Convert to ROTH? A contrarian view

[Broland]

Most financial planners say to convert IRA to Roth, but what is the actual benefit? I have a "simple math" comparison for consideration:

Common assumptions for a simplistic scenario:
Retired, no income, living off of investments only.
Won't be collecting SS for several years.
24% tax bracket (throttling expenditures to keep it no higher).
$100k starting amount.
10% return, compounding interest.
Access all monies at end of 10 years.

Scenario:
IRA money: year one $110K, ten years $259,397
$259,397@ 24% tax bracket leaves $197,124 after tax
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Roth money: year one $76K, ten years $197,124 after tax
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So where's the big advantage? Perhaps planning on tax rates going up in the future? What if they go down? What if I can lower expenditures in the future putting me in a lower tax bracket, then the "non Roth" scenario would actually have more after-tax money in 10 years.

I'm just trying to better understand why so many "smart people" say I should be doing it! Looking for some insight from y'all!

 

[RunningBum]

Benefits:

1. Pay the tax with outside money (from your taxable account). This puts the full $100k into the Roth, where it grows tax free. As long as you have the outside money to pay taxes, it's better to take $24K from taxable (where gains are taxed).

This strategy makes it worth while to convert at the same tax rate (or lower) than you expect to have in the future.

2. For early retirees, converting now before you start taking SS likely means you are in a lower tax bracket than once you have more income with SS. Also, you might be able to keep the amount of SS taxed lower.

3. The tax cuts are schedule to expire after 2025. While they could be continued, there's no guarantee of that. With the ever growing national deficit, it seems unlikely for them to go lower.

4. Many people have very high savings in their tIRA. Even if you can't convert all of it, you are better off "smoothing" your income to avoid tax spikes when you have to take MRDs.

You asked:

What if I can lower expenditures in the future putting me in a lower tax bracket, then the "non Roth" scenario would actually have more after-tax money in 10 years.

I don't know what the math is on that. But you should first realize that expenditures are not the same as taxable income. If you have $100K in a taxable account with a $50,000 cost basis, you can withdraw and spend $100K but only have $50K in taxable income.

I know you're only talking about IRA vs. Roth, but if that's all you have, then you aren't starting in the 24% tax bracket, so the numbers certainly favor doing Roth conversions thru the lower tax brackets.

Maybe there's some case for not converting. Leaving enough in an IRA to do QCDs for your charitable donations is a good strategy.

 

[pb4uski]

Its a tax arbitrage play. If there is no difference in marginal tax rate today vs when RMDs bite then there is no benefit.

But for many people, there are substantial differences between tax rates early in retirement and once pensions, SS and RMDs begin.

We are a good example. I retired at 56 so we have been living on "savings" since we have not yet started SS. I started my small pension at 62, but even with that pension income, absent Roth conversions our federal tax would be $0 since qualified dividends are not taxed and my pension is less than the standard deduction.

Once SS and RMDs start we will be in the 22% bracket.

So let's say that our other income before Roth conversions is $20k and is all ordinary income. The top of the 12% tax bracket in 2020 is $80,250. Add the $24,800 standard deduction for a married couple to that and you could have $105,050 of income.

So you have $85,050 of headroom for Roth conversions if you have $20k of ordinary income from other sources. You'll pay $9,235 of tax on that Roth conversion... $0 in the first $4,800 ($24,800 standard deduction less $20,000 of other income), $1,975 on the next $19,750 in the 10% tax bracket, and $7,260 on the $60,500 in the 12% tax bracket.... so effectively 10.85%.

10.85% now or 22% later... I chose 10.85% now. Since I retired I've converted about $389k, paid about $33k (8.5%) in federal tax and saved about $53k in federal tax.

It sounds like in your case you should probably be comparing 32% now to 35% or 37% later... so there isn't as much of an impact. In fact, if your beneficiaries are in a lower tax rate then it would probably be better to not do Roth conversions and let them pay taxes on inherited IRA RMDs at their lower tax rates.

 

[njhowie]

All you done is proven a few simple mathematical equations - whether you multiply or divide at the beginning or the end does not matter. You've shown that it's the same.

The key (which you've essentially shown) is if you expect your tax rate to be lower in retirement or higher. If the tax rate is lower in retirement, then traditional will work out better. If the tax rate is higher in retirement, then Roth will work out better.

Simple as that.

 

[NgineER]

Another wrinkle is that if you are married filing jointly now and one spouse dies, your tax bracket changes substantially...

 

[Bruceski44]

A big question is how do you think tax rates will change in the near future. I think they'll go up within ten years.

Another concern (at least for me) is the death of the stretch IRA earlier this year. My heirs could've kept the inherited IRA for their entire lives, taking RMDs every year and paying taxes. But now, they must liquidate the entire account within 10 years. This could be a huge tax burden on them with large RMDs possibly putting them in a higher tax bracket.

I'm converting, not only to Roths, but also to taxable brokerage accounts and real estate, both of which are more friendly to heirs. At least until Congress changes things up again, but such is life.

 

[davebarnes]

If you plan to leave money to your heirs, then convert.

 

[pb4uski]

If you plan to leave money to your heirs, then convert.

It depends. I don't think that converting make sense if your heirs are likely to have a much lower tax bracket than you do.... let them withdraw pay the lower tax rate.

 

[2017ish]

Another wrinkle is that if you are married filing jointly now and one spouse dies, your tax bracket changes substantially...

Huge factor for us. We could have had zero income tax each of our first years of retirement, but chose to max the 24% bracket for conversions each year. We'll continue to optimize conversions even though we'll need to draw out of the IRAs to live starting in 2021.

Otherwise, the RMDs on [very?] large IRAs, combined with single-taxpayer rates, would have been nasty--and planning likelihood is that DW would be dealing with it in her 80s and 90s....

 

[MichaelB]

So where's the big advantage? Perhaps planning on tax rates going up in the future? What if they go down? What if I can lower expenditures in the future putting me in a lower tax bracket, then the "non Roth" scenario would actually have more after-tax money in 10 years.

I'm just trying to better understand why so many "smart people" say I should be doing it! Looking for some insight from y'all!

One advantage that is often mentioned here is a Roth IRA is not subject to RMDs and one can withdraw when/as needed. A taxable IRA is subject to RMDs and the account holder must withdraw yearly without regard to need.

 

[FREE866]

Interesting conversation. I'm 54 and started to do partial conversions this year and plan on doing it for several years. The general logic was that I'm in the 12% tax bracket now and when I'm 70 the combo of RMD's and SS will most likely put me in a higher bracket for sure. I will also pay the taxes out of my taxable account so all the money will be invested. I really like the idea of having what should be a decent size account that I can draw on completely tax free.

 

[CRLLS]

It depends. I don't think that converting make sense if your heirs are likely to have a much lower tax bracket than you do.... let them withdraw pay the lower tax rate.

The other side of the coin is, if I leave a tIRA to my 2 children and both are in different tax brackets, then the net benefit is unbalanced. With a Roth, they both get equal buying power.


To the OP, I think that when one uses "simple math" and one set of "common assumptions", one quickly to the simple answer. But a lot of other perspectives and variables haven't been considered so it may not be the best answer for any one individual. Some of those are already mentioned above. I agree that based on the assumptions you made, it is a wash. ACA subsidies, IRMAA, reduced RMD's are just a few more things to decide if they are important factors to you. I'm sure you will get more input.

 

[Dave J]

Interesting conversation. I'm 54 and started to do partial conversions this year and plan on doing it for several years. The general logic was that I'm in the 12% tax bracket now and when I'm 70 the combo of RMD's and SS will most likely put me in a higher bracket for sure. I will also pay the taxes out of my taxable account so all the money will be invested. I really like the idea of having what should be a decent size account that I can draw on completely tax free.

Good for you. If you get enough in Roth's and don't have too much other taxable income, you may be able to make (keep) some if not all of your SS non-taxable.

 

[pb4uski]

The other side of the coin is, if I leave a tIRA to my 2 children and both are in different tax brackets, then the net benefit is unbalanced. With a Roth, they both get equal buying power. ...

Equal buying power perhaps, but less in total.

You don't have to leave them the same amount... you could allocate it so it is the same after payment of taxes (estimated of course).

The main point is that if their tax rate is lower than yours, even if they are different, then they are still ahead... since less is paid to Uncle Sam more ends up in their pocket than if the parent in a higher tax rate pays the taxes.

 

[Time2]

I’m 65 yrs old, MFJ and just did my first Roth conversion two days ago. I can stay in the 12% bracket.
I’m working with $65,200 Taxable IRA Distributions, ( A Roth Conversion) $39,000 LTCGs, $10,000 Dividends.
With an $8,100 HSA contribution (wife’s) and $26,100 Standard Deduction.
This leaves me with $80,000 taxable income and a tax bill of $3,328. This is because my LTCGs and Dividends are taxed at 0%. I get the same answer on a second calculator.
The Calculator I’m using says this,


"Your Taxes are estimated at $3,328.


[FONT=&quot]This is 2.91% of your total income of $114,200. Your outstanding tax bill is estimated at $3,328. This puts you in the 12% tax bracket."[/FONT]
[FONT=&quot]
[/FONT]
[FONT=&quot]The next [/FONT][FONT=&quot]$100 is taxed at 22%.[/FONT][FONT=&quot]
[/FONT]
[FONT=&quot] As I see it, at 72 I will have RMDs, SS and Dividends that would put me over $110,000 of income. I don’t see any way to finesse this income, I get it, if I want it or not. I expect this will put me over the 12% bracket. Plus, I expect higher tax rates 7 years from now. So, I hope to move as much as I can[/FONT]
[FONT=&quot]it Roths, before I start collecting RMDs, this will reduce the amount of RMDs I'm required to take.
[/FONT]
[FONT=&quot]I think it works in my case, your case might not be as clear cut. But, I wonder what your thought is about tax rates. With the excessive government spending before and especially after Covid, I just think rates will rise in the future.[/FONT]

 

[CRLLS]

Not only equal buying power but equal amounts also. Win-Win. Neither is promised anything. I know that "if this" and "if that" things could be less in the end than the whole before our demise, or it could be higher. My preference is that when we're gone, I don't want either of them repeating the Smother's Brothers argument. "Mom (and Dad) always liked you best."

 

[RetireBy90]

OP, there are a couple considerations that are important for me that I don’t think have been mentioned on this thread yet. If they have then whoops.

1) with trad IRA you have to take RMDS, with Roth no RMDS. Ok, already mentioned.
2) With Roth, you can rake a large sum without considering the tax hit. Say you want to buy a boat or beach house.
3) There are several “cliffs” that depend on your income. SS taxability, IRMAA for Medicare, and many more. Converting may allow you to dodge these or reduce the cost.
4) I want to pay my tax today before I loose any mental facilities and have the tax burden relieved. I’ll be down to small pensions and SS and rental income. I’ve done taxes for these many times so shouldn’t take a lot of facilities.
5) The Roth conversions are part of getting finances in order in case I pass before DW. I look at it as taking care of her after I’m gone.

 

[CRLLS]

Regarding #3 above, in Illinois, if seniors have a taxable income under $65,000 then RE taxes can be controlled somewhat by applying for the Senior Tax Freeze This freezes the assessment value so long as you stay under that $65K income. Unlike the state income tax, SS benefits, Pensions and IRA income (not Roth) are part of the total. This can be a BIG PLUS if one stays in the home for 20-30 years. The Roth conversion can be one tool to manage taxable income. I'm not sure what other states may have such a plan.

 

[Koolau]

I'm sure I've said all this before:

1. Converting all my IRAs to Roths has really simplified my life. Now, I only worry about RMDs due on my 401(k). My 401(k) is diligent in sending me a report telling me to the penny how much I need to send the IRS each year. Easy, peazy, etc. Yes, I'm sure ALL the 401(k) managers AND most IRA managers do the same thing. Still, it's just simpler for old guys like me.

2. What RunningBum said.

3. As Bruceski44 suggests: You gotta ask yourself "Do you feel lucky?" Do you really think tax rates won't go up? It's already been promised to happen under certain conditions ('nuff said.)

 

[Navigator]

I'm just trying to better understand why so many "smart people" say I should be doing it! Looking for some insight from y'all!

Roth conversions do not make sense for everyone. I had an accountant do the numbers for me and he was able to show that it made little sense for my particular situation. For some people Roth conversions are a wash and for others they make sense. If you are not sure, ask an accountant to go over the numbers for you. The cost is far less than making a mistake.

 

[RetireBy90]

Roth conversions do not make sense for everyone. I had an accountant do the numbers for me and he was able to show that it made little sense for my particular situation. For some people Roth conversions are a wash and for others they make sense. If you are not sure, ask an accountant to go over the numbers for you. The cost is far less than making a mistake.

This topic seems to be as dividing as the debate about owning rental property. If you convert enough that you are taxed at a higher rate than you plan for when doing withdraws then this would not be wise. However, unless you plan to be in a lower tax rate when you withdraw the funds how can it cost you ? I agree they may not be a big savings or may break even, and as mentioned there are several income cliffs that need to be considered but IMHO few situations where it would cost you.

 

[LRDave]

Isn't it fairly safe to say that converting to the top of the 12% bracket is a no-brainer?

 

[Looking4Ward]

Isn't it fairly safe to say that converting to the top of the 12% bracket is a no-brainer?

Maybe. Unless you're under 65 and benefitting from an almost $10K a year ACA subsidy for health insurance that you would most likely lose.

 

[RunningBum]

Maybe. Unless you're under 65 and benefitting from an almost $10K a year ACA subsidy for health insurance that you would most likely lose.

Converting to near the ACA cliff is my target. It's pretty close as to whether it's better to convert some or get a bigger subsidy. I'm already pretty close to the cliff, so I can't convert much, so any difference between the two choices is pretty trivial.

 

[Navigator]

Isn't it fairly safe to say that converting to the top of the 12% bracket is a no-brainer?

It may seem like it, but there are actually several instances where this may not be a good idea, such as for those receiving SS or ACA subsidies.