Roth conversions beyond the 15% bracket

[MrLoco]

I know the discussion of Roth conversions usually center on converting to the top of the 15% bracket and not beyond to keep taxes on any qualified dividends and LT capital gains at a rate of $0......but what about converting to the top of the 25% bracket and even into the 28% bracket?

I had this conversation with my CPA and his response was that so many people "think" they can project their tax rate in retirement and we already know that in many cases when including.... pensions, SS, taxable income, RMD's from Trad IRA's , annuities, etc.....that retirement income may actually vault one into a higher tax bracket. Plus he mentioned that tax rates will probably increase at a faster rate then income limits within tax brackets. Hence, the 25% tax rate today becomes the 30% rate 10 years from now....the 28% rate becomes the 33 or 35%, etc.

His thinking is that if you are 10 or more years away from taking RMD's from a Trad IRA....convert what you can well into the 25% bracket especially if you will have a healthy income stream from a pension and SS.

Also,when leaving a legacy to heirs, a ROTH is preferable to a tax deferred investment as distributions would be tax free. Food for thought.

NOTE: The above scenario is specifically geared to those where one or both spouses have earned income and this already places them in the 25% + tax bracket.

 

[ziggy29]

I suppose it's possible. But if one feels pretty sure their income would put them in what is now the 15% bracket in retirement, even if tax rates rise, I don't know that 15% would rise to 25%. Of course, if you currently live in a state with no income tax and plan to retire to a state with a fairly high income tax, that would factor in as well. We are in the 15% bracket now and live in a state with no income tax, so we "Roth" everything we can right now.

 

[nash031]

I have done one conversion on DW's Traditional IRA up to the top of 25%. I haven't done any since, only because we're butting up the next bracket. I don't see it as a huge deal as the amount of money we're talking about now is less than 5% of our total and going down as we put money into her Roth.

I have no idea how your CPA has any clue what tax rates are going to do... that's a SWAG I wouldn't put any stock in. JMO.

 

[RunningBum]

One reason to convert a lot early is to try to qualify for an ACA subsidy in your 60s when health insurance rates are highest, and the subsidy has the most impact. I tried to convert up to the top of the 25% bracket last year, but hit AMT taxes that put jumped the rate of that chunk over 30%, so I backed it out.

I wouldn't do it based on predicting higher future tax rates, but that's your decision.

 

[donheff]

Given historical market returns, I don't see any way out of the 25% bracket now or later. iORP says I should do several big Roth conversions now because I would likely save over the long term (based on a 6% return scenario) but the advantage is vanishingly small. My thought (without calculations to support it) is that the sequence of return risks counsels against taking a significant immediate loss (25% of the conversions) in the hope of a small gain later. Everyone assumes taxes will be higher in the future and I agree but it is possible that a Brexit or some other calamity will lead to a near term market collapse catapulting us down now in which case those early conversions could be a big mistake.

 

[LOL!]

Because much of my income comes from long-term capital gains, if I go above 15%, those gains start getting taxed at 30% instead of the 0% I am used to. This is because not only do I pay 15% on any ordinary income from conversions in the 15% bracket, but that ordinary income bumps LTCG into the bracket where they are taxed at 15%. So 15% + 15% is 30%. So for me, there is no 25% nor 28% bracket unless I really blow through some income numbers.

And why do I keep reading about CPAs that have weird ideas and make mistakes on taxes?

 

[Senator]

I am planning on converting tIRAs to a Roth at the 15% bracket.

In addition to the things you mentioned, here are a few other reasons. There are many one-time events that might force you to pay a very high percent in income taxes.

A potential inversion stock sale could boost your income way high. If you have Roth money, that can be withdrawn tax-free, rather than at the 39%+ bracket.

A house sale could boost your income high.

A missed 1031 exchange on a rental property window.

 

[2017ish]

We will convert to top of 25%; 28% will require some thought and calculations once we retire. (Grossly disproportionate share of portfolio is in big tax deferred accounts--and when only one of us is alive, the tax rate on RMDs would quickly hit 33% marginal even with no other income.)

 

[braumeister]

If you're converting into the 25% bracket (as I do), it's also important to keep in mind the MAGI thresholds for IRMAA (increased Medicare Part B premiums).

 

[Gone4Good]

I generally find Roth conversions difficult to justify at any tax bracket.

If I'm in the 15% bracket I'm better off harvesting capital gains and increasing my basis forever at 0% cost than pre-paying income taxes today and also potentially paying more in gains tomorrow.

If I'm currently in a higher bracket the upfront cost is also greater and only makes sense if I know with a good deal of certainty that my future tax rate will be higher still. That's not possible to know.

If, perhaps, you're old enough to have a clear line of sight as to what the rules will be for you in retirement; whether RMDs are still a thing; whether Roth accounts remain tax free; whether Social Security benefits are maintained or lowered; whether your tax bracket is lower or higher; whether gains and dividends are still preferentially taxed; whether their's a VAT; or whether any of a thousand other changes are made to the tax code - if you can forecast that with a high degree of accuracy then maybe it makes sense to engage in this kind of tax rule arbitrage.

If you're younger and have several decades of tax changes ahead of you, paying extra taxes today with a 100% certainty to maybe pay fewer taxes in the future doesn't strike me as a wise trade.

A bird in the hand is worth two in the Roth.

 

[2017ish]

...

If, perhaps, you're old enough to have a clear line of sight as to what the rules will be for you in retirement;... then maybe it makes sense to engage in this kind of tax rule arbitrage.

If you're younger and have several decades of tax changes ahead of you, paying extra taxes today with a 100% certainty to maybe pay fewer taxes in the future doesn't strike me as a wise trade.

A bird in the hand is worth two in the Roth.

This is a good point. Big difference between a 40 year old retiree and my planned 57... (And even in my case, the reluctance to convert beyond 25% bracket is based on inability to know what might change.)

 

[kaneohe]

Because much of my income comes from long-term capital gains, if I go above 15%, those gains start getting taxed at 30% instead of the 0% I am used to. This is because not only do I pay 15% on any ordinary income from conversions in the 15% bracket, but that ordinary income bumps LTCG into the bracket where they are taxed at 15%. So 15% + 15% is 30%. So for me, there is no 25% nor 28% bracket unless I really blow through some income numbers.

And why do I keep reading about CPAs that have weird ideas and make mistakes on taxes?

Might still be worth taking a look.............if you avoid doing conversions because of the "30%" marginal rate , it is possible that you might run into AMT/NIIT with 36% rates later.

 

[Trawler]

I just looked at the Roth Conversion Project for us and could only justify conversions thru the 10% and into some into the 15% bracket due to ACA subsidies. With only standard deduction in most years and 2 Personal Exemptions and $7,550 HSA. We currently live on non qualified monies till 59.5 and run out of non qualified money around 61. If we mange MAGI thru Roth conversions to $29,700 with total income of $37,250 our insurance cost and income tax cost is about 10%. if we take an additional $10,000 the incremental cost (tax and loss of some subsidy) on the $10K is 20.5% . If we take additional $20K the incremental cost is 25.8% . Would need to fund additional costs out of IRA distributions once we run out of non qualified money. Our projections for income at RMD time will be in 25% bracket. I do not believe future tax increases at income $150K and below are in the picture.

 

[kaneohe]

I generally find Roth conversions difficult to justify at any tax bracket.

If I'm in the 15% bracket I'm better off harvesting capital gains and increasing my basis forever at 0% cost than pre-paying income taxes today and also potentially paying more in gains tomorrow.

If I'm currently in a higher bracket the upfront cost is also greater and only makes sense if I know with a good deal of certainty that my future tax rate will be higher still. That's not possible to know.

If, perhaps, you're old enough to have a clear line of sight as to what the rules will be for you in retirement; whether RMDs are still a thing; whether Roth accounts remain tax free; whether Social Security benefits are maintained or lowered; whether your tax bracket is lower or higher; whether gains and dividends are still preferentially taxed; whether their's a VAT; or whether any of a thousand other changes are made to the tax code - if you can forecast that with a high degree of accuracy then maybe it makes sense to engage in this kind of tax rule arbitrage.

If you're younger and have several decades of tax changes ahead of you, paying extra taxes today with a 100% certainty to maybe pay fewer taxes in the future doesn't strike me as a wise trade.

A bird in the hand is worth two in the Roth.

Most threads I've read about conversions vs 0% CG seem to be relatively evenly split between the 2. Even this article seems to be quite neutral, not favoring one over the other in general ........ https://www.kitces.com/blog/end-of-...-gains-harvesting-paying-taxes-to-save-taxes/

Perhaps it depends on your particular circumstances and perhaps not a general rule to favor one over the other? Seems like if one were clearly more favorable, that would be the end of the discussion.

 

[samclem]

My thought (without calculations to support it) is that the sequence of return risks counsels against taking a significant immediate loss (25% of the conversions) in the hope of a small gain later. Everyone assumes taxes will be higher in the future and I agree but it is possible that a Brexit or some other calamity will lead to a near term market collapse catapulting us down now in which case those early conversions could be a big mistake.

+1. For us, the major advantages, if any, of big conversions to a Roth occur only if/when both of the following circumstances occur:
1) We are over 75 years old (i.e. we're much closer to the "finish line" than we are right now and
2) The stock market does really well and we are rolling in dough.

In that case, the true value (to us) of paying less in taxes is just not that high. But if we prepay a lot in taxes now (doing conversions and the markets do very poorly for the next 10 years, I'll have given money away that we'll need--maybe a lot.

Also, it seems inconsistent to assume that tax rates will be higher in the future without also assuming that changes will be made to the Roth withdrawal rules that also result in a higher payout to the government. It wouldn't have to be a direct tax on the Roth withdrawals (that would "break the promise")--but instead the Roth withdrawals could be counted as for the purpose of establishing the tax rates on >other< income (cap gains, interest, Social Security, earned income, etc). So, what you withdrew from the Roth wasn't taxed, but the withdrawal caused your LTCG and interest to be taxed at 15% (instead of 0%) and SS to be taxed at 25% (instead of 15%).

I'm still planning to draw down our tIRAs first, probably do some conversions, but I definitely won't be converting after I reach the top of the 15% bracket each year.

 

[Which Roger]

I generally find Roth conversions difficult to justify at any tax bracket.

+1 I discount the future a lot, given the uncertainty. As Gone4Good pointed out, a dollar saved today is money in the bank. My reasoning behind not doing Roth conversions:

1. If I'm in a high tax bracket in my later years, it will mean that my portfolio has performed well and I have won the game, and I will happily write big checks to the IRS.

2. If I'm in a low tax bracket in my later years, it will either mean that my portfolio has tanked, or that tax rates are lower. In either case, not doing Roth conversions earlier would have been the right decision.

3. If I'm dead, I won't be paying any taxes, so not doing the Roth conversions earlier would have been the right decision.

 

[GrayHare]

Since tax structure can change unpredictably I am uncomfortable basing a strategy on guessing how the tax code will change, because, well, that's gambling. When I bulk converted all tIRA to Roth years ago, enough to bump into the 30-something % bracket, it was because there were several knowns: 1) a fair portion of my tIRA was in non-deductible contribs and thus would not incur tax, 2) stocks had been knocked down by the recession, 3) I had significant deductions against the conversion income, and 4) Uncle Sam was running a "conversion special" that allowed one to spread the conversion income across multiple years. That combination of knowns has reduced my effective tax rate on the conversion to just 2%.

 

[Independent]

We have a very simple financial portfolio, and we're getting close enough to 70 that we should have a "clear line of sight".

The advantage of the convesion seems to be that I take some money that would have been RMDs invested in taxable accounts, and convert it to conversions into tax free Roth.

The disadvantage is that much of our tIRA is earmarked for LTC expenses. In the worst case, those expenses will be large and are likely to be tax deductible. We'd be able to access the tIRA tax free for those expenses.

Probably I should look at the numbers later this year.

 

[Gone4Good]

+1 I discount the future a lot, given the uncertainty. As Gone4Good pointed out, a dollar saved today is money in the bank. My reasoning behind not doing Roth conversions:

1. If I'm in a high tax bracket in my later years, it will mean that my portfolio has performed well and I have won the game, and I will happily write big checks to the IRS.

2. If I'm in a low tax bracket in my later years, it will either mean that my portfolio has tanked, or that tax rates are lower. In either case, not doing Roth conversions earlier would have been the right decision.

3. If I'm dead, I won't be paying any taxes, so not doing the Roth conversions earlier would have been the right decision.

+1 back at you

The path dependent nature of our future taxes is something that is hugely overlooked in most of these calculations. Paying more in taxes in the future is not just dependent on future tax rates but also on our future income. If our income is high, we have a greater ability to pay those higher taxes. If our income is low, our taxes are lower and that helps cushion the blow.

 

[Gone4Good]

Most threads I've read about conversions vs 0% CG seem to be relatively evenly split between the 2. Even this article seems to be quite neutral, not favoring one over the other in general ........ https://www.kitces.com/blog/end-of-...-gains-harvesting-paying-taxes-to-save-taxes/

This Kitces article doesn't try to compare harvesting gains at 0% and converting to a Roth at 15%. It just mentions both as potential strategies.

And it seems to confuse the idea of harvesting gains and never paying taxes on those gains with deferring gains into the future and paying taxes later. They're very different things.

I see this as a choice between two options:

1) Harvest gains today and guarantee that I'll never pay taxes on those gains ever. Offsetting that benefit are larger traditional IRA balances on which I may, or may not, pay more in taxes in the distant future than I would if I had converted to a Roth.

2) Do a Roth conversion where I may or may not pay less in taxes over my lifetime in exchange for maintaining larger unrealized capital gains balances that are subject to tax.

In one case I guarantee tax free income forever. In the other case I pay more in taxes today in an attempt to gamble and win on future tax rules.

 

[AnonEMouse]

1) Harvest gains today and guarantee that I'll never pay taxes on those gains ever. Offsetting that benefit are larger traditional IRA balances on which I may, or may not, pay more in taxes in the distant future than I would if I had converted to a Roth.

2) Do a Roth conversion where I may or may not pay less in taxes over my lifetime in exchange for maintaining larger unrealized capital gains balances that are subject to tax.

In one case I guarantee tax free income forever. In the other case I pay more in taxes today in an attempt to gamble and win on future tax rules.

How do you account for the the differences in tax treatment of the future gains?

1) The gains are tax free now, but all future gains from it are taxable

2) Converted values and their future gains remain tax free "forever"

Leaving aside possible changes to Roth in the future, wouldn't 2) be more beneficial for those with many decades left?

 

[audreyh1]

I've looked at it a few times and never pulled the trigger on Roth conversion because although we are in the 15% tax bracket now, most of our income is from capital gains. We have a chuck of it that we pay 0% taxes on since our ordinary income is so low. Doing a Roth conversion means we pay tax on cap gains instead. Social security income and ultimately RMDs will push us into the 25% tax on ordinary income in about 10 years.

It's actually worse - we aren't really in the 15% tax bracket on ordinary income. We're in the 26% tax bracket (our capital gains income triggers AMT on our ordinary income) and sometimes NIIT, add another 3.8%. Any Roth conversions would likely be taxed at a 29.8% rate as well as eliminating our 0% cap gains "bracket". Suddenly not so appealing to convert.

Our IRAs are only 10% of our retirement funds, so RMDs will not be large compared to our annual income (same with social security).

I'm focusing exclusively on reducing our capital gains annual income so that by the time we do have social security income and RMDs it won't have as large of an effect. Might still push us into the 25% tax bracket, but maybe some of the other high tax ramifications can be avoided including paying the highest Medicare rates.

 

[Gone4Good]

How do you account for the the differences in tax treatment of the future gains?

1) The gains are tax free now, but all future gains from it are taxable

2) Converted values and their future gains remain tax free "forever"

Leaving aside possible changes to Roth in the future, wouldn't 2) be more beneficial for those with many decades left?

I'm not sure we're understanding one another. So I'll go through my thinking in steps.

Roth vs. 401(k)
If your tax rate doesn't change, the after tax value of your Roth is identical to the after tax value of your 401(k). Paying 15% now and then never paying taxes again is identical to not paying 15% today but paying 15% on the entire account balance at the end.

So if your tax situation doesn't change you're basically indifferent between the Roth and the traditional 401(k) [inheritance issues excluded]

Gain Harvesting
As long as you stay within the 15% tax bracket all capital gains and qualified dividends are taxed at a rate of 0%.

So if I'm in the 15% tax bracket and I have a $200 investment that I bought for $100 I can sell it and immediately repurchase it tax free. I step up my basis from $100 to $200. I never have to pay taxes on that $100 gain. Any future gains or losses may be taxable or tax deductible.

Bringing both together
I can really only do one or the other transaction (or mix and match) while staying within the 15% tax bracket. Both Roth conversions and gain harvesting increase current income and push me toward higher brackets. So doing one reduces my ability to do the other dollar for dollar.

With that in mind, if I don't expect my future tax bracket to change I'm (mostly) indifferent between having a Roth and a traditional 401(k). And converting from a 401(k) to a Roth consumes my capacity to gains harvest tax fee.

So I have a choice. I can choose a Roth conversion which may or may not yield any benefit. Or I can harvest gains and permanently decrease my taxable asset value.

Caveats
Roth accounts have additional benefits over traditional 401(k) accounts not mentioned above. Because they don't have RMDs investments in Roth accounts remain tax-deferred for longer and can also be passed on to heirs.

Raising the tax basis of a security only conveys a tax benefit if that asset is ever sold in the future. If the asset is never sold, gain harvesting yields no benefit whatsoever.

At the same time, tax laws change and not always in the way we expect. The imposition of a VAT or carbon tax would mean that your Roth conversion gets taxed twice. It's not a certainty that future tax changes will benefit Roth accounts.

 

[samclem]

Married couples may also want to consider the implications to a surviving spouse when deciding whether (today) to convert tIRA monies to a Roth or reduce basis in taxable accounts by taking advantage of the 0% LTCG rate. If a surviving spouse winds up in the 25% bracket (very easy given the loss of deductions and reduced brackets), then any remaining cap gains would be taxed at 15% instead of 0%. The tax rate for tIRA funds would go from 15% to 25%. A 15% difference in tax rate is more than a 10% difference, so it favors harvesting those LTCGs rather than using up "headroom" in the 15% bracket to convert to Roth.

 

[Sunset]

+1 I discount the future a lot, given the uncertainty. As Gone4Good pointed out, a dollar saved today is money in the bank. My reasoning behind not doing Roth conversions:

1. If I'm in a high tax bracket in my later years, it will mean that my portfolio has performed well and I have won the game, and I will happily write big checks to the IRS. OR I'm in a higher tax bracket as tax rates rose and I missed the boat.

2. If I'm in a low tax bracket in my later years, it will either mean that my portfolio has tanked, or that tax rates are lower. In either case, not doing Roth conversions earlier would have been the right decision.

3. If I'm dead, I won't be paying any taxes, so not doing the Roth conversions earlier would have been the right decision.

I fixed your statement