Tax on Roth Conversions vs Tax on RMDs

[medelste]

Hi, my wife and I expect to be able to retire early in a couple years at age 45 (woo-hoo!) with about $1.25MM across 401k Pre-Tax and Traditional IRAs. We'll be converting some of those funds each year to a Roth IRA to distribute the taxable gain over decades. My question is: how do I figure out how much to convert each year? If I convert too much each year and drain the tax-deferred accounts too quickly, I'll have paid more taxes than I need to along the way. If I convert too little each year and the account balloons by the time I reach 70 1/2 in 25 years, I'll pay a ton of taxes then with RMDs. How can I find that sweet spot, where we, for example, keep ourselves in the 10% tax bracket both before 70 1/2 and after 70 1/2. How do I start to calculate such a puzzle and re-assess it every few years?

 

[aja8888]

You can use a program called Taxcaster by Turbo Tax to run tax scenarios. Or you can simulate a return for a year and adjust the Roth pull to see how it affects the tax rate.

 

[Animorph]

You'll need to look at what your taxes look like when you turn 70, in particular, and tIRA/401k RMD's start up and maybe SS as well if you delay. Then Roth convert whenever you can do so at a lower tax rate than the tIRA sees at age 70. Keeping in mind you might want to stay below ACA income thresholds, 0% capital gains thresholds, or other targets.


Good time for a spreadsheet.

 

[medelste]

You'll need to look at what your taxes look like when you turn 70, in particular, and tIRA/401k RMD's start up and maybe SS as well if you delay. Then Roth convert whenever you can do so at a lower tax rate than the tIRA sees at age 70. Keeping in mind you might want to stay below ACA income thresholds, 0% capital gains thresholds, or other targets.


Good time for a spreadsheet.

Thanks for responding! But how will I know what my taxes will look like when I turn 70 if I don't know how much I was reducing my tIRA by each year from 45-70? It seems like a chicken-and-egg thing so I don't know were to begin with my spreadsheet. Is the only way to do it by simulating converting $20k/yr, $30k/yr, $40k/yr, $50k/yr and seeing the result of each?

P.S. We'll assume we will delay SS to 70. Good point about ACA income thresholds.

 

[JoeWras]

Staying in the 10% bracket is pretty aggressive, eh?

Why don't you just try to max out to the 15% bracket, or ACA threshold, whichever is more important.

One challenge I see in this is dealing with year end income from our taxable accounts. You know, year end distributions of funds, etc. Gotta keep an eye on them and let some leeway occur, just to avoid the recharacterization headaches.

Another challenge is if inflation rears its ugly head, we'll actually end up with more income from our cash positions which could make some of this tricky. But perhaps I'm ahead of myself.

BTW: one thing I love about this site is the roth conversion trick during the ER years. I never would have thought of it until I read it here. Hopefully, it won't be taken away from us (by gov't) before we can take advantage of it.

 

[grasshopper]

Age 64 here. retired age 54, started converting to the top of 15% bracket at 59.5. We are losing the battle, growth of the tTRA, well just keeps growing. RMD's will likely put us over 25% with SS at 70 also.

 

[LOL!]

Use Optimal Retirement Planner - Parameter Form and TurboTax together to check the results.

 

[pb4uski]

Thanks for responding! But how will I know what my taxes will look like when I turn 70 if I don't know how much I was reducing my tIRA by each year from 45-70? It seems like a chicken-and-egg thing so I don't know were to begin with my spreadsheet. Is the only way to do it by simulating converting $20k/yr, $30k/yr, $40k/yr, $50k/yr and seeing the result of each?

P.S. We'll assume we will delay SS to 70. Good point about ACA income thresholds.

Well, it gets real complicated real quick. Essentially you need to construct a long term projection and then also include an annual tax calculation and then include Roth conversions to the top of your desired tax bracket (15% in my case) and see how things end up after pensions, SS and RMDs start. While each situation is different, my modeling suggests that if I do Roth conversions to the top of the 15% tax bracket from now (59) until I'm 70 that I only spend one year in the 25% tax bracket vs a decade, and my age 100 NW is 20% higher.

 

[bingybear]

when I looked at mine... and the ACA for 2 people... staying below the ACA subsidy cliff is a lower amount than staying in the 15% MTB.
Guessing what your tax rate will be at age 70 is just that, guessing... but it must be done. Use a moderate growth rate and assume your RMD will be 4% (ok... a tad lower.. but ok for quick estimation)... add your SS to that and wild swag for other taxable income (pensions, investments, etc). Assume the same rates as today... or maybe adjust the thresholds up a tad. You can get more complicated if you'd like.. but a lot can happen between now and RMD.

If you wait until December, you should be able to know your investment income pretty well. The distributions in December for many ETFs and MF are often estimated and available from the company running the funds. While people are saying to stay in the 15% MTR bracket... there is another important aspect to this. Going over this bracket can throw you into a 30% MTR where your roth conversion (taxes as normal income at 15%) pushes Q-divs or LTCG into the taxable range from the 0% tax income range... these get taxed at 15% also... thus you get a MTR of 30% adding the two together. This is likely something you want to avoid as this MTR may be higher than your MTR at RMD time.

Note... taxes can always change with the swipe of the pen... so can roths.

 

[Brett_Cameron]

Well, it gets real complicated real quick. Essentially you need to construct a long term projection and then also include an annual tax calculation and then include Roth conversions to the top of your desired tax bracket (15% in my case) and see how things end up after pensions, SS and RMDs start. While each situation is different, my modeling suggests that if I do Roth conversions to the top of the 15% tax bracket from now (59) until I'm 70 that I only spend one year in the 25% tax bracket vs a decade, and my age 100 NW is 20% higher.

This is what I did.

 

[pb4uski]

....While people are saying to stay in the 15% MTR bracket... there is another important aspect to this. Going over this bracket can throw you into a 30% MTR where your roth conversion (taxes as normal income at 15%) pushes Q-divs or LTCG into the taxable range from the 0% tax income range... these get taxed at 15% also... thus you get a MTR of 30% adding the two together. ....

I ran into this this year. I was slightly over the 15% bracket and that slight overage was going to be subject to 30% marginal taxes. But the solution was easy.. I just recharacterized the excess so the problem went away. My TI on my Form 1040 is exactly the top of the 15% tax bracket.

 

[Hermit]

In my situation, I cannot get below the 25% tax bracket due to SS and pension and likely will not be above the 28% tax bracket at 70. I can build my nest egg on money that would not be there if I converted to Roth. In my case, the tax hit is fairly small for not doing Roths. Who knows what the tax brackets will be in a few years. Point is the answer can be very different and very complex. I agree with others - run simulations in a spread sheet for the best guess. As pointed out above, the best answer is the size of your nest egg, not minimizing the tax hit.

 

[pb4uski]

I agree if the Roth conversions only made a 3% difference between the 25% tax bracket now and the 28% tax bracket later then it would be a whole different decision than in my case where it is 10% (and actually more since my marginal taxes on Roth conversions is only about 8% rather than 15%).

 

[aida2003]

Age 64 here. retired age 54, started converting to the top of 15% bracket at 59.5. We are losing the battle, growth of the tTRA, well just keeps growing. RMD's will likely put us over 25% with SS at 70 also.

Would you say that you wish you had started converting to Roth as soon as you retired instead of 59.5? OTOH, you're in great position nevertheless.

 

[RetireBy90]

I only got religion about Roth accounts about 4 years ago. Although in 28% bracket I still contribute all my 401K to a Roth account. I figure pay the taxes now while I can afford it. Also don't know how much taxes will increase in the future so less risk if I pay now, as long as they don't mess with the Roth rules.


I'll have to see what we can do in 2 years when I retire, but with 3 small pensions I don't see our tax rate being much lower than it is now. I'll try to move funds each year from Tira to Roth because by the time my RMDs kick in I'll have the rental paid off and have another $2K/month to go with the pensions and what ever SS I get so RMDs will be a big transfer from my IRA to govt. I just don't see any way around this as any movement from Ira to Roth will still trigger a 28% tax.


Good news is that we will have enough to live like we do today plus some and many aren't in that position. Count me blessed, cause I'm not any smarter than many that will spend those years looking for enough to get by on.

 

[Alan]

I retired age 55 and immediately did a ROTH conversion of all my tIRA since it was all non-deductible contributions so only had tax on the earnings. Next year I rolled my 401k to a Rollover IRA and did much smaller ROTH conversions for a couple of years to get tax diversification as I was in the 25% bracket (if rates go up in future).

However we decided to definitely split our time between here and the UK beginning next year, and had to change the tax forecasting to take this into account. Up until I am 70 I will be in the UK 20% bracket and in the US bracket of 25% (so I pay 25%) but RMD's would then push me into the UK 40% bracket

Fortunately the dual tax agreement means that ROTH conversions are taxable only in the US (tIRA distributions are taxed first in the UK) so I do still have time but I'm now converting to the top of the 25% bracket to avoid a 15% hit in 10 years time. Of course a lot can happen in 10 years, so I won't know how this throw of the dice will turn out for some time yet.

 

[Independent]

Hi, my wife and I expect to be able to retire early in a couple years at age 45 (woo-hoo!) with about $1.25MM across 401k Pre-Tax and Traditional IRAs. We'll be converting some of those funds each year to a Roth IRA to distribute the taxable gain over decades. My question is: how do I figure out how much to convert each year? If I convert too much each year and drain the tax-deferred accounts too quickly, I'll have paid more taxes than I need to along the way. If I convert too little each year and the account balloons by the time I reach 70 1/2 in 25 years, I'll pay a ton of taxes then with RMDs. How can I find that sweet spot, where we, for example, keep ourselves in the 10% tax bracket both before 70 1/2 and after 70 1/2. How do I start to calculate such a puzzle and re-assess it every few years?

If that's your goal, the best you can do is to fill up the 10% bracket each year with Roth conversions. No speadsheet needed.

That way you know that you're not in the 15% bracket today, and you've done as much as possible (within that constraint) to keep your future taxes low.

 

[Animorph]

Thanks for responding! But how will I know what my taxes will look like when I turn 70 if I don't know how much I was reducing my tIRA by each year from 45-70? It seems like a chicken-and-egg thing so I don't know were to begin with my spreadsheet. Is the only way to do it by simulating converting $20k/yr, $30k/yr, $40k/yr, $50k/yr and seeing the result of each?

P.S. We'll assume we will delay SS to 70. Good point about ACA income thresholds.

That's where you see questions on the board about projected rates of growth for stocks and bonds. Take your pick of growth rates and inflation rates and do the best you can to model your finances for each year.

Start with something really rough and then add more details as you go along. Mainly you want to know what tax bracket you're in at age 70. In my case, doing Roth conversions was a significant improvement in my spending capacity. Getting it fully optimized was much less rewarding.

 

[Animorph]

Here's a spreadsheet I developed to optimize spending, including taxes, SS, Roth conversions and everything else I could think of. It uses iteration to optimize spending, has minimal instructions, and who knows what numbers I left in it (though they're not mine)...

 

[RunningBum]

I would do 2 speadsheets, one with maxing out at 10%, the other at 15% (don't forget that includes all other income including dividends to keep from pushing you into 15+15%). Factor in an estimated growth rate on your remaining IRA. See where that leaves you at age 70. You should be able to find the MRD formula and see how much you'll get then, along with SS (and any pension?) to see what tax bracket it looks like you'd be in, if all else stays unchanged. If you find that maxing 15% is more than you need you could always do a bit less, but I don't think it matters so much whether you pay a little more at 15% now (and let it grow tax free) or 15% later. However, with as much as you have, I'm going to guess that you may not be able to stay in the 15% bracket.

What I'm saying is, I don't think there's an exact number that is a sweet spot, just an indication of whether to the top of 10%, 15%, or possibly even into 25% would seem to be best.

Another factor to consider is what the IRA income on MRDs does to SS taxation (again, assuming current rules are unchanged). It may be to your advantage to convert all or as much of your IRA as you can to reduce SS taxation, or you may find you'll be at the max anyway.

 

[Animorph]

I would do 2 speadsheets, one with maxing out at 10%, the other at 15% (don't forget that includes all other income including dividends to keep from pushing you into 15+15%). Factor in an estimated growth rate on your remaining IRA. See where that leaves you at age 70. You should be able to find the MRD formula and see how much you'll get then, along with SS (and any pension?) to see what tax bracket it looks like you'd be in, if all else stays unchanged. If you find that maxing 15% is more than you need you could always do a bit less, but I don't think it matters so much whether you pay a little more at 15% now (and let it grow tax free) or 15% later. However, with as much as you have, I'm going to guess that you may not be able to stay in the 15% bracket.

What I'm saying is, I don't think there's an exact number that is a sweet spot, just an indication of whether to the top of 10%, 15%, or possibly even into 25% would seem to be best.

Another factor to consider is what the IRA income on MRDs does to SS taxation (again, assuming current rules are unchanged). It may be to your advantage to convert all or as much of your IRA as you can to reduce SS taxation, or you may find you'll be at the max anyway.

That sounds pretty good. The only thing I'd like to add is that it tends to be beneficial to convert more now rather than later. So you may find it beneficial, again depending on your specific tax situation, to Roth convert beyond your target tax rate if it's only a few percent above your expected age 70 tax rate.

 

[pb4uski]

That's where you see questions on the board about projected rates of growth for stocks and bonds. Take your pick of growth rates and inflation rates and do the best you can to model your finances for each year.....

Yes, the potential Achilles heel of my plan is growth. Given my relatively conservative growth rate assumption if I continue to do Roth conversions until I am 70 then I'll only be in the 25% bracket for a year, however if growth is better than my assumption then I'll spend more years in the 25% tax bracket. The way I view it, if it happens then it will be a nice problem to have to deal with.

 

[grasshopper]

Would you say that you wish you had started converting to Roth as soon as you retired instead of 59.5? OTOH, you're in great position nevertheless.

Not if I had to pay a 10% penalty before 59 1/2.

 

[RunningBum]

Not if I had to pay a 10% penalty before 59 1/2.

You don't pay a penalty for Roth conversions.

 

[mathjak107]

don't forget as time goes on the brackets expand to allow more and more income through at lower tax rates. pretty soon 100k will be 15%.

Yes, the potential Achilles heel of my plan is growth. Given my relatively conservative growth rate assumption if I continue to do Roth conversions until I am 70 then I'll only be in the 25% bracket for a year, however if growth is better than my assumption then I'll spend more years in the 25% tax bracket. The way I view it, if it happens then it will be a nice problem to have to deal with.