Alternative to Roth Conversions?

[CardsFan]

OK. I have been converting for several years. We are both 66, so have some time before RMD's.

We have an after tax account with several old mutual funds, that throw off about $24k in cap gains, and about $8k in dividends (only a quarter which are qualified)

We could eliminate a lot of this income by selling and investing in ETF's, but it would take 3 years to do this with no taxes (could do it in 2 years paying about 10k in taxes).

DW is taking SS (10k/year) I am waiting (plan was FRA, but could move out).

I am starting to think eliminating the income may have more benefit than conversions.

My tIRA is large (over $2.5 million), so moving $100k/year into the Roth will have minimal effect on future RMD's. But eliminating the income from the after tax account is a certain reduction in income going forward.

I admit I have not dug deep into this. Just want to know if anyone else has looked at it, and was it worthwhile.

 

[Time2]

OK. I have been converting for several years. We are both 66, so have some time before RMD's.

We have an after tax account with several old mutual funds, that throw off about $24k in cap gains, and about $8k in dividends (only a quarter which are qualified)

We could eliminate a lot of this income by selling and investing in ETF's, but it would take 3 years to do this with no taxes (could do it in 2 years paying about 10k in taxes).

DW is taking SS (10k/year) I am waiting (plan was FRA, but could move out).

I am starting to think eliminating the income may have more benefit than conversions.

My tIRA is large (over $2.5 million), so moving $100k/year into the Roth will have minimal effect on future RMD's. But eliminating the income from the after tax account is a certain reduction in income going forward.

I admit I have not dug deep into this. Just want to know if anyone else has looked at it, and was it worthwhile.

I'll admit I don't understand why VTI would throw of fewer capital gains than VTSAX, so grain of salt.

But, even the Index fund will generate plenty of dividends.

 

[RunningBum]

I would map everything out in a spreadsheet. You say not doing conversions would have minimal effect on RMDs, but have you quantified this? I feel like people get frustrated that partial conversions aren't putting a dent in the tIRAs, without seeing how much bigger they would be getting without the conversions.

I made a somewhat similar move a few years ago when it was clear to me that the income thrown from a managed fund and an international index fund were going to put me over the ACA subsidy cliff. So I bit the bullet and skipped the subsidy one year and sold out those funds in favor of domestic index funds, and funded a donor advised fund (DAF) to soften the tax blow. I worry about letting the tax and subsidy tails wag my investment plan, but I could invest in the Intl fund in my Roth. I'd been avoiding it since I couldn't recapture the foreign taxes paid in a Roth, but I was having trouble getting the credit in taxable anyway.

 

[CardsFan]

I would map everything out in a spreadsheet. You say not doing conversions would have minimal effect on RMDs, but have you quantified this? I feel like people get frustrated that partial conversions aren't putting a dent in the tIRAs, without seeing how much bigger they would be getting without the conversions.

Fair comment, and no, I have not mapped everything out. Right now I am looking to see if anyone else has looked into this, to see if it might be worthwhile to look at deeper.

Using the Schwab calculator for RMD's, I estimate that my current conversions, staying below IRMMA, would reduce my future RMD's by about $15k, the first year (using the default 6% growth). This does not change much unless I go above 10% growth. Possible, but not likely with a 60/40 AA (though it HAS been there in this crazy time).

Anyway just looking at ideas, knowing full well that none of these will be earth-shattering, just incremental benefits.

 

[SecondCor521]

I'll admit I don't understand why VTI would throw of fewer capital gains than VTSAX, so grain of salt.

But, even the Index fund will generate plenty of dividends.

It sounds like OP's mutual funds are not VTSAX, but probably actively managed funds since they throw off cap gains (which VTSAX typically doesn't do).

OP, that's a tough situation. I'd probably try to develop a spreadsheet where I could dial up or down how much sales of the mutual fund to do vs. Roth conversions, and then figure out what I was trying to maximize, and then see what the math says to do.

You'd probably also need to decide what you think will happen with the step up in basis, ACA, and tax rates, as those variables (and maybe others) may impact your analysis.

If I were in your shoes I think I would bite the bullet and just get out of the problematic funds either in two years or three.

The only other thought I had was if you had any unrealized capital losses or HSA contributions or anything like that to soften the blow (I'm assuming you have a large LTCG in the funds also) that might be something to look at.

 

[SevenUp]

Fair comment, and no, I have not mapped everything out. Right now I am looking to see if anyone else has looked into this, to see if it might be worthwhile to look at deeper.

Using the Schwab calculator for RMD's, I estimate that my current conversions, staying below IRMMA, would reduce my future RMD's by about $15k, the first year (using the default 6% growth). This does not change much unless I go above 10% growth. Possible, but not likely with a 60/40 AA (though it HAS been there in this crazy time).

Anyway just looking at ideas, knowing full well that none of these will be earth-shattering, just incremental benefits.

Speaking of ideas...have you considered doing anywhere from ~$200K/yr to ~$340K/yr conversions for the next several years?

Yes, you would go up as many as four IRMAA tiers during those years, but that's only going to add a few percent to your tax rate.

Depending on a few expectations (e.g., heirs' tax situations; federal tax law; likelihood that one of you will be paying single rates for a number of years; etc.), doing large conversions now could be reasonable.

Of course, a different set of expectations could make doing no conversions now reasonable.

Just a thought....

 

[Sunset]

We got rid of a number of mutual funds because of the declared Capital Gains. Sometimes they were surprisingly high and threw us into another bracket.
We traded them in for ETF's.

 

[RetireBy90]

I would consider comment from Sevenup:

Yes, you would go up as many as four IRMAA tiers during those years, but that's only going to add a few percent to your tax rate.

My table from Kiplinger shows that if MFJ MAGI goes from $176K to $748K your IRMAA would go from $208 to $475 per month per person. So additional $260 or $512 per month or $6K/yr. That would make me mad but not as mad as paying taxes on additional $30K every year. In 22% bracket that would be $6K every year. Lots of room between those 2 MAGIs.

The difference between Roth conversions and realizing the cap gains, I would need a spreadsheet to see which cost more. Also consider how much of the TIRA you plan to use. I'm going to convert about half of ours and what is left will go to the kids. The remainder will go to QCDs and pass to a charity when we go, so we don't need to pay taxes on this part.

 

[Midpack]

Like others have said, you have to map out your options. I used Income Strategy software, at a cost of $20 for one month, but if your spreadsheet skills are sufficient to capture all the moving parts - that’s free. I’m converting $160-170K/yr over 6-8 years and it will make a huge difference in our lifetime taxes.

 

[audreyh1]

I’ve been working on bringing cap gains distributions down by converting to index funds where I can, but it’s been a long slow process and an extended bull market hasn’t helped.

A big market sell off provides an opportunity. The last one was so brief that I only got about a third of my fund exchanges done.

 

[CardsFan]

I would consider comment from Sevenup:
My table from Kiplinger shows that if MFJ MAGI goes from $176K to $748K your IRMAA would go from $208 to $475 per month per person. So additional $260 or $512 per month or $6K/yr. That would make me mad but not as mad as paying taxes on additional $30K every year. In 22% bracket that would be $6K every year. Lots of room between those 2 MAGIs.

The difference between Roth conversions and realizing the cap gains, I would need a spreadsheet to see which cost more. Also consider how much of the TIRA you plan to use. I'm going to convert about half of ours and what is left will go to the kids. The remainder will go to QCDs and pass to a charity when we go, so we don't need to pay taxes on this part.

I have given some thought to mega-conversions ($200k to $400k for 2-3 years), so that is in the mix, as well.

Like others have said, you have to map out your options. I used Income Strategy software, at a cost of $20 for one month, but if your spreadsheet skills are sufficient to capture all the moving parts - that’s free. I’m converting $160-170K/yr over 6-8 years and it will make a huge difference in our lifetime taxes.

Midpack, I remember reading about your analysis and decision. As I recall one time you said that while the tax savings are large, the net affect on the terminal value of your portfolio was not large (low single digits?). Is that correct?

Makes me wonder if the biggest benefit of conversions is the low hanging fruit, converting in the 12% bracket with an effective tax rate of 5-8%.

Anyway, thanks all for your insights.

 

[Dash man]

We’re planning $250,000 of conversions each year until we reach RMDs. If we don’t our taxes when we start RMDs will likely be much higher. But our main concerns are reducing the tax burden to the survivor after on of us passes. When estate taxes revert in 2026, we’ll also be on the borderline of our kids having to pay estate taxes and paying the income tax now reduces our net worth, lessening the impact of estate tax.

 

[audreyh1]

We’re planning $250,000 of conversions each year until we reach RMDs. If we don’t our taxes when we start RMDs will likely be much higher. But our main concerns are reducing the tax burden to the survivor after on of us passes. When estate taxes revert in 2026, we’ll also be on the borderline of our kids having to pay estate taxes and paying the income tax now reduces our net worth, lessening the impact of estate tax.

What about having beneficiaries other than spouse inherit a large amount of an IRA?

 

[SecondCor521]

What about having beneficiaries other than spouse inherit a large amount of an IRA?

As an alternative to Roth conversions? Sure, it's an idea to consider.

If they're non-spouse beneficiaries, they'd typically fall under the SECURE Act and have to drain the account in about 10 years. Depending on how many beneficiaries and what tax brackets they're in, if it's a traditional IRA that is being inherited, then the tax hit on them might be better or might be worse than on the original owner.

In my case, I have three kids, and by the time I will likely pass away they'll be in their 50s and therefore probably in the highest earning years of their careers. They'll either be taxed pretty heavily (although by then possibly still less heavily than I will be) or the inherited IRA will be enough to enable them to retire early themselves if they want to.

 

[CardsFan]

What about having beneficiaries other than spouse inherit a large amount of an IRA?

OP here.

I am considering that one as well. If I leave 1/2 of the tIRA to DS, and DW survives me by 10 years, then DS would effectively have 20 years to drain the total amount, plus DW's RMD's would only be 1/2.

Some big ifs there. The only downside would be if DW eventually would need the money, though that is a very unlikely scenario.

More food for thought.

 

[audreyh1]

As an alternative to Roth conversions? Sure, it's an idea to consider.

If they're non-spouse beneficiaries, they'd typically fall under the SECURE Act and have to drain the account in about 10 years. Depending on how many beneficiaries and what tax brackets they're in, if it's a traditional IRA that is being inherited, then the tax hit on them might be better or might be worse than on the original owner.

In my case, I have three kids, and by the time I will likely pass away they'll be in their 50s and therefore probably in the highest earning years of their careers. They'll either be taxed pretty heavily (although by then possibly still less heavily than I will be) or the inherited IRA will be enough to enable them to retire early themselves if they want to.

It really depends on relative ages and financial security of non-spousal heirs. In our cases it makes a lot of sense. Heirs are much older, within 10 years in most cases, and certainly aren’t FI but would retire if they could IMO.

 

[SecondCor521]

It really depends on relative ages and financial security of non-spousal heirs. In our cases it makes a lot of sense. Heirs are much older, within 10 years in most cases, and certainly aren’t FI but would retire if they could IMO.

Right. I didn't mean to sound critical - just that there are factors to consider when evaluating it as an option.

 

[Midpack]

Midpack, I remember reading about your analysis and decision. As I recall one time you said that while the tax savings are large, the net affect on the terminal value of your portfolio was not large (low single digits?). Is that correct?

Makes me wonder if the biggest benefit of conversions is the low hanging fruit, converting in the 12% bracket with an effective tax rate of 5-8%.

That is correct. However, that assumes that tax rates continue with TCJA and revert to pre-2017 rates/brackets thereafter. While that may well happen, I definitely don't expect that to last indefinitely and I expect rates/brackets can only increase in the 30 years ahead, in which case I may well have greater tax savings and a larger portfolio terminal value/earlier breakeven. I could be completely wrong but that's my story, and I'm sticking to it until we have more info.

And someone else may have said it above, but there are widow & heirs tax avoidance benefits as well to Roth conversions - another reason I went ahead with conversions. Best of luck, no universal right or wrong.

 

[CardsFan]

That is correct. However, that assumes that tax rates continue with TCJA and revert to pre-2017 rates/brackets thereafter. While that may well happen, I expect rates/brackets can only increase in the 30 years ahead, in which case I may well have greater tax savings and a larger portfolio terminal value. I could be completely wrong but that's my story, and I'm sticking to it until we have more info.

And someone else may have said it above, but there are widow & heirs tax avoidance benefits as well to Roth conversions - another reason I went ahead with conversions. Best of luck, no universal right or wrong.

Thanks for confirming my memory (it is not always that good )

As to the second point I highlighted in red, I fully agree. As a matter of fact, I think the heirs tax avoidance has the potential to be the biggest benefit because it would push DS and DDIL deep into the 32% bracket and maybe into the 35% bracket (which, of course, are likely to be higher).

 

[audreyh1]

Right. I didn't mean to sound critical - just that there are factors to consider when evaluating it as an option.

I didn’t read your post as critical at all. I was really replying to Dashman who had considered alternative beneficiaries for their IRAs in the past. Most people have the situation you do - heirs are children thus younger, subject to 10 year rule, likely at peak earning/taxation years. So it definitely depends. It just happens that in our case it’s a workable option, and with substantial after tax investments already, giving away half or so of the IRAs probably makes sense.

I also don’t feel nearly as obligated as many do to reduce taxes for our heirs. They would likely already be retired when they inherit, and in lower tax brackets anyway. We would likely pay much higher tax rates.

 

[RunningBum]

I also don’t feel nearly as obligated as many do to reduce taxes for our heirs. They would likely already be retired when they inherit, and in lower tax brackets anyway. We would likely pay much higher tax rates.

I don't feel obligated to reduce their taxes. But it's worth noting that tax consequences of a tIRA don't go away at your death. I optimize conversions and everything else for a long life span for myself, but even if I have a normal or shortened lifespan I know that my conversions weren't totally wasted. My heirs get the benefit of inheriting a Roth, even though the optimal plan for them might have had me not converting so much.

 

[CardsFan]

I also don’t feel nearly as obligated as many do to reduce taxes for our heirs. They would likely already be retired when they inherit, and in lower tax brackets anyway. We would likely pay much higher tax rates.

I don't feel obligated to reduce their taxes. But it's worth noting that tax consequences of a tIRA don't go away at your death. I optimize conversions and everything else for a long life span for myself, but even if I have a normal or shortened lifespan I know that my conversions weren't totally wasted. My heirs get the benefit of inheriting a Roth, even though the optimal plan for them might have had me not converting so much.

Let's face it, we are play the odds with all these plans. The odds are pretty high that our one heir, DS, will be in his peak earning years when both of us are gone, DDIL is younger, and will have even more years of higher earnings.

So, my driver has been conversions at lower rates to avoid what they might pay (32-35%).

There are additional benefits to us. Lower RMD's, for both and the survivor, and maybe staying below IRMMA, or at least in a lower bracket.

Now, that could all change. DS and DDIL having kids with a stay at home parent (one income), one of us lives to 99 (so we deplete the tIRA for the most part), but none of those make the conversions bad, just not as good, or maybe a wash.

So, I guess I have convinced myself to continue conversions. DS will get step-up basis on the after tax account, if that still exists.

Subject to change with changes in tax laws.

 

[Exchme]

I think your priority should be considering Roth conversions to the top of the 24% bracket for 2-3 years to knock the tax deferred balance down.

It's not the 1st year of RMDs that get you, it's a few years in when it rises to 6-7% of the account. Since the first few years of RMDS really just slow the account growth, my back of the envelope math is to project the account balance at age 72 and then use 6-7% withdrawals on that basis that are applicable to say 76-77. Imagine getting 6% growth on $2.5M for 6 years, so growing to $3.5M, then when RMDs get really rolling, you will be taking $220-250K in RMDs, plus SS, pension etc. So you will be at least the 24% bracket for a long time, so it's a good idea to convert to the top of that bracket now. Of course the risk of tax rate increases, one spouse passing or heirs also having a lot of income make it even more urgent.

If you practice optimum asset location of stocks in Roth and bonds in tax deferred, you will need to be holding quite a few bonds in the reduced size tax deferred, further blunting its growth. Then take a look as to whether you want to bite the bullet on paying LTCGs to minimize your dividend income.

I would look at the lifetime models like I-orp (scroll down to the Extended version). Do cases where you have lower and higher dividend income and let it choose the Roth path to do. If Roths dominate, then do Roths first, then come back and think about your high dividend stocks.

 

[TheWizard]

I think your priority should be considering Roth conversions to the top of the 24% bracket for 2-3 years to knock the tax deferred balance down.

It's not the 1st year of RMDs that get you, it's a few years in when it rises to 6-7% of the account. Since the first few years of RMDS really just slow the account growth, my back of the envelope math is to project the account balance at age 72 and then use 6-7% withdrawals on that basis that are applicable to say 76-77. Imagine getting 6% growth on $2.5M for 6 years, so growing to $3.5M, then when RMDs get really rolling, you will be taking $220-250K in RMDs, plus SS, pension etc. So you will be at least the 24% bracket for a long time, so it's a good idea to convert to the top of that bracket now. Of course the risk of tax rate increases, one spouse passing or heirs also having a lot of income make it even more urgent.

If you practice optimum asset location of stocks in Roth and bonds in tax deferred, you will need to be holding quite a few bonds in the reduced size tax deferred, further blunting its growth. Then take a look as to whether you want to bite the bullet on paying LTCGs to minimize your dividend income.

I would look at the lifetime models like I-orp (scroll down to the Extended version). Do cases where you have lower and higher dividend income and let it choose the Roth path to do. If Roths dominate, then do Roths first, then come back and think about your high dividend stocks.

I've been doing Roth conversions in the 24% bracket for a while now, but modest ones, not all the way to the top of the 24% bracket so as to avoid an even higher IRMAA tier.

I levelize my AGI by doing Roth conversions, basically.
I started age 70 SS fifteen months ago, so for the next two years, my Roth conversion amount will be roughly the same as my RMD amount starting in 2023.

I still like deferring taxes to a degree rather than paying large additional taxes earlier than needed, so my approach is a good compromise...

 

[sroby2020]

We’re planning $250,000 of conversions each year until we reach RMDs. If we don’t our taxes when we start RMDs will likely be much higher. But our main concerns are reducing the tax burden to the survivor after on of us passes. When estate taxes revert in 2026, we’ll also be on the borderline of our kids having to pay estate taxes and paying the income tax now reduces our net worth, lessening the impact of estate tax.

We're doing the same thing here with the same concerns about survivor taxes.
As for the increase in the IRMAA, someone once told me that if you consider is as a very small part of your net worth, the choice becomes much easier. Don't fret.