Retirement Tax Planning - Income Optimization?

[Midpack]

DW assures me this is not an acceptable option.

I caught that one too! Just be careful not to pitch her as you can knock me off early and your next husband will live a life of luxury

I'm interested, please provide details.

I didn’t phrase that very well did I...

 

[Midpack]

Hi Midpack, just re-read posts 104 and 111. I think if you convert less aggressively, the theoretical tax savings would be less but the payback would be quicker, due to a larger differential and tax brackets. Is that in fact what you found?

Thanks for asking. I wasn't sure (and my earlier guess was wrong) so I went back and added Roth conversions to 22% (vs 24%). To my surprise the lifetime savings were only 9% vs 31%, and the "breakeven" age was about the same. Doesn't make our decision any easier. It appears we either convert aggressively or not at all, not quite what I was guessing - but I have my consult later this week, so we'll see if I'm missing something. If nothing else, it appears I've gotten more than our money's worth on our $20 one month subscription. Who knows, I may continue it for more than a month, or even try their $50 premier version.

And like RunningBum, the tax situation we leave heirs isn't a top priority for us, though it's probably a very legit consideration for many households.

 

[bingybear]

Well there is the breakeven, which is aimed at optimizing after tax net worth. But there is also the payback period, which seems to be quite long for Roth conversion strategies, assuming you are collecting RMDs over a 20-30+ year remaining lifetime.

Pay taxes now, reduce future RMDs, but it takes you quite a few years to actually realize the benefit if your early tax payment in cash.

I see that Midpack explored this somewhat. But do most folks calculate this or just take the balance sheet approach i.e., paying early at theoretically lower rates nets higher net worth over time?

Like social security math, you have to live long enough to personally realize the benefits. Heirs could, but that is really reaching far into the future.

+1

There are other events that can make a strong impression if one has not roth converted:
The tax events that results from death of a spouse... having to file as single.

inheritance of a decent portfolio

I'm sure there are others. The first jumps your tax rates by filing status, the second can jump you taxes buy income (I know the you aren't taxed on the inheritance, but I assume you would invest it which could make the earnings taxable that could increase rates).

So the first reason for roth conversion may long term tax reduction, there are other events that may benefit from roth conversion. I expect there may be others.

While it may take a while to justify roth conversion (you need to live long enough to reach break even), the other benefits can make it easier to justify.

 

[RunningBum]

Well there is the breakeven, which is aimed at optimizing after tax net worth. But there is also the payback period, which seems to be quite long for Roth conversion strategies, assuming you are collecting RMDs over a 20-30+ year remaining lifetime.

Pay taxes now, reduce future RMDs, but it takes you quite a few years to actually realize the benefit if your early tax payment in cash.

I see that Midpack explored this somewhat. But do most folks calculate this or just take the balance sheet approach i.e., paying early at theoretically lower rates nets higher net worth over time?

Like social security math, you have to live long enough to personally realize the benefits. Heirs could, but that is really reaching far into the future.

This isn't like social security though. Not at all. With social security, the payments stop with your death, so the breakeven point matters as to whether taking early or late is better.

With conversions, you money lives on after your death and any unconverted pre-tax funds continue to get taxed. It doesn't matter that you have to reach far into the future, the important thing is to try to pay the least amount of taxes over the duration of the pre-tax funds, until they are drained.

The important things about retirement money is to not run out in your lifetime, to leave as much as you can to heirs, and/or to be able to spend more, right?

With social security, the breakeven is important because if you die before the breakeven it would be better wrt the above things to have started SS early, but if you die past the breakeven it would be better to start SS late.

Now let's look at the conversion of pre-tax to Roth issues. Spending is not a factor because you can't spend pre-tax money. You have to withdraw or convert it to be able to spend it. If you defer conversion, and die before the so-called breakeven, you may leave your heirs a larger dollar amount, but you also leave them a larger tax liability. So it really doesn't matter which side of the break even you die on, because with any pre-tax money you pass on, you also pass on the tax liability on it. What you really want to do is for the least amount of taxes to be paid over the duration of the pre-tax fund. If that means converting aggressively early because other things such as SS and pensions push it into a high tax rate later, do it.

The exception to this is if your heirs will be in a lower tax bracket than you are, and leaving them as much as possible is your priority and you figure it is very unlikely you will run out. In this case, converting less aggressively works out better.

The other thing that favors aggressive conversion is the death of a spouse, which puts you into the higher tax rates of a single filer.

 

[RunningBum]

While it may take a while to justify roth conversion (you need to live long enough to reach break even)...

Let me try one more time to say why it doesn't matter how long you live.

Let's say I figure out what my optimal conversion plan is if I live to be 100, but I actually die tomorrow.

If I do my yearly conversion today, my heirs get a little less because I've paid the taxes, but they also have a lower tax liability so the net after tax is, they inherit the same amount as they would if I had planned to do my conversion next week, and didn't do it before I died.

See? The breakeven point just doesn't matter, because the tax liability gets passed on with the pre-tax money. If I convert today and die tomorrow, I've paid more taxes in my lifetime, so I didn't "break even", but I'm dead, so it doesn't matter. My heirs come out the same because even though they inherited a little less money, they have a smaller tax liability because I paid the tax on the converted amount.

 

[Midpack]

+1

There are other events that can make a strong impression if one has not roth converted:
The tax events that results from death of a spouse... having to file as single.

inheritance of a decent portfolio

I'm sure there are others. The first jumps your tax rates by filing status, the second can jump you taxes buy income (I know the you aren't taxed on the inheritance, but I assume you would invest it which could make the earnings taxable that could increase rates).

So the first reason for roth conversion may long term tax reduction, there are other events that may benefit from roth conversion. I expect there may be others.

While it may take a while to justify roth conversion (you need to live long enough to reach break even), the other benefits can make it easier to justify.

This isn't like social security though. Not at all. With social security, the payments stop with your death, so the breakeven point matters as to whether taking early or late is better.

With conversions, you money lives on after your death and any unconverted pre-tax funds continue to get taxed. It doesn't matter that you have to reach far into the future, the important thing is to try to pay the least amount of taxes over the duration of the pre-tax funds, until they are drained.

The important things about retirement money is to not run out in your lifetime, to leave as much as you can to heirs, and/or to be able to spend more, right?

With social security, the breakeven is important because if you die before the breakeven it would be better wrt the above things to have started SS early, but if you die past the breakeven it would be better to start SS late.

Now let's look at the conversion of pre-tax to Roth issues. Spending is not a factor because you can't spend pre-tax money. You have to withdraw or convert it to be able to spend it. If you defer conversion, and die before the so-called breakeven, you may leave your heirs a larger dollar amount, but you also leave them a larger tax liability. So it really doesn't matter which side of the break even you die on, because with any pre-tax money you pass on, you also pass on the tax liability on it. What you really want to do is for the least amount of taxes to be paid over the duration of the pre-tax fund. If that means converting aggressively early because other things such as SS and pensions push it into a high tax rate later, do it.

The exception to this is if your heirs will be in a lower tax bracket than you are, and leaving them as much as possible is your priority and you figure it is very unlikely you will run out. In this case, converting less aggressively works out better.

The other thing that favors aggressive conversion is the death of a spouse, which puts you into the higher tax rates of a single filer.

+1. A lot of good insights here. Some apply to us, some don't - but all worthy of consideration to decide what each of us prioritize.

And to reiterate, my charts are based on future tax rates (Soc Sec & Medicare benefits) that I believe are overly optimistic as well (revert to prior tax code on TCJA expiration). I believe taxation will get worse, but I wouldn't know how or when specifically. IOW, the total tax savings from Roth conversions will probably be greater than my posts state.

 

[RunningBum]

If you don't care one bit about heirs, then it seems to me that you should plan for longevity, and to eventually totally convert or distribute all of your tIRA. So the breakeven still doesn't matter because you plan to convert/use it all, and you want to pay the lowest possible lifetime taxes on it that you can.

 

[RunningBum]

An exception to my last post: If you plan to leave your tIRA to charity, I believe they don't have to pay income taxes on it, so the tax liability dies with you. In this case, the breakeven point does matter, if you want to optimize the charity amount.

 

[Midpack]

An exception to my last post: If you plan to leave your tIRA to charity, I believe they don't have to pay income taxes on it, so the tax liability dies with you. In this case, the breakeven point does matter, if you want to optimize the charity amount.

Some might see Federal and State governments as worthy "charities" as long as we can hold them off while we're alive - they're all short on funds too. IOW, I don't want to run out of money, but when we're both gone, sending a big chunk to Fed & State DORs isn't the worst possible outcome for those of us without family heirs...

 

[bingybear]

Let me try one more time to say why it doesn't matter how long you live.

Let's say I figure out what my optimal conversion plan is if I live to be 100, but I actually die tomorrow.

If I do my yearly conversion today, my heirs get a little less because I've paid the taxes, but they also have a lower tax liability so the net after tax is, they inherit the same amount as they would if I had planned to do my conversion next week, and didn't do it before I died.

See? The breakeven point just doesn't matter, because the tax liability gets passed on with the pre-tax money. If I convert today and die tomorrow, I've paid more taxes in my lifetime, so I didn't "break even", but I'm dead, so it doesn't matter. My heirs come out the same because even though they inherited a little less money, they have a smaller tax liability because I paid the tax on the converted amount.

I agree with you on the QCD. I was thinking of doing them, but since the limit I believe is your RMD, this could be small if one converts too much of an TIRA.

I also agree with you on dying before the break even point does not bode well for the conversions. However, if you are married and one spouse passed (and does not remarry), this would likely pull the break even point in as the tax rates may increase based on single filing. I did not analyze it, but is just makes sense.

How well this works for you depends on your individual situation. It might not work for you or maybe only be marginal.

I've watched a friend who was widowed a decade ago live in the tax torpedo and that is a big incentive for me to do some preparing.

Do what works for you.

pax

 

[RunningBum]

I agree with you on the QCD. I was thinking of doing them, but since the limit I believe is your RMD, this could be small if one converts too much of an TIRA.

I also agree with you on dying before the break even point does not bode well for the conversions. However, if you are married and one spouse passed (and does not remarry), this would likely pull the break even point in as the tax rates may increase based on single filing. I did not analyze it, but is just makes sense.

I'm very confused because I didn't mention QCDs at all--nobody did. And I didn't say anything like the bolded part. In fact what I said is that dying before the breakeven point doesn't matter. I don't see how you pulled that from my post.

 

[bingybear]

I'm very confused because I didn't mention QCDs at all--nobody did. And I didn't say anything like the bolded part. In fact what I said is that dying before the breakeven point doesn't matter. I don't see how you pulled that from my post.

you noted giving TIRA to charity... often this is done tax free by using QCD. I thought that is what you meant.

 

[RunningBum]

you noted giving TIRA to charity... often this is done tax free by using QCD. I thought that is what you meant.

No, I meant after death.

 

[harley]

The tax events that results from death of a spouse... having to file as single.

I was already planning to some conversions to the top of 24% for the next few years, but I hadn't even thought of this aspect. Assuming we don't both go out at the same time in a fiery car crash or something similar, the survivor will definitely be in at least the 24% bracket. That makes it at worst a wash for doing it now. Thanks for pointing that out.

 

[bingybear]

No, I meant after death.

Sorry I misunderstood your intent. I'm more focused on on the tax planning and roth conversion. I had thought about using QCD for this (partially), but RMD's are over a decade and I don't think I can wait that long with the way things are unfolding.

Sorry again for not catching your meaning... my fault.

 

[Montecfo]

This isn't like social security though. Not at all. With social security, the payments stop with your death, so the breakeven point matters as to whether taking early or late is better.

With conversions, you money lives on after your death and any unconverted pre-tax funds continue to get taxed. It doesn't matter that you have to reach far into the future, the important thing is to try to pay the least amount of taxes over the duration of the pre-tax funds, until they are drained.

The important things about retirement money is to not run out in your lifetime, to leave as much as you can to heirs, and/or to be able to spend more, right?

With social security, the breakeven is important because if you die before the breakeven it would be better wrt the above things to have started SS early, but if you die past the breakeven it would be better to start SS late.

Now let's look at the conversion of pre-tax to Roth issues. Spending is not a factor because you can't spend pre-tax money. You have to withdraw or convert it to be able to spend it. If you defer conversion, and die before the so-called breakeven, you may leave your heirs a larger dollar amount, but you also leave them a larger tax liability. So it really doesn't matter which side of the break even you die on, because with any pre-tax money you pass on, you also pass on the tax liability on it. What you really want to do is for the least amount of taxes to be paid over the duration of the pre-tax fund. If that means converting aggressively early because other things such as SS and pensions push it into a high tax rate later, do it.

The exception to this is if your heirs will be in a lower tax bracket than you are, and leaving them as much as possible is your priority and you figure it is very unlikely you will run out. In this case, converting less aggressively works out better.

The other thing that favors aggressive conversion is the death of a spouse, which puts you into the higher tax rates of a single filer.

It is like social security only in the way I stated.

 

[Montecfo]

Let me try one more time to say why it doesn't matter how long you live.

Let's say I figure out what my optimal conversion plan is if I live to be 100, but I actually die tomorrow.

If I do my yearly conversion today, my heirs get a little less because I've paid the taxes, but they also have a lower tax liability so the net after tax is, they inherit the same amount as they would if I had planned to do my conversion next week, and didn't do it before I died.

See? The breakeven point just doesn't matter, because the tax liability gets passed on with the pre-tax money. If I convert today and die tomorrow, I've paid more taxes in my lifetime, so I didn't "break even", but I'm dead, so it doesn't matter. My heirs come out the same because even though they inherited a little less money, they have a smaller tax liability because I paid the tax on the converted amount.

There is no misunderstanding about that on my part. I'm just making a different point. My point is that the benefit you're describing, if any, goes to your heirs not to you if you die before it is realized by you.

People may differ on whether lower potentially lower taxes to heirs are an important consideration. That has been Illustrated in this thread.

 

[Montecfo]

+1. A lot of good insights here. Some apply to us, some don't - but all worthy of consideration to decide what each of us prioritize.

And to reiterate, my charts are based on future tax rates (Soc Sec & Medicare benefits) that I believe are overly optimistic as well (revert to prior tax code on TCJA expiration). I believe taxation will get worse, but I wouldn't know how or when specifically. IOW, the total tax savings from Roth conversions will probably be greater than my posts state.

You make several very good points here. In my mental analysis, I have assumed static rates.

I tend to believe that perhaps the greatest reason to do Roth conversions is as a hedge against the death of one spouse, and the resulting higher single tax rates. I think it is the most compelling reason because we know tax rates will be much higher in that case, even if other tax rates do remain static as I have assumed in my mental analysis.

 

[Midpack]

And just to make it even harder on myself, the difference in final portfolio ending balance at DW age 97 is less than 6% higher with aggressive Roth conversions vs NO Roth conversions at all and the unofficial "breakeven age" is 90! After over 40 years accumulating toward a higher portfolio value, the idea of voluntarily siphoning off a big chunk upfront is a mental challenge for me at least. And the overriding goal is to maximize the portfolio, not minimize taxes. Huge difference in taxable to heirs, but again not a priority for us.

For anyone who didn't see the tax summary, overall taxes were reduced by 31% and the breakeven age was about 84.

It's never easy, though the widow tax benefit and the likelihood of (much) higher future tax/CG rates, and secondarily the heir/charity tax benefits are worthwhile considerations.

 

[Montecfo]

And just to make it even harder on myself, the difference in final portfolio ending balance at DW age 97 is less than 6% higher with aggressive Roth conversions vs NO Roth conversions at all and the unofficial "breakeven age" is 90! After over 40 years accumulating toward a higher portfolio value, the idea of voluntarily siphoning off a big chunk upfront is a mental challenge for me at least.

For anyone who didn't see the tax summary, overall taxes were reduced by 31% and the breakeven age was about 84.

It's never easy, though the widow tax benefit and the likelihood of (much) higher future tax/CG rates, and secondarily the heir/charity tax benefits are worthwhile considerations.

It seems to me that the lower rate Roth conversions should yield both the highest percentage tax savings and the quickest payback. If that is in not in fact the case then there's something I don't understand about the software

 

[SevenUp]

It seems to me that the lower rate Roth conversions should yield both the highest percentage tax savings and the quickest payback. If that is in not in fact the case then there's something I don't understand about the software

Perhaps it is because the difference between paying 22% vs. 24% is slight, but the amount that can be converted at 24% is so much greater than at 22% that future RMDs at higher rates aren't much affected by the 22% amount compared with the 24% amount.

 

[Montecfo]

Perhaps it is because the difference between paying 22% vs. 24% is slight, but the amount that can be converted at 24% is so much greater than at 22% that future RMDs at higher rates aren't much affected by the 22% amount compared with the 24% amount.

I was referring to the range from 10-22%.

 

[RunningBum]

There is no misunderstanding about that on my part. I'm just making a different point. My point is that the benefit you're describing, if any, goes to your heirs not to you if you die before it is realized by you.

People may differ on whether lower potentially lower taxes to heirs are an important consideration. That has been Illustrated in this thread.

That's fine. I just think breakeven is a real issue with SS, but not so with conversions. With SS, if you delay taking it but die early, you lose. You miss out on those early benefits. With conversion, if you convert more early and die early, it's true that you paid more taxes in your own lifetime, but you didn't run out of money, and your heirs get the benefit of taxes being paid. So by converting aggressively, you both protect yourself against longevity (living past the "break-even") and give your heirs the tax benefit. You really are sacrificing nothing by paying the taxes early, so it doesn't really matter whether you have heirs you care about or not.

So while its true that it's like SS in that there's a breakeven point that you personally reap the benefit from if you outlive it, as you said, it's a pretty meaningless aspect for Roth conversions. Nobody loses (financially) if you don't reach the breakeven point

 

[Midpack]

Perhaps it is because the difference between paying 22% vs. 24% is slight, but the amount that can be converted at 24% is so much greater than at 22% that future RMDs at higher rates aren't much affected by the 22% amount compared with the 24% amount.

Yep, I can convert almost three times as much at 24% as I can at 22%.

I was referring to the range from 10-22%.

10% and 12% are non starters for us, so I haven’t modeled either.

 

[Montecfo]

Yep, I can convert almost three times as much at 24% as I can at 22%.

10% and 12% are non starters for us, so I haven’t modeled either.

Ok. That is the part I missed on rates.