Roth Conv: Go into 22% bracket to *average* 12% on conversion?

[ERD50]

I have a note that pb4uski mentioned something about how a Roth conversion should not be evaluated solely on the marginal rate. I don't have the post, and don't recall the entire context, so I may have the whole thing wrong, but I think maybe my 2022 estimates apply. Here's the scenario with rough numbers:

I can convert ~ $6K with zero added Fed Tax.
I can convert ~ $66K and be about the top of the 12% bracket.

So it occurred to me since the first $6K is at $0, I could convert an additional ~ $7.2K @ 22% so that the average cost of conversion is still at 12%.

Is that the right way to look at it, or do I have a blind spot to something? Assuming I want to stay within the 12% overall?

But I guess you can take that further. If the 12% bracket was 15%, would I still want to convert? I think so. So should I go up to an average 15%? Am I letting that marginal rate fool me?

Maybe not. As a thought experiment, what if converting more was at a 75% rate! You could still add a bit, and stay at an average of 15%. But it doesn't seem to make sense to convert at that higher rate than expected (hopefully!) future rates. But it is the same thing in a way, right? Then I should not convert anything extra.

TIA - ERD50

 

[Gumby]

I have a note that pb4uski mentioned something about how a Roth conversion should not be evaluated solely on the marginal rate. I don't have the post, and don't recall the entire context, so I may have the whole thing wrong, but I think maybe my 2022 estimates apply. Here's the scenario with rough numbers:

I can convert ~ $6K with zero added Fed Tax.
I can convert ~ $66K and be about the top of the 12% bracket.

So it occurred to me since the first $6K is at $0, I could convert an additional ~ $7.2K @ 22% so that the average cost of conversion is still at 12%.

Is that the right way to look at it, or do I have a blind spot to something? Assuming I want to stay within the 12% overall?

But I guess you can take that further. If the 12% bracket was 15%, would I still want to convert? I think so. So should I go up to an average 15%? Am I letting that marginal rate fool me?

Maybe not. As a thought experiment, what if converting more was at a 75% rate! You could still add a bit, and stay at an average of 15%. But it doesn't seem to make sense to convert at that higher rate than expected (hopefully!) future rates. But it is the same thing in a way, right? Then I should not convert anything extra.

TIA - ERD50

The one tricky part will be that if you go into the 22% bracket (actually $200 shy of it), you lose 0% treatment on any long term capital gains you may have in your taxable account.

 

[RunningBum]

No, you really want to look at marginal cost and rates, not average. That extra $7.2K is taxed at 22%. It doesn't matter that you had $6K at 0%. You've already got that locked in, independent of this extra $7.2K conversion. You want to compare the $7.2K conversion at 22% with the cost of withdrawing or converting it later.

Look at it this way. Suppose over the years you are able to convert all of your tIRA at 0% and 12%. Why would you convert any at 22%, just because it made for an average conversion of 12% one year.

 

[SevenUp]

I have a note that pb4uski mentioned something about how a Roth conversion should not be evaluated solely on the marginal rate.

I hope there is a misinterpretation in there somewhere, because it is indeed the marginal rates now vs. in the future that determine the best Roth conversion strategy.

I can convert ~ $6K with zero added Fed Tax.
I can convert ~ $66K and be about the top of the 12% bracket.

So the first $6K is a "go do". The next $66K might take you to the top of the 12% bracket, but if you are taking social security, the way Taxation of Social Security benefits works your marginal tax rate on that $66K could be higher. But let's proceed under the assumption your marginal tax rate on that $66K is between 10% and 12%.

So it occurred to me since the first $6K is at $0, I could convert an additional ~ $7.2K @ 22% so that the average cost of conversion is still at 12%.

Is that the right way to look at it, or do I have a blind spot to something?

It's a free country so you can look at it however you want.
But it really is costing you 22% on that extra $7.2K to convert now. If you expect that you will continue to be able to withdraw/convert at a 12-15% marginal rate, keep the $7.2K in the traditional account until next year.

It's a little different if you have to incur a high marginal rate for some dollars in order to reach a lower marginal rate at higher conversion amounts. The social security "tax torpedo" is one good example: the high marginal rates may apply only to a relatively small dollar amount, so push through that zone to reach lower rates.

 

[CardsFan]

The one tricky part will be that if you go into the 22% bracket (actually $200 shy of it), you lose 0% treatment on any long term capital gains you may have in your taxable account.

This is a good point. I would plug the numbers into tax software to see actual tax due and effective rate.

I tend to look at conversions a little differently.

First, I look at the overall effective rate for the conversion, and don't get bogged down if a small part of that had a higher rate.

Since the majority of our tIRA's were deferred in the 25-28% bracket, any conversion under 25% is a win for deferring. Before taking SS, it was easy to convert even into the 22% bracket, with an effective rate on the total under 15%.

I took SS at FRA, so now if I convert just below the first IRMAA bracket, the effective rate will be around 24% (accounting for the increased SS taxation). But that is where we will be in 5 years no matter what, and maybe we can hold off IRMAA for several more years after RMD's kick in by lowering the tIRA value.

Is it OPTIMAL? Darned if I know (If I can, I'll let you know after we both pass), but it seems reasonable.

 

[ERD50]

The one tricky part will be that if you go into the 22% bracket (actually $200 shy of it), you lose 0% treatment on any long term capital gains you may have in your taxable account.

Yes, good point. I did plug this into a tax program (https://www.mortgagecalculator.org/calcs/1040-calculator.php) and I do have a few $K of LTCG, so I'll play with those to see.

I'm leaning back to just the top of the 12%. To hold off on my pension and SS does mean tapping some principal until then, which will also probably mean more tax on top of it (unless I can offset a bit with losses).

Thanks to all for the feedback!

-ERD50

 

[SevenUp]

I'm leaning back to just the top of the 12%. To hold off on my pension and SS does mean tapping some principal until then, which will also probably mean more tax on top of it (unless I can offset a bit with losses).
-ERD50

If you are going to be in a 22-25% marginal rate zone after pension and SS start, and can pay the conversion tax from cash on hand (or with a low amount of realized gains so the tax cost of selling in taxable to pay the Roth conversion tax is low) then you might as well convert through at least the 22% bracket and possibly the 24% bracket, if IRMAA is not yet a concern.

 

[OldShooter]

There is the potential for lots of moving parts besides just the federal marginal rate. Additional taxes on SS, IRMAA, ACA, etc. Probably the best way to do it is to plug some numbers into a tax program that takes you to the beginning of the 22% rate, then add $1000 of tIRA income and see how much your total fed + state tax bill increases. That is the real cost of the contemplated conversion. Even this does not catch ACA issues.

Then the fun begins on the other end. Bequests to charities should NOT be from Roths, as you will have prepaid taxes that the charity wouldn't have to pay. Bequests to young people may be better done with tIRAs if the young person's marginal tax rate is likely to be lower than your conversion rate. Bequests to special needs trusts that should run longer than 10 years will probably be optimal if there is a tIRA component that can be drawn and paid out within 10 years and a Roth component that will comprise the corpus at the 10 year mark. The reason for this is that tIRA money drawn but not distributed will be taxed at the high trust rate.

 

[Montecfo]

This is a good point. I would plug the numbers into tax software to see actual tax due and effective rate.

I tend to look at conversions a little differently.

First, I look at the overall effective rate for the conversion, and don't get bogged down if a small part of that had a higher rate.

Since the majority of our tIRA's were deferred in the 25-28% bracket, any conversion under 25% is a win for deferring. Before taking SS, it was easy to convert even into the 22% bracket, with an effective rate on the total under 15%.

I took SS at FRA, so now if I convert just below the first IRMAA bracket, the effective rate will be around 24% (accounting for the increased SS taxation). But that is where we will be in 5 years no matter what, and maybe we can hold off IRMAA for several more years after RMD's kick in by lowering the tIRA value.

Is it OPTIMAL? Darned if I know (If I can, I'll let you know after we both pass), but it seems reasonable.

It is a free country and I see psychic benefits in converting at any point under 25 pct.

But it is really your future taxes that matter now. So your conversion decision will be most economical if it looks at future rates.

Meanwhile, good planning!

 

[pb4uski]

I have a note that pb4uski mentioned something about how a Roth conversion should not be evaluated solely on the marginal rate. ...

I look at both the marginal rate and the effective rate on the total Roth conversion. Since I expect to pay 22% when RMDs start, if the marginal rate is 22% then I stop just before that.

So for example, let's say that I want to convert to the top of the 12% tax bracket and before any Roth conversions I expect $20,000 in interest and pensions and $11,000 in SS. For 2022 with both married over 65 my tax is zero... and $0 of our SS is taxable.

Now I add $82,700 of Roth conversions. My TI is exactly equal to the $83,550 top of the 12% tax bracket. However, 85% of my SS income was taxed where 0% was taxed absent the Roth conversion. The tax bill is $9,615... 11.6% of the $82,700 amount converted.

The margina tax rate on the last $100 converted is 12%. However, if I convert another $100, $82,800 instead of $82,700... my tax goes up by $22 or 22%... I would not do the extra $100.

What is the 11.6%?... its complicated because its a combination of 0% (covered by standard deduction), 10% bracket and 12% bracket and the inclusion of 85% of SS as taxable rather than 0%. I'm suspect that somewhere between $0 and $82,700 in Roth conversions that the rate is pretty high because of the impact of SS... at most 12%*(1+85%) or 22.2%.

I don't particularly care because paying 11.6% now is better than paying 22% later, but I'm not interested in paying 22% now to avoid paying 22% later.

One could make the argument that if I converted and additional $50,000 and my tax went up by $11,000 to $20,615 that it is only 15.5% of the $132,700 converted so I should be hapy doing higher conversions as long as the effective rate on the conversion is less than 22% that I think I'll pay later... but I've never been able to get comfortable with that approach because of the 22% marginal cost after you get past the top of the 12% bracket.

P.S. I like using https://www.irscalculators.com/tax-calculator because it includes bothfederal and state income taxes even though state income taxes no longer apply me. However, there does seem to be a glitch in that if I select MFJ with both over 65 it shows a standard deduction of $28,500 for 2022 and I think it really should be $28,700... I just ignore $200 difference for now.

 

[Exchme]

The one tricky part will be that if you go into the 22% bracket (actually $200 shy of it), you lose 0% treatment on any long term capital gains you may have in your taxable account.

To be a bit more precise, it's the AGI going over $109,250 that is a horrible spot for Roth Conversions as that starts the phase-in of capital gains taxes. So the extra $ of Roth Conversions is taxed at 12% in the regular part of the tax code and pushes a $ of LTCG to be taxed at 15%, so you get a 27% marginal rate that lasts until all the LTCGs are taxed.

 

[pb4uski]

^^^ Yup.

 

[SecondCor521]

I personally look at the marginal rate of each additional Roth conversion dollar. This is because you can convert any dollar amount you want, so each incremental dollar represents an essentially independent choice that should be evaluated independently.

So in the OP's example, each of those 7,200 dollars converted at 22%, if they likely could be converted at 12% later, represents a 10 cent mistake. I wouldn't do it.

The only exception to this rule is if there is a situation where there is what I call a tax hump (and others have recently called a tax torpedo) - if the marginal rate is high for a bit but then falls again at a higher income level. Examples of this would be the transient 27% bracket for people with ordinary income and capital gains, or SS taxability.

In this scenario, I think it depends on how high and how wide the tax hump is, and how low and how broad the subsequent valley is at the higher income level. If I could find a point at a higher income level where the average tax rate on the intervening dollars was low enough *and* I felt a sense of urgency or necessity of doing a lot of Roth conversions (i.e., I was running out of years to do them, or had a large traditional IRA balance), then I'd consider doing a Roth conversion of all those intervening dollars.

So for example, if I had $100 of LTCG/QD and had a "later" tax rate of 25%, I'd probably power through that $100-wide 27% tax hump in order to convert more dollars at a 12% rate, even though 27% > 25%. Paying the $27 on that $100 LTCG/QD means I can probably convert thousands more at 12%, which is obviously worth it - it only would take about $208 worth of additional conversions ($27 / (25% - 12%)) to break even.

 

[Gumby]

To be a bit more precise, it's the AGI going over $109,250 that is a horrible spot for Roth Conversions as that starts the phase-in of capital gains taxes. So the extra $ of Roth Conversions is taxed at 12% in the regular part of the tax code and pushes a $ of LTCG to be taxed at 15%, so you get a 27% marginal rate that lasts until all the LTCGs are taxed.

Yes, that is a much clearer and more precise way to convey the point. (although you are assuming the standard deduction of $25,900)

 

[skyking1]

To be a bit more precise, it's the AGI going over $109,250 that is a horrible spot for Roth Conversions as that starts the phase-in of capital gains taxes. So the extra $ of Roth Conversions is taxed at 12% in the regular part of the tax code and pushes a $ of LTCG to be taxed at 15%, so you get a 27% marginal rate that lasts until all the LTCGs are taxed.

Thank you all for this nugget. I was going to toss a gob of conversion at 2024 to get started, and bump into the 22% a little bit. We also have some real estate to sell that would amount to ~50K of LTCG. Now I will be figuring to be well shy of that AGI to be sure. It is more important to us to shed that property with no LTCG as soon as possible, it is a vacation lot that we are moving farther away from.

 

[CardsFan]

It is a free country and I see psychic benefits in converting at any point under 25 pct.

But it is really your future taxes that matter now. So your conversion decision will be most economical if it looks at future rates.

Meanwhile, good planning!

Uhm, didn't I cover that with this:

I took SS at FRA, so now if I convert just below the first IRMAA bracket, the effective rate will be around 24% (accounting for the increased SS taxation). But that is where we will be in 5 years no matter what, and maybe we can hold off IRMAA for several more years after RMD's kick in by lowering the tIRA value.

Worst case, we are converting where we will be in 5 years. Possible case, tax rates will be higher. Eventual case, tax rate will be much higher for one survivor.

Side case: DS and DDIL are already in the low 24% bracket. If they inherit my sizable tIRA, they would likely be pushed into the 32% bracket if they wanted to empty it evenly over 10 years.

 

[Montecfo]

Uhm, didn't I cover that with this:



Worst case, we are converting where we will be in 5 years. Possible case, tax rates will be higher. Eventual case, tax rate will be much higher for one survivor.

Side case: DS and DDIL are already in the low 24% bracket. If they inherit my sizable tIRA, they would likely be pushed into the 32% bracket if they wanted to empty it evenly over 10 years.

Good points all around. My only quibble was the point I made, but i have no problem wirh the rest.

 

[RetireBy90]

So I think I understand and mostly agree with all that has been said, however I'm curious what you all think about the impact of the market on your strategy. Did any raise your conversion amounts in 2020 when market crashed ?
My thinking is
- If my TIRA is 100 shares
- If I convert 10 shares selling for $10 or $100, at 22% tax rate I pay $22.
- If I market tanks and I convert same 10 shares selling for $5 I only pay $11 in taxes.
- Or I can convert 20 shares selling for $5 and pay $22.
- If I convert at $10 only 10% is converted, at $5 20% is converted.

If my goal is to convert about half of the TIRA to Roth I get more percentage moved if I increase conversion amount in a down market. I know market timing and all would suggest this is not smart.
I converted an additional $100K in 2020 and thinking of doing it again this year with 2 times IRMAA costs. I can add another $100K if I move from MAGI of $182k to $284k and it would cost about $4,500 or 4.5% for Medicare (both of us now) and an additional $2K in taxes being in 24% vs 22% bracket.

 

[Smilinggirl]

Umm, wow, do you guys have any idea how smart you sound to just an average person trying to be smart with her money? It's like I'm reading a different language and trying to make sense of it.

So my question is about a plan I've slowly been forming for my modest ER. If I cut back to very part time, say maybe 6k a year, while I'll be receiving well earned alimony that is not taxable, I was thinking of converting a little over 12k per year of tIRA to Roth in order to put me above the MD income to qualify for ACA benefits rather than state Medicaid. Lately I've been wondering if I should go ahead and convert more each year. I clearly must have read something about this at some point because I have the IRS calculator bookmarked on my laptop, but what I thought might be relatively easy to figure out just got potentially more complicated based on this thread. Am I thinking correctly about converting in my situation?

Thank you for any help you can offer. The funny thing is that in my family, everyone thinks I'm the one who is "smart about money". They obviously haven't read this forum...

 

[pb4uski]

The first step is to estimate the tax bracket that you will be in once you retire start any SS and pensions and are subject to RMDs. That's a bit of an art, but I take SS when I plan to take it, my pension and 4% of my tax deferred balances since I don't expect to use tax deferred money for spending between now and RMD time. In my case, RMDs will likely vault us from near the top of the 12% tax bracket without RMDs into the 22% tax bracket and I estimate the effective tax rate on my RMDs to be 19.0%.

If I can do Roth conversions at less than 19.0% and less than a 22% marginal rate then I will save some in taxes.

So I convert to the top of the 12% tax bracket and have for a number of years now. For 2022, I plan to convert about $83k and expect to pay $9,600 in tax on that conversion... 11.5%... so I project that I'm saving around $6k by paying 11.5% now vs paying 19% later.

In your situation with ACA for any conversions above what you need to do for ACA you need to consider lost ACA subsidies in addition to the increase in tax. Others who do Roth conversions and are under ACA can weigh in but I suspect that using tax software like Turbo Tax's What-If Worksheet might be useful in assessing the ACA impact in addition to the tax.

It is very situational and YMMV.

 

[almost there]

Umm, wow, do you guys have any idea how smart you sound to just an average person trying to be smart with her money? It's like I'm reading a different language and trying to make sense of it.

So my question is about a plan I've slowly been forming for my modest ER. If I cut back to very part time, say maybe 6k a year, while I'll be receiving well earned alimony that is not taxable, I was thinking of converting a little over 12k per year of tIRA to Roth in order to put me above the MD income to qualify for ACA benefits rather than state Medicaid. Lately I've been wondering if I should go ahead and convert more each year. I clearly must have read something about this at some point because I have the IRS calculator bookmarked on my laptop, but what I thought might be relatively easy to figure out just got potentially more complicated based on this thread. Am I thinking correctly about converting in my situation?


Thank you for any help you can offer. The funny thing is that in my family, everyone thinks I'm the one who is "smart about money". They obviously haven't read this forum...

While not an expert here: I would say yes. Convert as much as you can at a low tax rate prior to SS and any large IRA distributions.

A lot of the abbreviations get me here as well. But I just google 'em.
And all of a sudden its simple. It just makes simple things look more complex. LOL LOL

As already mentioned, try to determine the tax bracket you will be in. Or want to be in when retired. (Many seem to skip this step) If you have time, you can manipulate things in advance to your advantage. Unless you have a large pension or similar. Then there really isn't much you can do about it. I have several acquaintances that have 6 figure city or state pensions. Plus SS, and tIRA's. So, it's almost impossible for them to MacGyver their income down to even the 22% bracket.

What I did was to take Roth conversions over the years. My only regret was not doing more. My plan is to take small tIRA distributions over a 20-25 yr span. Allowing me to control my annual income. And stay a the top of the 12% bracket. Single would be a bit more difficult. As its not easy to make $40,525 or less with SS and any real distributions or other types of income. So, with Roth conversions you are on the right track. In my opinion anyway. .

Conventional wisdom used to be, to save the Roth's till the end. The absolute last thing in retirement to be used.
I have read here thats no longer the case with many. And some use IRA and Roth $$ to take SS to 70.
But its still my plan for the Roth $$ to be the last $$ spent, as it grows tax free. And can be passed on.

One more thing. Fed tax rates may be going back up for 2026. So now is the time... If you can swing it.

 

[RetireBy90]

I agree with almost there, but would add consider including investments in taxable accounts, that is not IRA or 401K. A taxable account will generate capital gains and dividends that are taxable but you can also take funds while only being taxed on the gains. I have several CDs that throw off interest but I can take the principal tomorrow if I need or want the funds without having to worry about the tax implications or IRMAA or ACA cliffs.

Time to do the conversions is your best friend. If you have say $10,000 and 10 years you can do $1,000 each year and not materially impact your tax situation. If you only have 2 years then there will likely be more of an impact on taxes. Of course the $10K is only a number to illustrate.

I got a look over of my plans several years ago from a Fidelity advisor at no cost as my employer had 401K with them. If your situation is complex, I would find an advisor to look at my plan before I got too far into it. Many will do a quick review of your plan for free or you can find one that works on an hourly basis.



Best for your retirement !!

 

[Cobra9777]

...The only exception to this rule is if there is a situation where there is what I call a tax hump (and others have recently called a tax torpedo) - if the marginal rate is high for a bit but then falls again at a higher income level. Examples of this would be the transient 27% bracket for people with ordinary income and capital gains, or SS taxability.

In this scenario, I think it depends on how high and how wide the tax hump is, and how low and how broad the subsequent valley is at the higher income level. If I could find a point at a higher income level where the average tax rate on the intervening dollars was low enough *and* I felt a sense of urgency or necessity of doing a lot of Roth conversions (i.e., I was running out of years to do them, or had a large traditional IRA balance), then I'd consider doing a Roth conversion of all those intervening dollars...

Agreed.

We convert to the top of the 22% bracket. It's actually 22.6% for us since QDs and LTCGs fall into the dreaded 27% hump. I consider that the "entrance fee" we have to pay to gain access to the rest of the 22% bracket. That rate is extremely attractive by historical standards, but *temporary* per current law. So I want to maximize it while available.

So I consider 22.6% to be the relevant "marginal" rate for purposes of deciding whether to convert beyond 12%. If we do no further conversions beyond 12%, our RMDs would be taxed at a mix of 25% and 28%. Obviously, it makes no sense to stop at 12% just because of the small 27% hump.

OTOH, if the TCJA rates are extended or made permanent, and we made no further conversions beyond 12%, RMDs would be taxed at a mix of 22% and 24%. This is a much less compelling case for converting at 22.6%.

Either way, I will continue to convert at 22.6% until 24%/28% is off the table. After that, we'll have to see what the geniuses in DC decide to do in 2026.

 

[Out of Steam]

This thread reminds me that I need to increase withholding on my monthly Roth conversion. My wife keeps working more hours than she expected, which will put more of the conversion into the 22% bracket. Since I'd like to have more money in an after-tax account anyway, I will not stop the conversion.

 

[OldShooter]

... I know market timing and all would suggest this is not smart. ...

Well, if you think about it, almost every trade involves some kind of market timing decision. Sell today or tomorrow? Buy next week or wait? It's unavoidable.

The bad karma associated with "Market Timing (caps)," is really about trying to call tops and bottoms profitably, which the data says is impossible on a regular basis.

To recognize that it's advantageous to do conversions when the market is down is hardly Market Timing IMO. In fact the gummint's allowing recharacterization (again IMO) practically encourages timing.