Roth Conversion or not (on ACA)

[RetireRay]

Hoping to get some feedback regarding our unique situation. We're fortunate enough to have substantial savings in non-retirement accounts, as well as retirement accounts. I'm not sure I see the benefits of doing Roth conversions.

Situation:
Husband: 57 (retired early)
Wife: 59 (sole proprietor, doing consulting work to keep busy)
Married, Filing Jointly
Located in California.
Own our home, valued at $2.2M (still owe $280,000).
No Children.

Assets upon our deaths will go to charity, and some (minor amount) to nephews.

Brokerage Account: $2.6M
Traditional IRA/401k's: $2.8M
Roth 401K: $200,000

Health Insurance: On Covered California (ACA) and receive about $800-$1,000/month subsidy (based on approx $100K/year MAGI).

Taxable income (after business deductions, SEP-IRA contribution, deduction of Healthcare Ins Premiums): ~$23,000

Qualified Dividends: ~$17,000

Capital Gains....Due to our low Federal Tax bracket, we are able to take advantage of the 0% Capital Gains rate up to $83,000 (so..$43K in non-taxable Capital Gains). However, if we don't take advantage of this, we could instead convert $40-100K of IRA money into a ROTH-IRA. By doing so, we'll have to pay Federal and California state taxes (moving out of Calif to save on taxes is not an option). However, if we convert too much, we will lose our subsidy of $10K-12K/year).

Question...Is it worthwhile to do so since it appears we currently have enough money to live to 100 years of age, which I highly doubt we will do. In addition, at age 59.5, we can withdraw funds from our tIRA, if needed, which will reduce RMD's later in life.

Interested in your thoughts...Thanks in advance!

 

[Spock]

I don't have the same size nest egg or capital gains to be managed, but tax bracket management and the ACA subsidy are the biggest levers available when interest rate returns are this low.

A 800-1K/month ACA subsidy on a 100K MAGI seems really high for a family of 2, but then I don't live in California... To get a similar sized subsidy I have to manage to just clear the minimum required to avoid Medicaid. I end up maxing out our 0% tax bracket. When we go on Medicare I'll start maxing out the 10-12% brackets (which are due to expire before then).

 

[MichaelB]

Question...Is it worthwhile to do so since it appears we currently have enough money to live to 100 years of age, which I highly doubt we will do. In addition, at age 59.5, we can withdraw funds from our tIRA, if needed, which will reduce RMD's later in life.

Interested in your thoughts...Thanks in advance!

If you expect to outlive your assets and plan on leaving them to charity you are better off keeping your income low now and not converting. Charity pays no tax on the gift, even if it’s in an IRA, so a Roth conversion would probably reduce the net amount left for them.

In addition, if you do make it to advanced age you are more likely to have higher health care costs, especially if you need to move to assisted living or get in home care. The higher medical expense deductions could help offset taxable IRA withdrawals.

This is much discussed topic here so you’re likely to get some well though out responses from community members. It’s a good problem to have.

 

[SecondCor521]

I attempt to translate tax effects into marginal rates. I then compare the marginal rate on more income now vs. more income later and try to pay at a lower marginal rate.

For the ACA, the current law which sunsets 1/1/2026 provides larger ACA subsidies and eliminates the cliff. To see how this translates into a marginal rate, prepare a pro forma tax return in December with tax software, note your ACA subsidy from Form 8962, then increase your income by $1000 and see how much your ACA subsidy drops. If it drops by $300, then your subsidy is equivalent to a 30% marginal rate at your income level.

The key points though, are (a) it's not an on/off thing at the moment, it's a gradual reduction in subsidy, and (b) you can convert that subsidy loss into a marginal tax rate, and (c) you can, with effort, figure out what that marginal tax rate is.

It shouldn't be that high though. I think even at $83K of taxable income, you're over 400% FPL, so currently I think the subsidy loss in that range should be a flat 8.5%.

Given the nice low tax brackets for MFJ up through that $83K-ish number, I would definitely do either 0% capital gain harvesting or Roth conversions. Doing Roth conversions of ~$43K would result in the same AGI of $83K, and you'd pay 12% ordinary income taxes on those Roth conversions (plus whatever ACA subsidy loss you find above).

If you leave your IRAs alone until you are 72, that's another 13 years or so. Depending on what they're invested in, they will probably more than double and might triple, so you'll have somewhere between $5.6M and $8.4M. Let's go with $6M. The RMDs on that $6M will be about 3.65% of that, or $219K. You'll probably also have about $100K in taxable SS. So your taxable income, after subtracting your standard deduction, will be somewhere just under $300K.

That income will put you into the 24% bracket in the MFJ case, and you might get to tack on some IRMAA surcharges to that bracket.

When one of you dies, if the survivor inherits the other one's IRA and loses, let's say half of the taxable SS, the survivor will jump to the 35% bracket.

Depending on the relative sizes of your IRAs and the bequests to your nephews and the exact specifics of your estate plan, it might make sense for the surviving spouse *not* to inherit the IRA from the first to die. To provide flexibility, you could name the surviving spouse and let them partially disclaim. Or you could consider leaving the IRA to a trust for support of the surviving spouse - like a charitable remainder trust or similar.

I'd rather pay at 12% now than 24% or 35% later, especially because any taxable assets left to charities would avoid capital gains taxation (assuming they were LTCG assets), so any 0% capital gain harvesting you're doing now is not really helping much unless you're planning on living on those assets later and are reducing your taxation on those amounts from 15%/20% to 0%.

(ETA: I read @MichaelB's comments with interest. I'm not sure how the math works if leaving the IRAs to charity - paying the 12% now voluntarily vs. 24% or 35% later on the same amount of dollars: does that result in a larger or smaller IRA left to charity? It might also very well depend somewhat on which assets you plan to live on, which you plan to leave to the nephews, and which you plan to leave to charity.)

Note that the sooner you do Roth conversions (or IRA withdrawals), that gets that amount *and all future compounding* out of the IRA. Doing a conversion now can be half the size of a conversion in 8 or 10 years and have the same effect, because if you don't do it now, the money will double inside the IRA in that 8 to 10 years and double your tax bill.

If you're leaving any of the traditional IRAs to the nephews, note that they'll probably have to withdraw and pay ordinary income taxes at their rates on whatever you leave them within 10 years of your passing. Depending on their incomes, and the amount of the bequests, they might have to pay pretty high marginal rates then too.

The question of 0% LTCG harvesting versus Roth conversions - which is a better use of your low tax rate space - is a question I pondered a few years ago. There is a spreadsheet out there you can track down via the Bogleheads personal finance toolkit. I don't recall it being easy to use or interpret, but in most cases I think it will recommend Roth conversions over 0% LTCG harvesting. May be worth trying.

Also worth thinking about - does CA tax capital gains as ordinary income? A quick google suggests they do. My state does, and I think most do. So even if you're paying 0% federal on those LTCG, they're included in AGI and therefore reducing your ACA subsidies just as much as a Roth conversion would, and you might be paying CA state taxes on them also...looks like a 9.3% CA rate for you.

I try to include all tax effects of my AGI, so in my case I evaluate federal income tax, state income tax, ACA subsidy loss, IRMAA, SS taxation, and in my case for the next few years, FAFSA EFC impact. Over the term of my tax plan, these come into and out of play.

 

[SevenUp]

Roth Conversion and Capital Gains On ACA Health Insurance is a good article on this topic.

The Excel spreadsheet mentioned there is the same one SecondCor521 mentioned regarding the "0% LTCG harvesting versus Roth conversions" choice. There are different tabs in that spreadsheet for different topics.

 

[RunningBum]

A few thoughts on your situation.

If you thought there was a chance you'd ever move out of California, I wouldn't convert now because you would avoid those taxes in the future.

For at least the next 3 years, there is no ACA subsidy cliff. So there's no "too much" conversion that will cost you $10-12K, but instead every dollar converted loses 8.5 or more cents of ACA subsidy until you are down to $0 subsidy. Do a mock tax return to see how much it would be. The cliff may come back in 2026. I just treat the subsidy loss as additional tax for conversion, and extra 8.5% or so to compare to your tax rate at age 72.

Being able to withdraw from your tIRA at age 59.5 is not a good reason to skip converting now. Having the money grow tax free in a Roth after conversion is better than growing taxed in your taxable account, so I'd be considering converting now and after 59.5 up to when you have to start RMDs.

Regarding taking 0% tax gains vs. converting....will your tax rate be more than 15% higher when you start RMDs? If so, you probably want to convert. Otherwise you probably want to take the 0% cap gains. BTW, CGs are part of AGI, so those reduce your ACA subsidy too, even if your tax rate is 0%.

Consider what will happen if one dies well in advance of the other. All of a sudden those large RMDs are taxed at the single rate, which puts the survivor in a higher bracket. That favors converting while you are MFJ, probably.

Asking if it's worthwhile to convert because you might never need that money anyway isn't the right viewpoint, in my opinion. Money left in a tIRA is money you could never access. So if you go ahead and pay the tax on this deferred income, it is available for you to spend if you want.

On the other hand, there are some very good reasons not to convert, especially in your situation.

If one of you needs expensive LTC, you can withdraw what you need from the tIRA and probably deduct most or all of it with your medical expenses, and pay little or no taxes.

Also, since you are looking to leave much of your estate to charity, it really doesn't make sense for you to pay the income tax and leave less to the charity. If you bequeath the IRA, the charity pays no taxes. Likewise for your unrealized capital gains in taxable. You could also give up to $100K/yr (per person?) in QCDs if you want to see your impact while you are still alive.

For your heirs, do not leave them any of the tIRA, since they would have to pay taxes on it. Instead, leave them some of your taxable money, with the largest unrealized cap gains, because they get stepped up basis.

A lot of hedging here..do this...but maybe not because ... If it were me I'd probably be doing Roth conversions up to some income tax bracket, but I'd be taking longer than the 15 minutes I've thought about your situation. It's unlikely you'll both die shortly after starting RMDs so it's worth trying to reduce that tax bite, but you probably want to leave a lot in there for the charity to inherit tax free.

Maybe it's worth having a tax specialist look at this, or pay for Pralana Gold to analyze this. I haven't used that tool but I understand it's very good. And maybe you should see an estate attorney to see if there's a better way to manage your estate. It depends on how well you think you understand this. Nobody will be more motivated than you to get it right, but they may know things that you don't that will work better for you.

 

[SecondCor521]

I just treat the subsidy loss as additional tax for conversion, and extra 8.5% or so to compare to your tax rate at age 72.

Note that in the 100% to 400% FPL range, the effective marginal tax rate is higher than the applicable figure because of the way ACA subsidies are calculated - unlike regular tax brackets, the applicable figure is multiplied by all income, not just the amount over a certain dollar figure. This can double the effective tax rate if one is just under 300% FPL for example. See https://seattlecyclone.com/marginal-tax-rates-under-the-aca/ for a discussion of this effect, and https://seattlecyclone.com/aca-premium-tax-credits-2021-edition/ for a current version of graphs of the same idea.

You could also give up to $100K/yr (per person?) in QCDs if you want to see your impact while you are still alive.

Yes, QCDs are up to $100K per taxpayer per year, so since OP is MFJ they could give $200K per year, starting at age 70.5. This is also a good way to address runaway IRA compounding. QCDs also (a) reduce AGI and taxable income and (b) can satisfy RMDs.

 

[SevenUp]

Wife: 59 (sole proprietor, doing consulting work to keep busy)
Health Insurance: On Covered California (ACA) and receive about $800-$1,000/month subsidy (based on approx $100K/year MAGI).

Taxable income (after business deductions, SEP-IRA contribution, deduction of Healthcare Ins Premiums): ~$23,000

Qualified Dividends: ~$17,000

Missed the combination of ACA and self-employed health insurance deduction on the first pass.

Does your situation require the iterative calculation needed in some instances of that situation?

If you have any Excel ability it could be worth your time to use the case study spreadsheet (tool mentioned previously) to see your marginal rates for whatever range of Roth conversions you wish. Do you think you'll give that a try?

Knowing that the bulk of your estate (i.e., the amount going to charity) will incur a 0% tax rate makes things somewhat easier to decide, but then again you still have the "but what if one spouse has many years of paying at single rates if the worst happens...?" issue.

 

[Exchme]

The comments I read are playing small ball, that's not your situation. You didn't tell us about your asset allocation, but if it contains a reasonable amount of stocks, your IRA could double or more by the time you need to take RMDs.

What would your tax bracket be with RMDs from $5M or $7M? Now add SS and other income. Remember the tax code reverts to higher brackets in 2026. Once RMDs start, you'll be in a fairly high IRMAA tier and subject to NIIT taxes on those dividends and capital gains. Getting pretty grim, right? Now suppose one of you passes early, the other is really stuck, being in a single bracket and a very high IRMAA tier.

I don't know anything about California taxes, but from a federal point of view, you either need to be at the top of the 22% or the top of the 24%. I'm guessing that you should be at the top of the 24% bracket until you are subject to IRMAA at age 63, that also just about corresponds to the expiration of the TCJA tax cuts.

You need either a professional to do some tax planning for you or if you are patient, thorough and good with numbers, you need some competent software (spend some money, getting partial answers from DIY work with free tools could cost you hundreds of times more than some software or some professional help).

 

[RetireRay]

Thanks for all the valuable information!

I’d like to thank everyone for the detailed responses! Lots to think about. I’ll download the spreadsheet that was referenced and will work on that.

This is the best forum!

 

[Retire2023]

Very interesting spreadsheet. I have a question about one of the cells and was hoping someone here might know how this piece works. I entered the non-paycheck income as instructed, including $20K in LTCG (Cell D27) as a place holder. This amount is then included in the total in cell D42. This looks good to me, but then on row 72 this same amount in included again as "other untaxed income" and adds into cell D73 for Income before other expenses. This appears to inflate the income. Cell B72 is shaded green like it is expecting an input, but there is a formula there that pulls from the LTCG number. Should I manually override this cell to enter other funds I might need to cover expenses that would not be taxable? Thanks to all for sharing the knowledge!

 

[SevenUp]

Very interesting spreadsheet. I have a question about one of the cells and was hoping someone here might know how this piece works. I entered the non-paycheck income as instructed, including $20K in LTCG (Cell D27) as a place holder. This amount is then included in the total in cell D42. This looks good to me, but then on row 72 this same amount in included again as "other untaxed income" and adds into cell D73 for Income before other expenses. This appears to inflate the income. Cell B72 is shaded green like it is expecting an input, but there is a formula there that pulls from the LTCG number. Should I manually override this cell to enter other funds I might need to cover expenses that would not be taxable? Thanks to all for sharing the knowledge!

That's probably a mistake introduced when the developer decided to Assume capital losses are one-time things (e.g., a paper loss for tax loss harvesting) and do not affect cash flow in the most recent update.

That's also probably not a bad assumption, but there should have been a check to see if the LTCG was negative. Wouldn't be surprising if that gets fixed whenever the next version is released. Meanwhile, yes, overwriting that B72 formula with whatever is appropriate for you looks good.

 

[Retire2023]

Thank you SevenUp!

 

[SevenUp]

That's probably a mistake introduced when the developer decided to Assume capital losses are one-time things (e.g., a paper loss for tax loss harvesting) and do not affect cash flow in the most recent update.

That's also probably not a bad assumption, but there should have been a check to see if the LTCG was negative. Wouldn't be surprising if that gets fixed whenever the next version is released. Meanwhile, yes, overwriting that B72 formula with whatever is appropriate for you looks good.

Thank you SevenUp!

Hah! Just checked the latest post in Case Study Spreadsheet updates. My guess above for the reason was wrong, but the suggested fix (overwriting that B72 formula with whatever is appropriate for you) works.

 

[Retire2023]

Great, that's just what I did. Lots more to fill in though, so plenty of hours will be lost in the effort, but worth it!

 

[RetireRay]

SEP-IRA contribution and tIRA Roth conversion in same year?

Missed the combination of ACA and self-employed health insurance deduction on the first pass.

Does your situation require the iterative calculation needed in some instances of that situation?

If you have any Excel ability it could be worth your time to use the case study spreadsheet (tool mentioned previously) to see your marginal rates for whatever range of Roth conversions you wish. Do you think you'll give that a try?

Knowing that the bulk of your estate (i.e., the amount going to charity) will incur a 0% tax rate makes things somewhat easier to decide, but then again you still have the "but what if one spouse has many years of paying at single rates if the worst happens...?" issue.

I’ve played around with the case study spreadsheet, which is amazing. I figure we can convert about $60K of our rollover IRA accounts to Roth IRA’s ($30k for each of us) and still be in the 12% tax bracket. I have a question though which I can’t seem to find an answer to… My wife contributes each year to her SEP-IRA, which lowers our taxable income. Is this still advisable if we are also converting Rollover IRA’s to Roth’s, and are thus increasing our taxable income? Hope this make sense….

 

[SevenUp]

I’ve played around with the case study spreadsheet, which is amazing. I figure we can convert about $60K of our rollover IRA accounts to Roth IRA’s ($30k for each of us) and still be in the 12% tax bracket. I have a question though which I can’t seem to find an answer to… My wife contributes each year to her SEP-IRA, which lowers our taxable income. Is this still advisable if we are also converting Rollover IRA’s to Roth’s, and are thus increasing our taxable income? Hope this make sense….

The IRA conversion amount appears on line 4b of https://www.irs.gov/pub/irs-pdf/f1040.pdf, and the SEP contribution goes on line 16 of https://www.irs.gov/pub/irs-pdf/f1040s1.pdf, and eventually to line 10 of form 1040, so for the same amounts the net effect on federal Adjusted Gross Income is $0. Some states (e.g., Illinois) allow the IRA deduction but don't tax the IRA conversion, but I don't think that's what California does.

What she is doing might be called a "stealth SEP Roth IRA." If she already contributes the max to her Roth IRA, wants to do Roth contributions instead of traditional, and prefers to SEP to a solo 401k, then what she is doing is fine.

If any of the above "ifs" is false, then a different approach might be better. Hope that in turn makes sense.

 

[RetireRay]

What she is doing might be called a "stealth SEP Roth IRA." If she already contributes the max to her Roth IRA, wants to do Roth contributions instead of traditional, and prefers to SEP to a solo 401k, then what she is doing is fine.

If any of the above "ifs" is false, then a different approach might be better. Hope that in turn makes sense.

@SevenUp...thanks so much for your guidance! This is exactly what I needed.