Roth Conversions - Much Ado About Little?

[RunningBum]

Right, gains will never be taxed in a Roth.

 

[pb4uski]

Yes, we are living from our taxable accounts. If we did no Roth conversions we would pay no tax because our ordinary income is well below the combination of our itemized deductions and exemptions and our other income is qualified dividends and long-term capital gains (both of which are tax-free as long as our total income stays within the 15% tax bracket).

So our Roth conversions to the top of the 15% tax bracket get taxed at 0% to the extent of our unutilized itemized deductions and exemptions, then at 10% and then at 15% and it all averages out to ~7%.

The difference between what we are doing and drawing from our tIRA for living expenses is that we get to put the money into a Roth which is tax-free for the rest of time and can be inherited tax-free by our kids.

So since we are fortunate enough to have taxable funds we can live on for now, we are using Roth conversions to take the best advantage of our current low tax situation. I can't imagine that we will ever be in a position where we can extract funds from our tax-deferred accounts for ~7% so we are taking full advantage of it while we can.

 

[BBQ-Nut]

Yes, we are living from our taxable accounts. If we did no Roth conversions we would pay no tax because our ordinary income is well below the combination of our itemized deductions and exemptions and our other income is qualified dividends and long-term capital gains (both of which are tax-free as long as our total income stays within the 15% tax bracket).

So our Roth conversions to the top of the 15% tax bracket get taxed at 0% to the extent of our unutilized itemized deductions and exemptions, then at 10% and then at 15% and it all averages out to ~7%.

The difference between what we are doing and drawing from our tIRA for living expenses is that we get to put the money into a Roth which is tax-free for the rest of time and can be inherited tax-free by our kids.

So since we are fortunate enough to have taxable funds we can live on for now, we are using Roth conversions to take the best advantage of our current low tax situation. I can't imagine that we will ever be in a position where we can extract funds from our tax-deferred accounts for ~7% so we are taking full advantage of it while we can.

Just a question though - will you need the Roth accounts 'later' or are you doing the conversions cuz you can?

If you don't need the Roth money later, and given your current tax situation, couldn't you also just withdraw the deferred dollars and up your WR for 'better quality of life'?

 

[pb4uski]

I guess it depends on how you define "need" but we are not lacking in lifestyle right now but I'll concede we are intrinsically frugal and probably don't spend as much as we can.

The way I'm looking at it is that that money will get taxed at some point, either as RMDs or when my kids inherit it and draw on it and it is very unlikely that it will be taxed at less than the 7% that I am paying now while doing Roth conversions and very likely that it will be taxed at much more. I expect my tax rate will be higher later on once my pension and SS start and my kid's tax rate will be higher because they will be working when they inherit it.

So I guess more cuz I can.

 

[harley]

I guess it depends on how you define "need" but we are not lacking in lifestyle right now but I'll concede we are intrinsically frugal and probably don't spend as much as we can.

The way I'm looking at it is that that money will get taxed at some point, either as RMDs or when my kids inherit it and draw on it and it is very unlikely that it will be taxed at less than the 7% that I am paying now while doing Roth conversions and very likely that it will be taxed at much more. I expect my tax rate will be higher later on once my pension and SS start and my kid's tax rate will be higher because they will be working when they inherit it.

So I guess more cuz I can.

I'm right there with you. We have a similar situation, although I do have some taxable income so I lose the very bottom bracket for my Roth conversions. However, we mostly live on after tax cash. I put the money into the 401(k) while I was in a high (25+%) bracket. I can convert it in a much lower bracket. Right there I'm saving money. Plus I don't intend to ever need the money in the Roth, so it will be growing tax free for my daughter/grandkids to inherit some day. I really don't need to do the conversions, but it saves me money in taxes, and I get a big warm and fuzzy feeling when that happens.

 

[Animorph]

The net effect of a Roth conversion is that you get to move some of your taxable account money into a tax-free account. Not a wash over a full retirement period, providing you pay taxes, just a wash when you first do it.

Example:

Start:
$100 taxable ($20 untaxed capital gain at 15%), $100 tIRA (25% tax bracket), $0 Roth, NW after taxes = $100 - $20*15% + $100 - $100*25% + $0 = $172

Roth convert $20 of tIRA, pay taxes with taxable account so all $20 goes into the Roth:
Taxes paid = $20*25% = $5 conversion income,
$1 capital gain on average CG tax = $0.15
$94.85 taxable ($18.97 untaxed capital gain), $80 tIRA, $20 Roth,
NW after taxes = $100 - $5.15 - $18.97*15% + $100 - $20 - $80*25% + $20 = $172

So a wash for immediate after-tax net worth, $172 either way. But now you have the $15 after-tax value you moved from the tIRA to the Roth, and you have "moved" $5 of your taxable account into your tax-free Roth account. The benefit is that you avoid all taxes on that $5 in the future, capital gains or dividends or interest. But you only see that over time.

Strictly a way to minimize taxes. You must have enough money in a taxable account to live off of, and to pay the conversion taxes. You must have money in a tIRA to convert. You must have a tax rate for your taxable account that is greater than 0% so that you do actually save taxes by moving that money into a tax-free account.

As far as spending, if you spend from the tIRA instead of the taxable account, you don't get to move that $5 from the taxable account to the Roth account. You withdraw $20 from the tIRA, pay $5 of it in taxes, and spend $15. Your taxable account stays unchanged. If you spend $15 from the taxable account instead, while doing the Roth conversion, you have another $15 gone from the taxable account. Again, the after-tax NW is the same for either case. But with the Roth conversion you now have about $20 less in your taxable account and $20 more in your Roth account. That will lead to less taxes paid in future years. Same net worth now, less taxes due in the future.

I've assumed the tax rate remains the same from now until the tIRA is emptied. If you can get more money Roth converted now at a lower tax rate than your RMD's will have in the future that's an added bonus. If your tax rate is higher now than it will be during RMD's, you may not want to Roth convert.

As a tax reduction plan, Roth conversions are never going to double your yearly spending. At the very best it moves all of your taxable account into a Roth account and you no longer have to pay taxes on that money. Depending on the sizes of your taxable and tIRA accounts and your living expenses, you may be able to move all of your taxable account or only a fraction of it into the Roth. Depending on your tax rates, that may save you nothing or a significant amount.

 

[user5027]

The net effect of a Roth conversion is that you get to move some of your taxable account money into a tax-free account.

Thank you for providing the example. I've one comment...

A Roth conversion moves TAX DEFERRED (tIRA) money into a tax-free account.

A taxable account is money invested that was already taxed and tax is paid on the gains, dividends and interest earned.

 

[pb4uski]

The net effect of a Roth conversion is that you get to move some of your taxable account money into a tax-free account. Not a wash over a full retirement period, providing you pay taxes, just a wash when you first do it.....

Agreed, I misinterpreted your earlier post as being a wash in the long run. It would be a wash in the long run if the effective tax rate at conversion and when the money would otherwise be used (by you or an heir) are the same.

I'll admit that I this ER to pension/SS period where we can convert at very low effective tax rates was a pleasant surprise.

 

[Animorph]

Thank you for providing the example. I've one comment...

A Roth conversion moves TAX DEFERRED (tIRA) money into a tax-free account.

A taxable account is money invested that was already taxed and tax is paid on the gains, dividends and interest earned.

Yes, of course, but the net effect is a reduction of your taxable account. Just as if you took $20 from the tIRA, paid $5 of that in taxes, added back $5 from your taxable account, and then placed the $20 into your Roth. That makes the value proposition easier (for me anyway) to see.

 

[Animorph]

Agreed, I misinterpreted your earlier post as being a wash in the long run. It would be a wash in the long run if the effective tax rate at conversion and when the money would otherwise be used (by you or an heir) are the same.

I'll admit that I this ER to pension/SS period where we can convert at very low effective tax rates was a pleasant surprise.

Wait a minute, it's not necessarily a wash in the long run if the tax rates now and in the future are the same, though it could be if you don't owe any taxes on your taxable account throughout retirement. That's what my example showed, shifting taxable funds into the Roth account. The Vanguard Roth conversion calculator used to show that benefit as well. I assume it still does.

Luckily for me all this stuff came up on the forum in time for me to incorporate it into my plans. When I first started it was all 4% SWR discussions, then we gradually branched out to other useful ideas.

 

[GrayHare]

So a wash for immediate after-tax net worth, $172 either way. But now you have the $15 after-tax value you moved from the tIRA to the Roth, and you have "moved" $5 of your taxable account into your tax-free Roth account. The benefit is that you avoid all taxes on that $5 in the future, capital gains or dividends or interest. But you only see that over time.

It's mathematically commutative: in your example your after-tax NW remains the same with or without conversion to Roth no matter how much time passes.

 

[rayvt]

It's mathematically commutative: in your example your after-tax NW remains the same with or without conversion to Roth no matter how much time passes.

Correct.

What this really is, is a way of putting more money into a Roth than you could otherwise. As was pointed out above, $10K in a regular IRA is only 85% yours (depending on your tax bracket), so it's only $8500, but $10K in a Roth is 100% yours.

I *think* that with the commutativeness, it all cancels out -- but it's very confusing.

Financially, in your working years the financially best thing to do is put your money into a taxable S&P500 fund, rather than an IRA or a Roth.
One way or another, you pay ordinary income tax on IRA/Roth money, but only LTCG on taxable S&P500 money.

But this ONLY works if you keep your grubby hands off the S&P fund and buy-and-hold until you retire. That's the hard part for most people. Due to mental accounting, people generally won't touch the IRA/Roth until retirement, but in their mind the S&P fund isn't "retirement fund" so it'll get spent on car/house/boat/RV somewhere before they retire.

The other main reason for doing Roth conversion is to reduce the IRA balance so that you aren't forced to take a larger RMD than you want. Taxwise, as you say, there is no difference overall between IRA and Roth.

 

[gofan316]

Roth conversion will also impact ACA subsidy, if you intend to use it. For example if your AGI is 45k, and you fill up 17K with Roth conversion, to the ACA cliff $62k, your annual silver plan cost will be 62000*9.56%=$5927; without Roth, the same plan will cost $4200 for the original 45k income.

That will be additional 10% "tax rate" there: (5900-4200)/17000

Not sure if the ORP calculator takes that into considerations.

 

[Chuckanut]

Roth conversion will also impact ACA subsidy, if you intend to use it. For example if your AGI is 45k, and you fill up 17K with Roth conversion, to the ACA cliff $62k, your annual silver plan cost will be 62000*9.56%=$5927; without Roth, the same plan will cost $4200 for the original 45k income.

That will be additional 10% "tax rate" there: (5900-4200)/17000

Not sure if the ORP calculator takes that into considerations.

Good points. Of course, the Roth conversion may also prevent a similar thing from happening regarding the taxation of social security benefits when one hits the age of required distributions. A Roth conversion might save the day when those required distributions push a person into higher tax brackets where some advantages are lost.

It's confusing to say the least.

 

[kaneohe]

It's mathematically commutative: in your example your after-tax NW remains the same with or without conversion to Roth no matter how much time passes.

I've only seen that "c" word used in connection w/ IRA contributions:
e.g. contribute 10K to TIRA (if you could) vs 7.5K to Roth (if you could).
This is for the 25% tax bracket. Then if each doubles
TIRA = 20 K but after 25% tax , after tax is worth 15K
Roth doubles and is worth 15K. same same as you say and the same thing
and calculations apply if you do the Roth conversion using TIRA funds to pay the tax (if you could w/o penalty such as being old).

The difference comes if you use outside funds to pay the tax so that the Roth
starts bigger.
TIRA= 10 K plus 2.5K side fund; if each doubles TIRA= 20K; side fund 5K-
After tax of 25%, TIRA=15K, side fund = 5K-- with total of 20K --
the -- is due to the tax drag during the compounding period and the CG tax
of the side fund upon sale.

Roth=10K with 0 in side fund since the 2.5K was used to pay the conversion.
Roth doubles like the TIRA did to 20K so the Roth is somewhat ahead by the
-- since no taxes were due. The longer time/larger gains will make the delta even larger. This is why the common advice is to pay the tax w/ outside funds (plus if
<59.5 y.o.,you avoid the early withdrawal penalty).

Now if you are in 15% bracket with 0% rate on QDIV/LTCG , the -- might
shrink to 0.

 

[Rothman]

Good points. Of course, the Roth conversion may also prevent a similar thing from happening regarding the taxation of social security benefits when one hits the age of required distributions. A Roth conversion might save the day when those required distributions push a person into higher tax brackets where some advantages.

I think Chuckanut is on to something, a Roth conversion might save the day.....

Mr. Taxman never hangs around,
When he hears this Mighty sound,

Here I come to save the day!
That means the Mighty Roth is on the way!

Yes sir, when there is a tax to make right,
Mighty Roth will join the fight!

Excess RMDs or higher future taxes in the land,
He's got the situation well in hand!

We know that when there's tax danger, we'll never despair;
Because we know that when there's tax danger he is there...
On RMDs, on higher brackets, in staying below ACA.

We're not worrying at all
We just listen for his call
"Here I come to save the day!"
That means that Mighty Roth is on the way.

When there is a tax to make right,
Mighty Roth will join the fight
"Here I come to save the day!"
That means that Mighty Roth is on the way!


I thought that was catchier than a post about commutative laws don't apply with non-linearities in the tax situation.


Sent from my iPad using Early Retirement Forum

 

[GTFan]

Roth conversion will also impact ACA subsidy, if you intend to use it. For example if your AGI is 45k, and you fill up 17K with Roth conversion, to the ACA cliff $62k, your annual silver plan cost will be 62000*9.56%=$5927; without Roth, the same plan will cost $4200 for the original 45k income.

That will be additional 10% "tax rate" there: (5900-4200)/17000

Not sure if the ORP calculator takes that into considerations.

Exactly, and since we are trying to limit income from WDs etc. to stay below 250% of FPL (to maximize the Silver cost-sharing benefits) I won't be doing Roth conversions. It's a much better subsidy at those levels that you're forgoing if you go past 250% (around $39k income for a family of 2). We're actually going to try to stay below 200% FPL if we can because the Silvers are way better at those levels, both for subsidies and cost-sharing.

http://www.healthpocket.com/obamacare/cost-sharing-reduction-silver-plan

Add that to the lost investment growth of converted Roth money (i.e. the money lost to taxes and foregone subsidies) and it's really a wash at best in these scenarios IMO.