A real life Roth Conversion example

[Looking4Ward]

I've never been one who couldn't work with numbers but from a personal standpoint it's still really hard for me to get my head around this, so maybe someone can help me put it in real life terms:

I'm 60 and file head of household with one dependent (15) and am currently living off of my taxable investments with a sizeable tIRA that I won't need to touch for ten years.

Last year I had:

$22,813 in capital gains
$19,764 in dividends, of which $10,888 were qualified

So $43K minus standard deduction of $18,350 for a taxable income of $24,327.

I currently qualify for a monthly $793 ACA subsidy, will most likely exceed (but not surpass the maximum) FPL caps based on income when I file next year, but the child tax credit more than wipes out any penalties for understating income.

How much could I optimally convert to a Roth?

 

[pb4uski]

It gets complicated.

What you had last year (2019) for capital gains and dividends isn't relevant. What is relevant is what you expect to have in 2020.

But assuming HH with one dependent, $22,813 in long-term capital gains, $19,764 in dividends and $10,888 of qualified dividends in 2020, your tax would be nil.

Adding $29,773 for a Roth conversion, your income would be at the top of the 12% tax bracket and your tax would be $2,130 but you would get a $2,000 child tax credit so your net tax would be $130, or less than 1% of the $29,773 Roth conversion. So before considering the loss of ACA credits the Roth conversion would be very attractive as the tax cost is negligible... $0 with no Roth conversion vs $130 with a $29,773 Roth conversion.

But once you factor in the loss of $9,513 in ACA subsidies the Roth conversion is unattractive.

However, if you limit your Roth conversion so your total income is less than 400% of FPL you would get a better result. If your Roth conversion were $25,023 then your income would be $67,600 and you would still get ACA credits, but your tax would still be $0, so your effective tax rate on the $25,023 Roth conversion is 0%! You would have to figure out how $25,023 more income would affect your ACA credit but I'm guessing about $2,580... so your net tax cost would be about 10% of the conversion... still pretty attractive.

You may want to do some scenarios using either the What-If worksheet in TurboTax if you use TurboTax or the dinkytown tax calculator at https://www.dinkytown.net/java/1040-tax-calculator.html

Since the implications of exceeding 400% of FPL are so onerous... referred to as falling off the cliff... you might want to reduce the Roth conversion amount some to allow some leeway for any unexpected income.

YMMV.

 

[Looking4Ward]

It gets complicated.

What you had last year (2019) for capital gains and dividends isn't relevant. What is relevant is what you expect to have in 2020.

But assuming HH with one dependent, $22,813 in long-term capital gains, $19,764 in dividends and $10,888 of qualified dividends in 2020, your tax would be nil.

Adding $29,773 for a Roth conversion, your income would be at the top of the 12% tax bracket and your tax would be $2,130 but you would get a $2,000 chid tax credit so your net tax would be $130, or less than 1% of the $29,773 Roth conversion. So before considering the loss of ACA credits the Roth conversion would be very attractive as the tax cost is negligible... $0 with no Roth conversion vs $130 with a $29,773 Roth conversion.

But once you factor in the loss of $9,513 in ACA subsidies the Roth conversion is unattractive.

However, if you limit your Roth conversion so your total income is less than 400% of FPL you would get a better result. If your Roth conversion were $25,023 then your income would be $67,600 and you would still get ACA credits, but your tax would still be $0, so your effective tax rate on the $25,023 Roth conversion is 0%! You would have to figure out how $25,023 more income would affect your ACA credit but I'm guessing about $2,580... so your net tax cost would be about 10% of the conversion... still pretty attractive.

You may want to do some scenarios using either the What-If worksheet in TurboTax if you use TurboTax or the dinkytown tax calculator at https://www.dinkytown.net/java/1040-tax-calculator.html

Since the implications of exceeding 400% of FPL are so onerous... referred to as falling off the cliff... you might want to reduce the Roth conversion amount some to allow some leeway for any unexpected income.

YMMV.

This is exactly the sort of discussion I was hoping for - thank you! Yes, last year's numbers aren't relevant to this year but they were the most recent examples I have, and looking at the Vanguard data so far it looks like I'm in line for a repeat performance.

I would try to keep the total under the 400% ACA cap in order to keep the subsidy, and my experience has been that underestimating income results in a penalty that doesn't exceed the child tax credit as long as that income doesn't surpass the 400% cap.

So I've got 5 more years to be able to convert factoring in ACA and then 7 more years with Medicare before RMD's kick in. I had been planning on starting SS at age 62 but would then need to throw those numbers into the equation.

In any event, right now it looks like close to $25K could be converted in a manner that makes financial sense.

 

[kgtest]

It gets complicated.

What you had last year (2019) for capital gains and dividends isn't relevant. What is relevant is what you expect to have in 2020.

But assuming HH with one dependent, $22,813 in long-term capital gains, $19,764 in dividends and $10,888 of qualified dividends in 2020, your tax would be nil.

Adding $29,773 for a Roth conversion, your income would be at the top of the 12% tax bracket and your tax would be $2,130 but you would get a $2,000 child tax credit so your net tax would be $130, or less than 1% of the $29,773 Roth conversion. So before considering the loss of ACA credits the Roth conversion would be very attractive as the tax cost is negligible... $0 with no Roth conversion vs $130 with a $29,773 Roth conversion.

But once you factor in the loss of $9,513 in ACA subsidies the Roth conversion is unattractive.

However, if you limit your Roth conversion so your total income is less than 400% of FPL you would get a better result. If your Roth conversion were $25,023 then your income would be $67,600 and you would still get ACA credits, but your tax would still be $0, so your effective tax rate on the $25,023 Roth conversion is 0%! You would have to figure out how $25,023 more income would affect your ACA credit but I'm guessing about $2,580... so your net tax cost would be about 10% of the conversion... still pretty attractive.

You may want to do some scenarios using either the What-If worksheet in TurboTax if you use TurboTax or the dinkytown tax calculator at https://www.dinkytown.net/java/1040-tax-calculator.html

Since the implications of exceeding 400% of FPL are so onerous... referred to as falling off the cliff... you might want to reduce the Roth conversion amount some to allow some leeway for any unexpected income.

YMMV.

+1 I trust the math and agree to reduce the conversion by a $1,000 difference from your spot on TurboTax numbers. I always run my scenarios through last years TT to get as close an estimate as I could without thinking hard. I do this a couple times in the year after filing my actual taxes and just save the what-if file as NextYearsGuestimate.turbotax