ROTH conversion - asset growth question

[joesxm3]

My state recently passed a phase out of the 5% income tax on IRA distributions. It will start in 2023 and be 100% in 2026.

So, in 2022 if I convert up to the 12% limit, I am effectively paying 17%. If I convert at the 22% rate, it would be 27% and I doubt that I would be much in the 24% bracket later on. So it would not seem to make sense.

I already converted this year, so I am stuck. But I am considering limiting my conversions for the next two or three years.

That seems to be straight forward math.

What I am wondering about is if any of you have ever thought of considering the capital appreciation of the money left behind by a limited conversion strategy.

It would seem that there would be a difference between it growing tax free in the ROTH and at the, say, 22% rate if left behind in the TIRA.

I imagine that there are too many variables, such as rate of return, future tax rates etc. to make it worth worrying about. But I figured to throw it out to see what might be said on the subject.

I suppose I should just count myself lucky that if the state actually does the phase out and does not retract it later on, since all of the withdrawals post-2025 will avoid state tax.

[edit]

Well I did some simple math and it seems that if I took $100 and paid 27% tax on it now it would be $27.

If I let it grow for four years and then took it out paying 22% tax it would be $27.77.

So, depending on my expected return, it would seem to have a 1% or 2% difference.

Probably not worth losing sleep over.

 

[SevenUp]

Well I did some simple math and it seems that if I took $100 and paid 27% tax on it now it would be $27.

If I let it grow for four years and then took it out paying 22% tax it would be $27.77.

So, depending on my expected return, it would seem to have a 1% or 2% difference.

Probably not worth losing sleep over.

You're assuming 6%/yr growth - as good an assumption as any other. But it's not the tax paid that matters, it's the amount left after paying the tax.

1) Convert $100 now, paying 27% tax from the converted amount, then grow at 6%/yr for 4 years: ($100 - $27) * 1.06^4 = $92.16

2) Grow at 6%/yr for 4 years, then convert while paying 22% from the converted amount: $100 * 1.06^4 * (1 -22%) = $98.47

A sharper pencil could consider paying the original 27% tax from taxable funds, but the effect would likely be small and could go either way.

Up to you how much to care about a 6%-7% difference - but at least you have the choice.

 

[Sunset]

OP - if you are not going to roth convert for a couple of years, you might want to LTCG harvest at 0% tax rate if it fits in your income picture.

 

[PageTwo]

But it's not the tax paid that matters, it's the amount left after paying the tax.

1) Convert $100 now, paying 27% tax from the converted amount, then grow at 6%/yr for 4 years: ($100 - $27) * 1.06^4 = $92.16

2) Grow at 6%/yr for 4 years, then convert while paying 22% from the converted amount: $100 * 1.06^4 * (1 -22%) = $98.47

This is brilliant. Thank you for laying it out so clearly.

 

[joesxm3]

SevenUp,

Thanks for the nice equation. It makes sense and I learned about the "^" symbol in Excel.

At first I thought this would invalidate the entire concept of ROTH conversion, but I made the equations and put in the 17% tax rate and saw that converting at the 17% or 12% tax rate came out ahead. So I guess it depends on how much of a hit you take paying for the conversion.

I suppose I could try to model paying from the taxable account and then figuring the loss of gain in the taxable account paid at 15% LTCG rate, but I bet my head would start to smoke if I tried that.

Thanks again.

 

[joesxm3]

Sunset,

I did that last couple of years. Wish I did it this year. If I have any gains left after this blood bath, I probably will do that next year.

Thanks.

 

[Gumby]

My state recently passed a phase out of the 5% income tax on IRA distributions. It will start in 2023 and be 100% in 2026.

So, in 2022 if I convert up to the 12% limit, I am effectively paying 17%. If I convert at the 22% rate, it would be 27% and I doubt that I would be much in the 24% bracket later on. So it would not seem to make sense.

I already converted this year, so I am stuck. But I am considering limiting my conversions for the next two or three years.

That seems to be straight forward math.

What I am wondering about is if any of you have ever thought of considering the capital appreciation of the money left behind by a limited conversion strategy.

It would seem that there would be a difference between it growing tax free in the ROTH and at the, say, 22% rate if left behind in the TIRA.

I imagine that there are too many variables, such as rate of return, future tax rates etc. to make it worth worrying about. But I figured to throw it out to see what might be said on the subject.

I suppose I should just count myself lucky that if the state actually does the phase out and does not retract it later on, since all of the withdrawals post-2025 will avoid state tax.

[edit]

Well I did some simple math and it seems that if I took $100 and paid 27% tax on it now it would be $27.

If I let it grow for four years and then took it out paying 22% tax it would be $27.77.

So, depending on my expected return, it would seem to have a 1% or 2% difference.

Probably not worth losing sleep over.

As a fellow resident of Connecticut, I feel duty-bound to remind you that there is a hard cap on that exemption. Above $100k in federal AGI (married filing jointly), you lose it entirely. If you are in the 22% marginal federal bracket with a standard deduction, you are already over $100k AGI. ($83,550 + $25,900 = $109,450 AGI). In fact, as you can see, you can't even top out the federal 12% bracket before you lose the state exemption.

 

[joesxm3]

Gumby,

Well that certainly sucks.

Last week I discovered that deductions come after the AGI calculation that the state bases income tax on. I had moved a decent chunk to my charitable gift fund and figured it would cancel off the ROTH conversions. It does at the Federal level, but my wonderful state still has their hand in my pocket. I suppose the same will apply to this ephemeral break on the IRA tax.

I am a single filer, so the numbers are not as bad as you make them to be, but still . . .

If I am following your logic. I can have AGI of $53,675, which is max of the 12% bracket plus $12,900 standard deduction and stay in the 12% bracket.

If I have the AGI max limit for single of $75,000, I would have a taxable income of $62,100, some in the 22% rate.

I might be able to stay under those numbers before I turn 70, but once social security starts and at 72 RMD comes I doubt that I will be getting the IRA tax break.

I guess this is a first world problem, but still a sad state of affairs.

Thanks for the heads up before I did too much planning based on the incorrect assumptions.

 

[target2019]

As a fellow resident of Connecticut, I feel duty-bound to remind you that there is a hard cap on that exemption. Above $100k in federal AGI (married filing jointly), you lose it entirely. If you are in the 22% marginal federal bracket with a standard deduction, you are already over $100k AGI. ($83,550 + $25,900 = $109,450 AGI). In fact, as you can see, you can't even top out the federal 12% bracket before you lose the state exemption.

It works this way in the Garden State, New Jersey.
Tricky b@st@rds!

 

[Gumby]

Gumby,

Well that certainly sucks.

Last week I discovered that deductions come after the AGI calculation that the state bases income tax on. I had moved a decent chunk to my charitable gift fund and figured it would cancel off the ROTH conversions. It does at the Federal level, but my wonderful state still has their hand in my pocket. I suppose the same will apply to this ephemeral break on the IRA tax.

I am a single filer, so the numbers are not as bad as you make them to be, but still . . .

If I am following your logic. I can have AGI of $53,675, which is max of the 12% bracket plus $12,900 standard deduction and stay in the 12% bracket.

If I have the AGI max limit for single of $75,000, I would have a taxable income of $62,100, some in the 22% rate.

I might be able to stay under those numbers before I turn 70, but once social security starts and at 72 RMD comes I doubt that I will be getting the IRA tax break.

I guess this is a first world problem, but still a sad state of affairs.

Thanks for the heads up before I did too much planning based on the incorrect assumptions.

Something else to keep in mind is that the tax brackets move up every year roughly equal to inflation, but the federal AGI cutoff for the Connecticut IRA withdrawal exemption is not indexed to inflation and therefore will remain $100k (MFJ) and $75k (Single) unless and until the General Assembly changes it.

 

[SevenUp]

SevenUp,

Thanks for the nice equation. It makes sense and I learned about the "^" symbol in Excel.

You're welcome. See the Calculations section in the traditional vs. Roth wiki at Bogleheads for more.

I suppose I could try to model paying from the taxable account and then figuring the loss of gain in the taxable account paid at 15% LTCG rate, but I bet my head would start to smoke if I tried that.

Fortunately a couple of people have already done that and made tools available online. See the first bullet under More complicated situations in that same wiki article.