Future Taxmageddon Question

[sdfire]

Sorry for the hyperbolic title.

I am in the happy situation where I have a large IRA balance as well as a large investment in I bonds. I am still 17 years away from RMD's. Unfortunately, the RMD's start the same year that the last of the I bonds mature. As a result, I could have a very large tax bill that year.

I am thinking about potential solutions.

1. I could cash in the I bonds early. But, I hate to do this because the fixed interest rate is great and I've averaged 5%+ on the bonds. But, one or two years could help with tax bracket creep, etc.

2. I could try to move part of the IRA into a Roth IRA. I am just starting to look into this option. I've never qualified to make a straight Roth IRA deposit because of income limits. So, I'm not sure if there is a way to move over a significant amount of the IRA. And, of course, I'm also not sure it makes sense to advance the taxes. This question could get more compelling if we have a tax decrease. But, right now, my bracket may be similar now and after retirement.

I am wondering if this group could point me to resources where I can read up on IRA to Roth IRA transfers and the pluses and minuses of such. Of course, I would also be grateful for any wisdom that you can share.

A quick question: If your tax rate will be the same now and at RMD time, it doesn't make any sense to advance the taxes, right? I'm still working on that question as it is pretty difficult to predict tax policy in 17 years. But, conceptually, I think I have it right.

Final question: Is there a tax bracket over which you would not try to make an IRA to Roth IRA transfer?

Thanks for your thoughts.

 

[Whisper66]

See www.rothira.com for lots of good information. Read up on Roth "conversions". Then consider using www.i-orp.com to get an estimate on how much ira to convert to Roth each year to optimize taxes.

 

[kaneohe]

Post-Retirement Roth Conversion - Fairmark.com Fairmark.com

to start you off................

 

[pb4uski]

Generally speaking, IMO there is little merit to Roth conversions if the tax that you pay is the same or more than the tax that you would expect to pay in retirement.

 

[FlaGator]

Beyond taxes on RMDs, there are estate planning reasons to convert to Roth - your heirs are saddled with your distribution schedule, and that may not make sense for them, or be contrary to your wishes. Roth accounts don't have that requirement. Everything above is from my memory, please correct if I have "mis-remembered"

An option I'm starting to consider after maximizing Roth conversions is to draw down the tIRA earlier than traditionally recommended. Thinking it does a couple of things:
1. Preserves the taxable account. My estate is likely to pass without tax. My heirs are young and the RMD, split between them could get lost, and certainly not as meaningful as a lump sum. May take SS early for the same reason, as I have no spousal income considerations.
2. With a lower RMD when that time comes, I have more flexibility in managing the tax cost of my sources of living expenses.
3. Yes, would miss out on the tax-deferred compounding of earnings, but that is less valuable as I get closer to drawdown. Everything comes out as ordinary income anyway, while a taxable account has some tax preference with capital gains and dividends.

Ready with rawhide underwear for those with different opinions

 

[MooreBonds]

1. I could cash in the I bonds early. But, I hate to do this because the fixed interest rate is great and I've averaged 5%+ on the bonds. But, one or two years could help with tax bracket creep, etc.

A quick question: If your tax rate will be the same now and at RMD time, it doesn't make any sense to advance the taxes, right? I'm still working on that question as it is pretty difficult to predict tax policy in 17 years. But, conceptually, I think I have it right.

Don't forget that you can declare interest earned on uncashed savings bonds. The only catch is that you are supposed to use the same method for all savings bonds you own.

So for the first year you claim this, you will have a large interest income for years 0-current for interest earned. Then, each successive year (until you cash each bond in), you declare the interest earned that calendar year from Jan 1-Dec 31. Make sure you save each Schedule B when you declare this, and include previous years Schedule B when you cash it in and actually receive the interest. (when you do eventually cash them in, the bank will show the IRS earnings of your entire savings bond life...but all you do is note on Schedule B "Previously declared interest years 20xx-20xx", and show the previously declared interest as a negative number....I have done this for several years on my Schedule B and cashed in several bonds each year for the previous 6 years without any question from the IRS).

Also, be sure to look at the fine particulars of your taxes. Do you have any capital gains or qualified dividend income that would be taxed differently now vs later? Any capital losses to declare and start using up now and carryover to subsequent years? Any other sources of deductions (HSAs, charitable contributions, etc.)

 

[Whisper66]

If your tax rate will be the same now and at RMD time, it doesn't make any sense to advance the taxes, right?

Yes, that is right. One thing I used to find difficult to predict is my tax rate over the years. But found one of the outputs of I-ORP is a tax table by year. So you can see for the input you provided what your tax rate is likely to be (using current tax rules). By allowing ORP to suggest how much to Roth convert each year and comparing it to another run without Roth conversions, I can see the impact of using Roth conversions to optimize my tax expenditures.

Is there a tax bracket over which you would not try to make an IRA to Roth IRA transfer?

Depends on your goals and how you feel about paying taxes early. If your only goal is optimizing lifetime taxes assuming todays tax laws don't change, then there probably isn't a limit to the bracket you would be wiling to pay into. Practically speaking, most people that do Roth conversions and discuss it here limit their bracket to something. I personally limit to 28%. Anything lower wouldn't do me much good due to the large amount I have in tax deferred accounts. Anything higher seems like too aggressive to me (just a gut feel).

 

[sdfire]

Thanks

Thanks very much for the links and all of the information that you've all shared! Very helpful. I've started reading and learning already.

I didn't remember that I could report the I bond interest yearly. That is worth considering. But, most of my bonds were purchased over 3 years. So, by reporting the interest yearly, I would end up bunching all of the past interest into one year and likely create a similar tax problem (albeit smaller) in that first year than the one that I am trying to avoid. I will need to run the numbers. But, I fear that this won't help as much as I hoped when I first read the note.

I am lucky enough to have after tax accounts that are generating enough to put me into the 25-28% tax bracket now. About 1/3 of that is muni bond interest so I believe that will not impact my bracket. The rest is mostly LTCG or qualified dividends, although there is a small amount of taxable interest. If I were to add the current 70.5 year old RMD to this total today, it would push me well into the 33% bracket.

The other factor that bothers me is that I live in a very high tax state. So, any advanced income is subject to a high state tax.

Thanks for your thoughts!

I have some room in the 28% bracket that I could do a Roth conversion. I will run I-ORP. But, I am wondering if folks think it is worth making a conversion to use the 28% bracket space. Or, whether it is not worth advancing the taxes.

 

[Ready]

Many of the members on this forum stop earning income well before RMDs kick in. That is probably stating the somewhat obvious since this is the EARLY retirement forum.

If this applies to you, would you not have a good number of years where you will stop earning income, but be too young to apply for social security? Those would be the ideal years to convert your IRA to a Roth IRA. Doing this in small amounts at a time should allow you to stay in the lowest of tax brackets. While nobody can predict future tax brackets, I think it's a safe bet to say that your bracket will be lower when you stop earning income, and therefore will be in a more favorable position to do your ROTH conversions.

 

[Whisper66]

.....I have some room in the 28% bracket that I could do a Roth conversion. I will run I-ORP. But, I am wondering if folks think it is worth making a conversion to use the 28% bracket space. Or, whether it is not worth advancing the taxes.

Run I-ORP and see if you save very much on overall lifetime taxes by doing this. In my case, if I convert up to the 28% limit for a couple years, I will have more later years of taxes paying only 15%. So even though my tax rate in later years is lower than it will be this year, my total lifetime taxes will be lower if I convert up to the 28% limit this year. I have chosen to pay more taxes today purely to save on lifetime taxes as suggested by I-ORP calcs.

You will find many others here that choose not to convert in a similar situation. Prefer to hang onto the money for various reasons. Just different philosophies.

I personally don't see either philosophy as a clear cut winner since we really don't know what the tax laws will be nor what our asset returns will be over the rest of our lifetimes.

 

[sdfire]

Started playing with IORP. It doesn't show anything in the Roth category. Does that mean that it is telling me not to do a Roth conversion?

 

[jane_sm1th73]

Generally speaking, IMO there is little merit to Roth conversions if the tax that you pay is the same or more than the tax that you would expect to pay in retirement.

Here's how I see it. The tax bite is one time. The residual income after conversion is tax-free forever.

Ve grow too soon oldt undt too late schmardt.

 

[RE2Boys]

An option for the I Bonds, if you have children or grandchildren, is to cash them when you have a year where (MFJ) your AGI is less than $146.3K (2016 rates) and deposit the proceeds into a 529 college savings plan. For bonds issued after 1989, the interest would be fully or partially exempt from federal tax.

 

[2017ish]

Started playing with IORP. It doesn't show anything in the Roth category. Does that mean that it is telling me not to do a Roth conversion?

I believe the current default setting on i-Orp is to ignore Roth Conversions--too many people were freaking out over aggressive conversions and contacting the gentleman who provides that tool. Read the page and instructions closely.

You might also want to look at this boglehead calculator tool, but be warned that it takes some time and effort to load everything up: https://www.bogleheads.org/wiki/Retiree_Portfolio_Model

Agree with others--the post retirement, pre-social years are optimal for conversions. I am 4 years older than you and we see 13 years of conversions beginning this year. Made no sense while we were working, but under current law, maxing the 28% bracket is attractive... Others will max the 15 or 25% brackets. All depends upon how much you've got squirreled away in tax deferred.

Finally, you don't mention tax filing status. If you are MFJ, don't forget that in addition to RMD% increasing each year, so does the likelihood that you or your spouse will be widowed and thrust into single tax brackets. That is a factor in favor of more aggressive conversions.

 

[kaneohe]

Here's how I see it. The tax bite is one time. The residual income after conversion is tax-free forever.
.............................................................

In this case, the qualitative reasoning (instead of quantitative) is a bit simplistic and misleading. As a simple example:
1) $1000 TIRA converted at 25% tax rate yields $750 Roth. You paid a one-time tax of $250. The Roth then doubles to $1500,all of which is then tax-free. VS.
2) $1000 TIRA is left alone and doubles in same time to $2000. If it is withdrawn at 25% tax rate, you pay tax of $500 (double that of the Roth conversion in 1) (the analog of paying taxes"forever".) However even though
more taxes are paid, the after-tax value is $1500.......which is exactly the same
as in 1) so even tho the qualitative reasoning sounds enticing, there is no actual advantage in the end.

In reality, if you pay the taxes from non-TIRA funds so you end up with
a $1000 Roth, you can show by similar but somewhat more complex calculation
that the Roth is somewhat better than the TIRA so you are correct, but I'm not sure if the qualitative reasoning got you there.

 

[Whisper66]

Started playing with IORP. It doesn't show anything in the Roth category. Does that mean that it is telling me not to do a Roth conversion?

It may mean that you either haven't run the full version of ORP or haven't clicked the box that allows investigation of Roth conversions.

Go to the main orp page, this provides the "short form" version of ORP....
https://www.i-orp.com/

Go to the bottom of the page to the link for the "long form" version of ORP....
https://www.i-orp.com/ORPparms.html

On this long form, input your data and unclick the box at the bottom for Monte Carlo Risk Assessment.

Now go to the option for "IRA to Roth Conversions". Run one case with the default "no partial conversions", run a second case with "unlimited conversions"

In the output section, check the "Withdrawal Report". If there is a column shown as "IRA2ROTH", that is the column showing the recommended Roth conversion each year. You are more likely to get a recommendation for Roth conversions if you have a lot of savings in your IRA and plenty of money in your taxable account to pay taxes on a conversion.

 

[sdfire]

It may mean that you either haven't run the full version of ORP or haven't clicked the box that allows investigation of Roth conversions.

Go to the main orp page, this provides the "short form" version of ORP....
https://www.i-orp.com/

Go to the bottom of the page to the link for the "long form" version of ORP....
https://www.i-orp.com/ORPparms.html

On this long form, input your data and unclick the box at the bottom for Monte Carlo Risk Assessment.

Now go to the option for "IRA to Roth Conversions". Run one case with the default "no partial conversions", run a second case with "unlimited conversions"

In the output section, check the "Withdrawal Report". If there is a column shown as "IRA2ROTH", that is the column showing the recommended Roth conversion each year. You are more likely to get a recommendation for Roth conversions if you have a lot of savings in your IRA and plenty of money in your taxable account to pay taxes on a conversion.

Whew! I-ORP is pretty complicated on the first use. But, I think I've got a rough idea based on running two identical runs one with Roth conversions and one without as you recommended. ORP would have me convert all of my tax deferred to Roth. However, the identical runs show a relatively small advantage with the Roth conversion, a roughly 2.5% higher starting spending value as well as total plan value. My initial reaction is that a 2.5% potential difference may not justify the Roth conversion based on the unknowns of future tax policies and rates. But, I'm going to have to keep playing with ORP. One thing I'm still not following is the capital gains column.

Anyway, thanks for all your links and advice!

 

[sengsational]

You ended-up where a lot of folks end-up after running i-orp...it doesn't include the "bird in the hand" factor.

Not that I want to make it any more complicated, but if you want to convince yourself to make smaller Roth conversions, if you make the planning horizon shorter (die sooner, hehe!), the recommendation will begin to change, I think. Most people make their plan plenty long, not wanting to run out of money, but it might be worth running it at your statistical age of death instead of adding 10 years (or whatever).

The capital gains column isn't anything to worry about... it's there because that income is treated differently for tax purposes.