Roth Conversion Guide

[FlaGator]

Quote:

Originally Posted by schellem 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?

Just stepped through that scenario.

I used subsidy limits as the upper bound for income (ignoring tax rates). Then estimated ACA MAGI and deducted that from my chosen subsidy limit. The remainder is my conversion amount. Expect taxes on that to be minimal

[SevenUp]

Quote:

Originally Posted by sengsational This is a bogleheads thread.

Is that a bad thing?

[simple girl]

Quote:

Originally Posted by FlaGator Just stepped through that scenario. I used subsidy limits as the upper bound for income (ignoring tax rates). Then estimated ACA MAGI and deducted that from my chosen subsidy limit. The remainder is my conversion amount. Expect taxes on that to be minimal

That's exactly what I am doing, too.

[pb4uski]

Quote:

Originally Posted by Time2 I'm having a tough time extending this x/(1-t). My 1 is made of LTCGs, only 56% are taxable. My long way into this is Percentage taxable = Gross - (Gross- LTCG percentage) OR 1-(1-.56) =1-(.44) = .56 t = .56 * tax rate, then t = .56 * .12, so, t=0.0672 now if I plug t into x/(1-t) x/(1-0.0672) = x/.9328. So if I want $40,000, I divide by .9328 and get $42,881. Can anyone simplify that?

If 56% of your gains are taxable a LTCG at 15%, then isn't your effective tax rate on those sales 15%*56% or 8.4%?

So t would be 8.4% and the gross would be $43,668 and result in $24,454 of LTCG (56% of $43,668) and $3,668 of tax at 15%... for a net after-tax proceeds of $40,000.

[Time2]

Quote:

Originally Posted by pb4uski If 56% of your gains are taxable a LTCG at 15%, then isn't your effective tax rate on those sales 15%*56% or 8.4%? So t would be 8.4% and the gross would be $43,668 and result in $24,454 of LTCG (56% of $43,668) and $3,668 of tax at 15%... for a net after-tax proceeds of $40,000.

I think my LTCGs are Taxed at 0%.
I have 6 entries in Dinkytown.
MFJ
$9500 Div And Interest (I put $9500 in Both lines Ordinary and Qualified)
$42,265 LTCGs
$62,680 IRA Distribution
$8100 HSA Contribution
I checked the 'You are 65 box' (makes Standard Deduction $26,100)
Here's a picture of the report.

[pb4uski]

1/(1-t) only works well within a single tax bracket or for broad-based planning.

In your case, you actually have 3 tax brackets coming into play. Your ordinary income is $28,480 [$80,245 of taxable income less $51,765 of preferenced income (LTCG and dividends)]. The first $19,750 of ordinary income is in the 10% tax bracket and results in $1,975 in tax. The remaining $8,730 is in the 12% tax bracket and results in $1,048 in tax.... resulting in $3,023 in ordinary tax. Since your taxable income is over $80,000, the Roth conversion results in $245 of preferenced income being pushed into the 15% tax bracket and $37 of tax. So your total tax is $3,060.

So the first $62,435 of the Roth conversion results in $2,994 of tax (4.8%... a combination of $34,100 @ 0%, $19,750 @ 10% and $8,730 @ 12%) and the last $245 results in $66 of tax (27%).

If it were me, I would reduce the Roth conversion from $62,680 to $62,435 to avoid the 27% marginal tax rate on that last $245.

[Time2]

Quote:

Originally Posted by pb4uski 1/(1-t) only works well within a single tax bracket or for broad-based planning. In your case, you actually have 3 tax brackets coming into play. Your ordinary income is $28,480 [$80,245 of taxable income less $51,765 of preferenced income (LTCG and dividends)]. The first $19,750 of ordinary income is in the 10% tax bracket and results in $1,975 in tax. The remaining $8,730 is in the 12% tax bracket and results in $1,048 in tax.... resulting in $3,023 in ordinary tax. Since your taxable income is over $80,000, the Roth conversion results in $245 of preferenced income being pushed into the 15% tax bracket and $37 of tax. So your total tax is $3,060. So the first $62,435 of the Roth conversion results in $2,994 of tax (4.8%... a combination of $34,100 @ 0%, $19,750 @ 10% and $8,730 @ 12%) and the last $245 results in $66 of tax (27%). If it were me, I would reduce the Roth conversion from $62,680 to $62,435 to avoid the 27% marginal tax rate on that last $245.

Thanks pb, I thought the program was watching the last dollar tax rate, I see it's not, (seems it should). Now, I'll check by adding or subtracting $100, and check how the tax owed changes.

[SevenUp]

Quote:

Originally Posted by Time2 Thanks pb, I thought the program was watching the last dollar tax rate, I see it's not, (seems it should). Now, I'll check by adding or subtracting $100, and check how the tax owed changes.

A tax rate on $1 isn't of much use, unless it's only $1 in question. Usually much better to use a larger denominator when determining marginal tax rate.

[Time2]

Quote:

Originally Posted by SevenUp A tax rate on $1 isn't of much use, unless it's only $1 in question. Usually much better to use a larger denominator when determining marginal tax rate.

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?

[pb4uski]

You aren't... that's a sensible approach... you just need to keep in mind that type of income that you are adding... if you add $100 of ordinary income vs adding $100 of preferenced income then you'll get different marginal tax rates because there are two separate tax schemes that then get combined.

[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]

Quote:

Originally Posted by 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.

Agreed. That's an excellent approach.

[sengsational]

Quote:

Originally Posted by SevenUp 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]

Quote:

Originally Posted by Time2 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]

Quote:

Originally Posted by AtlasShrugged 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]

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]

Quote:

Originally Posted by sengsational 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!