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Traditional 401K Roth Conversions - How to determine the Benefits?
Old 08-04-2022, 09:50 AM   #1
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Traditional 401K Roth Conversions - How to determine the Benefits?

I have been using the NewRetirement PlannerPlus tool with the Roth Explorer feature. The Roth feature provides recommendations on when to execute Roth conversions for my DW and I 401k funds. Based on the conversions, it looks like I would eliminate any RMDs starting at age 72.

However, the Roth conversions have a huge tax bill for each year of the conversion.

Any feedback from other doing 401K Roth conversions and how to justify the benefits of the conversions.

Be patient with me as I'm a newbie on this topic.

P.S. I would need to tap into my 401K funds at age 57 (Rule of 55) and my wife will need to tap into her funds at age 61. I am 56 and my wife is 59.

Here is a YouTube video I'm using as a point of reference.

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Old 08-04-2022, 10:48 AM   #2
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The justification for the benefit, and the primary benefit, is to pay less tax now than what you would pay later (at RMD time).

It sounds like almost all your retirement income will come from the 401k (until SS kicks in). In that case the conversions are generally very favorable, but do take a while for the benefits to materialize (in having a lower tax bill later in life).

Another justification is when one spouse dies, the other is suddenly in a higher tax bracket for RMDs.

For those like myself, with significant secure income (pension) conversions are much less favorable.

In any case, find a calculator and run the numbers for your situation.
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Old 08-04-2022, 11:22 AM   #3
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...it looks like I would eliminate any RMDs starting at age 72.
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Originally Posted by SnowballCamper View Post
It sounds like almost all your retirement income will come from the 401k (until SS kicks in).
If SnowballCamper's inference is correct, then eliminating RMDs would mean you have converted too much.

That's because if your income is all SS plus Roth withdrawals, your Adjusted Gross Income (AGI) would be less than your standard deduction. Better to have converted less, and thus have paid less in conversion taxes, so that your non-zero RMDs could be covered by your standard deduction and thus still pay no tax on them.
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Old 08-04-2022, 11:28 AM   #4
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Originally Posted by SnowballCamper View Post
The justification for the benefit, and the primary benefit, is to pay less tax now than what you would pay later (at RMD time).

It sounds like almost all your retirement income will come from the 401k (until SS kicks in). In that case the conversions are generally very favorable, but do take a while for the benefits to materialize (in having a lower tax bill later in life).

Another justification is when one spouse dies, the other is suddenly in a higher tax bracket for RMDs.

For those like myself, with significant secure income (pension) conversions are much less favorable.

In any case, find a calculator and run the numbers for your situation.
Retirement income consists of wife and I pension, wife and I SS, and wife and I 401K. 3 legged stool of retirement.

I can share more information if you need it.
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Old 08-04-2022, 11:56 AM   #5
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I modeled three annual scenarios in Flexible Retirement Planner. Blue is no conversion, Red is 20K conversion, Green is 40K conversion. The curves are dependent on our inputs, like IRA total, when we hit RMD age, etc. The program calculated taxes at an effective rate of 15%.

I copied the detailed columns from FRP and placed in Excel. The chart is the result. It is applicable to our situation, but something similar occurs for other couples I would think.
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Old 08-04-2022, 12:15 PM   #6
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I modeled three annual scenarios in Flexible Retirement Planner. Blue is no conversion, Red is 20K conversion, Green is 40K conversion. The curves are dependent on our inputs, like IRA total, when we hit RMD age, etc. The program calculated taxes at an effective rate of 15%.

I copied the detailed columns from FRP and placed in Excel. The chart is the result. It is applicable to our situation, but something similar occurs for other couples I would think.
Wow. $20K and $40K conversions makes a different.

I will download the Flexible Retirement Planner tool.

https://www.flexibleretirementplanner.com/wp/
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Old 08-04-2022, 12:54 PM   #7
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The program calculated taxes at an effective rate of 15%.
Same rate for all conversion amounts?
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Old 08-04-2022, 03:51 PM   #8
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I'm single and in the 24% marginal bracket in retirement.
I've done moderate Roth conversions, in the $40-50k range, over the past several years.

I'm not expecting a tax arbitrage bonus, aside from the possible return to the 28% bracket in a few years.

My RMDs started this year and are a chunk lower than they would have been without any Roth conversions. And my AGI for this year should be just a bit more than last year, no big tax torpedo thingie.

I pay Medicare IRMAA, so those Roth conversions are helping me stay in my current tier, not getting into the next higher tier due to a big AGI jump.
The inflation adjustments to the IRMAA thresholds will be helping also.

And finally, I now have good sized tax-free fund that I can withdraw money from for infrequent large expenses without bumping my AGI up with LTCGs, etc...
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Old 08-04-2022, 04:28 PM   #9
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Weve decided to do large conversions through 2025 before the TCJA sunsets and we return to to previous tax brackets. We are paying a lot of IRMAA and Federal income tax until then.
After that we should pay relatively minimal taxes and IRMAA shouldnt effect us, or at worst the first tier. Without this, if one of us passed, wed leave the surviving spouse in a tax bind.
I used Pralana Gold and also Excel spreadsheets to map out our income and estimated taxes to age 95. Our approach should save us quite a bit in taxes over our lives, but were having to pay quite a bit now. We do have a good amount in taxable accounts that we can use to pay the taxes and live off of while we do this. Im not sure Id be as aggressive if I had to pay taxes by withholding from the conversions. That changes the math a bit.
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Old 08-04-2022, 04:42 PM   #10
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We’ve decided to do large conversions through 2025 before the TCJA sunsets and we return to to previous tax brackets. We are paying a lot of IRMAA and Federal income tax until then.
After that we should pay relatively minimal taxes and IRMAA shouldn’t effect us, or at worst the first tier. Without this, if one of us passed, we’d leave the surviving spouse in a tax bind.
I used Pralana Gold and also Excel spreadsheets to map out our income and estimated taxes to age 95. Our approach should save us quite a bit in taxes over our lives, but we’re having to pay quite a bit now. We do have a good amount in taxable accounts that we can use to pay the taxes and live off of while we do this. I’m not sure I’d be as aggressive if I had to pay taxes by withholding from the conversions. That changes the math a bit.
On the account that you are doing the conversions on (ex. TIRA, 401k), are you drawing down on those funds as well?

I will need to withdraw from some of the 401K funds (account I'm doing the conversion on) to live on as I do the conversions into the Roth.
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Old 08-04-2022, 04:55 PM   #11
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On the account that you are doing the conversions on (ex. TIRA, 401k), are you drawing down on those funds as well?

I will need to withdraw from some of the 401K funds (account I'm doing the conversion on) to live on as I do the conversions into the Roth.

No, we live off of our taxable accounts, along with a meager pension and Im also taking social security. DW is waiting until 70 to take her social security.
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Old 08-04-2022, 05:19 PM   #12
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Same rate for all conversion amounts?
Yes, effective tax rate is one rate applied to the total income.

I used 15% effective tax rate: 12% Federal and 3% State.

We're going into the 22% bracket this year after two years of 12%. It's a great problem to have, so not complaining.
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Old 08-04-2022, 05:26 PM   #13
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Don't worry about paying the taxes "early", or the dollar amount. Only the percent of each dollar withdraw taken in taxes counts. By converting gradually you minimize the tax brackets the withdrawals fall into. By converting too much you may leave potential low tax brackets unfilled late in retirement. Also consider that one spouse may die and the surviving spouse would be taxed as a single tax payer, with effectively higher tax rates for the same income.

A good way to think of your tIRA is this: Assume everything will come out at a 20% tax rate (for simplification). Then 20% of your tIRA belongs to the IRS. Pay them now or invest it for them and pay it later, 20% of every dollar withdrawn is theirs and they always own 20% of your tIRA balance. There is no advantage (if you can't change your tax rate) in delaying taxes like there is in a taxable account. Your advantage comes if you can reduce that 20% for at least some of the money. Then you get to take some of the IRS's money as your own.

At a fixed 20% tax rate your $100k tIRA is the same as an $80k Roth IRA. There's $80k of your tax-free money in that tIRA and $20k of the IRS's money in it as well. So everything being equal in this simple case, a Roth conversion is a total wash. The timing doesn't matter, you're just investing the IRS's money for a longer time if you wait.

An extra benefit of a Roth conversion is that when you withdraw that $100k and pay the IRS their $20k (or maybe it's now $200k and $40k after doubling your investment) you are still eligible to place a full $100k into the Roth, not just your $80k. So you pay the $20k taxes from your taxable account (possibly incurring taxable capital gains before you normally would, so it may not be without some cost), and put the full $100k in the Roth. Now $20k that was in your taxable account is in your Roth account instead, growing tax free. The value of that tax free growth may be nothing to something substantial (if you are highly taxed and leave it to grow tax free for a long time.)

So my financial optimization is to determine how much to withdraw from the tIRA/t401k each year to essentially minimize the tax rate of each dollar withdrawn throughout retirement (I actually try to maximize what I can spend, inflation adjusted, but close enough). I'll use the withdrawal for expenses if necessary (when taxable account dollars dry up) and everything else goes into the Roth for later.

And the exception to my lowest tax rate rule is when the added benefit of moving taxable money into the Roth outweighs a (slightly) higher withdrawal tax rate when all is said and done. It's not a big driver, but favors larger Roth conversions earlier in the process when your money has a longer time to grow in the Roth. About 10 years before Roth withdrawals will start was my cutoff for pushing the tax rate a little bit.

Be sure to consider income tax/credit/subsidy trigger levels that may add to your effective tax rate when converting. And also consider using the 0% capital gains tax rate that may be available to you. Hopefully many of these special cases won't apply or will always apply, simplifying your calculations.
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Old 08-04-2022, 05:48 PM   #14
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I modeled three annual scenarios in Flexible Retirement Planner. Blue is no conversion, Red is 20K conversion, Green is 40K conversion. The curves are dependent on our inputs, like IRA total, when we hit RMD age, etc. The program calculated taxes at an effective rate of 15%.
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Same rate for all conversion amounts?
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Yes, effective tax rate is one rate applied to the total income.

I used 15% effective tax rate: 12% Federal and 3% State.
If that's how FRP works, it's not a good recommendation for the tool.

The trick with Roth IRA conversions is how to navigate the non-flat US tax code in which higher conversion amounts usually incur higher marginal tax rates but not always. It's the marginal rates on the extra conversion amounts compared with the marginal rates on the decreased RMD amounts that matters.
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Old 08-04-2022, 06:06 PM   #15
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FRP is not a tax-planning tool. I mentioned that in another thread, and repeat it here for the curious. I added a graph which shows how taxes would increase if WE do nothing. It is teaching moment. Don't like it, fine.

The chart was not meant to be anything other than a depiction of how conversions can change the tax, you can use different conversion amounts, and so on.

These discussions are all analytical to some degree. Every tool I've seen can't predict the future. But tools can show how options you select may impact the long run.

The short story is convert enough to stay in the 12% now. Going further requires more analysis.

The long story is about how you might shift invested dollars from your tax-deferred pile to your tax-free pile.

YMMV.
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Old 08-04-2022, 06:29 PM   #16
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Don't worry about paying the taxes "early", or the dollar amount. Only the percent of each dollar withdraw taken in taxes counts. By converting gradually you minimize the tax brackets the withdrawals fall into. By converting too much you may leave potential low tax brackets unfilled late in retirement. Also consider that one spouse may die and the surviving spouse would be taxed as a single tax payer, with effectively higher tax rates for the same income.

A good way to think of your tIRA is this: Assume everything will come out at a 20% tax rate (for simplification). Then 20% of your tIRA belongs to the IRS. Pay them now or invest it for them and pay it later, 20% of every dollar withdrawn is theirs and they always own 20% of your tIRA balance. There is no advantage (if you can't change your tax rate) in delaying taxes like there is in a taxable account. Your advantage comes if you can reduce that 20% for at least some of the money. Then you get to take some of the IRS's money as your own.

At a fixed 20% tax rate your $100k tIRA is the same as an $80k Roth IRA. There's $80k of your tax-free money in that tIRA and $20k of the IRS's money in it as well. So everything being equal in this simple case, a Roth conversion is a total wash. The timing doesn't matter, you're just investing the IRS's money for a longer time if you wait.

An extra benefit of a Roth conversion is that when you withdraw that $100k and pay the IRS their $20k (or maybe it's now $200k and $40k after doubling your investment) you are still eligible to place a full $100k into the Roth, not just your $80k. So you pay the $20k taxes from your taxable account (possibly incurring taxable capital gains before you normally would, so it may not be without some cost), and put the full $100k in the Roth. Now $20k that was in your taxable account is in your Roth account instead, growing tax free. The value of that tax free growth may be nothing to something substantial (if you are highly taxed and leave it to grow tax free for a long time.)

So my financial optimization is to determine how much to withdraw from the tIRA/t401k each year to essentially minimize the tax rate of each dollar withdrawn throughout retirement (I actually try to maximize what I can spend, inflation adjusted, but close enough). I'll use the withdrawal for expenses if necessary (when taxable account dollars dry up) and everything else goes into the Roth for later.

And the exception to my lowest tax rate rule is when the added benefit of moving taxable money into the Roth outweighs a (slightly) higher withdrawal tax rate when all is said and done. It's not a big driver, but favors larger Roth conversions earlier in the process when your money has a longer time to grow in the Roth. About 10 years before Roth withdrawals will start was my cutoff for pushing the tax rate a little bit.

Be sure to consider income tax/credit/subsidy trigger levels that may add to your effective tax rate when converting. And also consider using the 0% capital gains tax rate that may be available to you. Hopefully many of these special cases won't apply or will always apply, simplifying your calculations.
I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?
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Old 08-04-2022, 06:41 PM   #17
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I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?
This is an excellent time to do Roth conversions.
Convert 5% of your 401k balance this year, ok?
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Old 08-04-2022, 06:49 PM   #18
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I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?
Definitely not too late! As a guess, converting this year would not be good because the conversion amount would be taxed "on top of" (i.e., at a higher marginal rate) your work income.

At a minimum, start by understanding the marginal tax rate(s) you'll pay on various Roth conversion amounts for the next several years (i.e., after retirement and before IRMAA and/or SS effects kick in).

Then estimate your RMDs, assuming some growth rate for your traditional balance, and no conversions, between now and age 72.

Then estimate what your marginal tax rate will be on those RMDs (including all other expected income as the base upon which the RMDs will be taxed).

As a start, look at doing Roth conversions up to the point the conversion marginal tax rate doesn't exceed the "no conversion RMD" rate. But then you need to re-estimate the RMD amount because doing conversions will lower it, and repeat.

A couple of tools that can help are mentioned in the Using a spreadsheet section of the Roth IRA conversion wiki in Bogleheads.

If that is more than you want to take on yourself (but if you have any spreadsheet ability it may be easier to do than it looks), whoever you might pay to do it for you should explain things in similar terms.

As target2019 rightly implied, predicting the future (e.g., what will your investments returns be? what will tax law be?) is part of this, so don't agonize over details. But for any tool to be much more useful than a Magic 8 Ball, that tool should have a least a rudimentary understanding that in general the higher the Roth conversion this year, the higher the tax rate on the conversion amounts.
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Old 08-04-2022, 06:50 PM   #19
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I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?


Be aware that since you are 56, if you have tax withheld from your conversions, youll also have to pay a 10% penalty for the portion used to pay taxes. This will be the case until you turn 59 1/2.

I remember in your Roth IRA thread you mentioned most of your money is in your retirement accounts. So if you dont have funds to fully contribute your $7k to a Roth, you may not have funds to pay the tax. In this case, wait until youre 59 1/2.
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Old 08-04-2022, 06:57 PM   #20
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I wouldn't do Roth conversions while still pulling down a decent working salary for the entire year.
Plug all the details into your spreadsheet and see what it says...
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