Finding my Roth Conversion Number and Taxes

[RASAP]

I have finished my 2020 taxes using TurboTax and I am now looking at optimizing my future IRA to Roth rollovers using my 2020 return as a baseline. While plugging different numbers for the rollover amount (changing no other entries) I have found something I didn't expect...

- For values from 31k to 91k the effective tax rate is 27%
- For values from 91k to 182k the effective tax rate drops to 22%

Does this seem right? I would not have expected the tax rate to drop for larger amounts which result in a greater taxable income.

 

[RunningBum]

Yep. For 31K to 91K, you are almost certainly not only being taxed 12% for the conversion, but you are pushing $60K (at 91K) of qualified dividends + LTCGs into being taxed at 15%, for a 12+15=27% effective rate.

Above $91K, you must have pushed all of your QDivs+LTCGs into being taxed, so now you are just being taxed for the conversion income. Right around here, the tax bracket goes from 12% to 22%.

One conversion strategy is to only go up to the brink of pushing QDivs/CGs into being taxed. But if you think for the best long term outcome you should convert more, then you should probably convert all the way through that 27% range and back into the 22% bracket, and perhaps even up to the top of the 24% bracket. Maybe some years convert big, and other years stop just before any QDivs are taxed. Maybe you convert big while taxes are lower, and do smaller conversions if tax brackets go back to 15/25/28/etc % as they will do in 2026 if congress takes no action.

 

[RunningBum]

Check out the Qualified Dividends and Capital Gains Worksheet Form on Turbo Tax as you increase the conversion number to see that effect.

 

[RASAP]

Thanks RunningBum. You are correct and I see now what is happening.

This is a great segue into my next issue....

I have 3 years until my first RMD. If I do minimal rollovers (staying within the 12% tax rate), my tax bill for the next 3 years would be in the neighborhood of 2k and my first RMD in 2024 will be about 76k with an estimated tax bill of about 17k.

If I were to max out the 24% tax bracket on rollovers for the next 3 years, for me that would be around $325k per year and my tax bill would be north of 65k each year and my first RMD in 2024 is reduced to about 38k with an estimated tax bill of 6k.

This does not seem like a good idea to me. Am I missing something?

 

[Bogle7]

my first RMD in 2024 will be about 76k with an estimated tax bill of about 17k.

1. $76K RMD implies you expect to have about $2M in 2024 in your tIRA.
2. QCDs can help reduce the tax bill. And, you can start those at age 70-1/2.
3. But, overall, for simplicity, you should expect to pay $500K in taxes as you do the Roth conversions.

 

[SecondCor521]

Thanks RunningBum. You are correct and I see now what is happening.

This is a great segue into my next issue....

I have 3 years until my first RMD. If I do minimal rollovers (staying within the 12% tax rate), my tax bill for the next 3 years would be in the neighborhood of 2k and my first RMD in 2024 will be about 76k with an estimated tax bill of about 17k.

If I were to max out the 24% tax bracket on rollovers for the next 3 years, for me that would be around $325k per year and my tax bill would be north of 65k each year and my first RMD in 2024 is reduced to about 38k with an estimated tax bill of 6k.

This does not seem like a good idea to me. Am I missing something?

Probably not.

The generic rule of thumb is to convert enough to even out your tax brackets now with your tax brackets later. But you don't want to convert too much and pay a lot in higher brackets now and end up in a lower bracket later - I call this overconverting.

Lots of people around here either have big IRAs, or big SS, or big pensions, or some combination thereof, so there are many people who will be in the 24% bracket later. Those people also think, and possibly rightly so, that tax brackets are going to go back up again soon (either in 2026 or maybe sooner).

For these people, recommending Roth conversions up to the 24% bracket makes sense - they're applying the generic rule of thumb to their specific situation.

But you don't want to apply their specific rule to your specific case, because your tax bracket later doesn't seem to be very high. In your case, converting that much looks like overconverting.

What bracket will you be in in 3 years with no Roth conversions? It's probably not good to convert any further than somewhere up to the top of that bracket (unless you think tax brackets will change sooner, or you want to protect a surviving spouse or something). (If you're single, it looks like that'd be the 22% bracket).

Have you started SS yet? Did you include SS in your analysis?

 

[RunningBum]

There are a few moving parts here, so it's hard to give you an answer that one is better than the other. These are at least some of the factors I see.

0. I give my usual reminder that you cannot spend anything from your tIRA until you pay the taxes. Some people don't like the idea of converting more and paying taxes that will most likely benefit their heirs, but remember that frees up that money for you to spend if you need to. The way I figure it is to assume I'll need all of the money from my tIRA, maybe because I'll live to 100 or maybe I'll just need it, so I optimize it for me draining the tIRA.

1. Have you started SS yet? Because one of the issues is the "SS Tax Hump" where more income pushes more SS into being taxed, up to 85% max. I can't tell how this affects you. What I found for me is that if I leave something in my tIRA such that I'll have RMDs, the first part of my RMD will be taxed at 49.9% because I'm pushing both more SS and more QDivs into being taxed. So I'm trying to totally convert my tIRA. You can't reasonably do this, and maybe you're going to have enough to max out your SS taxation no matter what. But if it's not, that would favor converting more before taking SS.

2. If you only make relatively small conversions now, your tIRA will grow more and you'll probably even have larger RMDs. Any growth on what you convert is in the tax free Roth, so this favors larger conversions.

3. You are married, correct? Most likely, one of you will die before the other. The surviving spouse will be in the smaller single tax brackets, so suddenly those RMDs are getting taxed more. Again, this favors larger conversions now. I think this is a pretty big one for married couples. As a single, I haven't done the tax return math to see how big.

4. What happens to your tIRA when you both die, if there's still a lot in your tIRA? Your heirs will likely have to fully withdraw within 10 years. If they are already in a high tax bracket this is an additional burden, so if you care about this, you could pay the taxes at your lower rate. On the other hand, if you have a bunch of heirs such that they all get a relatively small amount, they probably won't get hit hard on taxes.

5. Charitable giving: if you'd like to leave a lot to charities if you find you won't need all this money, then keep conversions small. Once you start RMDs you can use QCDs to get a full reduction of taxable income without having to itemize deductions. And if you put them as beneficiary, when you die they get the full remaining amount without having to pay taxes.

6. Tax rates: the TCJA cuts are set to expire after 2025. If you think tax rates are likely to revert to the previous rates, take advantage of lower rates now while you can by converting more. But if you think they will stay the same it matters less. If you think the tax code will be overhauled in favor of a consumption/VAT tax with lower income taxes, convert less.

I was thinking there was another one but can't come up with it now.

You could split the difference and convert to the top of 22% now, which may level out the taxes more evenly for the rest of your life.

For myself, when in doubt I prefer to convert more at a known tax rate so that I have access to the money, rather than defer longer without knowing what the future holds. I can't know if that's the right move to make, but under my assumptions it is. Others may have different assumptions.

If at all possible, it's best to pay conversion taxes out of your taxable account, which basically trades money in your taxable account (where growth is taxed) for money in your Roth (untaxed growth). Maybe that's not viable for your large IRA though.

 

[RunningBum]

One more thing, maybe this was the one I was thinking of. If one or both of you need long term care of some kind, that would favor smaller conversions and taking more income later, when you deduct the medical expense from that income.

 

[RASAP]

Lot of good help here and much appreciated. To possibly dial in some more specific advice, here are the details...

I am married and will have only one heir.
I will take my first RMD in 2024 so I have only 3 more years to do rollovers
Current tIRA balance: 1.9M
Current taxable balance: 911k
2020 Ordinary Dividends: 16.1k
2020 Social Security: 15.4k
2021 Social Security: 15.6k
2022 Projected Social Security: 39.2k (I start taking mine mid-year)
2023 Projected Social Security: 55.8k
2024 Projected Social Security: 56.2k
Yes, 85% of our Social Security is (and will be) taxed.
We currently live off of our Dividends, SS, and our taxable accounts which generate about 50k in LTCGs (for the next 3 years)

For tax year 2020:
I rolled 45.2k from my tIRA to my Roth which took me to the top of the 12% effective tax rate.

I guess I have to pick one so I will go with, "I think tax rates will be about the same in 2024 as they are now".

I estimate that if I rollover 30k for the next 3 years, my income in 2024 will be:
Divs: 14.2k
SS: 56.2k
RMD: 73.3k
Total: 143.7k (This is about 30k more than our projected annual budget for 2024)

This results in an estimated Federal tax of 13.7k (using TurboTax 2020) and I would be in the 22% effective tax bracket.

So, given all of this, what do you think is the best path forward in terms of rollovers? Any other information needed?

 

[SecondCor521]

In 2020, although you were in the top of the 12% bracket, that was probably really in the 27% hump since you probably had lots of dividends and cap gains, right?

Where will you be federal-bracket-wise this year (2021) if you do a 30K rollover? If you do a $0 rollover?

What do you think or predict in terms of your and your spouse's life expectancies? (Widely disparate life expectancies can leave the surviving spouse with a higher tax burden if the tax filing status changes to Single but most of the income is still coming in.)

Are the $50K LTCG just because you're realizing gains since you're living on taxable? Will those go away when you start RMDs?

 

[RASAP]

No, for 2020, I was just at the point where the next 1k in rollover would have been at 27% so I was just short of the hump.

If I do no rollover in 2021, I will have zero federal tax due.

If I do 30k rollover in 2021, Federal tax due will be 2,150 and I will be just entering the 27% effective tax rate.

My wife is likely to outlive me - maybe by 10 years.

Yes, the 50k LTCG is from our living expenses for the next 3 years. They will go to zero once I start RMDs due to higher SS and RMDs that are more than what we need.

 

[RunningBum]

I'd guess that there won't be a big long term difference between converting up to the 12/27% point, top of 22% or top of 24%. As I said before, my preference is to be more aggressive and convert more, but that doesn't mean it's the best, or that you have to.

 

[pb4uski]

Once you are both on SS and subject to RMDs, I get that before RMDs your tax will be nil and after RMDs it will be ~$14k based on $108k of taxable income ($14.2k div + $56.2k SS * 85% + $73.3k RMD - $27k std deductions). You will be in the 22% tax bracket and your marginal tax on the $73.3k RMD will be 19.1% ($14k tax/$73.3k RMD)

For 2021, I would at least do Roth conversions to bring my TI to $108k that it would be when you are subject to RMDs. I think that would be ~$106k of Roth conversions and the $14k in tax would be ~13.4% of the Roth conversion.

In both cases, you'll be in the 22% marginal tax bracket after conversions or RMDs. For 2021 you may want to do even more... to the top of the 22% tax bracket you would convert ~$169k and pay $28k in tax... a reasonable 16.6% of the ~$169k conversion amount.

 

[RASAP]

Hummm....

The first part of what you said is exactly what I get in my estimates. However, for 2021 to get my taxable income to 108k, it would be 16.1k div + 15.6k SS * 85% + 56k Roth Conv + 50k LTCG - 27.4k std ded. Federal tax of 9.1k with marginal tax on the 56k Roth conversion of 16.2%.

If in 2021 I go to the top of the 22% tax bracket (27% tax rate from 30k through 91k), by my estimation that would be 16.1k div + 15.6k SS * 85% + 182k Roth Conv + 50k LTCG - 27.4k std ded. Federal tax of 38.6k with marginal tax on the 182k of 21.2%.

This is making my brain itch! I'm not sure I understand the meaning/significance of the percentage value associated with the marginal tax on the conversion (21.2%).

 

[SecondCor521]

Since you think your wife will outlive you significantly, I'd look at the situation for her filing single.

With a lot of number floating around, it's hard to tell exactly, but it looks to me like if you passed away, she would be in the 24% bracket. To figure this, you'd want to subtract her SS from your income, and then look at the income brackets for Single.

If the tax brackets expire in 2026 (who knows, really) it looks like she would be in the 28% bracket.

As you said a few posts up, if you do 30K conversions you'd end up in the 22% bracket. I'm assuming you mean you'd be past the 27% hump in that scenario.

...

Give all of that, if I were in your shoes I'd probably be OK filling up the 22% bracket but I'd probably try to avoid paying the (tax hump) 27% rate or (if one of you dies and tax brackets revert) 28% rate.

I'd probably be agnostic about the 24% bracket - at that point I'd look at other factors like what bracket that heir might be in when they inherit - if they're in their higher earning years and wouldn't choose to FIRE based on inheriting your IRA, then they might be paying 32% or 35% or 37%. In that scenario, I'd probably be inclined to convert into the 24% bracket to save the overall family on taxes.

The way I'd do it is for each of the next three years, stick in the income that is already required/guaranteed, then see where you're at in the bracket. I'd convert anything up to the beginning of the 27% hump. I'd then look at how "wide" that 27% hump was. If it was narrow and I could get a lot in the 22% bracket, I'd probably do that.

This gets to what pb4uski is saying with the effective rate of the conversion - it blends the amount of the conversion in the 27% bracket and the 22% bracket and gives you sort of an idea of what you're doing to yourself. In your scenario, if the 27% bracket was only on $1 and the 22% bracket beyond was $100K wide, I'd convert into the 22% bracket. If the 27% bracket were $50K wide and the 22% bracket beyond was only $10K wide, then I'd probably not even try to get there.

You don't have any plans to move to a different state, do you? At the numbers we're talking about, state taxes could be equally important.

Another thing to look at would be IRMAA if you really want your brain to itch

 

[RASAP]

Ok. I have been trying to detail out the next 3 years to see how much I can roll over and here is what I have found:

For 2021:
I can roll 10.6k to get me to the start of the 27% bracket
The 27% bracket continues through to 90k then drops to 22% up to 181k

For 2022:
I can roll 6.5k to get me to the start of the 27% bracket
The 27% bracket continues through to 71k then drops to 22% up to 162k

For 2023:
I can roll 17.3k to get me to the start of the 27% bracket
The 27% bracket continues through to 57k then drops to 22% up to 147k

So, it looks like my rollovers will be minimal if I am to avoid the 27% tax bracket hump. If I am willing to convert over the hump then I can do a lot more but this is where I get stuck on whether it is a good idea or not.

 

[SecondCor521]

It's weird that 2022 would be such a lower conversion amount than 2023 and 2021. Did you put in your SS amounts properly when doing the analysis?

Also, yeah, I see your dilemma. I think it comes down to how wide that 27% bracket is for you each year. Probably also depends on if you have the taxable funds to pay that big of a tax bill. You might consider just doing one year up to the top of the 22% bracket, which then might allow you to stay in lower brackets in subsequent years. But that's a big tax pill to swallow, and lots would find it hard to pull the trigger.

The other thing I like to remember is that if it is that hard to make a decision and the benefits of the various options seem to be hard to distinguish, it probably means that the options are approximately equal and it honestly doesn't matter what you choose as all options are going to turn out about the same. Which is, pretty much I think, where RunningBum go to several posts ahead of me. ;-)

 

[RASAP]

Probably what is making the numbers seem inconsistent is that over these 3 years, a couple of things are happening that are being factored in - our mortgage gets paid off and I start taking my full SS benefit (I am currently getting spousal benefits). Both of these events result in requiring less from our taxable accounts thus lower LTCGs (but higher SS income).

It looks to me that the width of the 27% brackets are 79.4k, 64.5k, and 39.7 k for the next 3 years. I suppose that means 3.97k, 3.23k and 2k higher taxes (as compared to the 22% bracket) are paid to get past the hump.

Sure, I can pay the tax bill from our taxable account. Which, now it occurs to me that I have not accounted for the additional LTCGs I will have in order to pay those tax bills .

The options do look different to me but when I compare the differences in the tax bills for the various scenarios it's hard to comprehend which one is better. Maybe I need to become less focused on the tax bills and more focused on what provides more money for me to spend while I am able to spend it.

My brain is starting to itch again .

 

[pb4uski]

Hummm....

The first part of what you said is exactly what I get in my estimates. However, for 2021 to get my taxable income to 108k, it would be 16.1k div + 15.6k SS * 85% + 56k Roth Conv + 50k LTCG - 27.4k std ded. Federal tax of 9.1k with marginal tax on the 56k Roth conversion of 16.2%.

If in 2021 I go to the top of the 22% tax bracket (27% tax rate from 30k through 91k), by my estimation that would be 16.1k div + 15.6k SS * 85% + 182k Roth Conv + 50k LTCG - 27.4k std ded. Federal tax of 38.6k with marginal tax on the 182k of 21.2%.

This is making my brain itch! I'm not sure I understand the meaning/significance of the percentage value associated with the marginal tax on the conversion (21.2%).

I had missed the $50k of LTCG earlier.

Obviously, any Roth conversions are discretionary. You just need to decide how much you are willing to pay.... especially as a percentage.

From what you provided, if you do no Roth conversions in 2021 then your tax bill would be $0.

If you do $56k of Roth conversions then your tax bill is $9.1k or 16.2%.
If you do $182k of Roth conversions then your tax bill is $38.6k or 21.2%.

So that last $126k of Roth conversions increases your tax bill by $29.5k for an effective rate on those conversions of 23.4%.

I'm guessing that your marginal rate when you deferred that income was probably more than 23.4%.... if so, no matter what you do you win!

The difficult part is how to factor in whether one of you will die prematurely and that will vault the surviving spouse into a much higher ta bracket... which is why doing more sooner may be preferable.

If you could tell us which of you will die first and when and how tax rates will change between now and then we can give you a much better answer.

Good luck.

 

[RunningBum]

Does it make sense to try to pick the strategy that keeps you out of the 27% range the most number of years?

If you convert to 24% for the next 3 years, does that mean you won't be in that 27% range, or at least not very far into it, for the rest of your life? If that's the case, I'd do the large conversions now.

Or if you're going to be deep into 27% when you start RMDs no matter what, maybe it makes sense to avoid them these next 3 years while you can.

Otherwise, if you're up to it, try projecting out the rest of a long life, and probably the 10 years after that your heir is dealing with an inherited IRA, and see what strategy works out to give you the most money. This will give you the most accurate picture, though you have to make a bunch of assumptions on investment growth, future tax rates, life span, etc.

 

[SecondCor521]

Without checking, I think the IRMAA rates lie between the 22% and 24% brackets for MFJ, so what I would probably do in your shoes no matter what you decide about 2021 is figure out what AGI you're going to end up and make sure you don't go over an IRMAA mini-cliff.

Going $1 over an IRMAA threshold in 2021 subjects you and your wife to increased Medicare rates for Part B and Part D in 2023. The complicating factor is that IRMAA rates are inflation adjusted, so the rates that apply in 2023 aren't known yet. When I get to that point I think I'll just use the 2021 brackets.

You can see the 2021 rates here:

https://thefinancebuff.com/medicare-irmaa-income-brackets.html

The above numbers are IRMAA MAGI, which is AGI plus tax-free income (roughly).

But it looks like you might only get bit in 2021 based on your numbers posted in post #16. Hard to tell because I'm not sure if post #16 are taxable income or AGI.

In your scenario, IRMAA probably bites your wife harder after you pass away. She'll have most of the income but will pay IRMAA based on the Single IRMAA brackets. The first breakpoint drops from about $176K AGI to about $88K AGI.

 

[npage]

Just for this simpleton.

For a married couple, if one had zero other income and converted $24,000 from IRA to Roth and applied standard married couple $24,000 deduction, there would be no tax on conversion correct? Just a simple illustration to help.

To build then.

If we had $10,000 in income, converted $24,400 IRA to Roth, applied same $24,000 deduction, our taxable income would be $10,000?

About right? IRA balance entirely derived from a 401K rollover.

 

[SecondCor521]

Just for this simpleton.

For a married couple, if one had zero other income and converted $24,000 from IRA to Roth and applied standard married couple $24,000 deduction, there would be no tax on conversion correct? Just a simple illustration to help.

To build then.

If we had $10,000 in income, converted $24,400 IRA to Roth, applied same $24,000 deduction, our taxable income would be $10,000?

About right?

Correct, with a couple of minor nits:

1. The number is $25,100 for 2021. But you have the right idea.

2. There may be other tax effects: state income taxes, ACA subsidy loss, loss of various tax credits.

But yes, conceptually you have it correct. The extra $10K would be in the 10% bracket and so the federal income tax bill would be $1K.

 

[npage]

Appreciate it, I get there a few little nuances but that helps me be comfortable in my situation. Which looks more like I am quitting shortly (Next week). Wife keeps working for next 5 years in 22% bracket and we will have about $50 to $60K a year to work with in that bracket.

Plan is to convert what I can in those years up to the 22% to build a future ROTH withdrawal ladder when she retires in 5 years. These conversions will be used to manage income for ACA. Once she quits we will have more room for larger roth conversions.

If I waited totally for her to quit, we would not have enough Roth built up to take from and be required to take larger IRA withdrawals at some point above the ACA cliff.

If the ACA subsidy process or qualifications changes materially, well, who knows.