Should I Do A Roth Conversion Tutorial

[Midpack]

This comes up time and again here understandably. Here’s another video that does a decent job of explaining all the salient points for consideration for anyone in the fence about Roth conversions. It all comes down to present vs future taxes (yes, you have to make some assumptions) and IRMAA is a potential consequence to be aware of.

The situation case is a prime example in terms of age, spending, portfolio that some (not all) here may be able to relate to.

None of the quick and dirty online calculators I’ve seen do this topic justice. I know because they all told me conversions were probably a wash - highly unlikely once I actually did the year by year projections. Luckily I figured it out before it was too late, though it would have been better to start earlier.

Nothing new for those who’ve already done the math, but there are always new candidates coming up.

https://youtu.be/BkxYuQ0Vb88

 

[Slim11]

Thanks for this, I want to do a little by little conversion, but not sure if its worth it.

 

[Exchme]

The topic is complex and deserves a tutorial.

I agree that any quick and dirty model won't be very useful. Clearly the whole point of Roth Conversions is to shift income from high marginal tax years to lower ones. So a lifetime model that incorporates the whole tax code plus ACA is needed.

For those in the prime spot for conversion, it can be a six figure improvement in spending power/estate value and yet lots of people don't treat it that way, ignoring it, winging it, insisting on freebie tools or using buggy/incomplete homegrown tools.

Even "professionals" can be ignorant about them - I had a relative tell me their advisor told them it wasn't worthwhile, since I knew enough about the finances/goals etc. involved to know this was a prime candidate for conversions, I disagreed and said that the advisor was wrong or completely self-interested and didn't want the AUM balance to decline. I doubt I'll be invited to comment further.

 

[pb4uski]

As Midpack suggests, the decision is principally whether the cost of the conversion today exceeds the cost of RMDs if you don't do any conversions, but it gets real complicated real quick with state income taxes, IRMMA,, ACA subsidy impacts, SS taxability impacts, etc not to mention surviving spouse and heirs tax brackets and rates, future tax rates, etc.

For us it is pretty simple. Pay about ~9% now or 18% later. The ~9% is a mix of 0%, 10% and 12% tax brackets and the 18% is a mix of 12% and 22% tax brackets.

From what I've observed, if one can convert at the 10% or 12% bracket and avoid 22% later then there is a benefit to be had, but the benefit of converting at 22% to avoid 24% or converting at 10% to avoid 12% are negligible.

 

[SecondCor521]

Here's another one:

 

[Romer]

This is a great thread. One should consider married vs single tax rates as well in the tax evaluation. Of course you have to make an assumption that one will pass before the other. For me, the calculation was close, but when I considered my wife having to move to the single tax bracket, that was a factor for me and maybe not a factor for you. It came down to Single Tax brackets with SS tIRA withdrawals for expenses/RMDs vs single tax bracket SS only. For my wife, being simple and lowest possible taxes is something that was important should she push me off the railing of the cruise ship

The answer isn't the same for everyone.

 

[RetireBy90]

This is a great thread. One should consider married vs single tax rates as well in the tax evaluation. Of course you have to make an assumption that one will pass before the other. For me, the calculation was close, but when I considered my wife having to move to the single tax bracket, that was a factor for me and maybe not a factor for you. It came down to Single Tax brackets with SS tIRA withdrawals for expenses/RMDs vs single tax bracket SS only. For my wife, being simple and lowest possible taxes is something that was important should she push me off the railing of the cruise ship

The answer isn't the same for everyone.

(Bold added by me)
There are so many unknowns, what will your tax rates be in the future being the big one. The single rate for surviving spouse if applicable pushed us to be a bit more aggressive doing conversions only looking at tax rate arbitrage. It will also be simple for DW if she survives me. She can take any funds from the Roth account and not worry about taxes. Simple.

There is also the ability to not take any RMD if you don't want/need to or the other way to take a large draw from your Roth without an outsized tax hit that year. Simple
There is the simplification of planning future tax strategies as things change. With sufficient Roth for us to live on (with pensions and some SS) we will take whatever RMD is required as a QCD. Oops, this is another risk that it will change
For me it just made sense even if we stay in the same tax rate through the end and could pay the taxes later rather than sooner, it is done for the Roth money. KISS they used to say.



YMMV

 

[Alex The Great]

Indeed it is a complex topic but in my situation it looks pretty simple. I cannot afford Roth conversions while employed because of already highest tax bracket. I can afford small scale Roth conversions only once retired and under ACA to manage subsidies. And obviously cannot afford any once on SS as tax bracket would jump again. The only window of opportunity to have larger scale conversions is between 65 and 70 with no ACA and no SS yet but still under IRMAA consideration.

 

[qwerty3656]

I completely understand the "tax rate now vs the tax rate later" calculation. Where it get's a little hazy is doing a roth conversion when the market crashes. Like is it still only difference in tax rates, or If the market falls 50% could you be ahead doing a roth conversion even if your expected tax rate isn't lower now?

 

[CardsFan]

OK. Another chance to chime in on this topic

I retired at the beginning of 2016 at age 60. At that time, my attitude was "who cares, I won the game". FWIW, the vast majority of my deferred contributions were in the 25% bracket, or above.

Upon further review (based on what I read here), it became apparent that conversions up to the top of the 12% bracket were a no brainer. Effective rate of around 9%. Great tax arbitrage. It also became apparent that there is no way we could convert a substantial amount of our deferred savings (over $2million at time of retirement) at that rate.

So, we started going into the higher brackets, converting approx. what we would need to take at RMD time, paying 15%-16% effective rate. So now 26% of our IRA savings are in Roth IRA's, but we STILL have over $2million in the tIRA. Major first world problem

We decided, for variety of reasons to take SS at FRA (66.2 for us). So now we are paying an effective rate around 22%. Still less than the deferred rate.

This year we are taking a pause, as we converted all of our after tax mutual funds to ETF's to eliminate capital gains. That will reduce future income by $20-40k per year (and eliminate the variable unknown in planning).

All that said, our taxes going forward, after this year, will be fairly stable at around 12-15% of TOTAL income (including SS) of about 170k. Yes, some will be in the 22% bracket, but that looks like the average. Yes, income will increase as RMD's increase, but so will the tax brackets. When one of us bites the dust, the survivor will pay around 18%, on a slightly lower income (only one SS check).

For the record:

- We spend around $100k/yr, including all taxes
- currently SS and after tax income cover most of spend. We can draw from a savings account for the remainder. Basically we don't need to sell investments to fund our expenses. But if we need to, no problem.
- none of the above numbers include MO taxes of around 5%
- we have one son who will inherit everything eventually, and some of our planning figures that in, since he and DDIL could be in a much higher bracket with an inherited IRA.

So, circle back to the beginning. We won the game. We are just trying figure out the final score, and it really doesn't matter much in the grand scheme of things.

 

[SevenUp]

I completely understand the "tax rate now vs the tax rate later" calculation. Where it get's a little hazy is doing a roth conversion when the market crashes. Like is it still only difference in tax rates, or If the market falls 50% could you be ahead doing a roth conversion even if your expected tax rate isn't lower now?

From Roth conversion (in down markets) - Bogleheads

Being able to convert a larger fraction of your traditional account in a down market when the marginal tax rate for the conversion is favorable is a good thing, but a down market does not make incurring a higher marginal tax rate favorable.

 

[RetireBy90]

I completely understand the "tax rate now vs the tax rate later" calculation. Where it get's a little hazy is doing a roth conversion when the market crashes. Like is it still only difference in tax rates, or If the market falls 50% could you be ahead doing a roth conversion even if your expected tax rate isn't lower now?

I would look at it as what would it cost me to convert my QQQ shares today s what would it cost some other time. From that perspective it is still tax now vs later.
Ok, I’m a big fan of conversions so I tend to look for a good excuse to convert.

 

[Dash man]

I completely understand the "tax rate now vs the tax rate later" calculation. Where it get's a little hazy is doing a roth conversion when the market crashes. Like is it still only difference in tax rates, or If the market falls 50% could you be ahead doing a roth conversion even if your expected tax rate isn't lower now?

We didn’t even think twice when the market dropped during the initial Covid pandemic. We converted into the 35% bracket and paid the top IRMAA bracket last year as a result. But we moved a lot of shares and still believe it was a good move.

 

[Sunset]

I completely understand the "tax rate now vs the tax rate later" calculation. Where it get's a little hazy is doing a roth conversion when the market crashes. Like is it still only difference in tax rates, or If the market falls 50% could you be ahead doing a roth conversion even if your expected tax rate isn't lower now?

Yes, because the stock market will rebound.

Pretend the market fell 50%, it would mean you could convert 2x the stock and pay whatever extra tax would normally be paid.

My dream is for the market to fall to 1%, I'd convert every stock to my roth, and then let the market rebound back to 100%.

 

[pb4uski]

I completely understand the "tax rate now vs the tax rate later" calculation. Where it get's a little hazy is doing a roth conversion when the market crashes. Like is it still only difference in tax rates, or If the market falls 50% could you be ahead doing a roth conversion even if your expected tax rate isn't lower now?

What the market does is a separate, independent issue. One can transfer securities rather than cash for the Roth conversion so your AA is unchanged. Or you can sell ticker X in the tIRA, move the proceeds to the Roth via a Roth conversion and then buy back ticker X.

 

[RetireBy90]

What the market does is a separate, independent issue. One can transfer securities rather than cash for the Roth conversion so your AA is unchanged. Or you can sell ticker X in the tIRA, move the proceeds to the Roth via a Roth conversion and then buy back ticker X.

It may be a different way to look at conversions, but if your goal is to transfer a portion of your IRA to Roth and pay less taxes then moving 100 shares of X at $100 you will add $10,000 to your income that year and pay taxes on $10,000. If you move 100 shares of X at $50 you will only add $5,000 to your income and tax will be less. It is still pay less tax today or more tomorrow when X recovers to $100.

 

[LateToFIRE]

As Midpack suggests, the decision is principally whether the cost of the conversion today exceeds the cost of RMDs if you don't do any conversions, but it gets real complicated real quick with state income taxes, IRMMA,, ACA subsidy impacts, SS taxability impacts, etc not to mention surviving spouse and heirs tax brackets and rates, future tax rates, etc.

For us it is pretty simple. Pay about ~9% now or 18% later. The ~9% is a mix of 0%, 10% and 12% tax brackets and the 18% is a mix of 12% and 22% tax brackets.

From what I've observed, if one can convert at the 10% or 12% bracket and avoid 22% later then there is a benefit to be had, but the benefit of converting at 22% to avoid 24% or converting at 10% to avoid 12% are negligible.

This is a good way to think about it.

My situation is that think I'm going to be in a relatively high tax bracket no matter what, as my WD's will run in the ~$200K to $300K range.

I could largely fund these WD's with after-tax dollars. But then my pre-tax accounts will grow unfettered and RMD's will kick in 15 years hence.

The thing is, in my high tax bracket, just not sure Roth conversions are going to make a whole lot of sense. I could simply fund my WD's with a certain amount from my pre-tax accounts up to whatever income tax bracket instead of converting (which is taxable anyhow).

Does that make any sense

 

[LateToFIRE]

FYI, I vote yes, tutorial badly needed. Newbie here!

 

[pb4uski]

It may be a different way to look at conversions, but if your goal is to transfer a portion of your IRA to Roth and pay less taxes then moving 100 shares of X at $100 you will add $10,000 to your income that year and pay taxes on $10,000. If you move 100 shares of X at $50 you will only add $5,000 to your income and tax will be less. It is still pay less tax today or more tomorrow when X recovers to $100.

But at least for me and I suspect others, the decision is to convert $x to in my case the top of the 12% tax bracket. So if that $x ends up being 100 shares at $100/eachor 200 shares at $50/each then it doesn't much matter to me.

That and there is no guarantee that it will recover to $100 especially for individual stocks and even for stock funds, returns over the next decade are expected to be modest.

 

[pb4uski]

This is a good way to think about it.

My situation is that think I'm going to be in a relatively high tax bracket no matter what, as my WD's will run in the ~$200K to $300K range.

I could largely fund these WD's with after-tax dollars. But then my pre-tax accounts will grow unfettered and RMD's will kick in 15 years hence.

The thing is, in my high tax bracket, just not sure Roth conversions are going to make a whole lot of sense. I could simply fund my WD's with a certain amount from my pre-tax accounts up to whatever income tax bracket instead of converting (which is taxable anyhow).

Does that make any sense

Yes, both withdrawals and conversions reduce the tax-deferred balances and result in the payment of taxes exactly the same. The major difference is that for conversions the proceeds from the withdrawal end up in an account that is no longer subject to tax.

 

[RetireBy90]

Let me add a thanks to midpack for the video in post 1. You can agree with the presenter or not on the future of tax rates, but he shows the impact of doing conversions today compared to 1981 and 2017 rates. If no changes before 2026, rates will revert to 2017 rates. Again, thanks midpack

My understanding is that additional risk (of higher taxes) should only be taken if you are paid for that additional risk. If it is a wash, pay 12% today or 12% tomorrow you are not paid for the risk of rates going higher.

 

[LateToFIRE]

Yes, both withdrawals and conversions reduce the tax-deferred balances and result in the payment of taxes exactly the same. The major difference is that for conversions the proceeds from the withdrawal end up in an account that is no longer subject to tax.

Thanks - I think I'm starting to get it now - maybe. So, for example, using a simple round number of $100K WD need, I could either:

1) WD $100K from after-tax accounts (no income tax, but incur cap gains tax) + convert $100K of pre-tax IRA to Roth (incur income tax on the initial amount but future earnings/gains not taxable).

- or -

2) WD $100K from pre-tax IRA (incur income tax, same $ as Roth conversion), leave funds in after-tax accounts (owe future cap gains tax as realized).

In both cases I am:
(A) reducing the pre-tax IRA by $100K, hence reducing future RMD's, and
(B) incurring the same amount of income-tax

But, In case #2, I avoid unleashing cap gains taxes from the after-tax account, [EDIT: vs case #1 where I pay cap gains tax now but shift $100K of funds to a Roth where will never incur future income or cap gains taxes].

Did I get that right?

 

[pb4uski]

Yes. In your case where you are in a high tax bracket then you will be subject to taxes on LTCG, but that may not apply at overall lower levels of income.

On the LTCG, just remember that is if only on the gain, so in scenario 1 where you withdraw $100k from after tax accounts the gain will be less than $100k... so if the gain is $50k and subject to 15% LTCG tax then the total tax on the withdrawal is only $7,500 or 7.5%.

While I hate to add an additional complication, there is a school of thought to leave highly appreciated securities alone since whan you pass they are subject to stepped-up basis for heirs so the tax on those unrealized gains nver get paid.

My what a tangled web we have woven with the tax code, eh?

 

[Rianne]

We're struggling with this exact dilemma. So much to consider, tax rates for survivor if one of us dies is one of them. pb4uski posted a couple of valuable links a while ago that I use to guestimate possible scenarios.

https://www.irscalculators.com/tax-calculator

https://www.investor.gov/financial-...tors/required-minimum-distribution-calculator

The limitations are of course what happens after 2026? And when will RMDs kick in for us? The legislation will tell. We're 65 this year. As of today, we remain in the 12% tax bracket even with the 4%+ gains in our tIRA due to bond/cd laddering including SS at 65 and at 70.

For us, it looks like pay 12% today or 12% tomorrow.

 

[LateToFIRE]

Yes. In your case where you are in a high tax bracket then you will be subject to taxes on LTCG, but that may not apply at overall lower levels of income.

On the LTCG, just remember that is if only on the gain, so in scenario 1 where you withdraw $100k from after tax accounts the gain will be less than $100k... so if the gain is $50k and subject to 15% LTCG tax then the total tax on the withdrawal is only $7,500 or 7.5%.

While I hate to add an additional complication, there is a school of thought to leave highly appreciated securities alone since whan you pass they are subject to stepped-up basis for heirs so the tax on those unrealized gains nver get paid.

My what a tangled web we have woven with the tax code, eh?

Thanks for your response! All good points. So much to consider. My situation is far more complex than I described here, so will definitely get professional guidance. Somehow, I had thought my tax situation would become less complicated in retirement, silly me.