iOrp and Roth Conversions

[CardsFan]

I had not been to the iORP site for a while. When I visited today, the first page has changed to a "quick check" with a variety of canned assumptions.

Of particular note was this:
IRA to Roth IRA conversions are not included. At least one quantitative study (See page 47) reports that conversions offer little economic advantage but their dramatic increase in taxes paid in early retirement tends to panic the novice.

I did peruse the referenced study (which was done by Welch himself), but have not yet read it in detail. Here is the link: http://www.iarfc.org/documents/issues/Vol 15 Issue1.pdf .Per the article:
We find that in comparing two optimal plans, differing
only in whether or not conversions are allowed, that there
is in the neighborhood of a 1 percent improvement in the
conversion plan’s disposable income compared to the
non-conversion plan.

Buried in the study there is a comment that conversions at market lows would be a big improvement over this (seems obvious).

Since I can't guess my disposable income needs to 1% in advance, I wonder about the real, tangible, benefits to the retiree. I understand the benefits to heirs.

Note that the sample portfolio is for a 66yo, so it might really benefit very early retirees more.

Comments?

 

[Neill]

I couldn't get past conversions with anything but a 0% tax rate. I go from 0% to 30% if I convert too much. I would have shielded some income in my 401k when younger at a tax rate similar to that. You can't do any better than 0% and retiring early lets you do it for more years.
I see the GOP plan has tax rates for dividends as half the income tax rate so that means the 0% rate could well be gone. Standard deduction is going to be bigger at the first tax bracket is 12%. So presumably I might be converting at 6%. I could go for that.

 

[GrayHare]

I believe that accurately describes a large number of cases, perhaps even the majority. For many, tax rates during retirement will be roughly the same as before retirement, in which case Roth conversion offers little benefit. By comparison, if one manages to convert near a low in investment value, for example 2009 for equities, huge gains follow from the tax-free growth. How you know when the market has bottomed, so you can ideally time the conversion, is another matter entirely.

 

[H2ODude]

I've done some as I have better than half of our $ in my tIRA. I always figured it was kind of a wash but did some on the ASSUMPTION taxes would only likely go higher, not lower. Now I'm not sure about that for our bracket so will just stand pat. I know when I did the Iorp thing a year or two ago it had me converting almost all of it in one fell swoop and I wasn't going there.

 

[sengsational]

I've read that paper several times over the years (James came to the conclusion that Roth conversions were often of little benefit quite a long time ago).

The take-away for me is that if you run it both ways, and there is little difference between the two plans, it's probably not worth fiddling too much with Roth conversions. But if you run it both ways and the recommendation is to Roth convert without getting into the high tax brackets, then the pressure not to convert is really nothing...might as well do it.

The other thing to consider, though, is what if federal tax rates go up? If you have a a chunk of Roth funds and a chunk of tIRA/401k funds, then you've got a tax diversified portfolio. As with asset allocation, you'd always have something to complain about, but at least not everything would be in the same spot.

 

[pb4uski]

Now I'm confused... isn't i-orp the tool that in the past recommended doing way MORE conversions than many of us were comfortable with? And now they are saying, ah... fuggedaboutit?

In our case doing Roth conversions is a pretty easy decision. Our marginal tax rate was 28% or 33%. Over the past few years I have been doing Roth conversions at 10% or less (increase in tax divided by Roth conversion). Once we start SS I expect that we will be in the 25% tax bracket for quite a while, so given a choice of paying 10% or less now or 25% or more later, I chose 10% or less now. I'll continue to convert to the top of the 15% bracket until taxes change, at which point I will reassess.

 

[CardsFan]

Now I'm confused... isn't i-orp the tool that in the past recommended doing way MORE conversions than many of us were comfortable with? And now they are saying, ah... fuggedaboutit?

In our case doing Roth conversions is a pretty easy decision. Our marginal tax rate was 28% or 33%. Over the past few years I have been doing Roth conversions at 10% or less (increase in tax divided by Roth conversion). Once we start SS I expect that we will be in the 25% tax bracket for quite a while, so given a choice of paying 10% or less now or 25% or more later, I chose 10% or less now. I'll continue to convert to the top of the 15% bracket until taxes change, at which point I will reassess.

I understand your logic, but am now looking to simply spend tIRA money. Not quite the same, with out the tax free growth, but it does reduce the balance somewhat. With 2/3 of our saving in tax deferred accounts, we are unlikely to avoid the the big tax bill waiting at RMD time. I can mix and match a little to keep our taxes lower, at least for now.

If/when there is a big pull back in the market, I might well convert and spend out of cash that year. I know it sounds like market timing, but it would make some sense.

 

[braumeister]

I've been converting up to the limit of the 25% bracket (we'll never be in a lower one) and I've reached the point where more than 40% of the portfolio is now in Roth, with just over 25% still in Trad. So I'm calling it a day since RMDs are just around the corner.

Could have save a chunk of taxes by not converting but I'm happy with the result and glad I did it.

 

[Options]

...For many, tax rates during retirement will be roughly the same as before retirement, in which case Roth conversion offers little benefit.

...

What?? Not in the least. Income before retirement is taxed as ordinary income, the most disadvantageous tax situation to be in. Implementing tax management strategies post-retirement allows one to take advantage of LTCG and qualified dividend rates, tax loss and gain harvesting, roth conversions to minimize or in fact mitigate the age 70 SS/RMD tax torpedo, and a host of other strategies. At times, as in my case, the resulting taxes from retirement income are very close to zero.

Regarding i-orp, here's my take from another thread:

http://www.early-retirement.org/forums/f28/spending-down-ira-in-retirement-84874.html#post1821890

As I stated in another post, you have to be willing to do the work in order to calculate and optimize tax bracket management for your unique situation. Of course, if you prefer to just give $$ to Uncle Sam, then that's another story...

 

[GrayHare]

What?? Not in the least. Income before retirement is taxed as ordinary income, the most disadvantageous tax situation to be in.

A type of income does not change because one retires, for example, capital gains are taxed at capital gains rates both before and after retirement. Ordinary income, such as from an IRA, is taxed at ordinary income rates after retirement too.

 

[Options]

You've missed the point.

Ordinary income from working before retirement places one in a higher (and sometimes highest) tax bracket (versus post-retirement) thereby impacting LTCG and dividend tax rates. This all changes in retirement. This is why the best strategy for tax bracket management before retirement is to diversify retirement funding as much as possible in terms of taxation (i.e., a combination of taxable, tax-deferred and roths). As to ordinary income from tax-deferred vehicles, it can be mitigated through roth conversions, one of the most common strategies for those who retire early.

There is a reason Warren Buffet said he pays less taxes than his secretary. It's called tax management.

 

[CardsFan]

As to ordinary income from tax-deferred vehicles, it can be mitigated through roth conversions, one of the most common strategies for those who retire early.

It can/may be mitigated on the back end, if you pay it on the front end. You may be paying at a lower rate than in the future, but you WILL pay. It all depends how much you have in the tax deferred account, and how many years you have to convert. At 61, I can, at best, convert 20% of my tIRA to Roth (in the 15% bracket) before RMD's, and it will probably grow by more than that in 9 years. But to do this, I need to spend down the after tax account. Or I can let that grow and spend from a combination of tIRA withdrawals and after tax income (after tax int/div/cap gains factor into taxes no matter what).

There is no one perfect answer, and no matter what you do, it will not be the best solution when back tested 20 years from now.

I prefer to not waste my time worrying if I could increase my theoretical spend by 1% per year, when I am spending only 50-60% of what all the programs tell me I can spend.

Bottom line: I will hit the Tax Torpedo no matter what I do. Whoopee I won the game.

 

[Midpack]

Sounds familiar http://www.early-retirement.org/forums/f28/i-orp-no-longer-includes-roth-conversion-83927.html

 

[CardsFan]

Sounds familiar http://www.early-retirement.org/forums/f28/i-orp-no-longer-includes-roth-conversion-83927.html

Sorry I missed your thread a few months back. You beat me to it.

 

[GrayHare]

You've missed the point.
Ordinary income from working before retirement places one in a higher (and sometimes highest) tax bracket (versus post-retirement) thereby impacting LTCG and dividend tax rates. This all changes in retirement.

That's certainly true for some people. Depending on many factors, including age at retirement, many will be in a lower bracket after retiring, many will be in a higher esp when SS and RMDs kick in, and many (perhaps the majority) will be in roughly the same bracket. I don't have specific percentages that fit into each, but clearly there are people in each.

 

[Cobra9777]

We convert to the top of the 15% bracket. But this is a relatively small figure due to 2 pension annuities and rental income. It's a bit bigger every other year due to "bunching" deductions. But over 15 years, we will only convert about 15% of our tax-deferred balances. So for us, there is no avoiding 25% RMD tax (assuming reasonably "normal" market behavior over the next 15 years). The small conversions we're doing just reduce the amount of RMDs taxed at 25% and create some tax/withdrawal flexibility down the road.

Regarding i-ORP, the system previously recommended huge, early conversions into the 25% and even 28% brackets, with a very small single-digit percentage increase in lifetime spending capacity. No way. One optimal scenario and countless ways it could go horribly wrong. Dropping the conversion option from the system may actually buy-back some lost credibility. It wasn't just panicky novices who scoffed at those numbers.

 

[Options]

It can/may be mitigated on the back end, if you pay it on the front end. You may be paying at a lower rate than in the future, but you WILL pay. It all depends how much you have in the tax deferred account, and how many years you have to convert. At 61, I can, at best, convert 20% of my tIRA to Roth (in the 15% bracket) before RMD's, and it will probably grow by more than that in 9 years. But to do this, I need to spend down the after tax account. Or I can let that grow and spend from a combination of tIRA withdrawals and after tax income (after tax int/div/cap gains factor into taxes no matter what).

As I posted in another thread, my "WILL pay" amounts to less than $600/yr, and in paying no more than that in taxes for the remainder of PF life. All while paying ZERO on taxable dividends/LTCG's, even with tax gain harvesting. Moreover, nothing says you have to convert up to the 15% tax bracket; if you are not comfortable with that (as in my case). You can be flexible with regard to amounts converted.

There is no one perfect answer, and no matter what you do, it will not be the best solution when back tested 20 years from now.

Wrong. Calculating whether you will be in a higher tax bracket in the future requires no "backtesting." As I stated previously, you have to take the time to calculate the best strategy you can for your unique situation. Is mine perfect? Who knows (or cares), but I do know it's far superior than if I hadn't expended the effort.

I prefer to not waste my time worrying if I could increase my theoretical spend by 1% per year, when I am spending only 50-60% of what all the programs tell me I can spend.

This. It really is a cost/benefit analysis in deciding whether to dedicate the time to tax management (as in any other aspect of PF management, such as deep and shallow risk analysis). In considering, it's important to remember tax management benefits not only you but your SO as well as your heirs, if that's important to you (and in the case of single individuals, it might not be). I should add an important caveat that I didn't really start to dig into tax management until after I retired, and then, because I had the time, it actually became interesting versus a burden.

Bottom line: I will hit the Tax Torpedo no matter what I do. Whoopee I won the game.

No, you don't necessarily have to hit the tax torpedo. Even though I don't like/use i-orp, it does demonstrate the value of diversifying withdrawals from taxable/tax-deferred/tax-free vehicles to mitigate/minimize the torpedo and taxes in general.

Allan Roth has stated that investing is easy but tax management is hard. If I found it not worth my time, I definitely wouldn't do it, either. Yes, I found it hard at first (when I was planning out tax management to end of PF life), but don't at all anymore. Takes about 15 minutes a year now, and that's only due to executing transactions online to convert and later in the year recharacterize.

If you find your mileage varies, then by all means stay on the road you're on.

 

[Options]

That's certainly true for some people. Depending on many factors, including age at retirement, many will be in a lower bracket after retiring, many will be in a higher esp when SS and RMDs kick in, and many (perhaps the majority) will be in roughly the same bracket. I don't have specific percentages that fit into each, but clearly there are people in each.

Emphasis added

This not correct and is a misleading statement to make. People tend to make generalized statements when they are unwilling to do the hard work to educate themselves. Particularly in a forum such as this, it's a good idea to refrain from making implications based on conjecture or speculation. If interested, one of the best sources of tax management theory and strategy can be found by searching for such threads in the BH forum.

 

[sengsational]

Now I'm confused... isn't i-orp the tool that in the past recommended doing way MORE conversions than many of us were comfortable with? And now they are saying, ah... fuggedaboutit?

Way back when, the author was compelled to add Roth conversions because that was an option on the table for retirement planning. Not long after the feature was added to the optimization, he wrote the paper that said it didn't make much difference in a lot of scenarios. Nothing new here. Last summer the tool was enhanced to allow Roth conversions to be limited to a more comfortable level.

Sounds familiar http://www.early-retirement.org/forums/f28/i-orp-no-longer-includes-roth-conversion-83927.html

There was a simple page added that had Roth conversions "off" by default. It's still available in the full version, which is still available.

Regarding i-ORP, the system previously recommended huge, early conversions into the 25% and even 28% brackets, with a very small single-digit percentage increase in lifetime spending capacity. No way. One optimal scenario and countless ways it could go horribly wrong. Dropping the conversion option from the system may actually buy-back some lost credibility. It wasn't just panicky novices who scoffed at those numbers.

I completely agree that a financial plan should not go after the last dollar at the expense of adding a bunch of crazy risk. The tool was designed to give you an optimal solution but was never designed to include the kind of risk you're talking about; anyone who discounted the credibility of the tool because it didn't include the "bird in the hand" risk, simply didn't understand the tool. And they didn't read the paper where the author concludes that Roth conversions are probably not worth doing in most cases.

So flip the Roth conversion flag with your data and you learn something. As has been said many times, there's no one perfect calculator, but IMHO i-orp is one which produces some of the more interesting bits to the puzzle.

 

[CardsFan]

From Options:
"As I posted in another thread, my "WILL pay" amounts to less than $600/yr, and in paying no more than that in taxes for the remainder of PF life. All while paying ZERO on taxable dividends/LTCG's, even with tax gain harvesting. Moreover, nothing says you have to convert up to the 15% tax bracket; if you are not comfortable with that (as in my case). You can be flexible with regard to amounts converted."

I have not looked back at all your past postings, but I suspect you have a larger stash of after tax money, and a smaller stash of tax deferred money, than I.

There is no way I could convert a substantial portion of my tIRA money to Roth over the next 9 years, and only pay $600/year in taxes. Math is hard, but I can figure this out.

I am not complaining. as I said before, I won the game.

 

[Options]

Yes, I posted that $2 of every $3 is in taxable, so my strategy works for me. You don't have to convert a substantial portion of your IRA to roth, but again, if you don't find it worth your time, then that's that. Good for you for feeling you've won the game.

 

[N02L84ER]

We have no pensions and no rentals. Our only income comes from our taxable accounts because we are under 59 y.o. and have no need for tapping our IRAs. We believe our financial situation may become the norm for early retirees (readers of this forum) although with the much larger allowed contributions to 401Ks and IRAs, future early retirees may not be forced to save in taxable accounts like we were.
When we first ran i-orp many years ago, they recommended completely converting all of our IRAs over a 5 year period and paying the taxes. We decided that would be unwise since we would then have 0 taxable income for over a decade to offset exemptions and deductions.
When my DH retired 11 years ago, we had 2.3% in Roth, 32.2% in IRA, and 65.5% in taxable accounts. Similar to Options, $2 of every $3 was in taxable. We did small Roth conversions for the next 6 years while I continued to work part time, averaging 11K per year in conversions. When I retired almost 5 years ago, we bumped up the Roth conversions to around 33K per year to match our exemptions and deductions. We have now converted 263K and paid a total of $646 in federal taxes, which is only a 0.25% effective tax rate. Our state does not tax conversions. As long as the tax laws do not change, we expect to continue converting approximately 33K per year for another 12 years. By the time we are both 70, our projections show 85% in Roth and 15% in IRAs. This will result in no RMD tax torpedo. So, in our situation, partial Roth conversions make a lot of sense.
When we ran i-orp in 2012, their projections had changed to show more moderate Roth conversions until our taxable accounts were depleted, but since they expected us to spend a lot more than we do, it still didn't/doesn't match what we are doing.
YMMV.

 

[Options]

...We have now converted 263K and paid a total of $646 in federal taxes...By the time we are both 70, our projections show 85% in Roth and 15% in IRAs...

Emphasis added

Brilliant! $646 total taxes on $263K in conversions. Sweet. This also means by age 70 fully 85% of your PF will be tax-free while simultaneously shielded from the negative impact of future tax reform (except perhaps for forced RMD's on roths at 70, which is a reform possibility that's been discussed but even those consequences will be minimal). It rarely gets any better than what you've accomplished.

I am behind you in terms of total converted but my plan is about the same. Great job!

 

[Sunset]

We convert to the top of the 15% bracket. But this is a relatively small figure due to 2 pension annuities and rental income. It's a bit bigger every other year due to "bunching" deductions. But over 15 years, we will only convert about 15% of our tax-deferred balances. So for us, there is no avoiding 25% RMD tax (assuming reasonably "normal" market behavior over the next 15 years). The small conversions we're doing just reduce the amount of RMDs taxed at 25% and create some tax/withdrawal flexibility down the road.

Regarding i-ORP, the system previously recommended huge, early conversions into the 25% and even 28% brackets, with a very small single-digit percentage increase in lifetime spending capacity. No way. One optimal scenario and countless ways it could go horribly wrong. Dropping the conversion option from the system may actually buy-back some lost credibility. It wasn't just panicky novices who scoffed at those numbers.

+1
I feel exactly the same way, I'll do some, but not as intensely as iorp suggested.

 

[Midpack]

Sounds familiar http://www.early-retirement.org/for...d, only for additional reading on your topic.