Roth Conversion Taxes - Perspective (I Needed)

[Midpack]

I've found this optimizer very insightful in pondering these issues: https://i-orp.com/ZERO/index.html

It’s great for free, but i-ORP determines spending for the user. Not everyone wants to see answers based on i-ORPs spending assumptions (e.g. way more than I’d spend). And artificially reducing spending in i-ORP by jimmying residual isn’t the same...

You can get more flexibility and much more complete detail without spending a fortune.

 

[rathail]

I did not think it through on my 2019 conversion. Used RMD to pay roll taxes.
I have an inherited RMD that I did at the end of the year but only payed a 20% tax on the RMD. I should have payed ~80%-100%. Now I owe what I got as cash and a penalty unless I annualize my years income/expenses and I will probably be asked to do quarterly.

 

[Clone]

Kitces nicely describes and uses graphs to illustrate advantages and disadvantages.

Thank you for posting the link. That is one of the easiest to read and digest discussions that I have seen. There were a couple lines that I thought really stated the concept:

The specifics of the optimum plan is very much related to the individuals tax situation. Much of the debate and discussion on this forum is because there we have a diverse collection of financial situations, and there is no single one-size-fits-all approach.

Of course, where that balance point is will depend on the retiree’s overall income and wealth levels. For some, the balancing point may be to “just” fill up the 15% ordinary income tax bracket, and try to avoid any rates that are 25% or higher. For those with more significant retirement accumulations, the sheer size of the family balance sheet may make it impossible to avoid being in at least the 25% bracket, and the goal will just be to stay there and not drift up into the 28% or 33% brackets.

I speant many years saving money in tax deffered accounts as part of a plan that included 'not pay taxes'. To switch gears and voluntarily pay a lot of taxes is a challenging concept.

Nonetheless, the strategy for the tax-efficient spend-down of a retirement portfolio remains the same – to allow for maximal tax-preferenced growth in retirement accounts by spending from taxable brokerage accounts first, but not letting low tax brackets “go to waste” by filling them with partial Roth conversions along the way!

 

[Midpack]

I may have missed it - but did not see anyone previously post this very good article on Roth conversions (with capital gains consideration).

Kitces nicely describes and uses graphs to illustrate advantages and disadvantages.

https://www.kitces.com/blog/tax-eff...strategies-to-fund-retirement-spending-needs/

This chart from the Kitces paper summarizes nicely.

 

[james22]

… the brokerage account – which will never grow quite as quickly in the first place, as the annual drag of taxation on interest, dividends, and capital gains will reduce the ability of the account to compound.

My brokerage account of Berkshire (only) has no such annual drag. Does this change the calculation significantly?

 

[audreyh1]

… the brokerage account – which will never grow quite as quickly in the first place, as the annual drag of taxation on interest, dividends, and capital gains will reduce the ability of the account to compound.

My brokerage account of Berkshire (only) has no such annual drag. Does this change the calculation significantly?

Well yes, completely.

 

[audreyh1]

I may have missed it - but did not see anyone previously post this very good article on Roth conversions (with capital gains consideration).

Kitces nicely describes and uses graphs to illustrate advantages and disadvantages.

https://www.kitces.com/blog/tax-eff...strategies-to-fund-retirement-spending-needs/

How did I miss that! Very useful guide.

Funny - older tax brackets, still totally useful.

 

[pb4uski]

This chart from the Kitces paper summarizes nicely.

That chart says what many of us have been saying that it is a tax arbitrage play... pure and simple.

Regarding the quote:

Nonetheless, the strategy for the tax-efficient spend-down of a retirement portfolio remains the same – to allow for maximal tax-preferenced growth in retirement accounts by spending from taxable brokerage accounts first, but not letting low tax brackets “go to waste” by filling them with partial Roth conversions along the way!

(emphasis added)

I don't agree.... I don't think he is factoring in that a step-up in basis will make taxes on all unrealized gains in a taxable account go poof! and disappear.

What I was finding is that my taxable account equities were so highly appreciated that if I used the proceeds from sales of taxable accounts for living expenses that it used up a lot of the headroom that I had for Roth conversions. So I have shifted to leaving taxable accounts alone and other than taking dividends and capital gain distributions in cash to let them grow to get a stepped-up basis later and living off Roth withdrawals and replenishing the Roth with Roth conversions.... at least to the top of the 0% preferenced income bracket (which is $250 lower than the top of the 12% tax bracket) but once we are clear of state income taxes to the top of the 22% tax bracket.

 

[Time2]

That chart says what many of us have been saying that it is a tax arbitrage play... pure and simple.

Regarding the quote: (emphasis added)

I don't agree.... I don't think he is factoring in that a step-up in basis will make taxes on all unrealized gains in a taxable account go poof! and disappear.

What I was finding is that my taxable account equities were so highly appreciated that if I used the proceeds from sales of taxable accounts for living expenses that it used up a lot of the headroom that I had for Roth conversions.

I don't understand this. I have a taxable account that is about 50% LTCGs, I withdrew $120,000 and figure I only owe tax on $60,000, because the other half was already taxed. Also that $60,000 is LTCGs and fall in the 0% tax bracket being under $78,750.
What am I missing?

 

[pb4uski]

I don't understand this. I have a taxable account that is about 50% LTCGs, I withdrew $120,000 and figure I only owe tax on $60,000, because the other half was already taxed. Also that $60,000 is LTCGs and fall in the 0% tax bracket being under $78,750.
What am I missing?

What you're missing is that when the account holder dies that those taxable investments get a stepped up basis and never get taxed... the same as your 0% tax.

However, that $60k LTCG uses up $60k of headroom that could otherwise be used for Roth conversions at 0%, 10% or 12% depending on your other sources of income... rather than a higher tax bracket later once any pensions or SS are online.

So for example, we are in our mid 60s with a small pension and have not yet started SS. In 2019 I converted $67k and the conversion increased my federal tax by $7k (10.5%)... a blend of 0% (covered by unused standard deduction), 10% and 12%.

So I would rather let taxable grow ultimately get a stepped-up basis where the unrealized appreciation never gets taxed and use that headroom that I have now to do low tax cost Roth conversions.

 

[Gumby]

I guess the first thing to do when looking at this issue is to determine whether you want to leave a bequest or not. The proper strategy may differ depending on the answer to that first question.

 

[pb4uski]

I guess the first thing to do when looking at this issue is to determine whether you want to leave a bequest or not. The proper strategy will differ depending on the answer to that first question.

Fair point.... we have two kids so part of my objective is to optimize their inheritance... the rub is one is in a high tax bracket and the other is in a low tax bracket so I'm just doing my best and beyond that que sera sera.

 

[madsquopper]

Am I mostly correct in assuming it's basically pointless to withdraw from a regular IRA and then invest the money in taxable accounts? (e.g., long terminsh in stocks) As opposed to doing an immediate conversion into a Roth. If you do the former you'e basically taxes twice (on the withdrawal and then later on cap gains).

Once RMD's hit me at 72, our combined income (spouse's pension, my SS, and taxable dividends) is already going to be near the IRMAA Level 2 anyway, so I won't have much flexibility later, or even now. Looks like I can do some conversions over the next 5 years but mostly will likely end up just living off my RMD and SS, at least for the 5 or so years after I hit 72.

Larry

 

[pb4uski]

Yes, if you do the former.... withdraw and pay the taxes and invest the proceeds in stocks and then later sell the stocks to spend the proceeds then you'll pay tax on the withdrawal and tax on any gain when you sell (assuming that your income isn't low enough to qualify for the 0% rate).

OTOH, if you convert and reinvest in the same stocks and later withdraw to spend then you only pay tax on the conversion (same as the withdrawal) but when you later sell the stock and withdraw from the Roth the wtihdrawals are totally tax-free.

So the Roth is better because it avoids any taxes on the gains.

 

[Clone]

We are planning on leaving a significant amount of funds for our heirs. We have minimal after-tax accounts at the present time. Over time, I expect that we will ROTH convert much of our 401k type funds. The brokerage accounts will begin to grow.

Prior to SECURE, the idea of an inherited IRA was OK. Now, it would create RMDs that would be taxed at our heirs peak earning years incremental tax rate. So aggressive ROTH conversions it is.

Is there any advantage in building a traditional brokerage account over letting the funds build in a ROTH? I guess that depends on future changes to tax law? Today, any increase in the ROTH would be passed on without additional taxes. Any increases in a traditional brokerage account would be passed on with a step-up in basis.

 

[Sunset]

I guess the first thing to do when looking at this issue is to determine whether you want to leave a bequest or not. The proper strategy may differ depending on the answer to that first question.

I'm also holding off on selling taxable stocks, as wanting to keep lots of room for roth conversion.

The step up in basis applies to the spouse, which is my main interest.
The heirs can get whats left over after we both go...

 

[Midpack]

I'm also holding off on selling taxable stocks, as wanting to keep lots of room for roth conversion.

I’m doing the same. Fortunately we have enough dividends, interest and cash for (estimated) taxes and spending so we can leave taxable alone for years and avoid LTCG.

 

[davebarnes]

I read the Kitces article.
It ignores (as it was written in 2016) the "family" tax structure.
If you want to leave your child money, then you need to make lots of assumptions and consider the taxes paid by you and your child over the next 30 years.
The SECURE Act changed everything for us.
I am doing Roth conversions as fast as I can without going up into the 32% bracket. But, of course that puts us up income higher IRMAA brackets.
We have zero control over our 'base' income (SS, pension, RMDs).

 

[CRLLS]

I read the Kitces article.
It ignores (as it was written in 2016) the "family" tax structure.
If you want to leave your child money, then you need to make lots of assumptions and consider the taxes paid by you and your child over the next 30 years.
The SECURE Act changed everything for us.
I am doing Roth conversions as fast as I can without going up into the 32% bracket. But, of course that puts us up income higher IRMAA brackets.
We have zero control over our 'base' income (SS, pension, RMDs).

The control of your 'base' income is not zero. You are controlling RMDs. By Roth converting, you are reducing those 'base' taxes, albeit by pre-paying those taxes now.

For us, we are not "planning" on leaving some dollar amount to our heirs. We are simple plan is to not outlive our nest egg. In all practical reality, that will leave a sizable sum to our heirs. Since we do not know when our demise will occur, nor what our heirs' income tax will be at that time, we take a more pragmatic approach to that issue. What they get will be what they get. Something, minus whatever taxes they may have to pay, is better than us spending our nest egg and leaving them nothing. Let the taxes fall where they may. Each to their own I guess.

 

[atmsmshr]

Roth Decision Tree

Great idea by someone to refine some Roth conversion decision tree questions. The Kitces article was the best ‘guideline’ that I could find, but it did not boil it down to simple steps and observations for my preference. I am not a CPA, but will take a shot at submitting a straw man for the forum to modify.


Overall Strategy to minimize your taxes when filing single and inheritance:

1) Keep IRA to Roth conversion tax rate lower than the future highest expected bracket for Single at age 85, considering Required Minimum Withdrawls from IRAs and all other income.

2) Determine if a maximum conversion will help to minimize effects of tax torpedo for Social Security.

3) Minimize RMD impact and maximizing tax free inheritance by use of an allocation and withdrawl scheme and a minimum Roth conversion. For example; an 80/20 allocation in the Roth and a 30/70 allocation in the IRA. Benefit is that the allocation and higher expected Roth growth is a non-taxable conversion strategy to draw down IRA and grow the Roth.

4) Keep an IRA reserve to fund medical shock events and have additional deductible resources or risk prepaying taxes on what would otherwise be a 0% tax bracket. (Such as deductible expenses for Long Term Care).


Tactical Goal Setting:

1) To determine your maximum conversion tax bracket, identify if you are minimizing taxes for your lifetime and spouse, or if you are minimizing inheritance taxes to children. Don’t convert an IRA to Roth above this tax bracket.

2) Determine your optimal claiming age for Social Security. For many couples, it is 70 for the high wage earner, and 67 (or FRA) for the low wage earner. This will help to establish the optimum time window available for Roth Conversions.

3) Understand your opinion of the future of federal and state income tax. Currently, the tax structure will by law revert in 2026. Personally, I think that the 0% capital gains tax bracket is at risk of being eliminated in the near future, so I want to take advantage of that benefit sooner rather than later.

4) If taking LTCG strategy of 0% taxes, postpone pension/annuity/SS until gains harvest is complete. During LTCG harvest window, consider minimizing Roth conversions during this period to only fill standard deduction, or else every dollar taxed at 12% also pushes LTCG above $80,000 into the 15% bracket for an effective marginal conversion of 27%. LTCG tax rates ‘float’ up over all other income.

5) Keep enough in IRA to fill lower tax brackets when combined with SS, Qdiv, pension/annuity income.


Annual Steps (which can be projected)

1) Determine your living expenses, and marginal tax bracket. Evaluate how much is left in that tax shelf to the start of the next brackets. This is the potential size of your annual IRA to Roth conversion.

2) Project your annual expenses and income at age 80, filing Single and Married.

3) Using above, project your marginal tax rate at age 80, filing Single and Married. This is your Roth conversion ceiling – don’t convert above this tax bracket.

4) In order to stay below the age 80 tax bracket determined above, estimate how much would have to come from a Roth account, how much from IRA and other income (SS and pension). This is the ‘split’ between your IRA and Roth to help estimate total amount for conversion.

5) Add any amount to the Roth that you desire for tax free inheritance.

6) Understand the impact that Roth conversion may have on Net Investment Income Tax and IRMAA. Re-evaluate conversion as needed.


As I have mentioned earlier, iORP is a free online tool, but it lacks sophistication for optimizing certain tax scenarios.

 

[target2019]

atmsmshr,
That's very beneficial. Thanks for taking the time to analyze and posting up.

 

[pb4uski]

atmsmshr,
That's very beneficial. Thanks for taking the time to analyze and posting up.

+1

 

[Midpack]

atmsmshr,
That's very beneficial. Thanks for taking the time to analyze and posting up.

+2, nicely done!