39 year old doing retirement analysis for 70 year old parents

[grayparrot]

Hi, I'm 39 years old, and financially independent after many years of 1) working as an investment analyst and 2) living like a hermit with a tightwad complex.

My main interest at the moment, as I have posted in more detail on the FIRE & Money board, is in comparing notes with others who have devoted time to ROTH conversion decisions. I'm working on this project to help my parents as they begin their retirement.

Here are my parents particular circumstances; if it is considered poor etiquette to post about a situation other than oneself, then please ignore the post and forgive me.

My parents' question: Should we convert?

Details: Mom is not working. Dad about to retire after 40 year university career. Due to a lifetime of passionate frugality and some unexpected inheritances, the financial picture is this:

$5.5MM current net worth, of which

-$1.9 million is in TIAA/CREF retirement plans

the remainder includes
-$750k retirement home
-$350k current home (conservative, post transaction proceed estimate)
-$250k rental duplex
-$1.2 MM in cash & cds
-$1.1MM in outside stocks


The TIAA/CREF plan is comprised of roth-eligible funds, and also a TIAA annuity that will provide transfer payments each year over the next 10 years and is not convertible now. Each year's transfer payment is convertible to the extent of of the excess of RMD for that year. This portion is worth $950k, so checks will average a bit more than $100k each year as the account grows at a guaranteed 3% (4% currently).

The remaining $950k is convertible, and I am urging my parents to use part of their $1.1 in cash to do so over the next three years.

The average tax on this conversion will be about 38% including federal and state.

Their future tax rate would be no less than 37%.

They need about $125k net of income per year to live on, and they also want to use another $400k of cash immediately to purchase land around their retirement home.

Anybody do a similar analysis and go through year by year to see where the breakeven is, how long they have to rely on outside assets before the ROTH "catches" up and is worth more than the outside assets?

In my view, they do have enough to get by for the decade or so that would make a ROTH conversion now a no-brainer. What do you guys think? Any general tips, personal experiences from working through these decisions, etc. would be welcome. Anybody want to swap spreadsheets? Thanks!

 

[Trawler]

I recall doing the math on this on our particular circumstance and I believe it took more than 12 years to capture the lost opportunity cost of paying the tax today on a conversion and we are in a lower tax bracket than the 37%. In the case above I would thing the time would be longer as you woul be looking at paying more than 350K out of principal in tax over the three years. When I did my math I did a year by year spreadsheet using tax and gain assumptions to determine best coarse. There will be a period of time in our RE when income other than dividends, capital gains and interest will be non existant thus plan to convert then while in a lower bracket .

 

[pimpmyretirement]

Your parents have enough assets that estate planning should be considered. How do you minimize the tax burden as assets pass from generation to generation? That will probably influence how you manage the wealth now.

 

[pb4uski]

With the amounts involved, I suggest that you seek professional help and as pimpmyretirement suggests it needs to be coordinated with their estate planning. Generally, I don't see much benefit to conversion if your tax rate is the same now as in retirement.

 

[Nords]

My parents' question: Should we convert?
$5.5MM current net worth, of which

We don't have much experience with taxation (especially AMT) at those stratospheric levels of conversion.

You could play around with a copy of ESPLanner, but you really need to play around with a tax CPA and an estate-planning lawyer.

 

[RockyMtn]

I agree on the CPA and lawyer suggestions. Also, if they don't already have an estate trust set up I suggest you do that as well.

 

[GrayHare]

If tax rates now and later will be about the same, conversion won't make much difference to your parents, however the beneficiary (you?), could stand to gain from a Roth in two main ways: 1) a portion of the apparent growth of a Traditional IRA is due to inflation, and upon distribution tax is paid on those inflated, illusory gains, while conversely in a Roth, growth from inflation is not taxed; and 2) a Roth has no RMDs, thus if IRA funds are not needed in retirement, more tax free dollars are left to the beneficiary. Given enough time, these two factors can combine in a Roth to dramatically boost the after-tax dollars to the beneficiary.

 

[GrayHare]

I should have also mentioned a Roth can reduce estate taxes. Both Traditional and Roth IRA will be included in the gross estate, and be subject to estate tax, however conversion to a Roth before death reduces the value of the estate by the amount of tax paid on the conversion. Example: a $1m conversion taxed at 35% reduces the gross value of the estate by $350,000. If federal+state estate tax in some future year is 50%, that leaves $175,000 more to the heirs.

 

[farmerEd]

With the size of your parents estate, you/they should be paying for very competent help.

 

[LOL!]

If tax rates now and later will be about the same, conversion won't make much difference to your parents, however the beneficiary (you?), could stand to gain from a Roth in two main ways: 1) a portion of the apparent growth of a Traditional IRA is due to inflation, and upon distribution tax is paid on those inflated, illusory gains, while conversely in a Roth, growth from inflation is not taxed; and 2) a Roth has no RMDs, thus if IRA funds are not needed in retirement, more tax free dollars are left to the beneficiary. Given enough time, these two factors can combine in a Roth to dramatically boost the after-tax dollars to the beneficiary.

But if medical costs go way up, they will be deductible and reduce taxes. I just don't see a Roth conversion as being that beneficial.

As for inheriting a Roth, there are RMDs on an inherited Roth. The heir will not pay taxes on the Roth RMDs, but the parents may have paid more taxes to get it into a Roth than the heir would've paid themselves on traditional IRA withdrawals. That is, the recipients could easily be in a lower tax bracket.

As the parents are 70 years old, so "Given enough time" is really stretching it.

Parents have enough wealth that they can make some meaningful charitable contributions and save a ton of taxes.

 

[clifp]

I also don't see any reason to do a Roth Conversion. There is estate is right at the border of the likely exemption for estate tax, so why pay taxes now when in 10-20 years, the estate could pass tax free to the heirs.

I'll echo the need to get an estate attorney and CPA. At this level there are so many tax saving tricks, long term care insurance, life insurance trusts, survivor trusts, charitable remainder trusts that I sure it would be money well spent

 

[grayparrot]

Thanks for the thoughtful replies all. Although I am a finance geek and hence can't help diving into the numbers myself, my folks of course will run my analysis past both tax and estate planners.

A couple points of debate I would raise for certain responses:

1) In a way I disagree that any benefits of a conversion would flow only to my parents' heirs, and not to them. They plan on making a minimum bequest...let's say they plan to pass on $1MM at minimum. Leaving $1MM in a ROTH is significantly more valuable than leaving it in taxable assets. Thus, they can spend more liberally on themselves using outside assets.
2) The question about the cost of paying high (38%) taxes now vs. possibly lower taxes later is not applicable in this case, according to my models. For one thing, they will be retiring to a state where the tax rate will be 3-5% higher than what they would pay for state now. For another, I am highly confidant that tax rates will be rising, especially on the more affluent (not to get political but personally, I don't have a problem with that in principle). Total taxes on my parents' future years will never be below 37% and could easily top 44%, just based on scheduled expiration of the 33% tax bracket and the move to 35%. Top tax rates, should they need to make a large single year withdrawal, could be as high as 49% combined federal and state, again just based on already scheduled rate changes. Maybe those changes will be further delayed, but in my view the 10 year trend is toward significantly higher taxes.

The effect of higher taxes later does not automatically invalidate a ROTH conversion in any case. The only effect is to increase the "breakeven" period where outside assets must be used before the ROTH has time to "catch up" on a tax-adjusted basis vs. an IRA. If you have the cash to make the conversion without using assets in the IRA to pay tax, and if you have enough assets to cover living expenses for whatever the "breakeven" period is, then it makes sense to convert, except perhaps in extreme cases where beneficiaries are broke and in the absolute lowest tax brackets and can not afford to benefit from the tax free stretch from an inherited IRA.

 

[GrayHare]

Leaving $1MM in a ROTH is significantly more valuable than leaving it in taxable assets.

That is true, but the funds to pay the tax on the conversion must come from somewhere. I believe it is fairer to compare the estate's total value with and without the conversion, rather than the impact on selected portions independent of others. After all, your parents might later change who gets what, and IMO the primary consideration should be the effects on them.

I agree tax rates for a given income level are more likely to be higher than lower later this decade. If anything, that argues for converting sooner, while rates are relatively lower. Even after a conversion to Roth, your parents will have a significant assets remaining that generate taxable income against which deductions (medical expenses, etc.) can be taken.

 

[grayparrot]

That is true, but the funds to pay the tax on the conversion must come from somewhere. I believe it is fairer to compare the estate's total value with and without the conversion, rather than the impact on selected portions independent of others. After all, your parents might later change who gets what, and IMO the primary consideration should be the effects on them.

I agree with you. To demonstrate how I calculated, allow me for cross-posting this reply from my other post, to a reviewer who believed that if tax rates are the same, then there is no future value difference between converting or not.

Sorry I am not buying that explanation because I know the rules of arithmetic. If the tax rate is the same, there is no difference.

I do appreciate your responses, but with respect, I assure you that your math is incorrect in this case. The actually calculations are significantly more complex than just the basic arithmetic required to calculate differences in tax rates. You have to calculate the exponential growth of various pools of money to get the future values. I provide below a calculated example to illustrate.

Imagine two options for handling a taxable IRA that is eligible for conversion, and for which RMDS will (as you suggest) start immediately. In each case, the IRA is paired with an outside "tax payment fund" so that we can be apples-to-apples fair as you say, and compare the future total value of the ROTH+TAXFUND vs the future value of the REGULAR+TAXFUND at the end of whatever term we are considering. (The assumption here is that the "parents" would have enough other taxable assets, besides the tax fund, to live for a number of years before they needed to tap the ROTH, or leave it to heirs. Same with RMDs from the taxable IRA...they are just added to the tax fund, so all value from each IRA winds up in the eventual apples-to-apples total. Naturally, the value of a ROTH only arises from the ability to pay taxes from outside assets, and leave the full initial value of the ROTH to grow for the specified number of years.)

So our hypothetical 71 year old retiree has two options for his IRA with a starting IRA value of $100,000, and his starting tax fund of $35,000. Let's assume taxes are constant for everything at 30%...tax on growth of taxable assets, income tax to convert now, tax on RMDs, etc. etc. Growth rates are also identical for all asset pools. Here are the two options. Our projected term is 15 years.

1) Regular IRA. RMDs are taken smoothly as required each year, and added to the outside Tax Fund. The Tax Fund assets grow at 8% per year, but also pay the tax on RMDS at 30%. The remaining IRA assets each year of course continue to grow tax-deferred at 8%. At the end of 15 years, the value of the tax fund is $154,000. The value of the IRA (still pre-tax, of course) is $160,000. Total value is $314,000.

2) Roth conversion. 30% tax is paid immediately out of the tax fund to convert the entire IRA balance to a ROTH with a value of $100,000. So the tax fund is now zero. However, the ROTH grows tax free at 8% for 15 years with no RMDs required. At the end of 15 years, the tax fund is still zero, but the ROTH IRA is worth $317,000.

So, after 15 years even the PRE tax value of the IRA, plus the tax fund, is worth less than the completely tax free ROTH. But wait, there's more. Suppose the parents had only enough living assets for 15 years...at the end of the term, they have to pull out all remaining assets from the IRA, pay taxes, and add the funds to their bank account. They could pull $317,000 out of the ROTH on day 1. The money pulled from the IRA would be much less...perhaps the tax would 25% in a lower tax year...so they would have their tax fund of $154,000, but the after-tax value of their withdrawal would only be 75% of $160,000 or $120,000. So they have a total after-tax withdrawal of $154,000 plus $120,000 = $274,000 vs. $317,000 for the ROTH.

So a true after-tax breakeven value comes even EARLIER than 15 years.

Now of course, if we make the ROTH more expensive to convert, all that does is increase the years to breakeven. For example, if we say IRA RMDs and everything else are still taxed at 30%, but a ROTH conversion costs 35% right now, the breakeven value is simply extended to a bit under 18 years. The point is, any difference in taxes can be made up with an extension of the breakeven period.

Moreover, this is just for the parents. Beneficiaries who inherited and stretched the ROTH IRA would remove SIGNIFICANTLY more over their lives than if they inherited even the same value as a taxable IRA...let alone the lower value they'd get if parents survived the breakeven year.

If anybody is interested in the actual calculation formulas so you can build your own spreadsheet, or if it is permitted for me to share/upload/pm or whatever my spreadsheet for the forum's non-commercial use, just tell me how.

Again, I do thank you for your attention to my posts.

 

[LOL!]

....
Let's assume taxes are constant for everything at 30%...tax on growth of taxable assets, income tax to convert now, tax on RMDs, etc. etc. Growth rates are also identical for all asset pools. Here are the two options. Our projected term is 15 years.
....

This is a totally bogus assumption. The tax on growth of taxable assets could be 0% if they use tax-exempt munis*. If they use tax-efficient passively-managed index funds, then unrealized cap gains are not taxed and qualified dividends are taxed at a a preferred rate. Let's say they get QDI of 2% of assets which is taxed at 15% to 20%, that is like a 0.3% to 0.4% tax on the overall taxable portfolio and nowhere near 30%.

Furthermore, tax-loss harvesting can reduce the taxes on the taxable portfolio even more. So can charitable giving of appreciated shares. LTCG tax rates are not 30% either. And finally, if one parent dies, the entire taxable portfolio will usually get a stepped-up basis for the other parent and heirs.

Thus when RMDs come out of the tax-deferred portion and go into the taxable portion, they get a very very low tax rate thereafter and not 30%.

*Your parents would not use bonds in taxable anyways since they can put bonds in tax-advantaged. They would use tax-efficient index funds of equities in taxable. The taxes on taxable assets really would be under 1%.

Bottom line: Many folks do not realize that investing tax-efficiently in a taxable portfolio can sometimes be as good as a Roth IRA.

 

[obgyn65]

I agree with this.

With the amounts involved, I suggest that you seek professional help

 

[Berkshire_Bull]

If you're a 39y/o retired investment analyst, why are you not:

1. Seeking out a team of trusted professionals who can help you help your folks
Or
2. If you want do it yourself, asking elementary questions on an internet message board?

 

[Helen]

This is an interesting thread, I'm glad you posted Grayparrot.

Berkshire, your post was a bit rude IMO.

 

[grayparrot]

If you're a 39y/o retired investment analyst, why are you not:

1. Seeking out a team of trusted professionals who can help you help your folks
Or
2. If you want do it yourself, asking elementary questions on an internet message board?

1) Because I like to prepare by educating myself in all ways possible to maximize my understanding of the professional second opinion that my parents and I ultimately intend to seek.

2) Because as I continue to educate myself, I am not arrogant enough to assume that I have already thought of all the salient points that quantitatively oriented users of these boards might have considered, and because I'd be interested in comments from those who have done similar calculations themselves, and reached either similar or different conclusions.

If you have something useful to contribute to the discussion, I'm all ears.

 

[pb4uski]

....Berkshire, your post was a bit rude IMO.

+1

 

[pb4uski]

Interesting post. I am so far away from RMDs that I haven't given much thought to the economics of the alternatives once one is in RMDs. I agree a bit with LOL that the assumptions for the taxable account and the IRA should be different and you probably need to modify your analysis to reflect that likelihood. It seems that a full conversion is advantageous once you get to RMD age if you are in a high tax bracket, but probably less advantageous than your analysis suggests. I'll have to make a note to look at this for my Mom when I do her tax return this year.

 

[grayparrot]

Let's compare two extremes where you have 100 in an IRA today. Your tax rate now and later is 30% and you expect that you can invest and earn 5% annually.

In the first case you leave it in the IRA, let it grow at 5% for 10 years to 163. 163= 100* (1+5%)^10. Then you withdraw it and spend it. Assuming a 30% tax rate you would have 114 to spend. 114 = 163*(1-30%).

On the other extreme, you convert the entire amount today, pay the 30 of tax and invest 70 in a Roth IRA that earns 5%. In 10 years the 70 would grow to 114 and you could then spend the 114. 114 = 70 *(1=5%)^10

If the tax rate and rate of return are the same, it shouldn't make a difference.

Hi, thanks for the comment. (Somehow it showed up under my profile, rather than on the board, so I'm quoting it here.)

Your underlying math is, of course, correct but you are overlooking a key component of the strategy I propose, which makes all the difference to the ROTH's advantage.

Simply: You pay the taxes with OUTSIDE money, NOT with funds from the IRA. I really think this is a key point many overlook when evaluating the ROTH conversion options.

Therefore, in your formula above, instead of 70*(1+.05)^10, the correct formula would be 100*(1.05)^10.

Now of course you will immediately observe that we have to pay the taxes from SOMEWHERE. The mathematically fair way to compare an IRA vs ROTH is to have the same $100 IRA, but also have an assumed outside "tax payment fund" of say 30% of the IRA or $30. Now what happens, is that in the regular IRA, you don't prepay anything and you wait for RMDs. You use that tax payment fund to make the small annual tax payments on those RMDs. Meanwhile, of course, your remaining tax payment fund is growing each year. In the case of the ROTH conversion, the tax payment fund immediately goes to zero. However, the ROTH account remains full at $100, and can grow for as long as you can afford to live on outside assets. At a certain point, the tax free growth of 100% of the original value of the IRA will exceed the total sum of a)the tax-deferred growth of the IRA plus b)the remaining tax payment fund that has been growing.

So, one has to make assumptions for the growth of the ROTH, the growth of the IRA, the growth of the Tax Fund, the tax rate for a conversion, the tax rates for RMDs, the tax rate on the growth of the tax payment fund, etc. It gets complicated, but I've worked through it all, including working in higher tax rates for the upfront conversion vs lower bracket annual taxes on RMDs, etc. etc.

The end result is that even on a pretax basis, growing at 4% a year, the ROTH will equal the regular IRA+taxfund after 20 years. Now of course, at that point the ROTH would be available totally tax free, while the regular IRA would be subject to tax rates that could be very high if a large withdrawal was required in any one year. Also, the regular IRA would require those RMDs throughout the period, while the ROTH does not require RMDs either for the participant or for a spousal beneficiary.

After more like 13-16 years, depending on the growth assumptions, the "aftertax" value of the ROTH if withdrawn suddenly will exceed the "aftertax" value of the regular IRA+taxfund if also withdrawn.

In summary, my proposal for this kind of scenario is that IF you can live off outside assets for 15 years or so, EVEN AFTER paying the conversion tax on up front FROM OUTSIDE ASSETS, then the conversion will pay for itself after that 15 years, and moreover, if you are able to leave a bequest, the bequest delivered as a ROTH can lead to extraordinarily higher lifetime value for your beneficiaries if they optimize the stretch opportunities. Just as an illustration, on a current $5-$6MM portfolio, assuming parents never touch the IRA, the conversion will provide in excess of $1MM extra dollars to inheritors over their lifespans.

I'd be happy to share my spreadsheet with anybody who is interested in my process, if that is allowed on this forum. If so, perhaps moderators can educate me on the accepted method of sharing spreadsheet files.