Spending down and taxes

[lawman]

I need help..I am 65 years old and will soon begin to spend down on my savings..I am invested as follows and am unsure of the best order to make withdrawals in order to minimize my tax liability. I have only one child that will inherit what I leave..

We have pensions that provide for all necessities..

Rollover IRA'S - 27.83%
Regular brokerage account - 47.1% (all stock and bond mutual funds)
I Bonds - 12%
Cash - 12.9%
Thanks

 

[pb4uski]

Not enough to go on. How much do you need to live on and what are your current and future income sources (pensions, SS, etc.)? What tax bracket does that income put you in?

If you have not yet started SS and don't have a pension, then this may be an opportune time to live off of cash and do Roth conversions to reduce your tIRAs and reduce future RMDs.

 

[pacergal]

Not an expert by any means, but since you state your pension pays for all expenses and you still have SS to add:
Also don't know your current tax bracket, or amounts in your retirement portfolio, so based on my wild guess to limit your taxes, maybe cash and brokerage since cap gains taxed less?Many, many more experts here than me, so take this with grain of salt

 

[pb4uski]

Oops.... I missed the pensions part.

In that case, the key question becomes what is your current marginal tax rate and what do you expect it to be once you are collecting SS (if any)?

A common approach is to do Roth conversions to the top of your current tax bracket or even the top of the tax bracket that you'll be in when collecting SS and pay the tax from taxable account money.

 

[ziggy29]

Another question is about your taxable account. If you don't think you will ever *need* any of this money for living expenses, leave it alone (paying tax on only the diistributions from the fund) and let your heirs inherit a step up in cost basis. And since it has no RMDs, you never need to touch it if you don't need it.

 

[pb4uski]

^^^^ +1 that is a big factor in our plan

 

[homestead]

Oops.... I missed the pensions part.

In that case, the key question becomes what is your current marginal tax rate and what do you expect it to be once you are collecting SS (if any)?

A common approach is to do Roth conversions to the top of your current tax bracket or even the top of the tax bracket that you'll be in when collecting SS and pay the tax from taxable account money.

I think people should also look at the loss of principal and interest on the amount you pay in extra taxes on a large conversions. Since this money goes to the govt never to be seen again and over 20 years or so could exceed the amount saved on lower taxes.

 

[lawman]

Thanks...After seeing this and thinking about my situation I think I should probably just forget about my IRA's and I - Bonds and just spend off my brokerage account..My income from pensions and SS is already more than I spend..I'm thinking of using my investments for capital expenditures like a swimming pool, new vehicles, home improvements etc..I see no reason for tapping my tax deferred accounts..Is it more complicated than that?

 

[pb4uski]

I think people should also look at the loss of principal and interest on the amount you pay in extra taxes on a large conversions. Since this money goes to the govt never to be seen again and over 20 years or so could exceed the amount saved on lower taxes.

^^^ It doesn't really work that way.

Let's say that your marginal tax rate is 20% and you have a $100k IRA... if you convert today and pay the taxes you have $80k in a Roth... if over 20 years the Roth triples in value you have $240k.

Now OTOH, let's say that you don't convert and over 20 years the IRA triples in value to $300k and you withdraw and pay $60k in taxes... you have $240k to spend.

 

[pb4uski]

Thanks...After seeing this and thinking about my situation I think I should probably just forget about my IRA's and I - Bonds and just spend off my brokerage account..My income from pensions and SS is already more than I spend..I'm thinking of using my investments for capital expenditures like a swimming pool, new vehicles, home improvements etc..I see no reason for tapping my tax deferred accounts..Is it more complicated than that?

Yes. It probably isn't so much that you'll be doing harm but more that you might be ignoring low-hanging fruit.

You might want to read through this paper https://www.kitces.com/blog/tax-eff...strategies-to-fund-retirement-spending-needs/

and this thread https://www.early-retirement.org/fo...erspective-i-needed-102073-6.html#post2376544

 

[homestead]

^^^ It doesn't really work that way.

Let's say that your marginal tax rate is 20% and you have a $100k IRA... if you convert today and pay the taxes you have $80k in a Roth... if over 20 years the Roth triples in value you have $240k.

Now OTOH, let's say that you don't convert and over 20 years the IRA triples in value to $300k and you withdraw and pay $60k in taxes... you have $240k to spend.

I'm not saying not to convert, but at some point larger conversions taxes paid overshadow the tax savings. At least it did on my calculations out 25 years
when figuring the loss of taxes paid and interest.

 

[lawman]

This stuff makes my head hurt but I guess it's a good problem to have..

 

[Out-to-Lunch]

I think people should also look at the loss of principal and interest on the amount you pay in extra taxes on a large conversions. Since this money goes to the govt never to be seen again and over 20 years or so could exceed the amount saved on lower taxes.

I'm not saying not to convert, but at some point larger conversions taxes paid overshadow the tax savings. At least it did on my calculations out 25 years
when figuring the loss of taxes paid and interest.

I am not 100% sure I understand your point, so let me try to explain why I think the there is a problem with this reasoning. (Again, you may have something else in mind.)

First, though, you mention "large conversions." (Nearly) everyone agrees you should not do conversions so large that the marginal tax you pay on the conversion is larger than you would pay upon taking the funds out of tax-deferred in the future. (Of course, you don't always know your future marginal rate!) So if this is what you mean, I certainly agree.

If you are NOT converting into a higher tax rate, but same as the rate you would be withdrawing in anyway, then the analysis that pb4uski presents is the relevant one. If you pay the taxes out of the IRA (as he discussed in that intenionally simple example), the conversion is a wash. Even better, if you pay the taxes with your taxable account, you are effectively moving some money from your taxable to your Roth. In that case, the interest that you mentioned that you will receive in the future will be tax-free!

 

[homestead]

Let me say it another way. When I was working on my roth/rmd calculator program I focused on lowest overall taxes over a 25 year period. Then in thinking about what were the costs in doing those conversions I thought of the lost principal and interest on the taxes paid over 25 years. I added that to my calculator and the result was the optimal conversions amount went down. The optimal conversion amount was chosen by the highest roth/ira/aftertax balances rather than lowest taxes which was my original thinking.

 

[Out-to-Lunch]

Let me say it another way. When I was working on my roth/rmd calculator program I focused on lowest overall taxes over a 25 year period. Then in thinking about what were the costs in doing those conversions I thought of the lost principal and interest on the taxes paid over 25 years. I added that to my calculator and the result was the optimal conversions amount went down. The optimal conversion amount was chosen by the highest roth/ira/aftertax balances rather than lowest taxes which was my original thinking.

Can I see if I understood correctly? You first tried to minimize taxes paid, but then you realized that it was more important to maximize Roth/tira/aftertax balances, right? If so, I agree, subject to the next comment.

However, I think you want to optimize spendable funds in your balances. In your analysis, are you taking into account that the balance in your Roth allows you to spend more money than the same amount in your TIRA? A dollar in Roth is worth more than a dollar in taxable is worth more than a dollar in TIRA.

As pb4uski showed above, that "lost" principal (and foregone interest) is not really lost. It gets the money into the Roth, from where 100% of it and its gains can be spent without future losses to taxation. Again, if you use TIRA funds to pay the taxes, it is a wash. If you use taxable monies to pay the taxes, you are actually shielding from future taxation some interest that would have been taxed if you hadn't converted.

 

[homestead]

I see what you are saying about spendable funds.
I agree with you that I would have more in roth with larger conversions and that is desirable for most people, but for us all the categories are pretty much the same since our typical spending doesn't come out any of them.
Not sure about current laws is it better now for our heirs to inherit say 400k ira or 400k roth?

Just suggesting for those calculating conversions/rmd's to also figure in the total cost of the conversion and then decide.

 

[ERD50]

Another question is about your taxable account. If you don't think you will ever *need* any of this money for living expenses, leave it alone (paying tax on only the diistributions from the fund) and let your heirs inherit a step up in cost basis. And since it has no RMDs, you never need to touch it if you don't need it.

In addition, if any of those taxable investments has a capital loss, sell off those first. The losses get lost in the step-up. Also consider any investments that have very small cap gains.

-ERD50

 

[Out-to-Lunch]

I see what you are saying about spendable funds.
I agree with you that I would have more in roth with larger conversions and that is desirable for most people, but for us all the categories are pretty much the same since our typical spending doesn't come out any of them.
Not sure about current laws is it better now for our heirs to inherit say 400k ira or 400k roth?

Just suggesting for those calculating conversions/rmd's to also figure in the total cost of the conversion and then decide.

Absolutely, no question about it, it is better for your heirs to get $400k in a Roth than $400k in a TIRA. They will have to pay taxes on the funds coming out of the TIRA, but not so on the Roth funds.

But that is probably not the right question. Let's say that YOUR marginal tax rate for potentially converting TIRA funds to Roth is 20% (to make the math easier). Probably, the right question is: Is it better for your heirs to inherit a $400k TIRA or a $320k Roth? And the answer mostly depends on whether their marginal tax rate on TIRA withdrawals is higher than 20% or lower than 20%.

 

[homestead]

Well that gets real complicated figuring each of their tax rates in the future.
And who knows how they are going to change the tax laws in the future.

If I do multiple smaller conversions the end total is 116k larger and 144k total taxes.
Less taxes now and more later on.
Ending up with
55% aftertax
25% roth
20% ira

If I do multiple conversions (3x above amount above) total taxes are 106k
More taxes now and less later on.
Ending up with
35% aftertax
55% roth
10% ira

 

[Out-to-Lunch]

Well that gets real complicated figuring each of their tax rates in the future.
And who knows how they are going to change the tax laws in the future.

Yep, you are right about that!

BTW, I am far from dogmatic on whether (and how much) one should convert. As you say, there are so many factors that complicate the decision, and some pertain to one person and not to another. I am only trying to convey the rules of thumb and try to encourage how to make the comparison fairly.

In my case, one of the main drivers for converting is the assumption that my DW will be filing single at some point, and so her future tax rate will be higher even if tax rates don't change. The other main consideration is that I can use pre-medicare and pre-SS years to convert, and thereby keep us out of higher IRMAA tiers if we convert, and not if we don't. But, I do want to preserve a sizable deferred bucket for possible QCD and/or medical/LTC expenditures.
On the other hand, I have almost no bequest motive, so that eliminates a host of considerations that you (homestead) have to contend with. For example, pb4uski's recent comment about preserving taxable for inheritance (in consideration of the stepped-up basis) was not one that I have had to contemplate.

If I do multiple smaller conversions the end total is 116k larger and 144k total taxes.
Less taxes now and more later on.
Ending up with
55% aftertax
25% roth
20% ira

If I do multiple conversions (3x above amount above) total taxes are 106k
More taxes now and less later on.
Ending up with
35% aftertax
55% roth
10% ira

You almost gave us enough info to figure out your situation. (Actually, I thought you did, but the numbers do not appear to be all internally consistent, maybe?) Not that you asked, but I personally would be hard-pressed to choose between those situations, but then I don't have all the information.

 

[Out-to-Lunch]

By the way, apologies to lawman for the thread drift, but I hope maybe this discussion is useful to you??

 

[kgtest]

My dad had $$$$ in his IRAs when he retired and 0 in his Roth. He made 1 contribution that last year he worked since he could qualify. Then, the rest was roth conversions, paying taxes on each one and the amount was determined by the room he had leftover after all of his other taxable income outside the conversion... less 77,400 or whatever the 12% tax bracket ceiling was. SOOO

For the sake of this thread, he had roughly 35k of taxable income (pension + social security). THEN he roth converted up to that $ 77,400 (this year in 2020 its $78,950) ceiling so...


Roth Conversion Amount = $78,950 (12% Tax Bracket Ceiling) - $35,000 (taxable income like SS and Pension)

Roth Conversion Amount = $43,950 . A dollar more and it gets taxed at the 22% bracket. DO NOT convert if your future tax rates WILL BE LOWER than current tax rates.

 

[homestead]

Thanks...After seeing this and thinking about my situation I think I should probably just forget about my IRA's and I - Bonds and just spend off my brokerage account..My income from pensions and SS is already more than I spend..I'm thinking of using my investments for capital expenditures like a swimming pool, new vehicles, home improvements etc..I see no reason for tapping my tax deferred accounts..Is it more complicated than that?

OP, I would project what the expected balances could be on your IRA's at age 72 and then use a RMD calculator to see what RMD's you would have to be taken and see what that extra income would do to your taxes. Then decide if you want to start taking IRA distributions or conversions to help minimize your taxes later.

AARP has an RMD calculator here.

 

[pb4uski]

My dad had $$$$ in his IRAs when he retired and 0 in his Roth. He made 1 contribution that last year he worked since he could qualify. Then, the rest was roth conversions, paying taxes on each one and the amount was determined by the room he had leftover after all of his other taxable income outside the conversion... less 77,400 or whatever the 12% tax bracket ceiling was. SOOO

For the sake of this thread, he had roughly 35k of taxable income (pension + social security). THEN he roth converted up to that $ 77,400 (this year in 2020 its $78,950) ceiling so...


Roth Conversion Amount = $78,950 (12% Tax Bracket Ceiling) - $35,000 (taxable income like SS and Pension)

Roth Conversion Amount = $43,950 . A dollar more and it gets taxed at the 22% bracket. DO NOT convert if your future tax rates WILL BE LOWER than current tax rates.

Not sure where you are getting that $78,950

The top of the 12% tax bracket in 2020 for a married couple is $80,250 of taxable income. The top of the 0% qualified dividends and LTCG bracket for a married couple is $80,000.

And you need to be careful.... if one has qualified dividends and LTCG and you do Roth conversions that put you a dollar over the $80,000 limit then the marginal tax rate is 27% (12% on that $1 of additional ordinary income and 15% on a dollar of preferenced pushed from the 0% bracket to the 15% bracket). It is 27% until all preferenced income is pushed into the 15% bracket and then reverts to 22%.