PSA - Roth conversion plan miscalculation

[pb4uski]

Deferring income definitely is not going to help me avoid paying a higher tax rate when I start RMDs. I wish I had not put so much in my tax-deferred accounts. Even with Roth conversions while delaying Social Security, I'm going to be bumping up my tax bracket with RMDs. Also, for some people, if they are intending to leave money to heirs, traditional IRAs and 401(k)s may not be that tax friendly for the heirs.

I wish Roth accounts had been available to me when I was younger because it is even more beneficial then due to the time that the money has to grow tax-free. I would be doing Roths as a youngster even if I were not in a higher tax bracket.

The last part is a popular misconception. The benefit from growth is negligible The more relevant considerations are the taxes saved when the income is deferred, which is known, and the taxes paid when the deferred income is withdrawn for spending or withdrawn as RMDs.

An example. Tax rate 20% and you have.100 of tIRAs and 20 of taxable funds. 10 year time horizon and 8% annual growth.

Option 1; Convert the 100 to Roth and use the 20 of taxable to pay the tax. The 100 in the Roth grows to 216 at the end of 10 years.

Option 2. Do nothing. tIRA grows from 100 to 216. 20 taxable grows from 20 to 37. Withdraw 216 from tIRA, pay 43 in tax and have 210 for spending.

216 = 100 * (1+8%)^10
37 = 20 * (1+(8%*(1-20%)))^10
43 = 216 ° 20%

The difference between 216 and 210 of 6 or 2.9% is only due to tax savings on the taxable account over the 10 years.

So at the same tax rate the savings are negligible.

Where the tax savings come from are differences in the tax rate, in my case deferring at 28% federal and 6% state or 34% total and now withdrawing at 10-12% federal and 0% state or 10-12% total. Also paying 10-12% now is better than paying ~18% at RMD time once my SS moves is into a higher tax rate. (18% is a blend of 12% and 22%).

 

[TheWizard]

... I wonder if anyone else has experience with retirement savings strategies that are geared towards minimizing the need for Roth conversions? Is what I’m doing sound reasonable or are there factors that I’m missing that make my current strategy less than optimal? I’d be curious to hear the thoughts of others.

It depends on the relative size of your various investment accounts: tax-deferred vs Roth vs taxable.
Many of us have over 50% of nominal $$$ in tax-deferred so it makes sense to Roth convert some of that prior to your 70s.

If you somehow have a much smaller percentage of tax-deferred to start with, then you could just leave that alone until age 70.5 and then start QCDing it to various charities...

 

[TheWizard]

...The last part is a popular misconception. The benefit from growth is negligible The more relevant considerations are the taxes saved when the income is deferred, which is known, and the taxes paid when the deferred income is withdrawn for spending or withdrawn as RMDs...

Agree.
I seem to see this misconception a lot, as for example when someone Roth converts $10k an then pays $1200 tax on it from additional tIRA funds, thus it takes a few years to recover from that tax hit. Incorrect.

And there are additional reasons to Roth convert beyond tax arbitrage but that's a separate topic...

 

[RunningBum]

Deferring income definitely is not going to help me avoid paying a higher tax rate when I start RMDs. I wish I had not put so much in my tax-deferred accounts. Even with Roth conversions while delaying Social Security, I'm going to be bumping up my tax bracket with RMDs. Also, for some people, if they are intending to leave money to heirs, traditional IRAs and 401(k)s may not be that tax friendly for the heirs.

I wish Roth accounts had been available to me when I was younger because it is even more beneficial then due to the time that the money has to grow tax-free. I would be doing Roths as a youngster even if I were not in a higher tax bracket.

Obviously deferring income results in higher RMDs. Does it look like your tax rate will be higher with RMDs than it was when you were deferring income? And my advice was specifically for the OP who is probably in or near peak earning years, rather than fresh out of school.

Just for example, if your tax rate looks to be 24% with RMDs, that may feel like a stiff hit compared to 12% before SS and RMDs. But it's still good compared to 28% or 30+% marginal rates you may have been paying while working.

 

[TheWizard]

Obviously deferring income results in higher RMDs. Does it look like your tax rate will be higher with RMDs than it was when you were deferring income? And my advice was specifically for the OP who is probably in or near peak earning years, rather than fresh out of school.

Just for example, if your tax rate looks to be 24% with RMDs, that may feel like a stiff hit compared to 12% before SS and RMDs. But it's still good compared to 28% or 30+% marginal rates you may have been paying while working.

Exactly.
I am continually surprised by the number of people who somehow are dismayed by having high income in retirement..

 

[NomDeER]

The last part is a popular misconception. The benefit from growth is negligible

That may be the case for you. It is not the case for everybody. It depends on your incomes, the tax brackets, the amount of money involved, as well as other circumstances, such as whether RMDs are going to have an impact on IRMAA or on the withdrawals and taxes required for your beneficiaries. I think a mix often works the best. However, I skewed severely to tax-deferred. (It was about 10:1.) There definitely were years where doing a Roth would have made more sense for me, in whole or in part.

I do definitely agree, though, that people sometimes make the mistake of not accounting for opportunity costs resulting from paying taxes to contribute or convert to a Roth IRA.

An example. Tax rate 20%

You can pick and choose circumstances to make the numbers work. It will work for some and not for others.

I may try to get the kids more earlier rather than later so they can enjoy it and we can watch them enjoy it.

Was listening to radio today. DJ still busts his daughters chops since she doesn't remember her first trip to Disney at 3 1/2. Remembers zilch. I Would think Plane, hotel, disney characters..... but Nothing...

Hopefully she enjoyed the Disney experience at the time, even if she doesn't remember it now.

I definitely know grandparents who use their savings/RMDs to help grandchildren. Sometimes it's simply things like vacations or college funds for younger kids. But, I know one young woman who wouldn't have saved while she was a teenager or going to school or first began her career. Her grandparents gave her money each year on the condition that she put it in a Roth IRA, and it has been great for her. Since you are not a fan of Roth IRAs, once your grandchildren are teenagers who are old enough to work, you can gift them and have your grandkids invest the money in traditional IRAs. (Of course, I would make the argument that they are better off doing Roth IRAs with such low tax rates.)

 

[Sunset]

Was listening to radio today. DJ still busts his daughters chops since she doesn't remember her first trip to Disney at 3 1/2. Remembers zilch. I Would think Plane, hotel, disney characters..... but Nothing...

I have no memories prior to age 5.
I know that as I was 5 when we moved to a new place, and all the other places are a blank, parents had photos and nope, can't recall anything.

 

[Koolau]

Exactly.
I am continually surprised by the number of people who somehow are dismayed by having high income in retirement..

I suppose the dismay is the other half of the surprise of high income in retirement. I never thought my income would be this high. Can't say I'm actually dismayed, but I am w*rking to lower my taxes though I should have started a lot sooner.

 

[RunningBum]

I have no memories prior to age 5.
I know that as I was 5 when we moved to a new place, and all the other places are a blank, parents had photos and nope, can't recall anything.

Sometimes it's not the specific memories, but just the burned impression of family fun and togetherness that promotes good parent-child relationships. That's my theory, anyway.

 

[pb4uski]

That may be the case for you. It is not the case for everybody. It depends on your incomes, the tax brackets, the amount of money involved, as well as other circumstances, such as whether RMDs are going to have an impact on IRMAA or on the withdrawals and taxes required for your beneficiaries. I think a mix often works the best. However, I skewed severely to tax-deferred. (It was about 10:1.) There definitely were years where doing a Roth would have made more sense for me, in whole or in part.

I do definitely agree, though, that people sometimes make the mistake of not accounting for opportunity costs resulting from paying taxes to contribute or convert to a Roth IRA.

You can pick and choose circumstances to make the numbers work. It will work for some and not for others. ...

No, I wasn't cherry picking the numbers. You'll get to the same decision if the tax rate is the same no matter what the tax rate is. Use 10% or 12% or 15% or whatever. It will still show that if the tax rate is the same when converted vs RMD that the benefit of converting is negligible.

The real benefit, over the negligible benefit where tax rate is the same, is where the tax rates differ, which basically proves that the benefit is from differences in tax rates and not from growth. It is a popular misconception that tax-free growth in a Roth is a benefit vs tax-deferred.

 

[pb4uski]

I have no memories prior to age 5.
I know that as I was 5 when we moved to a new place, and all the other places are a blank, parents had photos and nope, can't recall anything.

Agree but the other thing is if I see pictures of me and others from back before I was 5 I think that the picture fools me in to thinking that I remember the experience when I'm really just remembering the picture of the experience.

 

[Koolau]

No, I wasn't cherry picking the numbers. You'll get to the same decision if the tax rate is the same no matter what the tax rate is. Use 10% or 12% or 15% or whatever. It will still show that if the tax rate is the same when converted vs RMD that the benefit of converting is negligible.

The real benefit, over the negligible benefit where tax rate is the same, is where the tax rates differ, which basically proves that the benefit is from differences in tax rates and not from growth. It is a popular misconception that tax-free growth in a Roth is a benefit vs tax-deferred.

Agree. Having said that, there are other advantages to Roths. Financially, the one I think is important (if you can swing it) is paying the taxes on the conversion with "free cash" instead of from your tIRA. This effectively means that (for instance) a $100K tIRA becomes a $100K Roth (not a 80K + or -) Roth (losing maybe 20% for taxes). In effect, you have slipped an extra 20K into your Roth to grow tax deferred.

Roths also have advantages to heirs, of course.

 

[NomDeER]

It will still show that if the tax rate is the same when converted vs RMD that the benefit of converting is negligible.

That "if" is an awfully big assumption. My tax rates have not been the same. Lots of people's tax rates do not remain the same over their lifetimes. Plus, the choices about whether to tax defer or not affect tax rates both at that time and later.

I did not say that Roths are always better. As I said, it depends on your incomes, the tax brackets, the amount of money involved, as well as other circumstances, such as whether RMDs are going to have an impact on IRMAA or on the withdrawals and taxes required for your beneficiaries.

And, as I said, a mix is often what works best. It's not one or the other.

 

[TheWizard]

Agree. Having said that, there are other advantages to Roths. Financially, the one I think is important (if you can swing it) is paying the taxes on the conversion with "free cash" instead of from your tIRA. This effectively means that (for instance) a $100K tIRA becomes a $100K Roth (not a 80K + or -) Roth (losing maybe 20% for taxes). In effect, you have slipped an extra 20K into your Roth to grow tax deferred...

Absolutely correct.
I've tried explaining this in the past, but I don't think that a lot of people grasp the concept.
And it's tax-free, not tax-deferred...

 

[sengsational]

I took apart a grease gun last week and can't get it back together without growing two more hands so I threw it in the trash and am going to just buy another one.

You forgot to say "so I can do my own vehicle maintenance to save money"

I'll quote the portion that's missing, above

The real benefit, over the negligible benefit where tax rate is the same, is where the tax rates differ, which basically proves that the benefit is from differences in tax rates and not from growth. It is a popular misconception that tax-free growth in a Roth is a benefit vs tax-deferred.

 

[pb4uski]

That "if" is an awfully big assumption. My tax rates have not been the same. Lots of people's tax rates do not remain the same over their lifetimes. Plus, the choices about whether to tax defer or not affect tax rates both at that time and later.

You obviously are NOT getting it. By having the tax rate stay the same in the illustration and including some significant growth and seeing that the results are so similiar it proves that growth does NOT provide any substantial benefit as you claimed.

 

[Montecfo]

No, I wasn't cherry picking the numbers. You'll get to the same decision if the tax rate is the same no matter what the tax rate is. Use 10% or 12% or 15% or whatever. It will still show that if the tax rate is the same when converted vs RMD that the benefit of converting is negligible.

The real benefit, over the negligible benefit where tax rate is the same, is where the tax rates differ, which basically proves that the benefit is from differences in tax rates and not from growth. It is a popular misconception that tax-free growth in a Roth is a benefit vs tax-deferred.

This is true. The issue is conceptual and honestly IRAs were sold this way, touting the tax savings over the pre-distribution life of the account, while ignoring the future tax payments and amounts.

While Pb4uski laid out a detailed example, the link below explains the whys in math terms for IRAs.

The Commutative Law of Multiplication

The Commutative Law of Multiplication is a fancy way of saying when you multiply two numbers, it doesn't matter which number you put down first and which

thefinancebuff.com

 

[sengsational]

... due to the time that the money has to grow tax-free.

This is the problematic portion, I think.

I would be doing Roths as a youngster even if I were not in a higher tax bracket.

Selecting a Roth over tIRA while in a bracket that's expected to be lower than retirement is the obvious choice nowadays, in hindsight. But at the time, for me, selecting tIRA to drop to a cheaper bracket was tempting. Of course there was no Roth option at the time. I don't think I was thinking about my expected retirement bracket. And if I did have a cursory thought, it would have been "I won't have a pay check, only Social Security, so I'll be in a low bracket" not thinking through paying taxes on tIRA withdrawals.

 

[pacergal]

If you and your kids love Disney, then go now and have fun. The grandkids won't remember, but you will have pictures and stories.
You can always plan another BTD trip when they are a bit older. Use your inheritance $ to make memories with your family.
That is what we do every year with our inheritance from my folks. Our kids and grandkids look forward to their summer trips with Papa and Grandma.
I never counted on inheriting in our retirement plan, so it works.

 

[TheWizard]

This is true. The issue is conceptual and honestly IRAs were sold this way, touting the tax savings over the pre-distribution life of the account, while ignoring the future tax payments and amounts.

While Pb4uski laid out a detailed example, the link below explains the whys in math terms for IRAs.

The Commutative Law of Multiplication

The Commutative Law of Multiplication is a fancy way of saying when you multiply two numbers, it doesn't matter which number you put down first and which

thefinancebuff.com

I'm not sure that the various tax-deferred accounts were promoted under false pretenses. Practically everyone knows they will be taxed as Ordinary Income later on.

But I fully agree with you and pb4 about the commutative law and it's impact on growth in one's investments.

In real life, the concept of marginal tax rates being the same before/after a Roth conversion can be an issue one year at a time, forget about a decade or two in the future.

In my case, for example, I'm close to the top of the 24% Federal tax bracket to start with. So the past few years, I've taken time at year's end to compute a modest Roth conversion dollar amount that will:
1) keep my AGI and TI from getting into the 32% bracket;
2) keep my AGI from getting me into the next higher IRMAA tier two years later.

But for 2024 taxes, my total AGI was just over the nonindexed NIIT threshold ($200k) causing me to pay just a few extra $$ of tax.

Fortunately, I can do larger QCDs as needed to keep from paying more than 24% for my Roth conversions...

 

[pb4uski]

I don't think that tax-deferred saving was promoted under false pretences at all. The vast majority of retirees do have a lower tax rate in retirement than they did while working... I was a high earner and we do and my modest means friend does as well.

Even though I was a high earner and have been more financially successful that I expected when I was deferring that income, I have made out like a bandit... saved 28% federal and 6% state when saved and paying, say, 18% federal (blend of 12% and 22%) and 0% state... so a 16% savings.

What perplexes me is that so many people, occasionally including authors of articles, seem to think that big benefit of Roth conversions is tax-free growth.

 

[TheWizard]

...What perplexes me is that so many people, occasionally including authors of articles, seem to think that big benefit of Roth conversions is tax-free growth.

Depending on the context of the discussion, it sort of IS.

The usual and correct recommendation is to load up your Roth IRA with 100% stock funds, while keeping bond funds and other fixed income investments in your tax-deferred accounts to extent needed to achieve your AA...

 

[Montecfo]

I never said anything about false pretenses.

But there was certainly never a discussion of tax arbitrage. The tax deferral was the key feature and if you refer to the provided link the misunderstanding is illustrated. And even up-thread.

But the major issue is making sure we understand them now, and many do not. Hence my point.

 

[pb4uski]

No doubt that once in the Roth it is tax-free.

While it seems beneficial at first blush, if the tax rate is the same it really isn't.

Easier to see where taxes are paid from the conversion.

(100*(1-t))* (1+g)^n = (100*(1+g)^n)*(1-t)

where g = growth and t = tax rate.

 

[TheWizard]

No doubt that once in the Roth it is tax-free.

While it seems beneficial at first blush, if the tax rate is the same it really isn't.

Easier to see where taxes are paid from the conversion.

(100*(1-t))* (1+g)^n = (100*(1+g)^n)*(1-t)

where g = growth and t = tax rate.

The math equivalency isn't the main issue here. The issue is optimal asset location.

Let's say Fred has $1.5M in tax-deferred, $500k in Roth and has a target AA of 60/40 to contain risk.
Optimal location strategy is then $500k stock funds in Roth, along with $700k stocks and $800k fixed income in tax-deferred...