Those Who don't/didn't do Roth Conversions

[PatrickA5]

This has been mentioned a few times, but it assumes (I think) that income remains the same, and tax brackets change to 'single' from 'married filing joint'.


In our case, when I die, income from social security and two pensions will go away, so the problem could be reduced income rather than increased tax.

+1

In some cases, just losing the spouses Social Security income is enough for a now Single filer not to get bumped up a bracket. Only way to know is to run the numbers.

We'll most likely stay in the 12% bracket after RMDs and both on SS. Having some "already taxed money" (Roth) available will give us some leeway if large unexpected expenses come up without having to jump up into the higher bracket by withdrawing from TIRA.

 

[ERD50]

Re: "it takes time to get all your money back in savings."

That's the main part I don't understand. The $1M was sitting in the tIRA, and you took advantage of the opportunity to pay only 12% tax in order to get it into the Roth, from which it can be spent tax-free at any time.

Had you not done so, it would now require paying 22% to get at the tIRA money for any spending, so it seems your payoff is "immediately upon having a 22% marginal tax rate instead of 12%."

+1. That's exactly how you should look at a Roth conversion.

But I think what you are missing (or I'm thinking wrong about it), is that the w/d is an RMD. You have to take that amount (and I'm assuming you take no more).

Since I have to take it, I'll be taxed at an assumed 22% rate for this example. And to keep things simpler, assume it all is pushed into the 22% bracket.

If my conversions lowered the amount of my tIRA from $1M to $750K, my RMD is 25% lower, due to the conversions. So only 25% of that year's RMD benefited from being taxed at 12% rather than 22%. The 75% isn't affected by the conversions.

I guess it would be different if over and above RMDs, I liquidated the entire tIRA in a few years, all at 22%?

-ERD50

 

[PERSonalTime]

OP - Do you do long term capital gains harvesting to get tax free money or are your pensions too high ?

Sunset, (un)fortunately it's too high.[emoji846]

 

[Midpack]

How are you defining "break even"?

I pay cumulatively more in taxes until the breakeven age, and then cumulatively less thereafter until I go poof...

Assuming 30 year longevity, If I had done nothing I would have paid 12% marginal for 7 years, and 25% for the next 23 due to large RMDs. Instead I am paying 22% for 7 years and 15% marginal for the next 23. And that's if tax brackets/rates don't increase from after TCJA expiration - I don't think that's even remotely possible, but everyone has to make their own assumptions.

 

[RunningBum]

But I think what you are missing (or I'm thinking wrong about it), is that the w/d is an RMD. You have to take that amount (and I'm assuming you take no more).

Since I have to take it, I'll be taxed at an assumed 22% rate for this example. And to keep things simpler, assume it all is pushed into the 22% bracket.

If my conversions lowered the amount of my tIRA from $1M to $750K, my RMD is 25% lower, due to the conversions. So only 25% of that year's RMD benefited from being taxed at 12% rather than 22%. The 75% isn't affected by the conversions.

I guess it would be different if over and above RMDs, I liquidated the entire tIRA in a few years, all at 22%?

-ERD50

Not sure what you are talking about with RMDs. This is talking about converting at a lower rate, which is most likely before starting RMDs, and maybe before SS and pensions.

Of course the benefit is limited to the amount you convert.

 

[SevenUp]

How are you defining "break even"?

I pay cumulatively more in taxes until the breakeven age, and then cumulatively less thereafter until I go poof...

Assuming 30 year longevity, If I had done nothing I would have paid 12% marginal for 7 years, and 25% for the next 23 due to large RMDs. Instead I am paying 22% for 7 years and 15% marginal for the next 23. And that's if tax brackets/rates don't increase from after TCJA expiration - I don't think that's even remotely possible, but everyone has to make their own assumptions.

It's not the amount of tax one pays, but rather the amount available to spend after tax that matters.

To get money out of a traditional IRS, you must (unless having zero taxable income after standard/itemized deductions) pay tax. If you can pay 12% now instead of 22% later, that's a good deal - regardless of how many years elapse between "now" and "later".

 

[SevenUp]

But I think what you are missing (or I'm thinking wrong about it), is that the w/d is an RMD. You have to take that amount (and I'm assuming you take no more).

Since I have to take it, I'll be taxed at an assumed 22% rate for this example. And to keep things simpler, assume it all is pushed into the 22% bracket.

If my conversions lowered the amount of my tIRA from $1M to $750K, my RMD is 25% lower, due to the conversions. So only 25% of that year's RMD benefited from being taxed at 12% rather than 22%. The 75% isn't affected by the conversions.

I guess it would be different if over and above RMDs, I liquidated the entire tIRA in a few years, all at 22%?

-ERD50

Not sure what you are talking about with RMDs. This is talking about converting at a lower rate, which is most likely before starting RMDs, and maybe before SS and pensions.

Of course the benefit is limited to the amount you convert.

Same thoughts as RunningBum's.

Roth conversions are significantly different from the usual "payback time" scenario. E.g., a company builds a new factory and earns money on the factory output. In that case Payback Period is the time it takes the company to recoup the money it paid for all the materials and labor to build the factory.

With a Roth conversion, it's just a question of the "access cost" to get at the money in the traditional account. If you can access the money by paying 12%, that's better than having to pay 22% to access the money, regardless of how many years elapse between having the 12% option vs. being forced to pay 22%.

 

[SecondCor521]

If my conversions lowered the amount of my tIRA from $1M to $750K, my RMD is 25% lower, due to the conversions. So only 25% of that year's RMD benefited from being taxed at 12% rather than 22%. The 75% isn't affected by the conversions.

True.

However, it is just not one year's RMD. All RMDs will be 25% less, so for all the RMDs you take in years when your bracket would be 22%, you realize a tax benefit. (And your heirs likewise realize a tax benefit for their 10 year SECURE withdrawal window, assuming they would be in 22%+ during that time frame. And they have to empty the account completely, so it does eventually affect every dollar in the IRA.)

Also, and you hint at this, the effect of Roth conversions is cumulative. I've made Roth conversions every year for seven years. Each of those seven years of conversions impact all of those future RMD years.

Personally I simply prefer to think of it in terms of each year's conversion. If I convert $10K at 12% now vs. 22% later, that's a $1K tax savings. Since money is fungible, you'd have to apply some ordering rules to decide "which" dollars you're converting and withdrawing to decide when the tax benefit is accrued if you wanted to get into it more than that.

 

[ERD50]

Not sure what you are talking about with RMDs. This is talking about converting at a lower rate, which is most likely before starting RMDs, and maybe before SS and pensions.

Of course the benefit is limited to the amount you convert.

Yes, convert before RMDs (and probably before SS and pensions, to be in the lower bracket).

I'm assuming (maybe wrongly) that in most cases, people do Roth conversions because the RMDs on their tIRA will push them into a higher bracket. Isn't that consistent with what I posted? I guess I don't understand what's not being understood?

-ERD50

 

[ERD50]

True.

However, it is just not one year's RMD. All RMDs will be 25% less, so for all the RMDs you take in years when your bracket would be 22%, you realize a tax benefit. .... it does eventually affect every dollar in the IRA.
...

Yes, the 25% in my scenario plays out every year - you (or your heirs) eventually get it back. But that is the 'break-even' I think Midpack was referring to, and I'm agreeing - it takes some years for the tax savings to accumulate enough to pay back the early tax you paid.

Maybe it doesn't matter, depending on your view, since it all comes back eventually, but I guess you can say it does matter from a cash flow view. You had to increase your cash flow to pay the tax on the conversion, and later, you only get a portion back each year.

So it's different from the SS 'break-even' situation, where when you die you lose it all (assuming no spouse). Here, the tax benefit carries on past your death.

-ERD50

 

[qwerty3656]

I guess I don't understand what's not being understood?

-ERD50

You said "If my conversions lowered the amount of my tIRA from $1M to $750K, my RMD is 25% lower, due to the conversions. So only 25% of that year's RMD benefited from being taxed at 12% rather than 22%. The 75% isn't affected by the conversions."

That is what was confusing to me. 100% of your IRA money is going to eventually be spent. The only question is how much money IN TOTAL you get to spend. If pay taxes at 12% rather than 22% ALL that difference goes to the bottom line

 

[ERD50]

You said "If my conversions lowered the amount of my tIRA from $1M to $750K, my RMD is 25% lower, due to the conversions. So only 25% of that year's RMD benefited from being taxed at 12% rather than 22%. The 75% isn't affected by the conversions."

That is what was confusing to me. 100% of your IRA money is going to eventually be spent. The only question is how much money IN TOTAL you get to spend. If pay taxes at 12% rather than 22% ALL that difference goes to the bottom line

See my post right before yours - I agree with eventually. But that's the point - it takes time to catch up.

-ERD50

 

[qwerty3656]

See my post right before yours - I agree with eventually. But that's the point - it takes time to catch up.

-ERD50

"Break-even" usually means if you die before, then it was a bad idea. In that sense there is no "break-even" here. If you die the day after you do the conversion, your Heirs are ahead.

 

[N02L84ER]

If you don't think of your tIRA balances as pretax then you will understand the immediate savings of doing the conversions. Think of it this way. Assume you have $1 million in the tIRA and you (or your heirs) will be paying 22% tax on the RMDs. So you (or your heirs) will end up paying $220K in taxes. You will have $780K to spend. So think of your tIRA as having a $780K after tax balance.

If you can convert $250K to a Roth at 12%, you will pay taxes of (250*12%)+(750*22%) = $195K in taxes so you really have $1,000K-$195K = $805K to spend. This is a $25K larger amount to spend starting the day after the conversion.

 

[RunningBum]

Maybe it doesn't matter, depending on your view, since it all comes back eventually, but I guess you can say it does matter from a cash flow view. You had to increase your cash flow to pay the tax on the conversion, and later, you only get a portion back each year.

Your cash flow is much much better after a conversion with the money in a Roth (assuming you are of age to withdraw it) than money tied up in a tIRA that you can't access without paying taxes.

 

[SecondCor521]

Yes, the 25% in my scenario plays out every year - you (or your heirs) eventually get it back. But that is the 'break-even' I think Midpack was referring to, and I'm agreeing - it takes some years for the tax savings to accumulate enough to pay back the early tax you paid.

Emphasis added.

I think whether the tax paid is "early" can be a matter of how one does the accounting and perspective. (Note that I know just enough about accounting to be dangerous.)

One pays the tax when the withdrawal (or conversion) is made, no earlier and no later, so in that sense it is always paid "on time". The breakeven thought seems to rely on the premise that if the withdrawal (or conversion) was not made at the time, that it would have been made later.

One could easily and I think just as accurately say that the tax would have been made earlier (at the time of deferral aka contribution to the IRA or workplace plan). In this view, the payback is immediate, because the person would have otherwise paid taxes at 22% or more when the contribution was made, and paying it at 12% later completes things.

The risk to the "breakeven" point of view and logic is that it's not really known when that dollar that was withdrawn or converted would have ultimately been taxed later. (This comes up in "whether to convert" discussions all the time.) The laws might change. Rates might change. The IRA dollars might end up going to charity and essentially come out tax free.

From an accounting point of view, I think it depends on whether one puts on their balance sheet anything to account for the embedded tax liability associated with the IRA dollars. Most people (including me) think and act on a cash, not accrual basis, so we don't formally account for that embedded liability.

 

[LateToFIRE]

Emphasis added.

I think whether the tax paid is "early" can be a matter of how one does the accounting and perspective. (Note that I know just enough about accounting to be dangerous.)

One pays the tax when the withdrawal (or conversion) is made, no earlier and no later, so in that sense it is always paid "on time". The breakeven thought seems to rely on the premise that if the withdrawal (or conversion) was not made at the time, that it would have been made later.

One could easily and I think just as accurately say that the tax would have been made earlier (at the time of deferral aka contribution to the IRA or workplace plan). In this view, the payback is immediate, because the person would have otherwise paid taxes at 22% or more when the contribution was made, and paying it at 12% later completes things.

The risk to the "breakeven" point of view and logic is that it's not really known when that dollar that was withdrawn or converted would have ultimately been taxed later. (This comes up in "whether to convert" discussions all the time.) The laws might change. Rates might change. The IRA dollars might end up going to charity and essentially come out tax free.

From an accounting point of view, I think it depends on whether one puts on their balance sheet anything to account for the embedded tax liability associated with the IRA dollars. Most people (including me) think and act on a cash, not accrual basis, so we don't formally account for that embedded liability.

Not to get picky here (been lurking around trying to learn something and this is definitely well outside my sphere of knowledge) but aren't you really saying the embedded liability is a contingent liability. Because it is not truly known what the future tax bill, if any, will be and who may (or may not) end up paying it. Therefore placing a number on that tax liability is truly an art of guesswork.

 

[SecondCor521]

Not to get picky here (been lurking around trying to learn something and this is definitely well outside my sphere of knowledge) but aren't you really saying the embedded liability is a contingent liability. Because it is not truly known what the future tax bill, if any, will be and who may (or may not) end up paying it. Therefore placing a number on that tax liability is truly an art of guesswork.

Sure. I don't think either "embedded" or "contingent" are accounting terms, but I've already disclaimed expertise in that area. I think both terms apply - the IRA dollars are embedded with a tax liability, and it's unclear what that amount is so it's contingent on assumptions.

As an aside, I'm not really trying to argue or score points in this thread. I'm just trying for improved clarity on how to think about this topic.

 

[LateToFIRE]

Sure. I don't think either "embedded" or "contingent" are accounting terms, but I've already disclaimed expertise in that area. I think both terms apply - the IRA dollars are embedded with a tax liability, and it's unclear what that amount is so it's contingent on assumptions.

As an aside, I'm not really trying to argue or score points in this thread. I'm just trying for improved clarity on how to think about this topic.

Disclaimer: I only know enough accounting to be a hazard to myself and others.

FWIW, contingent liabilities are an accounting term under GAAP (Generally Accepted Accounting Principals). Basically, addresses liabilities that are difficult to value because they may or may not be triggered depending on a set of future events, circumstances or outcomes (a toxic environmental clean-up cost would be a common example).

I only emphasize the point because its clear to me that the question of convert vs no convert features a fair degree of uncertainty (longevity, tax rates, etc.). So, as I think about the question, I'm asking myself which approach features more or less certainty vs pay-off (i.e. tax savings). So far, it's still looking like a tough question to answer.

 

[DangerDad]

It's not the amount of tax one pays, but rather the amount available to spend after tax that matters.

To get money out of a traditional IRS, you must (unless having zero taxable income after standard/itemized deductions) pay tax. If you can pay 12% now instead of 22% later, that's a good deal - regardless of how many years elapse between "now" and "later".

I believe you’re correct: With a 10% difference in marginal tax rate (12 vs 22%) it seems very likely that Roth conversions would be a good idea.

However I’m not sure that the time element (how many years elapse between now and later) is irrelevant. Money has a “time value” such that a dollar today is worth more than a dollar tomorrow. I’m still learning about this stuff, so maybe I’m way off—but isn’t the time element relevant in these calculations, especially when the difference in marginal tax rate is smaller..?

 

[SecondCor521]

Disclaimer: I only know enough accounting to be a hazard to myself and others.

FWIW, contingent liabilities are an accounting term under GAAP (Generally Accepted Accounting Principals). Basically, addresses liabilities that are difficult to value because they may or may not be triggered depending on a set of future events, circumstances or outcomes (a toxic environmental clean-up cost would be a common example).

I only emphasize the point because its clear to me that the question of convert vs no convert features a fair degree of uncertainty (longevity, tax rates, etc.). So, as I think about the question, I'm asking myself which approach features more or less certainty vs pay-off (i.e. tax savings). So far, it's still looking like a tough question to answer.

Thanks. I'm aware of GAAP but it quickly gets more complicated than I want to spend the effort to get to know.

Regarding the "certainty" of payoff, I'll requote myself from earlier:

One could easily and I think just as accurately say that the tax would have been made earlier (at the time of deferral aka contribution to the IRA or workplace plan). In this view, the payback is immediate, because the person would have otherwise paid taxes at 22% or more when the contribution was made, and paying it at 12% later completes things.

Making a withdrawal now at a lower rate than when the income was deferred is a guaranteed and immediate win when looking through the above lens. What remains uncertain is if one could have won more or less by waiting even longer. Mostly I tend to ignore such counterfactuals as I can do nothing about them other than have regrets.

 

[LateToFIRE]

Regarding the "certainty" of payoff, I'll requote myself from earlier:

Making a withdrawal now at a lower rate than when the income was deferred is a guaranteed and immediate win when looking through the above lens. What remains uncertain is if one could have won more or less by waiting even longer. Mostly I tend to ignore such counterfactuals as I can do nothing about them other than have regrets.

Yes, agree if I understand your reasoning correctly. I think we're on the same page. If you're like me, you've already "won" because tax rate in retirement is going to be materially lower than tax rate while working - with a fairly high degree of certainty.

Question then becomes, can you win more. Answer is subject to a great deal of uncertainty. In the face of so many unknowables, default is not to take action. Worst case is some amount of regret at not having maximized the winnings.

I would add that the "contingent" level of regret, at least for me, would be directly related to whether or not the money potentially left on the table would have made a significant difference in my financial security (I'm not worried about taxes for heirs).

 

[pb4uski]

Not to get picky here (been lurking around trying to learn something and this is definitely well outside my sphere of knowledge) but aren't you really saying the embedded liability is a contingent liability. Because it is not truly known what the future tax bill, if any, will be and who may (or may not) end up paying it. Therefore placing a number on that tax liability is truly an art of guesswork.

Not a contingent liability in my view, and certainly not a conventional contingent liability like a lawsuit.

It is really just a deferred tax liability but is more difficult to measure compared to conventional deferred tax liabilities because unlike corporate taxes which have a fixed 21% tax rate, the effective rate is variable. It could be as low as zero if the taxpayer does extensive QCDs or is in a low tax bracket or it could be a married filing jointly single tax rates or heir rates in some circumstances.

 

[SevenUp]

I believe you’re correct: With a 10% difference in marginal tax rate (12 vs 22%) it seems very likely that Roth conversions would be a good idea.

However I’m not sure that the time element (how many years elapse between now and later) is irrelevant. Money has a “time value” such that a dollar today is worth more than a dollar tomorrow. I’m still learning about this stuff, so maybe I’m way off—but isn’t the time element relevant in these calculations, especially when the difference in marginal tax rate is smaller..?

Yes and no.

The "no" part is easier to explain. A dollar today will buy more than a dollar tomorrow, but when looking at a Roth conversion then any purchase isn't going to occur today: whether a conversion works well or not depends on the after tax money available to spend when withdrawing (not converting) from traditional or Roth in the future. That's governed by the commutative property of multiplication which has no time dependence.

The "yes" part is when considering "Traditional plus taxable" vs. Roth - in other words, when the conversion tax is paid with money from outside the conversion. In that case, the amount of tax drag in the taxable count may vary with time.

Roth conversions are not a panacea. Someone expecting to use money in traditional accounts for charitable purposes (e.g., via QCDs and bequests) wouldn't want to pay any tax on the traditional balance because the charities can receive it tax free.

Keep "after-tax spendable amount" in mind and things may become clearer - do they?

 

[LateToFIRE]

Not a contingent liability in my view, and certainly not a conventional contingent liability like a lawsuit.

It is really just a deferred tax liability but is more difficult to measure compared to conventional deferred tax liabilities because unlike corporate taxes which have a fixed 21% tax rate, the effective rate is variable. It could be as low as zero if the taxpayer does extensive QCDs or is in a low tax bracket or it could be a married filing jointly single tax rates or heir rates in some circumstances.

Thanks for the terminology clarification - makes sense. I was thinking in the direction of "contingent" because as you pointed out, the range of potential $$$ outcomes is exceptionally wide and varied, even for a specific taxpayer, compared to what we'd typically think of as a deferred tax liability where maybe timing is question mark, but tax rate is fairly known variable.