Is Roth Conversion Worth It?

[turbo89]

I’m specifically looking at a mega back door. We both contribute the max to our 401k /roth 401k (50/50 split to max dollar amount) and our earned income is too high for a traditional Roth (although we both have them, and contributed before our incomes caught up with us).

Honestly, I’d even be open to “just” a back door Roth if I could keep taxes below our max income tax rate.

[SevenUp]

Quote:

Originally Posted by turbo89 I’m specifically looking at a mega back door. We both contribute the max to our 401k /roth 401k (50/50 split to max dollar amount) and our earned income is too high for a traditional Roth (although we both have them, and contributed before our incomes caught up with us). Honestly, I’d even be open to “just” a back door Roth if I could keep taxes below our max income tax rate.

Neither the backdoor nor the mega-backdoor will affect your taxes (for better or worse) in the current year.

That may or may not address your question "I’m not sure I quite follow how I avoid paying addition income tax on this?"

If it doesn't help - can you be more specific about your concern(s)?

[pb4uski]

Quote:

Originally Posted by RetiredHappy @pb4uski I don't see that you are accounting for the growth of that money you have given up to pay taxes. The growth of that money that you no longer have, could account of the $ difference in the tax rate of now vs. later.

It doesn't matter... you are falling into a common trap/popular misconception.

Say you have $10,000 in an tIRA and $2,000 in taxable accounts and your tax rate is 20% and your investments grow at 7% annually.

One choice is to Roth convert where you end up with $10,000 in a Roth and the taxable account is used to pay the $2,000 tax bill. After 10 years at 7% the $10,000 Roth has grown to be a $19,672 Roth that can be spent.

Alternatively, you don't convert. Over the 10 years, the $10,000 tIRA grows to $19,672. Meanwhile, the $2,000 taxable account grows to $3,449 (growth is less because each year's 7% get's taxed at 20% so the after-tax growth is 5.6%). If you withdraw the $19,672 tIRA to spend, pay the 20%/$3,934 in tax, at the end you only have $19,187 to spend ($19,672+$3,449-$3,934).

You actually come out ahead with the Roth because you avoid tax on the taxable account earnings... so where is this alleged growth that you are so concerned about?

Let's say that there isn't tax on the taxable account earnings, so over the 10 years it grows to be $3,934.... after you withdraw the $19,762 tIRA and pay the 20%/$3,934 in tax you have $19,672 left to spend... the exact same as the Roth.

So the Roth comes out better for the tax avoided on the taxable account growth if you don't convert.

And... this all assumes that the future tax rate is the same as today's tax rate... if today's tax rate is lower then you come out even further ahead... run the numbers for yourself and see.

So this simple example proves that you come out ahead even if the tax rate is the same then its pretty easy to see that if the tax rate is lower today that you come out further ahead... no complex models needed!
---------------------------------------------------------------------------------------------------
$19,672 = $10,000*(1+7%)^10
$3,934 = $2,000*(1+7%)^10
$3,449 = $2,000*(1+7%*(1-20%))^10

[turbo89]

Quote:

Originally Posted by SevenUp Neither the backdoor nor the mega-backdoor will affect your taxes (for better or worse) in the current year. That may or may not address your question "I’m not sure I quite follow how I avoid paying addition income tax on this?" If it doesn't help - can you be more specific about your concern(s)?

Yea, I guess I’m just a bit confused and need to read a bit more on back door conversions. I got the impression that a back door conversion was taking money from a tax advantaged account (e.g. 401k) and placing it in a Roth account (tax free growth), without penalty /fees.

This article seems to imply I can do that conversion “and then some”, up to $58k. It seems like this would increase my out of pocket tax amount by the excess amount I converted?

I think I’m mostly confused about how I would convert “extra money” (beyond my 401k contribution limit),

[Exchme]

I don't think we have enough information about OP's overall financial picture to make informed guesses. OP needs to define the goals - the reason for Roth Conversions is tax arbitrage, trying to convert at low rates to avoid high rates later. Converting huge chunks all at once seems the opposite of that.

Chassis mentioned the Bogleheads Retiree Portfolio Model, that is an excellent tool, (though the input is a bit quirky, you have to be patient and read the instructions). If you go to the Bogleheads site their wiki has a link to the regular version and with search for a thread by BigFoot48, you will find the link to the latest Beta version which has a unique feature that allows you to vary the stock/bond asset allocation in each type of account.

I find that putting your bonds preferentially in your t-IRA greatly reduces the optimum amount of Roth Conversions you should do. As no tool is perfect, I also approximated the same situation in Pralana Gold (it includes has more of the tax code in some respects, but requires manual approximation of the asset allocation optimization) and get the same trend.

If your advisor is not talking to you about your goals - maximizing your security?, maximizing your spouse's security if you die early? maximizing after tax bequests to heirs? maximizing charitable gifts? etc. and then helping you set up a strategy to reach your goal, they are useless.

[SecondCor521]

Quote:

Originally Posted by turbo89 I got the impression that a back door conversion was taking money from a tax advantaged account (e.g. 401k) and placing it in a Roth account (tax free growth), without penalty /fees.

Uh, nope.

The regular Roth back door just allows you to contribute to a Roth IRA via an indirect method when your income is high enough to preclude a direct contribution.

The mega back door Roth just allows you, under certain circumstances, to contribute a lot more to a Roth IRA than the $6K or $7K regular limit by contributing to an after-tax 401(k) account (or Roth 401(k) - not sure which) and then rolling over those contributions to a Roth IRA.

Neither of these two methods allow you to get pre-tax money into a Roth without taxes.

You may be confused because in certain situations a mega back door Roth involves contributing to a 401(k) account. But those contributions are after-tax, not pre-tax because they're made to either an after-tax 401(k) account or a Roth 401(k) account (I'm not honestly sure which - the mega back door Roth came about after I had FIREd - but you could google it).

A regular Roth conversion can be done without penalties or fees, but generates taxable income of the converted amount (which usually results in income taxes).

[SevenUp]

Quote:

Originally Posted by turbo89 Yea, I guess I’m just a bit confused and need to read a bit more on back door conversions. I got the impression that a back door conversion was taking money from a tax advantaged account (e.g. 401k) and placing it in a Roth account (tax free growth), without penalty /fees.

Taking an amount of money that hasn't been taxed (e.g., what has been in your traditional 401k account for years) and moving that to a Roth account (either Roth 401k or Roth IRA) makes that amount taxable in the year you move it. See the "Roth IRA conversion" article linked previously.

The backdoor (involving IRAs) and mega-backdoor (involving 401ks) processes are indirect but legal ways to contribute new, already-taxed, money into Roth accounts. See those two articles linked previously.

Quote:

This article seems to imply I can do that conversion “and then some”, up to $58k. It seems like this would increase my out of pocket tax amount by the excess amount I converted?

Because you haven't taken and won't take any tax deduction for the amounts contributed in either backdoor process, you won't be liable for tax when you convert those amounts.

[RetiredHappy]

Quote:

Originally Posted by pb4uski It doesn't matter... you are falling into a common trap/popular misconception. Say you have $10,000 in an tIRA and $2,000 in taxable accounts and your tax rate is 20% and your investments grow at 7% annually. One choice is to Roth convert where you end up with $10,000 in a Roth and the taxable account is used to pay the $2,000 tax bill. After 10 years at 7% the $10,000 Roth has grown to be a $19,672 Roth that can be spent. Alternatively, you don't convert. Over the 10 years, the $10,000 tIRA grows to $19,672. Meanwhile, the $2,000 taxable account grows to $3,449 (growth is less because each year's 7% get's taxed at 20% so the after-tax growth is 5.6%). If you withdraw the $19,672 tIRA to spend, pay the 20%/$3,934 in tax, at the end you only have $19,187 to spend ($19,672+$3,449-$3,934). You actually come out ahead with the Roth because you avoid tax on the taxable account earnings... so where is this alleged growth that you are so concerned about? Let's say that there isn't tax on the taxable account earnings, so over the 10 years it grows to be $3,934.... after you withdraw the $19,762 tIRA and pay the 20%/$3,934 in tax you have $19,672 left to spend... the exact same as the Roth. So the Roth comes out better for the tax avoided on the taxable account growth if you don't convert. And... this all assumes that the future tax rate is the same as today's tax rate... if today's tax rate is lower then you come out even further ahead... run the numbers for yourself and see. So this simple example proves that you come out ahead even if the tax rate is the same then its pretty easy to see that if the tax rate is lower today that you come out further ahead... no complex models needed! --------------------------------------------------------------------------------------------------- $19,672 = $10,000*(1+7%)^10 $3,934 = $2,000*(1+7%)^10 $3,449 = $2,000*(1+7%*(1-20%))^10

That is how I look at it. Convert to ROTH now or not does not make a significant difference. So instead of messing with it now, I will worry about IRA taxes when they hit me. For estate planning, I plan to use disclaiming part of IRA inheritance to pass a part of the IRA to other beneficiary(ies) who maybe in a lower tax bracket. Problem solved!

[Markola]

Doing nothing is often the best course, when it comes to money and investing. Since I don’t anticipate being in a higher bracket later in life, I see no advantage to Roth conversions now. YMMV.

[turbo89]

Thank you Seven / second, that clarifies it quite a bit! I’ll go back and re-read through those links.

[SevenUp]

Quote:

Originally Posted by RetiredHappy Convert to ROTH now or not does not make a significant difference...

...if tax rates now and later are the same - yes.

If tax rates now vs. later are 10% different (e.g., 12% vs. 22%) then it makes a 10% difference in the after-tax result. Whether 10% is significant or not may be in the eye of the beholder.

[RetiredHappy]

Quote:

Originally Posted by SevenUp ...if tax rates now and later are the same - yes. If tax rates now vs. later are 10% different (e.g., 12% vs. 22%) then it makes a 10% difference in the after-tax result. Whether 10% is significant or not may be in the eye of the beholder.

We are already at 22% and 24% tax brackets, I won't sweat over future tax rates.

[chassis]

@pb4uski when (what age) do you expect to break even on the taxes paid on Roth conversions, to eventually arrive at 7% better net worth at age 100?

@SecondCor521 it looks to me like you don't like the message (McQuarrie's), and are attempting to shoot the messenger (McQuarrie) by casting aspersions on his credentials. Kitces and McQuarrie are both psychologists. Strange....or not strange?

There have been people in the past whose message wasn't well received by the populace. You yourself know of an example.

[SevenUp]

Quote:

Originally Posted by chassis ...when (what age) do you expect to break even on the taxes paid on Roth conversions...?

Break-even is immediate on any Roth conversion if the tax rate doesn't change.

[pb4uski]

+1. Breakeven is immediate if tax rate today is the same or lower than future tax rate when RMDs happen... which it is in my case.

[cat4ever]

Quote:

Originally Posted by pb4uski And... this all assumes that the future tax rate is the same as today's tax rate... if today's tax rate is lower then you come out even further ahead...

THIS!! Even if your models tell you it's break even, this is a BIG reason to do Roth's regardless up to the tax bracket you expect to be in when RMD's and SS start. I guess if taxes go down in the future then conversions probably won't pan out, but i'd be happy to take that loss and have that be the case.

Of course the ultra-cynical might say there's nothing to stop 'them" from taxing Roth's along with other tax increases our friendly government may come up with.

[rwdflynavy]

Did the OP ever clarify Medicare vs. Medicaid? Seems like that's an important piece of information.

[SecondCor521]

Quote:

Originally Posted by chassis @SecondCor521 it looks to me like you don't like the message (McQuarrie's), and are attempting to shoot the messenger (McQuarrie) by casting aspersions on his credentials. Kitces and McQuarrie are both psychologists. Strange....or not strange? There have been people in the past whose message wasn't well received by the populace. You yourself know of an example.

You might want to look again.

I never wrote that I disliked the message. I thought the arguments to support the message were poorly constructed, so I disregarded the message.

And I'm not casting aspersions on his credentials - I think I was objectively pointing out the lack of evidence of any relevant credentials.

How something is received by other people in general has little to no bearing on whether I subscribe to an idea or not. There are a lot of things I do and believe that are quite common, and a number of things I do and believe that are uncommon.

Since he was an academic in a business school and his paper was published in some financial publication, I started reading his paper with a positive expectation. As noted in my earlier reply, I read the first several pages of his paper and came across numerous holes in logic.

I then wondered how someone who worked in a business school at what I consider to be a good university could write so poorly on a financial topic, and how a financial publication could have published such stuff. So I investigated his credentials and the characteristics of the publication. Since there was no evidence of relevant credentials, the review standards of the publication were not very high, and his message was poorly argued, I chose to discard it.

I wouldn't characterize either McQuarrie or Kitces as psychologists based on their respective careers and experience.

I think you are quite right to imply that my previous reply on McQuarrie may have focused too much on his lack of credentials and less on his poor logic. Since it has been several months since I wrote that post, I don't recall exactly why. It may have been that I thought the poor logic in the paper was self-evident, or at least more obvious than the credentials issue. It was probably partly that most of what I read in his paper simply didn't apply to me. And it was probably more my fascination with what I saw as people (people in the personal finance area generally, not you specifically, although it seems clear you agree with McQuarrie on this subject) reading and accepting what he had to say without much due diligence. Finally, I think I was just being lazy - pointing out all the flaws in his logic would have taken too much time and energy for me to bother with.

I prioritize the logic and the evidence over the credentials, by the way. But in the case of both McQuarrie and the other person to whom you allude, I haven't seen any need to do so.

HTH, I'll give you the last word if you want it.

[chassis]

@SecondCor521 thanks. I don’t want the last word on anything. I want to bring the ground truth to light on Roth conversions. It’s an element of my own retirement financial planning that I don’t think makes sense for me. I don’t understand how it can make sense for as many people as seem to be in support of Roth conversions on this site and bheads. McQuarrie’s work for me is one small piece of information in a large bucket of information. I briefly read some of his work and moved on.

I have used i-orp, RPM and my own spreadsheet and I don’t see the benefit for Roth conversions. To gain a wider perspective, I have asked HNW, UHNW individuals and a family office trustee (UUHNW families) and none of them are doing Roth conversions for themselves or their clients.

You said you are Roth converting with zero tax, correct? How does that work?

[pb4uski]

Yup. Math is hard.