Budgeting for Roth Conversion Taxes

[truenorth418]

I am retired in my early 50s, and I am beginning to make Roth IRA conversions. The only other income I have currently is from dividend and cap gains in my after tax accounts. As is usually recommended, I intend to pay the income taxes on the Roth conversions from a separate, after-tax account. This will not be a problem.

However, there is another rule of thumb I follow which is that current year's income taxes should be paid from within one's predetermined withdrawal rate, just like any other ongoing expense.

Before including taxes on these Roth conversions, my income tax payments are minimal since they consist of dividend and cap gains taxes, and so these tax payments barely put a dent in my annual withdrawal rate.

However, if I include taxes for Roth conversions, suddenly my current year's taxes take up a much more significant amount of my spending and a significant percent of my withdrawal rate, which of course crowds out all the money I have set aside for retirement living expenses and discretionary spending.

How do others account for Roth conversion taxes in their budgets? Do you budget for them within your current year withdrawal limits, or do you pay for them above and beyond your predetermined withdrawal rate?

[RunningBum]

Above and beyond. Roth conversion is a good long term strategy, at least for me. I don't want to derail it by adhering to a short term strategy withdrawal limit. This is why when I calculate my net worth, I deduct future taxes due from my Roth, so that when I do all these calculations I don't have to include the Roth incomes taxes as part of yearly expenses/withdrawals.

[kaneohe]

Quote:

Originally Posted by truenorth418 .............................. However, there is another rule of thumb I follow which is that current year's income taxes should be paid from within one's predetermined withdrawal rate, just like any other ongoing expense. ..................................

not sure you should be a slave to this rule since you aren't really consuming when you do the Roth conversion.......you're just prepaying taxes that would be due when you withdraw from the TIRA if you hadn't converted. For example if you are in the 15% bracket and have 10K in TIRA and 1.5K in taxable, you might think you have 11.5K but you can't use the10K in TIRA w/o paying taxes so you really have 8.5K (after tax) in TIRA and 1.5K in taxable for a 10K total.

If you convert, you'll use the 1.5K in taxable to pay the taxes and have 10K also so the results before/after conversion are the same in terms of after tax funds.

This seems more like a liquidity issue........the converted funds in Roth are tied up (to avoid penalty) for 5 yrs so if your taxable account can support those missing funds (tax payments) for 5 yrs, then those conversion amounts will be able to withdraw from the Roth w/o penalty. Note there is a separate 5 yr clock on each conversion until you reach 59.5 year old.

Have you calculated that you will really benefit from the Roth conversion?
What is your tax rate to convert the funds now vs what will you pay later when you withdraw from TIRA if you don't convert?

[pb4uski]

+1 with others not worrying about it. The reason that you are converting is because you are saving money by paying a lower tax rate now by converting rather than not converting and paying more taxes later. As kaneohe points out you are not consuming, you are prepaying... at a discount.

I'm in the exact same situation as you, except that I am older. My tax would be nil if I don't do any Roth conversions but my effective tax on conversions is only abut 7-8% (that is the incremental tax divided by the conversion amount). That beats the heck out of 25% or more later on.

One thing you should know though. I convert to the top of the 15% tax bracket. Even if you are just a little over, the effective tax rate on the excess is actually 30%... however that problem can be easily solved by recharacterizing the excess.

[Mo Money]

This issue will soon be relevant for me, too. pb4uski, an admittedly dumb question: Can you please clarify what you mean by "recharacterizing the excess?"

Math n numberz wuz never my strong sute.

[youbet]

truenorth418........

If you want your FireCalc model to be reasonably accurate, you must, in some manner, account for the taxes you will pay on Roth conversions. Ignoring them, despite the fact that a Roth conversion is a "good thing to do," is incorrect. These taxes are an expense in FireCalc just like any other expense.

Modeling these taxes in FireCalc quickly becomes a head-scratcher. They represent increased withdrawals at the time they are paid and likely result in reduced withdrawals later, in for form of tax savings (the reason you're doing the Roth conversions).

I did it this way. I estimated the amount my taxes would increase in aggregate over the years due to Roth conversions. Then I subtracted this amount from the value of the TIRA. So as to not double-count these taxes, I did not include them as part of my annual withdrawal. Since having more money in my Roth, less in my TIRA and therefore lower future taxes, results in lower spending, I have a slightly smaller ongoing WR.

Then I ran FireCalc, got satisfactory results, and plowed ahead. This method is easy to do in FireCalc. The tough job is coming up with how much of your TIRA "disappears" due to paying income taxes on the conversions. But you really need to do that anyway just to understand whether you should do the Roth conversions to begin with.

[kaneohe]

Quote:

Originally Posted by Mo Money This issue will soon be relevant for me, too. pb4uski, an admittedly dumb question: Can you please clarify what you mean by "recharacterizing the excess?" Math n numberz wuz never my strong sute.

I think pb4uski means is that if you overshoot (when making Roth conversions) the top of the 15% bracket for whatever reason.....human error or unexpected income late in the year.....
you could run into the 30% marginal tax bracket (if LTCG/QDIV) get pushed above the 15%/25% tax bracket boundary. If this occurs, you can belatedly correct it even early next year by recharacterizing in whole or in part, the amount of your Roth conversion to make it small enough that you get below that 15%/25% tax bracket boundary. This is a rare case when you can do things after the yr ends and change the taxes. Your broker should be able to help you do this.

[walkinwood]

I had a similar question a few years ago. This thread may have additional information for you.

FWIW, I take the tax hit as part of my annual planned withdrawal. As it stands now, we're not spending our whole withdrawal any way, so it doesn't hurt. If it did, I may have to reconsider.

I now make sure I am not eligible for PPACA subsidies before making ROTH transfers

http://www.early-retirement.org/foru...ers-60722.html

[pb4uski]

As an example lets say that your convert $50k and when you a finalizing your tax return you discover that you overcooked it a bit and that you are $1k over the top of the 15% tax bracket. The tax on that extra $1k is $300 which is steep IMO.

You can "recharacterize" or essentially reverse that $1k excess and avoid the $300 tax bill. As I recall you have until October 15 of the following year to do the recharacterization.

[pb4uski]

If I was going to include the taxes in Firecalc, what I would do is figure the tax for your first full year of retirement and then include that amount either as an off-chart spending starting at ER and then an offsetting off-chart income starting at 70 when RMDs begin or using the manual entry of spending.

Alternatively, if the cost as $x per year, you could just reduce your starting portfolio by (70 - age you ER)*$x to provide for that fixed term expense.

In my case, they are not significant enough to make a difference so I chose to ignore them.

[Whisper66]

Like some others here, I do not include tax money needed to make Roth Conversions as part of my yearly % withdrawal. When I run my retirement analysis, I devalue my total assets input into the calculation by the amount I pay for taxes on the tIRA.

For those interested, here's good info on recharacterization from Bogleheads Wiki .. https://www.bogleheads.org/wiki/IRA_recharacterization

[truenorth418]

Quote:

Originally Posted by kaneohe Have you calculated that you will really benefit from the Roth conversion? What is your tax rate to convert the funds now vs what will you pay later when you withdraw from TIRA if you don't convert?

Yes, I've used a few of the online calculators (Fidelity, Vanguard) as well as i-orp, which suggests a very aggressive conversion program. They all recommend to convert, but there are so many variables.

State taxes are a consideration. I currently live in NYC, which means a high combined state/city income tax rate in addition to federal taxes. I expect to live in low tax or no tax state someday, but I am not ready to make that move yet.

In addition to tax consequences, there is also the matter of giving up ACA subsidies as the conversion moves my MAGI over the 400% FPL line. I have come to accept this, though, since the current subsidy is pretty modest for me and who knows it might be more substantial when I am in my early 60s and after I have completed my conversions.

As for budgeting, it sounds like the consensus here is to consider the conversion taxes "above and beyond" - and either reduce the net worth calculation by the amount of remaining future tIRA taxes or else accept the lower net worth that comes after paying the taxes on the conversions each year.

[Animorph]

Our budget is for spending. Taxes on the portfolio, including Roth conversions, I charge to the portfolio. However, all taxes are also included in all our planning. So it's just a decision about how you think about it and where you record the numbers.

A Roth conversion should be saving you money. Why would it cause a big charge against your withdrawal limit?

[mickeyd]

Quote:

How do others account for Roth conversion taxes in their budgets?

AS I recall my plan was to not do a conversion until December and then I would look at my cash reserves and ask my self "how much can I carve away for Roth conversion taxes?". Once I had that number, I would figure out how much of my IRA could be converted to Roth that would generate taxes to equate with what I could afford at that time. It worked pretty well as long as I did not forget basic arithmetic.

[bingybear]

Quote:

Originally Posted by truenorth418 Yes, I've used a few of the online calculators (Fidelity, Vanguard) as well as i-orp, which suggests a very aggressive conversion program. They all recommend to convert, but there are so many variables. State taxes are a consideration. I currently live in NYC, which means a high combined state/city income tax rate in addition to federal taxes. I expect to live in low tax or no tax state someday, but I am not ready to make that move yet.

just a question.... does NYC tax your conversion. Where I live the retirement income is not taxed by the city. However, one does not get to deduct contributions to retirement accounts on city taxes from earned income.
I kind of ignore the effect of taxes where in the long run is to reduce overall taxes. But then my WR is 1.5%... so a major purchase here or there is somewhat unimportant.
You are questioning if you should model the taxes for the conversions as part of income (kind of a toss up from current responses), I would ask "are you modeling your taxes as income during RMD time when your RMDs and possibly SS will put you in a much higher tax bracket? If you really want to model the whole process... then model the full stream

[jim584672]

NYC would tax your breath if they could.
NY state has a $20,000 pension / ira withdrawal exclusion for those 59.5+.