What tax bracket should I stop doing Roth Conversions

[chassis]

Regarding the discussion of putting deferred tax liabilities on the balance sheet,

@Out-to-Lunch do you carry deferred tax liabilities on your balance sheet? Do you carry future SS, pension or other income not yet received as an asset? What other deferred liabilities and assets are on your balance sheet? Do you have a year-by-year model that estimates (forecasts) net worth, income and expenses?

 

[pb4uski]

...My view is that Roth conversions don't gain many people anything at all. But rather they are subtractive to net worth during the planning horizon, until demise of the principals.

....I don't see that putting deferred tax liabilities on the balance sheet is relevant. ...

If you don't think DTLs are relevant then don't bemoan that Roth conversions are subtractive to net worth.... they are only subtractive because you don't view DTLs as relevant.

 

[Out-to-Lunch]

Regarding the discussion of putting deferred tax liabilities on the balance sheet,

Let me briefly answer your questions, but then discuss my approach a little more qualitatively later. I am genuinely interested in ways to evaluate this decision.

You have stated that your principal metric is net worth. I guess if I had to name mine, it would be ability to generate spendable income. In my view, then, a future cash flow (pension, SS) is just income, and that income and tIRA withdrawals will be reduced by taxes.

@Out-to-Lunch do you carry deferred tax liabilities on your balance sheet?

Yes.

Do you carry future SS, pension or other income not yet received as an asset?

No.

What other deferred liabilities and assets are on your balance sheet?

None.

Do you have a year-by-year model that estimates (forecasts) net worth, income and expenses?

Yes.

One version of my year-by-year model is meant to evaluate the advisability of Roth conversions; therefore, in addition to net worth, income, and expenses, it estimates RMDs and taxes. Accordingly, I have many replicates that employ different conversion strategies, and also different dates of death for me. (I also assume my spouse will outlive me.)

My main driver for the decision is my wife's situation after I pass (assuming I go first). Pensions and SS will use up most of whatever the low brackets are. Without conversion, she will probably be in IRMAA Tier 4, and whatever the 24% bracket will be (presumably 28%). With conversions, I think she will be in IRMAA Tier 2, and maybe in the 22% (-> 25% ) bracket. Meanwhile, (before SS), I will be converting in the 12% and 22% brackets. I acknowledge this is not life-altering, but seems like a worthwhile thing to do for her. (Of course, maybe she will remarry and get back to MFJ! )

 

[Exchme]

@Chassis: You are clearly quite familiar with the issues, but the metric of using zero as your estimate of future taxes on tax deferred seems to me to be unlikely to be a good estimate. It seems like to be approximately valid requires some kind of financial disaster scenario like a future market crash with no recovery or an unusual beneficence from Washington that drops you off the tax roles.

Folks are simply suggesting that a more likely case is that things keep going as they have, with positive average returns and plentiful taxes on them. The IRS is the big dog here, they are going to eat first and we only get the leftovers.

 

[chassis]

@Chassis: You are clearly quite familiar with the issues, but the metric of using zero as your estimate of future taxes on tax deferred seems to me to be unlikely to be a good estimate. It seems like to be approximately valid requires some kind of financial disaster scenario like a future market crash with no recovery or an unusual beneficence from Washington that drops you off the tax roles.

Folks are simply suggesting that a more likely case is that things keep going as they have, with positive average returns and plentiful taxes on them. The IRS is the big dog here, they are going to eat first and we only get the leftovers.

@Exchme Thanks. I don't think we are speaking the same language. Why do you write "zero as your estimate of future taxes"? This makes no sense to me. Where did those words come from?

My year-by-year model does indeed account for taxes on all income from now until end of plan. I assume that SS is fully taxable, in addition to tIRA distributions. RMDs are taxed.

Your post is coming across as garbled to me. Please say again.

 

[Exchme]

@Exchme Thanks. I don't think we are speaking the same language. Why do you write "zero as your estimate of future taxes"? This makes no sense to me. Where did those words come from?

My year-by-year model does indeed account for taxes on all income from now until end of plan. I assume that SS is fully taxable, in addition to tIRA distributions. RMDs are taxed.

Your post is coming across as garbled to me. Please say again.

Thanks for the question, I certainly could be misunderstanding what your model is doing.

As I understand your method, you are doing cash accounting, taking a debit for the prepaid taxes in a Roth conversion and then in subsequent years giving credit for the lower taxes year by year during RMDs. Then you are judging the value of a Roth conversion by using Net Worth vs time.

But here I want to look at tax arbitrage, so I don't exactly want a NW calculation, I want an estimate of the difference in spendable assets between the Roth conversion and the No Roth conversion case. Since it's a tax arbitrage, the tax rates on withdrawals from different asset categories are of course crucial, so I apply the most appropriate tax rate to each type of account.

If you use a pure NW calculation, taking the value of the t-IRA account as 100 cents on the dollar, that gives the same result as doing a spendable asset estimate assuming a zero tax rate for the future taxes in the t-IRA.

What you are doing is not providing an estimate of your total spendable assets and it's not consistent with what you want to do to get to a final liquidated value of your estate. An accrual based method that recognizes the liability in t-IRA deferred taxes would put you on the same road as others.

I can tell you are quite familiar with the topic, but I can't understand why you are doing it this way.

 

[chassis]

Thanks for the question, I certainly could be misunderstanding what your model is doing.

As I understand your method, you are doing cash accounting, taking a debit for the prepaid taxes in a Roth conversion and then in subsequent years giving credit for the lower taxes year by year during RMDs. Then you are judging the value of a Roth conversion by using Net Worth vs time.

But here I want to look at tax arbitrage, so I don't exactly want a NW calculation, I want an estimate of the difference in spendable assets between the Roth conversion and the No Roth conversion case. Since it's a tax arbitrage, the tax rates on withdrawals from different asset categories are of course crucial, so I apply the most appropriate tax rate to each type of account.

If you use a pure NW calculation, taking the value of the t-IRA account as 100 cents on the dollar, that gives the same result as doing a spendable asset estimate assuming a zero tax rate for the future taxes in the t-IRA.

What you are doing is not providing an estimate of your total spendable assets and it's not consistent with what you want to do to get to a final liquidated value of your estate. An accrual based method that recognizes the liability in t-IRA deferred taxes would put you on the same road as others.

I can tell you are quite familiar with the topic, but I can't understand why you are doing it this way.

@Exchme I don't get what you are saying. If you adhere to accrual accounting, and you put a deferred tax liability on your balance sheet, then you must put all deferred assets and liabilities on your balance sheet. Do you agree? This means you must put the present value of your Social Security claiming strategy on your balance sheet, do you agree? While doable, this is folly in my view.

Tax arbitrage is useless on its own merits. So what if I pay a lower tax rate today, if I have foregone investment returns to do it? I've cut my nose off to spite my face. I've died a death of a thousand tax cuts, but darned if I haven't avoided the feared tax bullet.

Tax arbitrage sounds smart, it sounds sexy. It sounds like an investor knows what he/she is doing. I don't buy it.

Net worth is king. Net worth is immediately convertible to spending money, noting that Uncle Sam gets paid during the conversion.

 

[SevenUp]

Tax arbitrage sounds smart, it sounds sexy. It sounds like an investor knows what he/she is doing. I don't buy it.

Given that marginal tax rates now vs. future are pretty much the only things that determine whether traditional or Roth works better, ....

 

[chassis]

Given that marginal tax rates now vs. future are pretty much the only things that determine whether traditional or Roth works better, ....

@SevenUp and.... what's the rest of the story?

What role does portfolio or market return have in this puzzle?

 

[SevenUp]

@SevenUp and.... what's the rest of the story?

What role does portfolio or market return have in this puzzle?

Comparing current vs. future marginal tax rates sounds a lot like tax arbitrage, but you said you don't buy tax arbitrage, so...?

The assumed ROI may affect that future marginal tax rate estimate.

 

[OldShooter]

... So what if I pay a lower tax rate today, if I have foregone investment returns to do it? ...

Huh? How does this work?

... What role does portfolio or market return have in this puzzle?

You didn't ask me, but I would say: None.

 

[Midpack]

What role does portfolio or market return have in this puzzle?

You didn't ask me, but I would say: None.

Not necessarily. If you convert $100K you create $100K in income and the tax liability that goes with that. If the underlying fund(s) drop in value, such that your $100K is now worth $70K, you've paid excess taxes (you would have a $30K drop in value either way, but not the added taxes). [-]You have until mid Oct of the year after to recharacterize, but after that you're stuck.[/-] At least that's how I understand it - please correct me if I'm mistaken. If you don't believe investments are going up long term, that would be another factor in the decision to do Roth conversions.

 

[Out-to-Lunch]

You have until mid Oct of the year after to recharacterize, but after that you're stuck. At least that's how I understand it - please correct me if I'm mistaken. If you don't believe investments are going up long term, that would be another factor in the decision to do Roth conversions.

Wasn't the option to recharacterize conversions eliminated by the TCJA: https://www.irs.gov/retirement-plans/ira-faqs-recharacterization-of-ira-contributions ?

 

[OldShooter]

Not necessarily. If you convert $100K you create $100K in income and the tax liability that goes with that. If the underlying fund(s) drop in value, such that your $100K is now worth $70K, you've paid excess taxes (you would have a $30K drop in value either way, but not the added taxes). You have until mid Oct of the year after to recharacterize, but after that you're stuck. At least that's how I understand it - please correct me if I'm mistaken. If you don't believe investments are going up long term, that would be another factor in the decision to do Roth conversions.

No. You're right. I forgot about that case/assumed that accounts always go up.

Actually, the last conversion I did I put the assets into a separate Roth account. This was in the spring and my plan was to recharacterize if the value went south. It didn't, so then I moved the assets into my regular Roth and closed the extra account.

 

[Exchme]

@Exchme I don't get what you are saying. If you adhere to accrual accounting, and you put a deferred tax liability on your balance sheet, then you must put all deferred assets and liabilities on your balance sheet. Do you agree? This means you must put the present value of your Social Security claiming strategy on your balance sheet, do you agree? While doable, this is folly in my view.

Tax arbitrage is useless on its own merits. So what if I pay a lower tax rate today, if I have foregone investment returns to do it? I've cut my nose off to spite my face. I've died a death of a thousand tax cuts, but darned if I haven't avoided the feared tax bullet.

Tax arbitrage sounds smart, it sounds sexy. It sounds like an investor knows what he/she is doing. I don't buy it.

Net worth is king. Net worth is immediately convertible to spending money, noting that Uncle Sam gets paid during the conversion.

Your comments about cutting off your nose to spite your face if you do a Roth conversion mean you have not thought through the commutative property of multiplication. The order of operation doesn't matter, so unless you pay into a higher rate than the average you would have had on RMDs in your and your heirs' lifetimes or unless markets crash, you are never behind when you do a Roth (knowing exactly what that breakeven tax rate is the hard part).

Your tax deferred account belongs in part to you and in part to the government. When you withdraw, you get some of your money and some is theirs. If we had flat taxes, your taxes would be in proportion to the gains by the commutative property of multiplication. However, with a progressive tax system, when you withdraw, gains in the government's share takes up some of the space in your tax brackets, leaving some of your income taxed at higher rates. It's mathematically proven that in the face of such convexity, the best you can do is even tax rates, which is a main point of Roth conversions. (Though obviously things like ACA subsidies can mess up the pristine math).

I fully agree that Uncle Sam gets paid in any withdrawal from tax deferred, but surely it’s clear that the amount you owe them in the future goes down if you’ve paid some already in a Roth conversion, but your focusing on Pre tax net worth doesn’t show that obvious fact. For example, if there were two identical folks, one that did a Roth conversion just before death and one that did not, and then their heirs immediately liquidated all assets in both cases, both would obviously have identical amounts of money. But your Pre-tax net worth calculation would not have predicted that - so it's just not a good measure for evaluating Roth conversions. Roths start even, but if given market growth, time and equal-ish tax brackets, the Roth will pull ahead.

Truly, people are trying to save you and other readers money.

 

[OldShooter]

...Roths start even, but if given market growth, time and equal-ish tax brackets, the Roth will pull ahead. ...

Please provide a numerical example. Start with a $100K tIRA and assume the owner's tax situation is unchanged from beginning to end. Your choice of time frame and market growth.

 

[JeKa]

Total SS 45k or your? SS will be for survivor would be the higher of either earner. If it's 30k for you and 15 for her, if you pass she will get get 15k plus 15k providing both of you wait til at least both FRA.

 

[pb4uski]

....Tax arbitrage is useless on its own merits. So what if I pay a lower tax rate today, if I have foregone investment returns to do it? I've cut my nose off to spite my face. ....

No.

Investment returns don't make a difference. Let's say that you have $10k in a tIRA and $2k in taxable funds and your tax rate today and in the future is 20%. Further let's say that your investments grow at 7%/year for 10 years.

If you Roth convert and use the taxable account to pay the tax you end up with $10k in the Roth, and in 10 years it is worth $19,672 ($10,000*(1+7%)^10) and can be spent.

If you don't convert in 10 years the $10K tIRA grows to $19,672 and the taxable account grows to $3,449 ($2,000*(1+(7%*(1-20%)))^10). If you then withdraw and pay 20% in tax of $3,934 you have $19,186 to spend.

So you come out $485 ahead with the Roth conversion even is the tax rate is the same because the amount in the taxable account ends up in the Roth if you convert today and it grows tax free.

Now if your rate today is lower than in the future, then you come out even further ahead. Let's say it is 15% now and 20% from next year onwards.

If you convert and pay $1,500 in tax out of the taxable account, the roth grows to $19,672 and the $500 left in the taxable account grows to $862 so at the end of 10 years you have $20,624 to spend.

If you don't convert then it is the same as the first example... the tIRA grows to $19,672 and the taxable account grows to $3,449 ($2,000*(1+(7%*(1-20%)))^10). If you then withdraw and pay 20% in tax of $3,934 you have $19,186 to spend.

So if you convert at the lower tax rate after 10 years you come out $1,438 ahead.

 

[Cobra9777]

Well, pb4 beat me to it, but I'll post my example as well, since I took the time to write it.

...So what if I pay a lower tax rate today, if I have foregone investment returns to do it?...

No. You do not forego any investment returns to pay the lower tax today. You just haven't really thought this through yet.

You have to start by accepting the fact that you don't own all of your tIRA. Embedded in your tIRA is a tax liability that grows in lock-step with the taxable funds that could be used to pay tax in a conversion. IOW, when you continue to defer, the embedded tax liability continues to grow by the same amount as your would-be tax dollars on a conversion. When you convert, it's really just like paying off a liability early in the hope that the liability will be less today than in the future (due to tax rate differences).

But enough words. Here's an example:

Assume: tIRA of $10K, taxable account of $1.2K, tax rate 12% now and 12% later, rate of return 7%, and 15-year timeframe.

If converted, obviously the tIRA and taxable go to zero, and the Roth of $10K grows to $27.6K at 7% over 15 years.

If NOT converted, the tIRA grows to $27.6K and the taxable account grows to $3.3K, which is exactly how much is needed to pay tax on the $27.6K tIRA. Net after-tax proceeds are exactly the same as the convert scenario.

Basically, the investment returns on the taxable account were negated by the growth in the embedded tax liability in your tIRA. The investment returns that you actually OWN, on the Roth or the after-tax tIRA, are exactly the same.

Now, if you assume the tax rate is 12% now and 22% later, the convert scenario wins easily. In actuality, the convert scenario wins even when the tax rates are the same. In the convert scenario above, the $1.2K taxable balance was, in effect, "transferred" tax-free into the Roth. No tax will ever be due on the $1.2K going forward. In the no-convert scenario, the taxable account grows to $3.3K and will inevitably have some tax due over that period of time. So the real after-tax value of the no-convert scenario is less than $27.6K, but this is negligible compared to the effect of tax rate differences.

 

[Midpack]

Wasn't the option to recharacterize conversions eliminated by the TCJA: https://www.irs.gov/retirement-plans/ira-faqs-recharacterization-of-ira-contributions ?

+1. I was thinking that in the back of mind, but didn’t check. I’ll edit the above.

 

[chassis]

Folks, thanks for the comments. I do think I've thought through it. I fully agree and accept that taxes are payable when due.

I do think we have a difference viewpoint on what investment returns are achievable.

@pb4uski uses investment return several times in post 93. @OldShooter says investment return doesn't matter in post 86.

Which is it? Do investment returns matter, or not matter, in the convert/don't convert decision? The beloved, by some site members, i-orp results are strongly affected by portfolio returns.

@OldShooter are you an i-orp user or advocate?

 

[Out-to-Lunch]

@pb4uski uses investment return several times in post 93. @OldShooter says investment return doesn't matter in post 86.

Which is it? Do investment returns matter, or not matter, in the convert/don't convert decision?

It has been put forth that an individual is better off converting after a market drop (becase less will be due in taxes). I observe that this is only true if somehow the funds one will be using to pay the taxes are invested differently than the overall portfolio.

The commutative law of multiplication says that, the temporal order of gains vs. taxes paid is irrelevant (if the marginal tax rate is the same and the portfolio is homogeneous). However, if you are paying taxes from funds that are invested differently than the funds in the tIRA, you may come out ahead or you may come out behind. But this is no different from any market timing or rebalancing question -- the optimal solution is only known in hindsight.

 

[pb4uski]

.... I do think we have a difference viewpoint on what investment returns are achievable.

@pb4uski uses investment return several times in post 93. @OldShooter says investment return doesn't matter in post 86.

Which is it? Do investment returns matter, or not matter, in the convert/don't convert decision? ...

No.

Investment returns don't make a difference.

I thought I was pretty clear.... You suggested that your reason for not doing Roth conversions was that you didn't want to forego investment returns... I just proved that all else being equal that investment returns don't make much of any difference... it is simply a tax arbitrage play.

But for some reason you just don't get it so I'm done wasting my time with you.

 

[SevenUp]

Which is it? Do investment returns matter, or not matter, in the convert/don't convert decision?

The usual assumption is that the return rates in the traditional and Roth accounts are identical. Do you agree with that assumption?

Next:
a) If one assumes current and future tax rates, then the investment returns don't matter.
b) If one uses an assumed real return rate to estimate a future tax rate, then the investment returns matter.

Do you see the difference between a) and b)?

Does all the above make sense?

 

[chassis]

The usual assumption is that the return rates in the traditional and Roth accounts are identical. Do you agree with that assumption?

Next:
a) If one assumes current and future tax rates, then the investment returns don't matter.
b) If one uses an assumed real return rate to estimate a future tax rate, then the investment returns matter.

Do you see the difference between a) and b)?

Does all the above make sense?

@SevenUp thanks.

Agree that market (portfolio) returns are the same in tIRA vs a Roth converted account.

a) I don’t assume future tax rates to be any different than they are today.
b) I do all modeling in nominal dollars, and use inflation applied to living expenses.

@pb4uski do you ascribe to the approach in i-orp?

@OldShooter you didn’t answer the question - do you ascribe to or support the approach in i-orp?

@SevenUp same question - do you support the approach used by i-orp?

i-orp’s results are strongly influenced by assumed market (portfolio) performance. It says that investment returns matter.

Separately, it has been agreed in another thread that the morning after you wake up from doing a Roth conversion, having paid Uncle Sam his due, you are poorer than the day before the Roth conversion.

Why would I make myself poorer? If over the planning horizon I found myself richer, having made myself poorer through Roth conversions, I would see the benefit.

However, I don’t see the benefit. Allowing once again for a tolerance of error on the analysis, any benefit to me over the planning horizon is nearly nil. It’s de minimis.