as scenario A. Heirs could be a little more clever about this and not withdraw all $200K (really $274K) at once, they could stretch it out same as inherited Roth IRA.

If there is any chance that the heirs pay lower taxes, I think they would come out ahead. For example, heirs are retired and living off of taxable investments.

Also, I think if the IRA is a mix of stocks and bonds (and perhaps mostly bonds) while the taxable account is equities, then the taxable account may have a higher return than the IRA, but if not, that means more tax-loss harvesting opportunities, concomitant lower taxes, and an overall tax of less than zero on the taxable assets.

My experience is that I don't pay any taxes on my 7-figure taxable account and will not for the next 10 years or so since I am taking into account tax-loss harvesting, tax-efficient investing, and foreign tax credit. How about you?

 

[GrayHare]

If at best A and B result in the same asset levels, I'd opt for A: it does not require the planning, complexity and investment limitations of tax-loss harvesting, foreign tax credits, etc. At the over $1m taxable asset level in grayparrot's case, I doubt it possible for the B scenario to avoid all taxation while maintaining a reasonable AA.

Also, at the asset level of this thread, estate taxes need to be considered a possibility. In scenario A (Roth), there's $200k subject to estate tax, while in scenario B (TIRA), there's $274k. If federal+state estate tax ends up totaling 50%, scenario A will require payment of $100k estate taxes, but B will require $137k, thus the A (Roth) approach leaves $37k more for the heirs.

 

[LOL!]

It is absolutely true that paying taxes ahead of time reduces the size of the estate and the estate taxes that go with it.

 

[grayparrot]

Let's try this math.

Parents have $100K in trad IRA and $37K invested tax-efficiently in a taxable account.

A. They convert $100K of trad IRA to Roth IRA and use the $37K in taxable to pay the taxes. Roth IRA doubles to $200K. They die and give $200K Roth IRA to heirs. Heirs must take RMDs from Roth IRA, but they stretch it out.

--or--

B. They leave assets alone, tIRA doubles to $200K and taxable account doubles to $74K. Taxes on taxable account are zero since they invested tax-efficiently and unrealized cap gains are not taxed while QDI is offset by tax-loss harvesting and foreign tax credit. They die and give $274K to their heirs. $74K is tax-free and $200K is tax-deferred. Heirs use the $74K to pay the 37% tax on the $200K withdrawal. Net result is that heirs get $200K, same as scenario A. Heirs could be a little more clever about this and not withdraw all $200K (really $274K) at once, they could stretch it out same as inherited Roth IRA.

If there is any chance that the heirs pay lower taxes, I think they would come out ahead. For example, heirs are retired and living off of taxable investments.

Also, I think if the IRA is a mix of stocks and bonds (and perhaps mostly bonds) while the taxable account is equities, then the taxable account may have a higher return than the IRA, but if not, that means more tax-loss harvesting opportunities, concomitant lower taxes, and an overall tax of less than zero on the taxable assets.

My experience is that I don't pay any taxes on my 7-figure taxable account and will not for the next 10 years or so since I am taking into account tax-loss harvesting, tax-efficient investing, and foreign tax credit. How about you?

Unfortunately your examples are full of both errors and omissions.

1) If you are claiming that the ROTH has doubled, then if growth rate assumptions are constant between the ROTH and the tIRA, then the tIRA would NOT have doubled as you suggest. It would have been reduced annually by RMDs, which would then be taxed before subsequently adding the remainder to the tax fund. This is a major point, as there is SOME value in the ability to stretch a taxable IRA, not just a ROTH. The taxable IRA would be a lot better off if it could magically avoid RMDs and double just like the ROTH did. But it won't, and all those RMDs, which if things work perfectly could possibly grow tax free for quite some years, would still be OUTSIDE any kind of account that allows for heirs' enjoyment of many years of further tax deferred growth.

2) While I agree with you that if we're looking at a case where my parents will not touch either the $100k or the the tax fund, and instead leave the appreciated values of both to their heirs, then investing the tax fund in something which you never sell and which pays no taxable distributions would result in a step up for heirs. However, after that, heirs would not be able to make any use of this no-tax-account, unless they wanted to pay their own cg and/or income taxes distributions or sales.

It is an interesting point though about the step-up, one which my dad raised. So, I built it into my model as an alternative scenario. Investing in a perfectly tax-deferred account until death, then receiving the step-up, is better than nothing. However, the calculations clearly show that there are many situations and opportunities (need for huge withdrawal all at once; tax-free compounding for decades with no future tax due) where a ROTH would be immensely more valuable. These are the situations that apply to my case, which is why your assertion that it makes no difference if tax rates are the same is simply wrong mathematically.

3) You are correct that the benefit of a ROTH diminishes if the time before it is tapped is shortened. Thus, your example of the heirs making the ROTH withdrawal IMMEDIATELY and IN ITS ENTIRETY upon inheritance greatly shortens the period of tax free growth and diminishes the argument for a ROTH, especially if parents don't live a long time and thus even THEY don't enjoy much ROTH-deferral-time. However, for one thing if heirs needed the money right away, a lump sum withdrawal of a highly appreciated taxable IRA would likely result in very high taxes for the heirs in my family's case. But here is the most fundamental inaccuracy of your argument: ignoring the specifics of my case, where ROTH can be left to stretch for decades further beyond inheritance. It is completely inaccurate to say that it is economically the same to inherit X dollars in a taxableIRA+taxfund, rather than the same dollars in a ROTHIRA+taxfund. If an immediate withdrawal is made, the ROTH loses some potential, but delivers an enormous benefit in terms of being able to deliver a large sum in a single tax year without a penny of tax. Much more importantly, in specific cases like mine, there will be no immediate need for the ROTH assets, and the fact that some dollars (net of tax-free RMDs) will continue to compound tax free for decades with no tax on any withdrawal at any time, make the ROTH an enormously more valuable asset than inheriting the same value of a taxable IRA and tax payment fund.

You also continue to make the argument that taxes can be essentially zero indefinitely through some kind of perfect process of constant loss-harvesting, foreign tax credits, etc. I believe you when you say that you have enjoyed tax DEFERRAL on your seven figure account. If you need to ACCESS that tax deferred appreciation, however, especially in large chunks, you WILL eventually pay taxes on it...probably at a higher rate than you do now based on my long term view of tax rates. But you will pay taxes, make no mistake about it. Or your heirs will. If your account is worth $100, then yes their tax rates may be very low on withdrawals (assuming base income is also very low, which again is not the case in my scenario). Otherwise, they will have lost the value of tax-free growth that a ROTH offers to those, regardless of income level or tax rate, who are in a position to maximize the time that each dollar of the ROTH can be left intact.

Again, your perspective may well work for your case, although I am unconvinced that you actually have done the math to reveal what your tax will be in each year of your future based on various withdrawal scenarios, and which provides side by side comparisons of ROTH vs taxable variations. Your math and perspectives based on the specifics of my own case are both completely misguided. Assumptions are of course unreliable, but math doesn't lie.

As a former English major, however, I do have to give you some bonus points for the use of "concomitant".

 

[haha]

I've been offline for a while during my move. Nice to see that people are still in fighting trim.

Ha

 

[grayparrot]

If at best A and B result in the same asset levels, I'd opt for A: it does not require the planning, complexity and investment limitations of tax-loss harvesting, foreign tax credits, etc. At the over $1m taxable asset level in grayparrot's case, I doubt it possible for the B scenario to avoid all taxation while maintaining a reasonable AA.

Also, at the asset level of this thread, estate taxes need to be considered a possibility. In scenario A (Roth), there's $200k subject to estate tax, while in scenario B (TIRA), there's $274k. If federal+state estate tax ends up totaling 50%, scenario A will require payment of $100k estate taxes, but B will require $137k, thus the A (Roth) approach leaves $37k more for the heirs.

An excellent point; of course what the estate tax exemptions will be in the future is anyone's guess. As of now it is $5MM per person or $10MM for a married couple. So in my case, unless the exemption is drastically reduced in the future or we live in a state with lower exemptions, I don't think it will be an issue....much as I would like it to be of course But if asset growth proves greater and my folks live a long time as I hope and believe they will, and they don't spend as lavishly on their retirement as I hope they will, then gifting strategies and life insurance might need to be incorporated.

 

[kaneohe]

As a former English major, however, I do have to give you some bonus points for the use of "concomitant".

Thanks to this I learned there is a "search this thread" function I wasn't aware of (couldn't find where that dang word was) and also a new word. You just never know when/where nuggets of gold will turn up.
Concomitant - Definition and More from the Free Merriam-Webster Dictionary

Anyways.......carry on with the titanic struggle. Something to be learned from both sides..............

Round 7, is it?

 

[LOL!]

OK, another round. I've been taking to task for looking at some "Rule of Thumb for ROTH conversion?" and not being specific enough.

So I ran the calculator at Optimal Retirement Calculator and Retirement Decision Support System with $2.3 million in taxable account and $1.9 million in TIAA-CREF as per OP's post on the other thread. I also looked at TaxCaster with the RMDs suggested by i-ORP, etc. One thing I notice is that the parents are nowhere near the 37% tax bracket despite having the RMDs. The reason is that the parents spend down their taxable account (that 7-figure amount of cash is basically taxless), their SS, and just take the RMD.

I also ran with adjusted numbers as if they had done a large conversion.

Admittedly my numbers are more ballpark than grayparrot probably has at hand. Nevertheless, the portfolio utility is higher without the early Roth conversion. While I have issues with i-orp (it calculates taxes higher than Intuit's TaxCaster), I think it gives one some things to think about.

So my question in this round is: grayparrot, did you look at i-orp and TaxCaster at all to see if their modellng was useful to you?

 

[grayparrot]

So I ran the calculator at Optimal Retirement Calculator and Retirement Decision Support System with $2.3 million in taxable account and $1.9 million in TIAA-CREF as per OP's post on the other thread.
So my question in this round is: grayparrot, did you look at i-orp and TaxCaster at all to see if their modellng was useful to you?

Well, since you refer to the original post I should point out that in that post I listed assets totaling $5.5MM. You apparently ran the report with $4.2MM in assets? I don't know what assumptions you used for my parents' other income, cost basis, home value, and various other options .

I did plug in the exact figures for all categories (I do have all the specific data). Optimal Retirement Calculator appears to indicate that my parents can leave a multi-million dollar estate while maintaining a retirement spending plan far in excess of their current wishes.

It simply remains the reality that IF you wish to leave a multimillion dollar estate, and IF you have the current cash available to pre-pay a ROTH conversion tax up front from outside-of-IRA assets, and IF you have enough assets to maintain desired spending for well over a decade before any need to tap an IRA would arise, then your heirs are most certainly better off inheriting x million in a ROTH versus the same x million in any kind of taxable IRA, outside assets, or even appreciated assets eligible for a step-up. It's simply the way ROTH tax-deferral works. The only varying factor is the length of time before the IRA is tapped. If you are in a high tax bracket now, a tiny tax bracket in a few years, and you'll need to tap the IRA soon, then of course a ROTH makes no sense. And if you make extreme assumptions about tax rates (i.e, it'll cost you 50% to convert now vs. only 10% on any income you get gradually for the next 30 years) then the timeframe required for a ROTH deferral to breakeven is extended so long that it is impractical. For all realistic ranges of tax bracket, deferral plans, stretch plans, etc., at this level of assets the math simply indicates that heirs will be better off after a conversion, and that parents will not have any affect on their lifestyle...they will simply spend outside assets and the last dollars they leave will be in their untouched ROTH accounts.

Anyhow, I see that I'm not going to convince you. I think the salient point is that while I can certainly provide many examples where a ROTH conversion would NOT make sense, in contrast it seems evident that you are not inclined to accept that a ROTH conversion EVER makes sense for an affluent retiree. In this you are in disagreement with many widely respected experts on the subject. (If I am incorrect in this assertion, then please provide an example of what level of assets/income/tax rates etc. would cause you to recommend a ROTH conversion to my parents.)

I remain confident that in my parents' case a ROTH conversion makes sense. Following my initial plan, which so many on this board have also recommended, I have made a series of appointments with my parents in January to run all of my models by one of the nation's most respected independent fee-only CFP-staffed financial planning firms. Their team includes former physicists, engineers and IRS enrolled agents. They regularly consult on conversion decisions for affluent clients and are, I'm sure, well equipped with the full complement of professional modeling tools.

I will report back on their independent recommendations, even in the event that they do not validate my own perspectives. Meanwhile, I am heartened by the fact that others on this board have reached very similar conclusions to my own after developing their own detailed spreadsheet models.

 

[tightasadrum]

Thanks to this I learned there is a "search this thread" function I wasn't aware of (couldn't find where that dang word was) and also a new word. You just never know when/where nuggets of gold will turn up.
Concomitant - Definition and More from the Free Merriam-Webster Dictionary

Anyways.......carry on with the titanic struggle. Something to be learned from both sides..............

Round 7, is it?

Kaneohe,
I'm no English major either, just an old number crunching engineer. But I'm pretty sure there is no such word as "anyways". Can you find it in your Free Merriam Webster?

 

[kaneohe]

Kaneohe,
I'm no English major either, just an old number crunching engineer. But I'm pretty sure there is no such word as "anyways". Can you find it in your Free Merriam Webster?

Makes us even, then. How much was the bet? Library doesn't allow copy/paste of urls so left as an exercise for old engineers.

 

[LOL!]

..., I have made a series of appointments with my parents in January to run all of my models by one of the nation's most respected independent fee-only CFP-staffed financial planning firms. ....

I will report back on their independent recommendations, even in the event that they do not validate my own perspectives. Meanwhile, I am heartened by the fact that others on this board have reached very similar conclusions to my own after developing their own detailed spreadsheet models.

Is it time for an update?

 

[donheff]

Is it time for an update?

Yes, do tell. I only tuned in because this topic actually interests me.

 

[RetireBy90]

AFAIK there are two reasons for a Roth, 1) in inheritance it is tax free, a child inheriting a traditional IRA may have to take withdrawals at their peak earning period and 2) it is very flexible tax wise-one could draw it for an emergency item (car replacement?) without increasing taxes as would a traditional IRA. It could allow one to have an income level without going into a higher tax bracket.
Having taxable, tax deferred and tax free resources leaves the most options but is the most complicated.
DW & I are slowly converting about $5K a year from a traditional IRA to a Roth IRA as these are intended to be our legacy to our two sons. We will have a go at spending the rest down and it is still an emergency fund if we need it.

Despite the previous discussions about taxes on TIRA and Roth, I would add couple reasons to opt for a Roth. I put 10% in my R401k and 6% in trad 401K. Company match goes into Trad account.

A) Taxes aren't going down. I'm retired military and draw a pension, so does my DW. DW will also get a pension from the school system next year when she is done. So, we will draw about $60K or more in pensions each year, and also some SS. If I do my 401K to Roth then I won't affect (or effect ?) my SS taxable amount. I expect to be in a similiar tax bracket when I fire as I am now.

2) Call it piece-of-mind. I may pay a couple % more now than if I paid once retired, but my piece of mind will get smaller and smaller. I've been reading about your ability to make good finance decisions starts to decrease like at 65 or so, present company excluded of course. So, if I pay now I will have one decision made already and will perhaps be able to sleep better later. That has to be worth something.

3) With the flexibility you mention, you may not want to take any draw or may want to take a large draw.

 

[kaneohe]

A) ................................... So, we will draw about $60K or more in pensions each year, and also some SS. If I do my 401K to Roth then I won't affect (or effect ?) my SS taxable amount. I expect to be in a similiar tax bracket when I fire as I am now.

Have you checked this out on a tax calculator ? I don't know what part of that 60K pension is taxable but if it is anywhere near 60K, drawing from your Roth won't affect taxation of the SS but it is also likely that drawing from a TIRA also wouldn't because you'd be at/past the saturation point where 85% of SS was taxable.

 

[grayparrot]

Update

Is it time for an update?

My apologies for the delay. I did consult with a financial planning firm. Although I probably should not advertise their name here, they are a member of the Garrett Financial Planning network of fee-only advisors, they have an excellent reputation in California and their principals have been nationally recognized as being among the best independent fee-only planners.

I made contact with one of their partners, who has an engineering background prior to his finance experience. I described my parents' situation, and asked if he would review my materials, which he kindly agreed to do. I sent him a half dozen spreadsheets that I created to illustrate various components of the ROTH conversion decision. A few days later he wrote back a note suggesting that he didn't feel that it would be worthwhile for him to pursue review of the project. His explanation was that, while he had an unanswered question or two (such as the desirability of lumping conversions in fewer years vs. spreading them out over more lower-tax years, even if they then might be subject to RMDs) overall it was clear to him that my analysis appeared to be on target overall, and was not only taking into account all the primary facts, but also was rather more detailed than the vast majority of their cases, which typically rely on output from one of the packaged software solutions (moneytree, I believe.) The adviser's explanation was that he estimated it would take 10 hours for him just to familiarize himself with my models, and since their contract rate is $240/hour, he just didn't feel that the total cost he would need to charge to review my work, do his own calculations, and present his own suggestions would be justified since my approach appeared to be similar.

Anyhow, there you have it. I am actually still trying to suggest to my parents that it might be wise to make that investment just to get the second opinion. However, I'm confident in my math and my folks are inclined now to follow my advice, after we reviewed my analysis together. They will be converting over the next 24 months to avoid RMDs; they appear to have sufficient resources to both pay for the entire conversion with non-IRA assets, as well as to fund their spending goals for nearly a decade without tapping the new ROTH assets, giving the ROTH plenty of time to make up the conversion cost with tax-free growth. Within their lifetimes, the conversion will reach "breakeven" compared to a non-conversion scenario even for them, based on very conservative actuarial assumptions. And any assets they may leave to their heirs will be significantly more valuable than if they had been inherited in a taxable IRA and/or in non-IRA assets.

I remain entirely willing to share my spreadsheets with anybody who is interested, as long as doing so is ok/possible on this forum. I do see the "attachment" link feature, but I just want to make sure that submitting this kind of material, either on the forum or view private message, is kosher.

 

[RetireBy90]

Not to fan the flames, but after reading and re-reading the postings, I must say I agree with grayparrot. However, it has been educational (and entertaining) to follow the discussion.

One item I haven't seen discussed is what if we finally get a significant tax over haul, and end up with a national sales tax. Now after converting to a Roth, you end up paying the tax again when you spend the draws. OK not too likely, but that is the only down side I could come up with for the Roth. Has anyone given any thought to this possibility?

 

[Texas Proud]

Not to fan the flames, but after reading and re-reading the postings, I must say I agree with grayparrot. However, it has been educational (and entertaining) to follow the discussion.

One item I haven't seen discussed is what if we finally get a significant tax over haul, and end up with a national sales tax. Now after converting to a Roth, you end up paying the tax again when you spend the draws. OK not too likely, but that is the only down side I could come up with for the Roth. Has anyone given any thought to this possibility?

Just want to comment on your post... not the rest...

If a national sales tax is enacted, it probably does not change a whole lot.. IOW, you will still pay income tax on the IRA distributions and the sales tax.. the only way to save is if the rate on income is lower than what you converted it at...