Roth conversions

[pb4uski]

There is still a benefit even if tax rates are the same but is it relatively minor... essentially the $179 in the example in post #45 because you end up with taxable account money in the Roth where it is no longer subject to tax.

 

[RunningBum]

And if one of you dies, the other might be in a higher bracket as a single, or more likely to push SS benefits into being taxed.

Sounds more to me like it makes no sense not to convert, as it's probably breakeven at worst (if tax brackets are equal), probably slightly better to convert (as pb4 notes, when you pay taxes out of taxable), possibly a lot better (if you do get into 22%, or even if tax brackets revert back to 15% as the current law has them doing). But I don't know your whole situation.

 

[CRLLS]

And if one of you dies, the other might be in a higher bracket as a single, or more likely to push SS benefits into being taxed.

Sounds more to me like it makes no sense not to convert, as it's probably breakeven at worst (if tax brackets are equal), probably slightly better to convert (as pb4 notes, when you pay taxes out of taxable), possibly a lot better (if you do get into 22%, or even if tax brackets revert back to 15% as the current law has them doing). But I don't know your whole situation.

This is often either overlooked or understated here. There are no guarantees in life. There is a high chance that the 2 of us will not pass in the same tax year, thus putting us in this situation. The single's tax bracket can become a larger consequence as the years being single increases. If the 2nd passes a year or two after the 1st, the problem is not so bad (still bad though). Now consider paying that single tax penalty over 10 or 20 year period...….

 

[Greg V]

If charitable contributions are part of your plan, QCDs, at age 70 and later, can mitigate the tax consequences of not converting...or just the tax torpedo. They also let you take advantage of charitable contributions even when using the standard deduction. Just another item to add to the discussion...

 

[Scuba]

I guess that it depends on what ultimately happens to that Roth money because even if you don't spend it, it ultimately ends up in someone's pocket.



If any of the money ultimately ends up in the hands of an individual heir (vs a charity) then having it be tax free for the rest of time is a valuable benefit.

Sure, but we figure our heirs will be fortunate to inherit whatever we have at that point. We did set up a trust to minimize tax consequences to heirs, but would rather not take money from our portfolio now to pay taxes for heirs.

The point about one spouse passing away sooner and the survivor being taxed as a single is a good one, and something I hadn’t considered. I’ll ask my CPA about that.

My CPA said that because Roth money grows tax free, many investors never tap into it, especially if they have enough assets from other sources to live their desired lifestyle. So Roths are often left for heirs.

 

[googily]

This is often either overlooked or understated here. There are no guarantees in life. There is a high chance that the 2 of us will not pass in the same tax year, thus putting us in this situation. The single's tax bracket can become a larger consequence as the years being single increases. If the 2nd passes a year or two after the 1st, the problem is not so bad (still bad though). Now consider paying that single tax penalty over 10 or 20 year period...….

As someone who landed in this situation much earlier than anticipated (I'm in my early 50s), there's also the reality that a nest egg that was big enough for two of us to retire early with is now very much more than enough for just me (with no heirs). So I'm looking at eventual RMDs of my 401k *and* his 401k (now an inherited IRA that's already a good bit larger than my own), and very likely an IRA that my father will pass to me. Alongside SS (likely starting survivor's at 60), and my pension (have already started taking his pension).

I will definitely convert as much as I can from my pretty paltry IRA and from the inherited IRA as soon as I quit working.

It's a better problem to have than to be a widow without hardly any savings, but if you are someone who thinks about things like higher tax rates for single taxpayers and tax torpedoes, this situation has a lot looming.

I'd better buy more Roombas.

 

[RetireBy90]

As someone who landed in this situation much earlier than anticipated (I'm in my early 50s), there's also the reality that a nest egg that was big enough for two of us to retire early with is now very much more than enough for just me (with no heirs). So I'm looking at eventual RMDs of my 401k *and* his 401k (now an inherited IRA that's already a good bit larger than my own), and very likely an IRA that my father will pass to me. Alongside SS (likely starting survivor's at 60), and my pension (have already started taking his pension).

I will definitely convert as much as I can from my pretty paltry IRA and from the inherited IRA as soon as I quit working.

It's a better problem to have than to be a widow without hardly any savings, but if you are someone who thinks about things like higher tax rates for single taxpayers and tax torpedoes, this situation has a lot looming.

I'd better buy more Roombas.

Thanks for a real example. For too long I have been playing/planning with textbook assumptions. Real sorry to hear you are by yourself, but it is very helpful for me to get a real life scenario like this.

 

[RunningBum]

Sure, but we figure our heirs will be fortunate to inherit whatever we have at that point. We did set up a trust to minimize tax consequences to heirs, but would rather not take money from our portfolio now to pay taxes for heirs.

The point about one spouse passing away sooner and the survivor being taxed as a single is a good one, and something I hadn’t considered. I’ll ask my CPA about that.

My CPA said that because Roth money grows tax free, many investors never tap into it, especially if they have enough assets from other sources to live their desired lifestyle. So Roths are often left for heirs.

OK, if you think you'll leave a lot for heirs, AND they will be in a lower tax bracket then you are now, then maybe it makes sense to not convert. It sounds like this may be your case.

If they aren't going to be in a lower tax bracket, I don't see why you wouldn't go ahead and convert if it's favorable to you, and go ahead and spend some from that Roth. Just because your CPA says many investors don't tap into it doesn't mean you can't. I'll probably tap my Roth before I sell my highly appreciated taxable assets, so I can avoid paying LTCG taxes that my heirs won't have to because of step-up basis on inheriting taxable accounts.

Also consider that after 70 you start paying MRDs, so you may wind up paying a good part of those taxes anyway.

I don't put any importance in delaying paying taxes vs. paying them now. What I look at is, if I wind up draining all of my assets, how will I get the most out of them, considering taxes paid, and return on investments, including the extra return on taxes deferred.

If you want to consider heirs, you can look at the same scenario for how to maximize you money assuming they will drain those assets, which they likely will have to due to inherited RMD rules. It could be, that if their prospects for making income aren't good, that it's better to let them inherit a tIRA and let them pay the taxes at their lower rate, but if they decide to take it as a lump sum they'll get hit hard.

If it comes out better for myself or my heirs to pay some taxes now, I'll do it. It doesn't bother me in the least if I'm spending my money to pay taxes for my heirs, because I'm going to spend whatever I'm going to spend, and with pre-paying taxes I may leave them a little less, but in a better tax situation. So they'll still win, and not at my expense.

If you think you simply won't spend from your Roth because it's tax free growth, then I can't help you. You are no longer making a financial decision.

If I'm missing something, I'd like to learn what.

Wait! You said in post 26 you don't have heirs, and now you're saying you do. I think I just wasted my time. I guess it gave me time to think through the inheritance angle, but I don't think my son will be in a lower tax bracket than I'm in now so I don't think it changes my plan.

 

[pb4uski]

.... My CPA said that because Roth money grows tax free, many investors never tap into it, especially if they have enough assets from other sources to live their desired lifestyle. So Roths are often left for heirs.

That is the plan in our case, but if once our taxable funds are gone we might use Roth money to avoid going into the next tax bracket... IOW... if pension, SS and RMDs put us in the 12% tax bracket we would do additional voluntary tIRA withdrawals up to the top of the 12% tax bracket, then use Roth money rather than do tIRA withdrawals into the 22% tax bracket.

 

[joylesshusband]

I'm not sure what your reasoning was, but let's use a simple realistic example. Today, one has $10,000 in a tIRA and $1,200 in a taxable account. Tax rate today is 12%, but will be 22% after SS starts. Earnings rate is 7%.

Scenario 1: Do nothing. The $10,000 grows to $19,672 and the $1,200 grows to $2,182 in 10 years. The taxpayer withdraws the $19,672 pays $4,328 (22%) in tax... ending the day with $17,526.

Scenario 2: Convert the $10,000 to a Roth and pay $1,200 in tax. The $10,000 grows to $19,672 in 10 years.

Taxpayer ends up $2,146 ahead as a result of converting... mostly the $1,000 of tax savings, which grows over 10 years to $1,967 and then the tax savings on the after-tax account of $179.


-----------------------------------
$19,672 = $10,000 * (1+7%)^10
$2,182 = $1,200 * (1+(7%*(1-12%)))^10
$1,967 = $1,000 * (1+7%)^10
$179 = $1,200 * (1+7%)^10 - $1,200 * (1+(7%*(1-12%)))^10

No one questioned the general reasoning for doing Roth conversions.
What was questioned was the precision of the criteria applied to how much, and when to convert.
My point of contention is that a simple tax arbitrage oversimplifies the picture, as it ignores opportunity costs.

What you suggested is the most simplistic model, which is hardly applicable to anyone’s actual situation.

It is understood that all models (all and any model well beyond the Roth conversion subject) are imperfect, being skewed limited replicas of the real thing, but I don’t see a reason to use the most simplistic one due to its obvious inaccuracy, and make decisions based on it.
If I had in mind an acceptable way of quantifying the opportunity cost of paying extra income tax due to conversions, I would have presented it herein. I am still working on it.

 

[joylesshusband]

If you are paying the tax before you have to, you want to be very confident it will be at a lower rate than if paid later. And you want to try to manage the risk you pay taxes you might never have to pay.

The text I bolded above is a classic example of misunderstanding what the goal is.

It is not the tax rate that has to be lower.
It is not even the total tax amount that has to be lower.
It is the extra _value_ gained by "paying the tax before you have to" as you aptly put it.

This value is not a simple matter of tax arbitrage.
Perhaps you just prefer to see it that way, as otherwise your brain cells would have to work a little bit harder, and you don't feel like dealing with tired brain cells at the moment...

 

[RunningBum]

Somebody tell me if this person (I tried about 5 different words here but all of them would probably get me in trouble) ever posts anything of substance. All I see are insults, and nothing at all to back his claims. Welcome to my ignore list.

 

[googily]

Thanks for a real example. For too long I have been playing/planning with textbook assumptions. Real sorry to hear you are by yourself, but it is very helpful for me to get a real life scenario like this.

Thanks. And don't forget the additional potential tax torpedo of selling a home and only having a $250k CG exemption rather than $500k. Even with the stepped-up value, the likely gains on my house are already well past $250k, since we bought more than 20 years ago in a neighborhood that has since become extraordinarily sought after. I'm not moving right away, but we always knew it was not going to be a house where we could age in place, so I will likely sell it at some point. That'll be a fun year tax wise.

 

[oldphd]

That is the plan in our case, but if once our taxable funds are gone we might use Roth money to avoid going into the next tax bracket... IOW... if pension, SS and RMDs put us in the 12% tax bracket we would do additional voluntary tIRA withdrawals up to the top of the 12% tax bracket, then use Roth money rather than do tIRA withdrawals into the 22% tax bracket.

My thought is similar. In our case, we will have the 12% bracket almost filled with pension and SS at age 70 (works out for each of us independently, so being widowed doesn't change the bracket). We should also have depleted our taxable accounts by that point. Since I will fall into the 22% at that point, I plan to do Roth conversions prior to that point to fill the 22% for me (we currently file separately to save on state taxes). Using nominal returns over the years until 70, If I just fill the 12%, I will still have bunches of traditional IRA. If I go to 22% for us MFJ, I can deplete it a few years in advance and then have room left in the 12%, so that doesn't make sense. Like Goldilocks, the middle of the road is just right, converting to 22% for me filing separately, with DW maxing out the 12%. I would still have money in the traditional IRA but not huge amounts so RMDs would be modest.

That seems confusing as I read it, so I hope it makes sense. The point I want to make is that my plan is to do decide what I want my tax return to look like, do that, and then use the Roth as my source of funds. If I spend less than an arbitrary 4% SWD, it's still earning money in a tax free way. At that point, I don't see a reason to have more than a nominal amount in a taxable cash type account (savings, checking, whatever).

Think of your Roth as a tub filled with water. You are pouring into it at a rate you choose to fine tune your 12/22/whatever tax bracket. Independently, you are drawing out of it to spend money on life. As long as there's enough in when you start, the level goes up and down over time.

The ultimate goal whether in your lifetime, your spouse, or other heirs, is to minimize the taxes owed. This is tax deferred, and WILL get taxed at some point coming out.

Another point for our consideration, and would be for at least some others here, is IRMAA. If I would stick to the 12% conversion for those earlier years and then either of us is widowed, we'd get hit by IRMAA with RMDs. So there's a little more than just the tax bracket to consider.

 

[Montecfo]

The text I bolded above is a classic example of misunderstanding what the goal is.

It is not the tax rate that has to be lower.
It is not even the total tax amount that has to be lower.
It is the extra _value_ gained by "paying the tax before you have to" as you aptly put it.

This value is not a simple matter of tax arbitrage.
Perhaps you just prefer to see it that way, as otherwise your brain cells would have to work a little bit harder, and you don't feel like dealing with tired brain cells at the moment...

I stand ready to entertain your explanation of the extra value gained by paying taxes before you have to. Understanding how tax rates and amount of tax are irrelevant will also be enlightening, no doubt.

 

[pb4uski]

No one questioned the general reasoning for doing Roth conversions.
What was questioned was the precision of the criteria applied to how much, and when to convert.
My point of contention is that a simple tax arbitrage oversimplifies the picture, as it ignores opportunity costs.

What you suggested is the most simplistic model, which is hardly applicable to anyone’s actual situation.

It is understood that all models (all and any model well beyond the Roth conversion subject) are imperfect, being skewed limited replicas of the real thing, but I don’t see a reason to use the most simplistic one due to its obvious inaccuracy, and make decisions based on it.
If I had in mind an acceptable way of quantifying the opportunity cost of paying extra income tax due to conversions, I would have presented it herein. I am still working on it.

Nice solilioquy. Specifically what opportunity costs does it ignore? In your opinion, what complications are lacking?

Seems to me like you are asserting that there are other things that need to be considered with no earthly idea of what they are. So put up....

And BTW, that model is quite applicable to many of our situations, specifically mine.

 

[pb4uski]

Somebody tell me if this person (I tried about 5 different words here but all of them would probably get me in trouble) ever posts anything of substance. All I see are insults, and nothing at all to back his claims. Welcome to my ignore list.

+1 All hat.....

 

[bigcmagor]

+1 All hat.....

As someone who has previously been accused of having more hat than herd, methinks this comparison is disrespectful to hats.

 

[CardsFan]

Getting back on topic.

In our case, converting to the top of the new 12% bracket is a no-brainer, at least before taking SS.

We avoided about 25% in taxes when we invested, and we can now pay an effective tax rate of 12% (or less) when we convert, and let the balance grow tax free. Whether we use it, or our DS does when we pass (which is the likely use of the money), there is a net benefit of over 13% .

If we take SS at FRA, as we plan, then the conversion benefits may go away if they increase the amount of SS that is taxed. So we will re-evaluate in 3 years when we get there.

As far as converting in the 22% bracket, that is a lot more iffy in terms of tax savings. I am not inclined to simply pre-pay taxes for DS.

That said, we will likely get hit with the tax torpedo at RMD age no matter what we do. We may decide to increase our charitable donations. But when all is said and done, if one or both of us is in the 35% tax bracket due to RMD's, well, we won the game .

FWIW, in the case of SCUBA, with no heirs, it may make perfect sense to NOT convert, and then use charitable contributions to minimize the effect of of RMD's on taxes.

 

[harley]

My CPA said that because Roth money grows tax free, many investors never tap into it, especially if they have enough assets from other sources to live their desired lifestyle. So Roths are often left for heirs.

This is a feature, not a bug. If it doesn't fit in your plans, don't do it. But for us the ability to pass on our hard earned money at a lower tax penalty is a significant bonus. Even f we end up drawing against it ourselves having the money available at the much lower overall rate would feel great.

Somebody tell me if this person (I tried about 5 different words here but all of them would probably get me in trouble) ever posts anything of substance. All I see are insults, and nothing at all to back his claims. Welcome to my ignore list.

The self proclaimed (I read his profile when he first started posting) troll is a waste of space. I wish you would all quit quoting him. Then I could truly ignore him.

 

[samclem]

As far as converting in the 22% bracket, that is a lot more iffy in terms of tax savings. I am not inclined to simply pre-pay taxes for DS.

That said, we will likely get hit with the tax torpedo at RMD age no matter what we do. We may decide to increase our charitable donations. But when all is said and done, if one or both of us is in the 35% tax bracket due to RMD's, well, we won the game .

This is a point that I think sometimes gets overlooked. DW and I won't be converting (i.e. pre-paying taxes) if the projected advantage isn't quite significant. For us that means we won't go beyond the top of the [-]15%[/-] 12% bracket. We've got a long road to travel on this retirement path, and keeping that extra $$ in our accounts rather than using it to pay taxes could provide an important cushion. If our investments do poorly, then our "take" will be lower in $$ every year and the proportion of withdrawals at low tax rates will be even higher. And if our investments do great and we pay more taxes as we near the finish line when we know our money will not run out anyway, then that's okay.

 

[RetireBy90]

This is a point that I think sometimes gets overlooked. DW and I won't be converting (i.e. pre-paying taxes) if the projected advantage isn't quite significant. For us that means we won't go beyond the top of the [-]15%[/-] 12% bracket. We've got a long road to travel on this retirement path, and keeping that extra $$ in our accounts rather than using it to pay taxes could provide an important cushion. If our investments do poorly, then our "take" will be lower in $$ every year and the proportion of withdrawals at low tax rates will be even higher. And if our investments do great and we pay more taxes as we near the finish line when we know our money will not run out anyway, then that's okay.

Since there are many different people on the list, once we get past basic textbook answers, past the math, we can have different conclusions. Reading just this thread, there are different objectives, so different answers.

Sounds like it works for you, so it is the right answer. I try to make sound financial decisions, but sometimes sleeping at night tells me to do something different. Each decision is personal and what is right for you may not be right for anyone else. Drive on !!

 

[Scuba]

OK, if you think you'll leave a lot for heirs, AND they will be in a lower tax bracket then you are now, then maybe it makes sense to not convert. It sounds like this may be your case.

If they aren't going to be in a lower tax bracket, I don't see why you wouldn't go ahead and convert if it's favorable to you, and go ahead and spend some from that Roth. Just because your CPA says many investors don't tap into it doesn't mean you can't. I'll probably tap my Roth before I sell my highly appreciated taxable assets, so I can avoid paying LTCG taxes that my heirs won't have to because of step-up basis on inheriting taxable accounts.

Also consider that after 70 you start paying MRDs, so you may wind up paying a good part of those taxes anyway.

I don't put any importance in delaying paying taxes vs. paying them now. What I look at is, if I wind up draining all of my assets, how will I get the most out of them, considering taxes paid, and return on investments, including the extra return on taxes deferred.

If you want to consider heirs, you can look at the same scenario for how to maximize you money assuming they will drain those assets, which they likely will have to due to inherited RMD rules. It could be, that if their prospects for making income aren't good, that it's better to let them inherit a tIRA and let them pay the taxes at their lower rate, but if they decide to take it as a lump sum they'll get hit hard.

If it comes out better for myself or my heirs to pay some taxes now, I'll do it. It doesn't bother me in the least if I'm spending my money to pay taxes for my heirs, because I'm going to spend whatever I'm going to spend, and with pre-paying taxes I may leave them a little less, but in a better tax situation. So they'll still win, and not at my expense.

If you think you simply won't spend from your Roth because it's tax free growth, then I can't help you. You are no longer making a financial decision.

If I'm missing something, I'd like to learn what.

Wait! You said in post 26 you don't have heirs, and now you're saying you do. I think I just wasted my time. I guess it gave me time to think through the inheritance angle, but I don't think my son will be in a lower tax bracket than I'm in now so I don't think it changes my plan.

I suppose it depends on what you mean by heirs. We don’t have children, nor is there anyone in our lives we feel obligated to leave money for when we die. However, our estate does have designated beneficiaries. We were willing to pay a small four figure amount to set up a trust to maximize the after-tax inheritance they will get. However, we aren’t willing to pay five or six figures of income tax from our portfolio in order to do Roth conversions so that our beneficiaries won’t have taxes on their inheritance when we’re dead.

And as I said previously, so far since our ER, our tax bracket has not been at a lower level than we expect it to be in the future, so there has not been any reason to convert. We’ll see if that changes in the future.

 

[MrLoco]

One thing folks may not be aware of:


On Sept. 21, 2016 the Senate Finance Committee voted 26-0 to "kill the stretch IRA" provision on inherited non-spousal IRA's. Thankfully, this was not voted into law at the time, but could in the future. Why is this important?


Like many, my wife and I have worked hard and squirreled away enough thru 401k's and IRA's that the amount is more than we could have anticipated. And like many, we would like to leave some to the children.



If the stretch IRA provision is ever done away with this leave two options. Heirs can take the money all at once or over a 5 year period. And there is a $450,000 exemption (which is paltry). So if a parent leaves a $2 million Trad. IRA to a child/grandchild....$1.5 million would need to be taken over a 5 year period no later than Dec. 31 the year following the original IRA owner's death. This would place most heirs of the inherited IRA in the highest (or close to it) tax bracket.Obviously, a money grab by Uncle Sam. And even if all the money was in A ROTH IRA....no taxes would be due, but the heir would still be required to liquidate the IRA within 5 years.....giving up perhaps decades of additional tax free growth.


Just another wrinkle.

 

[pb4uski]

^^^^^ I would have no problem with tamping down the stretch IRA... the original intent was to provide tax benefit to the worker/saver... not to their heirs.... and a $450k exemption is pretty generous. Hardly a "money grab".

If I were king I would make it $250k exemption and the rest over up to 10 years.