Rule of 55 vs. Roth Conversions

[jimbohoward69]

I've been racking my brain and doing a lot of research to see which path would better suit the situation I'm in:

• Current federal GS employee and I've maxed out my traditional TSP every year since I started (all traditional to lower my taxable income)
• Receive DoD monthly pension (taxable)
• Receive VA monthly pension (non taxable)
• The salary/DoD pension combo continues to push me into the 22% bracket each year (by roughly $35K)
• Eligible for a reduced FERS pension at 57 or a full pension if I defer to age 62
• Max out Roth IRA each year

I'm 53 and plan to fully retire in May 2025. So, I will fall under the "Rule of 55". Since I'll be able to tap into my TSP penalty free, I'm wondering what the benefit would be to do any Roth conversions. Once I no longer have the salary to "deal with", I can withdrawal from the TSP up to the 12% bracket cap, with the single standard deduction, and still meet my projected expenses (remember, VA pension isn't taxed). And I'll be able to do that for 12 years...with the current brackets of course. Also, my health insurance is through Tricare so I won't be dealing with ACA subsides or anything like that.

Using my family history as a guide, I don't see myself living past 80 yoa.

Can anyone argue that Roth conversions would be more beneficial than just tapping into my TSP using the info above? I understand I'm in a pretty good spot either way but was just curious of everyone's thoughts. I can provide more info if need be.

 

[pb4uski]

When you are in your 70s and RMDs start, whay do you expect your tax bracket to be with RMDs and before RMDs? What do you expect your tax bracket to be before Roth conversions during your early years of retirement?

Roth conversions are principally a tax arbitrage play... paying some taxes now when your tax rate is lwoer to avoid paying more in taxes later when your tax rate is higher.

So for example, I'm very sure that when RMDs start that we will be near the top of the 12% tax bracket and well into the 22% tax bracket after RMDs... so I estimated our effective tax rate on RMDs to be about 17%.

Now, our income before Roth conversions is just barely in the 10% tax bracket... so I can fill the rest of the 10% tax bracket and all of the 12% tax bracket with Roth conversions and it costs me about 11.5% in tax.

So I save 5.5% in tax... only about $5k but not bad for 10 minutes of work.

 

[SevenUp]

Roth IRA conversion - Bogleheads goes into some detail on this, and offers a couple of spreadsheets for self-analysis if you are so inclined.

 

[SecondCor521]

There are really three reasons I know of to do Roth conversions:

1. To set up a Roth pipeline aka Roth ladder. This is one of the ways to access retirement money before 59.5. Seems this one doesn't apply to you.

2. Tax arbitrage. See @pb4uski's post above. It sounds like you're able to hit the "right" amount of TSP withdrawals to hit the right tax rate.

3. To save excess income for spending later. This might apply to you.

So the only reason I can see is if your spending is "low", and the TSP withdrawal to hit the right taxes is "high" in any given tax year. Roth converting in this scenario (instead of a TSP withdrawal) of the difference between income and spending would result in tax deferral on that amount.

It also will lock up that conversion money for a period of time, but given that you'll be close to 59.5, and would spend any Roth contributions first, probably not a problem.

 

[RetireBy90]

One other benefit of a Roth is you don't have to worry about tax considerations if you take a large distribution in one year. For example, if you want to buy a beach house and want to pay cash, there would be no tax due if taken from a Roth. And to the previously mentioned tax arbitrage, we don't know what the rates will be in 10 years so tax paid today removes that uncertainty. We do have current law reverts to higher federal rates in 3 years.

 

[SnowballCamper]

My favorite calculator for this question has gone offline (I-orp.org). In the case like yours (and mine) where you have a lot of secured income, the Roth conversion is less advantageous. For the conversion to be advantageous, it has to result in a lower future tax bracket, and so you have to live long enough for that to pan out.

 

[pb4uski]

My favorite calculator for this question has gone offline (I-orp.org). In the case like yours (and mine) where you have a lot of secured income, the Roth conversion is less advantageous. For the conversion to be advantageous, it has to result in a lower future tax bracket, and so you have to live long enough for that to pan out.

I think you mean lower current tax bracket and higher future tax bracket... right?

 

[RetireBy90]

One more, not sure how much it would apply to you with Pensions, but when one of a couple dies, the survivor will be taxed at single rates not married, which can cause a much higher tax rate for the same income. DW and I both have pensions without survivor benefits so pension income would be lower but then RMDs would send taxable income back up at a higher rate.

 

[SnowballCamper]

I think you mean lower current tax bracket and higher future tax bracket... right?

No, I think the reason to do a Roth conversion is to be in a lower tax bracket in the future than I otherwise would be...Or to have less income in a higher bracket in a future year than what would be the case without the conversion.

 

[SevenUp]

No, I think the reason to do a Roth conversion is to be in a lower tax bracket in the future than I otherwise would be...Or to have less income in a higher bracket in a future year than what would be the case without the conversion.

The comparison should be between your current marginal rate vs. your future marginal rate - not between two different future marginal rates.

E.g., converting at 32% now to reduce one's future tax bracket from 12% to 0% would not be a good idea.

 

[SnowballCamper]

The comparison should be between your current marginal rate vs. your future marginal rate - not between two different future marginal rates.

E.g., converting at 32% now to reduce one's future tax bracket from 12% to 0% would not be a good idea.

Absolutely, do that comparison. But the whole purpose of a conversion is to reduce future taxes. Why pay more taxes now if it isn't going to result in significantly lower taxes in the future? And then, is it worth paying that tax now for a reasonably predicted but uncertain advantage some years down the road. As is the case with the OP and myself, significant secure income reduces the advantage, as compared to those living off investment income with the ability to manage income levels.

 

[pb4uski]

.... For the conversion to be advantageous, it has to result in a lower future tax bracket, and so you have to live long enough for that to pan out.

I think you mean lower current tax bracket and higher future tax bracket... right?

No, I think the reason to do a Roth conversion is to be in a lower tax bracket in the future than I otherwise would be...Or to have less income in a higher bracket in a future year than what would be the case without the conversion.

I think we were both saying the same thing, it is just that I'm not used to it being framed like you did and at least in my case it doesn't really work that way because no matter how much I do in Roth conversions within reason I'll still be in the 22% tax bracket come RMD time. The only way I could get out of the 22% tax bracket is to do Roth conversions beyond what makes common sense between now and RMD time.

So I look at it more that if my effective tax rate on current year Roth conversions, is less than or equal to the effective tax rate on RMDs without Roth conversions then it makes sense to pay taxes today to save more in taxes in the future. So I've been converting to the top of the 12% tax bracket and paying about 11.5% of the amount converted to avoid paying 17% or more later and saving about 5.5% of the amount converted. The savings are not life changing but they are worthwhile given that it only takes me about 10 minutes a year to do.

 

[SnowballCamper]

Thanks pb4uski for your measured reply. You're obviously a respected voice here, and advocate strongly for the Roth conversion which is surely appropriate for those with situations similar to yours. I wrestled with the decision for several months, and being in the 22% bracket from pension income, the benefit of a conversion is minimal, and would take decades to materialize.

 

[SevenUp]

Absolutely, do that comparison. But the whole purpose of a conversion is to reduce future taxes. Why pay more taxes now if it isn't going to result in significantly lower taxes in the future? And then, is it worth paying that tax now for a reasonably predicted but uncertain advantage some years down the road. As is the case with the OP and myself, significant secure income reduces the advantage, as compared to those living off investment income with the ability to manage income levels.

We may be agreeing more than disagreeing.

Note that any conversion now will (with exceptions such as charitable beneficiaries) reduce future taxes.

The timing of a conversion, much like the choice of contributing to traditional vs. Roth, should be based on the comparison of current vs. future tax rates. Yes, "future" implies some guesswork, but the future tax rate will determine whether the original choice was beneficial or not.

For some situations (e.g., converting at 12% to reduce future 22% taxes, or converting at 24% to reduce future 32% taxes, etc.) the choice to convert is clearer than in others (e.g., converting at 24% now and paying the tax from a checking account to reduce future 22% taxes).

 

[SnowballCamper]

We may be agreeing more than disagreeing.

Note that any conversion now will (with exceptions such as charitable beneficiaries) reduce future taxes.

Yes, but framed this way it sounds like everyone should do conversions. I'm not writing a tax check today for 22% of 80k (convert up through 24% bracket) in order to avoid paying the same (or a possibly different) tax in over 20 years (when I expect my income to be in the same bracket, but a higher amount).

I know I'm kinda beating this horse...but I feel like the voices promoting conversion drown out the other perspective. For those with secured income, it is not a clear cut thing to do, and requires significant personal assumptions about ones future, and future tax policy, and a willingness to wait a long time for the benefits to materialize.

 

[SevenUp]

But the whole purpose of a conversion is to reduce future taxes.

Note that any conversion now will (with exceptions such as charitable beneficiaries) reduce future taxes.

Yes, but framed this way it sounds like everyone should do conversions.

The point was that "reducing future taxes" should not be the measuring stick for conversions, because all conversions do that - both favorable and unfavorable conversions.

The measuring stick should be current vs. future marginal rates on the conversion amount: pick the lower (with some exception: see the More complicated situations discussion in the Bogleheads wiki).

I know I'm kinda beating this horse...but I feel like the voices promoting conversion drown out the other perspective. For those with secured income, it is not a clear cut thing to do, and requires significant personal assumptions about ones future, and future tax policy, and a willingness to wait a long time for the benefits to materialize.

Yes, conversions are not necessarily advantageous for everyone at all times - depends on those current vs. future marginal rates, and adding the conversion "on top of" other income does tend to cause higher marginal rates for the conversion.

 

[sengsational]

Everyone's situation is different, but it's a pretty easy decision for many early 55ish retirees who will have an abrupt halt in W2 income, and will be spending after tax money, and who have a 401k/tIRA balance that let's them RE. For the typical of this type, the marginal rate without conversion or tIRA withdrawals is highly likely to be significantly lower than at RMD time.

Too bad i-orp is gone...it didn't model it perfectly, but it was close, and flipping conversion on, vs off, one could get an idea of the magnitude of the benefit.

 

[TheWizard]

I did modest Roth conversions, up to $40,000, each year from 2013 to 2021. Those conversions were sized to be roughly the same as my projected SS (starting in 2020) plus RMDs (starting 2022).
This approach keeps my AGI roughly the same, adjusted for inflation, before and after age 72.

My recent conversions were all in the 24% bracket, no tax arbitrage consideration except possibly for the return to 28% bracket in a few years...

 

[CRLLS]

RMD's will be in the 22% bracket for us. It was supposed to be this year, @70-1/2.. Then it was extended a year and a half. Who knows if we will get another extension when the dust settles on the Secure Act 2.0? My mental dilemma is that no matter how much I have converted over the last few years, while staying at a reasonable cost, my IRA account at the next year has still been higher than what it was (damned market growth). My brain just seems to think I am not getting ahead with the conversions. I know this is the wrong way to think of it. Of course, I am. Sometimes it doesn't feel like it. This year's market correction seems like it may be different.

I do believe, and this has come up in other Roth conversion discussions, that the tax brackets will not stay this low in the future. In fact, it is guaranteed to go up in a few short years if not voted to maintain the current brackets. My point is to make a choice based on one's best judgment of what we think will be the future situation, not necessarily of what is now the rules. A few years of "lower" tax brackets and a couple of extra years to make a larger conversion helps sway the decision for me. I'll continue to do Roth conversions even if everything says there is no benefit and so long as there is no detriment. YMMV.

 

[snoopy1963]

Make sure your 401k administrator allows periodic withdrawals under the rule of 55 and doesn't make you take a lump sum distribution.

 

[cat4ever]

Make sure your 401k administrator allows periodic withdrawals under the rule of 55 and doesn't make you take a lump sum distribution.

And even if you don't have to do lump sum, make sure you can specify what parts of your money to withdraw so that none of your roth money has to be taken while it's still subject to the 5 year conversion clock penalty every time you make a withdrawal. I know in my case this was not possible so doing a roth conversion in my 401k was out of the question.