Roth Conversion Guide

[AtlasShrugged]

I suppose there are multiple ways to skin the marginal tax rate cat. I submit the best way is to do before and after calculations as described in my paper. I have reproduced that discussion from the top of page 6

Conceptual Background Information
Some people make the mistake of estimating the cost of a Roth conversion by multiplying
conversion income by the tax bracket rate they think will apply. The problem with this simple
method is that it understates your total costs. It fails to account for the wide-ranging effects that
Roth conversions (and tIRA RMDs) have on income taxes and government benefit costs. Those
effects include:

1) Ordinary income taxes – Roth conversions and tIRA RMDs increase ordinary income and are
likely to bump your taxable income into higher tax brackets. These items may also push income
over certain thresholds causing: i) Social Security to be taxed; ii) deduction phase outs (e.g.,
medical expenses or rental property losses); or iii) credit phased outs (e.g. child care credit).

2) Qualified dividends and LT capital gains taxes – The preferential tax rate on qualified dividends
and capital gains is based on total taxable income. Conversion income or RMDs may increase
total income such that the preferential rate goes from 0% to 15% or from 15% to 20%. If so,
your qualified dividend and capital gains income will be taxed at a higher rate.

3) Net Investment Income Tax (NIIT) – Conversions or RMDs may push adjusted gross income over
the NIIT thresholds of $200,000 for a single person or $250,000 for a married couple.
Conversions and RMDs may trigger an additional 3.8% tax on all of your investment income
(e.g., interest, ordinary dividends, qualified dividends and capital gains).

4) Medicare Part B and D premiums – Medicare premiums are based on a recipient’s modified
adjusted gross income (MAGI). Conversion income or RMDs may push MAGI over various
Medicare thresholds thereby triggering additional Medicare premiums. These premiums are
known as Income Related Monthly Adjustment Amounts or “IRMAA.”

5) Affordable Care Act (ACA) subsidies. Lower/middle-income people who purchase ACA health
insurance may receive significant subsidies that lower their premiums. Roth conversions may
push their taxable income over ACA subsidy thresholds. The financial impact of lost subsidies
can be quite severe for these people.

The more accurate way to estimate the tax cost of Roth conversions (and tIRA RMDs) is to perform
a marginal tax analysis that accounts for the above effects. This analysis tells you how much your
income taxes and government benefit costs will increase as a result of including income from Roth
conversions or tIRA RMDs in your income tax returns.

A marginal tax rate analysis requires two sets of before and after-tax calculations. The first set is
to estimate the marginal tax rate on a current year Roth conversion. The second set is to estimate
the marginal tax rate on future tIRA RMDs. Here’s how it works:

Set #1: For current year Roth conversions:
1) Calculate income taxes and government benefit costs before income from Roth conversions.
2) Calculate income taxes and government benefit costs after income from Roth conversions.

Set #2: For future tIRA RMDs:
1) Calculate income taxes and government benefit costs before income from future tIRA RMDs.
2) Calculate income taxes and government benefit costs after income from future tIRA RMDs.

Note: The income tax component of these calculations may be determined using: i) a tax software package; ii) an
online tax calculator; or iii) your own tax model. Unfortunately, government benefit costs for Medicare and ACA must
be calculated manually using government schedules for these items.

The difference between the before and after calculations is marginal tax costs stated in dollars.
Dollars are not a good way to compare the cost of conversions and RMDs. We must use marginal
tax rates to make them comparable. Marginal tax rates are easily derived by dividing marginal tax
costs by the taxable income that produced those costs. Let’s use two examples to illustrate:

- Conversion example - if you made a $100,000 Roth conversion and its marginal tax cost was
$25,000, your marginal tax rate would be 25% (25,000/100,000).

- tIRA RMD example - if you had to take a $50,000 RMD and its marginal tax cost was $15,000,
your marginal tax rate would be 30% (15,000/50,000).

Once you calculate your estimated marginal tax rates for conversions and RMDs, you can assess
the attractiveness of a current year conversion. Using the examples above, we can see that a
conversion may be attractive because its marginal tax rate is 25% versus 30% when you take RMDs.

 

[pb4uski]

^^^^ and it looks to me that the TurboTax What-If worksheet does a good job of covering off all of the above except for IRMAA... so unless your income is in IRMAA territory you can use just the What-If worksheet of before and after Roth conversion to see the federal impact... then add in state and IRMAA if applicable.

 

[AtlasShrugged]

^^^^ and it looks to me that the TurboTax What-If worksheet does a good job of covering off all of the above except for IRMAA... so unless your income is in IRMAA territory you can use just the What-If worksheet of before and after Roth conversion to see the federal impact... then add in state and IRMAA if applicable.

Agreed. That's an excellent approach.

 

[sengsational]

Is that a bad thing?

Thanks for asking. No, it's not a bad thing. Bogleheads threads are referenced here often. The best posts that mention a link also have a bit of background, which I attempted to add.

 

[SnowballCamper]

I found https://www.i-orp.com/GlidPath/index.html to be especially useful for my own decision. It's a bit different than other calculators, but does multiple years all at once.

EDIT: just looked at it and 2018 was the last update... might not be updated anymore

 

[SevenUp]

I used $100, but, I don't understand where the problem lies. If In add $100 to my income and the the tax increases $12,
I think I'm still in the 12% tax bracket. If I add $100 and The tax increases $22, then I'm in the 22% tax bracket. I do this to optimize the numbers, when I add that last $100 and I jump from 12% bracket to 22% bracket, I have $100 too much income.
Where am I wrong?

Nothing wrong about that.

People sometimes get hung up on using the "last dollar" or the "next dollar". That's fine when things are simple, but when evaluating things such as Worth pushing through the Social Security hump and/or IRMAA cliffs?, one should look at much larger changes. The $100 you used is often sufficient but sometimes (e.g., see the chart in the linked wiki section) an even larger denominator is useful.

 

[SevenUp]

Note: The income tax component of these calculations may be determined using: i) a tax software package; ii) an
online tax calculator; or iii) your own tax model. Unfortunately, government benefit costs for Medicare and ACA must
be calculated manually using government schedules for these items.

Nice write-up!

Regarding the quoted section, there is at least one available tax estimation spreadsheet that will handle IRMAA tiers, ACA premium tax credits (e.g., see Tax Calculator With ACA Health Insurance Subsidy), along with many other federal and some state tax items. See Case Study Spreadsheet updates if interested.

 

[cat4ever]

Roth 401K and rule of 55

How does the rule of 55 affect access to a roth account in a 401K. Is it simply all the same rules as if you were 59 1/2 and outside of your 401K? e.g. If I did a conversion into my 401K roth from my 401K non-Roth account this year, would I have non-penalty, tax-free access to the converted amount immediately upon retirement (I'm 56 and retiring 1/6/2021), or would I have to wait 5 years? Or until I'm 59 1/2? I've read a lot of articles but they never seem to cover rule of 55 rules specifically.

 

[sengsational]

cat, The easiest way to answer the question "for sure" is call your plan administrator. But if you're still working, I understand that might be tipping your hand. I called-up my plan administrator and asked 20 questions, most of them, I knew the answer but it served two purposes. First, it let me know if I should call back to get someone smarter about the plan, and second, provided "cover" for questions that involved access after I left employment.

After I left the company, I called my plan administrator and was told that any withdrawal from Roth 401k would be a taxable event because it hadn't been opened more than 5 years. I didn't argue or pursue the question further (i.e. investigate if the deposited funds were available and only the gains would cause the taxable event) because I was only a few months from having the Roth getting to 5 years old. I was between 55 and 59 1/2 at the time. Once the 5 year mark came, I pulled everything except the traditional 401k monies.

 

[Out-to-Lunch]

I called-up my plan administrator and asked 20 questions, most of them, I knew the answer but it served two purposes. First, it let me know if I should call back to get someone smarter about the plan, and second, provided "cover" for questions that involved access after I left employment.

Very clever!

 

[cat4ever]

cat, The easiest way to answer the question "for sure" is call your plan administrator.

After I left the company, I called my plan administrator and was told that any withdrawal from Roth 401k would be a taxable event because it hadn't been opened more than 5 years.

Hmm, "taxable" doesn't seem right, and I don't think plan administrators are usually trained to give such advice. Mine told me yes, I can withdraw, but the rest is between me and the IRS. That being said, I think the 5 year rule is for triggering a penalty, not taxes. You pay the taxes when you do the conversion, I don't see them taxing it again because of the 5 year rule.

In the end, I'd like to know if when you are using the rule of 55, can you replace 59 1/2 in the below paragraph from the OP's guide, with 55, as I've done in the red text? In that case it would seem all distributions would be immediately penalty and tax free from the converted Roth...

Converted amounts are deemed to be distributed next. Again, there are no income taxes on
distributions of converted amounts because you’ve already paid taxes on these dollars.
Conversions may be withdrawn at any time by anyone with no income tax cost, including
people under 59½. A 10% early withdrawal penalty, however, may apply if you’re under 59½ (or under 55 if using rule of 55)
The purpose of the penalty is to prevent people who are under 59½ (or under 55 if using rule of 55) from circumventing the
10% early withdrawal penalty that applies to tIRAs. In other words, you can’t use Roth
conversions to do an end around the tIRA early withdrawal rules. That said, even if you are
under 59½ (or under 55 if using rule of 55), there are three ways to avoid the penalty.
First, hold converted amounts in your Roth for at least five years. Second, use the distribution
for what the IRS calls a “qualified purpose,” including: a qualified first-time home purchase,
qualified medical expenses, health insurance premiums while unemployed, or qualified higher
educational expenses. Third, die or become disabled.

 

[pb4uski]

How does the rule of 55 affect access to a roth account in a 401K. Is it simply all the same rules as if you were 59 1/2 and outside of your 401K? e.g. If I did a conversion into my 401K roth from my 401K non-Roth account this year, would I have non-penalty, tax-free access to the converted amount immediately upon retirement (I'm 56 and retiring 1/6/2021), or would I have to wait 5 years? Or until I'm 59 1/2? I've read a lot of articles but they never seem to cover rule of 55 rules specifically.

No, I wouldn't think so... not to the amount converted... but you would have penalty free access to previous contributions assuming that you qualify for the rule of 55.

But if you qualify for the rule of 55 and just withdraw from the traditional 401k rather than convert, then you you would have penalty-free access but you would have to pay the tax just like you would on the conversion.

IOW, as I understand it the rules work the same as a tIRA and Roth IRA except for the penalty which is based on rule of 55 rather than ataining 59 1/2.

https://fitaxguy.com/roth-401k-withdrawals/

 

[DrBrisket]

I'm in the conversion calculation dilemma, I just retired in June at 58, DW will follow in a year or so. We will have a lot of time to do conversions with little income. I've started on spreadsheet but just keeps getting more and more complex.

The latest issue to add to the spreadsheet is to figuring out the road between shooting for low nearly tax free income and getting ACA subsidies versus trying to take advantage of the 24% bracket while we have it. I think we can get subsidies of around 8-10K.

Anyone have any tips in relation to considering ACA subsidies?

I realize its too late for much adjustment for 2020 taxes, but I am in the process of revisiting my tax estimations for 2020 to finalize the last tweak available for me (IRA contributions since I had a bit of 1099 income in 2020). Our taxes are fairly complex due to royalty and rental income, W2 income from a non-qualified plan, 529 distributions, ACA subsidies, AOTC, child tax credits, and a long litany of other small complications. In short, serious levels of "first world problems"! LOL

Long story short, I did a "trial run" through TurboTax to get a better idea of the marginal tax increase of Roth conversions. Without getting into the minutiae, tIRA to Roth conversions are showing a ~40% marginal tax rate even though we are in the lower half of the MFJ 12% bracket wrt taxable income.

In our case, ACA subsidies are substantial (family of 6, with 5 on ACA plans in 2020), but I haven't taken the time to chase through all the turbotax calculations to understand where all causes of the insane tax cost of Roth conversions.

 

[RunningBum]

Maybe your bracket + subsidy loss + more capital gains being taxed? If you're collecting SS you could be pushing more SS into being taxed.

 

[pb4uski]

Interesting. If you're in the lower half of the 12% tax bracket, I would think that any Roth conversions would be 12% up to your ACA MAGI limit (400% FPL), then jump to 12% plus lost ACA subsidies... given the cliff aspect of ACA credits I guess I can see 40%.

If your income before Roth conversions is less than the ACA cliff, what is your marginal tax rate on Roth conversions to just under the cliff? And then the marginal rate from just under the cliff to the top of the 12% tax bracket? For the second one you should be able to see the impact of the increase in taxes and the lost ACA subsidy.

The TT What-If worksheet is handy for doing these calculations and comparisons.

 

[DrBrisket]

It is interesting, in the most pejorative sense of the word.

I am using TT Premier for the estimation and changing the amount of Roth conversion. Instead of trusting the number written down on a piece of paper from my efforts in December, this morning I reran the numbers. TT did an update, so not surprised to see differences today. It is better, but 33% marginal tax rate on conversions is still painful.

MFJ + 4 dependents, so we are nowhere near the ACA cliff (~$140k). No SS income. Income sources: rentals, royalties, 1099-NEC, non-qualified pension plan, 1099-INT, short-term cap gains. Tax credits/reductions: child tax credit, AOTC, LLC, QBI, PTC. Standard deduction. Also have 1099-Q distributions, but all gains are non-taxable as they are offset by qualified expenses.

Here's what TT is showing by simply changing the amount of Roth conversion on a 1099R:

Roth Conversion |Marg. Tax increase from previous row| Overall Decrease of PTC
$100 | ~0 | ~0
$5000 | ~0 | ~0
$10,000 | 540 | 536
$15,000 | 1,660 | 1,780
$20,000 | 1,660 | 2,750

 

[pb4uski]

Your table is a bit confusing. If I understand it correctly, if you add a $20k Roth conversion then your tax increases by $3,860 (19.3%). Is that just federal tax? I assume so. The 19.3% infers that before any Roth conversions that your taxable income was deep into the 12% tax bracket... so some of the Roth conversion is at 12% and the remainder at 22%.

And it appears that the PTC reduction also has a significant bite... and if you do a $20k Roth conversion that your overall economic cost is $6,610... and 33% of the Roth conversion. If it were me, I would hold off on Roth conversions until ACA credits were no longer in play.

The way you are fretting about it it seems that you think that Roth conversions should be free.

 

[DrBrisket]

Sorry about the confusion of the table. Your interpretation is correct and I have no state income tax. I have another related tax issue/opportunity that I was trying to understand and so I tried to pull out/summarize the relevant info in the table above.

I did hold off on conversions for now for exactly the rationale you stated.

I was not expecting the conversions to be free--in fact, I have been doing Roth conversions when it was at an advantageous marginal tax rate over the past 20+ years. Rather, I was surprised to find a marginal tax rate of 30%+ for the conversion even with a relatively low marginal tax rate.

 

[SevenUp]

Our taxes are fairly complex due to royalty and rental income, W2 income from a non-qualified plan, 529 distributions, ACA subsidies, AOTC, child tax credits, and a long litany of other small complications.

Don't know if it will handle all of those, but at a quick glance it seems the case study spreadsheet could do so, and automatically give you a marginal rate chart for whatever range of Roth conversions you wish.

 

[DrBrisket]

Don't know if it will handle all of those, but at a quick glance it seems the case study spreadsheet could do so, and automatically give you a marginal rate chart for whatever range of Roth conversions you wish.

Thanks for the link! Haven't had time to do much yet, but as you point out, it is quite comprehensive and will save a lot of hassle for 2021 estimates.

Since my last post, I did find a helpful thread on another forum that shows the unusual marginal tax rate implications of Roth Conversions with the ACA for a simpler tax situation than mine. It is important to note that the IRS updates the values for calculating the ACA subsidies each year and a quick scan of prior years shows the marginal tax rate for incremental taxable income is slowly increasing.

Since it's water under the bridge for 2020 taxes, I have been spending time modeling the balance between the long-term implications of Roth Conversions versus the short-term higher taxes for our particular situation. Prior to this year, I had been converting when my tax rate was low and skipping conversions when our income had a significant bump. It is now clear that I need to have a "Micro-" and "Macro-" view of Roth conversions where Macro-planning is looking more carefully at the long-term (30+ years/legacy planning) along with Micro-planning on a yearly basis looking at the Roth conversion and Capital Gains Harvesting opportunities that arise from FAFSA planning, dependents becoming independent, known changes in income, etc. Still have more details to model better, but it looks like a strategically maximizing subsidies in some years and going over the fiscal cliff in other years is the best. All in all, what started as a seemingly "simple" tax estimation exercise is proving to be very rewarding-both monetarily and psychologically.

 

[ArmchairMillionaire23]

i hope you find it useful.

Here's the link to it.

https://www.dropbox.com/s/istw0kr1tsckzw8/roth conversion guide.pdf?dl=0

Link not working anymore...

 

[qwerty3656]

View attachment 38700

Link not working anymore...

+1 link not working

 

[braumeister]

The author sometimes takes his essays down for revision, but hasn't posted here in a couple of months. He may have lost interest.

 

[Bruno]

AtlasShrugged I just wanted to say "Thank You " for the papers you wrote. I hope you are doing OK.

Bruno

 

[frayne]

AtlasShrugged I just wanted to say "Thank You " for the papers you wrote. I hope you are doing OK.

Bruno

+1 interesting and timely post.