Traditional 401K Roth Conversions - How to determine the Benefits?

[G-Man]

I have been using the NewRetirement PlannerPlus tool with the Roth Explorer feature. The Roth feature provides recommendations on when to execute Roth conversions for my DW and I 401k funds. Based on the conversions, it looks like I would eliminate any RMDs starting at age 72.

However, the Roth conversions have a huge tax bill for each year of the conversion.

Any feedback from other doing 401K Roth conversions and how to justify the benefits of the conversions.

Be patient with me as I'm a newbie on this topic.

P.S. I would need to tap into my 401K funds at age 57 (Rule of 55) and my wife will need to tap into her funds at age 61. I am 56 and my wife is 59.

Here is a YouTube video I'm using as a point of reference.

 

[SnowballCamper]

The justification for the benefit, and the primary benefit, is to pay less tax now than what you would pay later (at RMD time).

It sounds like almost all your retirement income will come from the 401k (until SS kicks in). In that case the conversions are generally very favorable, but do take a while for the benefits to materialize (in having a lower tax bill later in life).

Another justification is when one spouse dies, the other is suddenly in a higher tax bracket for RMDs.

For those like myself, with significant secure income (pension) conversions are much less favorable.

In any case, find a calculator and run the numbers for your situation.

 

[SevenUp]

...it looks like I would eliminate any RMDs starting at age 72.

It sounds like almost all your retirement income will come from the 401k (until SS kicks in).

If SnowballCamper's inference is correct, then eliminating RMDs would mean you have converted too much.

That's because if your income is all SS plus Roth withdrawals, your Adjusted Gross Income (AGI) would be less than your standard deduction. Better to have converted less, and thus have paid less in conversion taxes, so that your non-zero RMDs could be covered by your standard deduction and thus still pay no tax on them.

 

[G-Man]

The justification for the benefit, and the primary benefit, is to pay less tax now than what you would pay later (at RMD time).

It sounds like almost all your retirement income will come from the 401k (until SS kicks in). In that case the conversions are generally very favorable, but do take a while for the benefits to materialize (in having a lower tax bill later in life).

Another justification is when one spouse dies, the other is suddenly in a higher tax bracket for RMDs.

For those like myself, with significant secure income (pension) conversions are much less favorable.

In any case, find a calculator and run the numbers for your situation.

Retirement income consists of wife and I pension, wife and I SS, and wife and I 401K. 3 legged stool of retirement.

I can share more information if you need it.

 

[target2019]

I modeled three annual scenarios in Flexible Retirement Planner. Blue is no conversion, Red is 20K conversion, Green is 40K conversion. The curves are dependent on our inputs, like IRA total, when we hit RMD age, etc. The program calculated taxes at an effective rate of 15%.

I copied the detailed columns from FRP and placed in Excel. The chart is the result. It is applicable to our situation, but something similar occurs for other couples I would think.

 

[G-Man]

I modeled three annual scenarios in Flexible Retirement Planner. Blue is no conversion, Red is 20K conversion, Green is 40K conversion. The curves are dependent on our inputs, like IRA total, when we hit RMD age, etc. The program calculated taxes at an effective rate of 15%.

I copied the detailed columns from FRP and placed in Excel. The chart is the result. It is applicable to our situation, but something similar occurs for other couples I would think.

Wow. $20K and $40K conversions makes a different.

I will download the Flexible Retirement Planner tool.

https://www.flexibleretirementplanner.com/wp/

 

[SevenUp]

The program calculated taxes at an effective rate of 15%.

Same rate for all conversion amounts?

 

[TheWizard]

I'm single and in the 24% marginal bracket in retirement.
I've done moderate Roth conversions, in the $40-50k range, over the past several years.

I'm not expecting a tax arbitrage bonus, aside from the possible return to the 28% bracket in a few years.

My RMDs started this year and are a chunk lower than they would have been without any Roth conversions. And my AGI for this year should be just a bit more than last year, no big tax torpedo thingie.

I pay Medicare IRMAA, so those Roth conversions are helping me stay in my current tier, not getting into the next higher tier due to a big AGI jump.
The inflation adjustments to the IRMAA thresholds will be helping also.

And finally, I now have good sized tax-free fund that I can withdraw money from for infrequent large expenses without bumping my AGI up with LTCGs, etc...

 

[Dash man]

We’ve decided to do large conversions through 2025 before the TCJA sunsets and we return to to previous tax brackets. We are paying a lot of IRMAA and Federal income tax until then.
After that we should pay relatively minimal taxes and IRMAA shouldn’t effect us, or at worst the first tier. Without this, if one of us passed, we’d leave the surviving spouse in a tax bind.
I used Pralana Gold and also Excel spreadsheets to map out our income and estimated taxes to age 95. Our approach should save us quite a bit in taxes over our lives, but we’re having to pay quite a bit now. We do have a good amount in taxable accounts that we can use to pay the taxes and live off of while we do this. I’m not sure I’d be as aggressive if I had to pay taxes by withholding from the conversions. That changes the math a bit.

 

[G-Man]

We’ve decided to do large conversions through 2025 before the TCJA sunsets and we return to to previous tax brackets. We are paying a lot of IRMAA and Federal income tax until then.
After that we should pay relatively minimal taxes and IRMAA shouldn’t effect us, or at worst the first tier. Without this, if one of us passed, we’d leave the surviving spouse in a tax bind.
I used Pralana Gold and also Excel spreadsheets to map out our income and estimated taxes to age 95. Our approach should save us quite a bit in taxes over our lives, but we’re having to pay quite a bit now. We do have a good amount in taxable accounts that we can use to pay the taxes and live off of while we do this. I’m not sure I’d be as aggressive if I had to pay taxes by withholding from the conversions. That changes the math a bit.

On the account that you are doing the conversions on (ex. TIRA, 401k), are you drawing down on those funds as well?

I will need to withdraw from some of the 401K funds (account I'm doing the conversion on) to live on as I do the conversions into the Roth.

 

[Dash man]

On the account that you are doing the conversions on (ex. TIRA, 401k), are you drawing down on those funds as well?

I will need to withdraw from some of the 401K funds (account I'm doing the conversion on) to live on as I do the conversions into the Roth.

No, we live off of our taxable accounts, along with a meager pension and I’m also taking social security. DW is waiting until 70 to take her social security.

 

[target2019]

Same rate for all conversion amounts?

Yes, effective tax rate is one rate applied to the total income.

I used 15% effective tax rate: 12% Federal and 3% State.

We're going into the 22% bracket this year after two years of 12%. It's a great problem to have, so not complaining.

 

[Animorph]

Don't worry about paying the taxes "early", or the dollar amount. Only the percent of each dollar withdraw taken in taxes counts. By converting gradually you minimize the tax brackets the withdrawals fall into. By converting too much you may leave potential low tax brackets unfilled late in retirement. Also consider that one spouse may die and the surviving spouse would be taxed as a single tax payer, with effectively higher tax rates for the same income.

A good way to think of your tIRA is this: Assume everything will come out at a 20% tax rate (for simplification). Then 20% of your tIRA belongs to the IRS. Pay them now or invest it for them and pay it later, 20% of every dollar withdrawn is theirs and they always own 20% of your tIRA balance. There is no advantage (if you can't change your tax rate) in delaying taxes like there is in a taxable account. Your advantage comes if you can reduce that 20% for at least some of the money. Then you get to take some of the IRS's money as your own.

At a fixed 20% tax rate your $100k tIRA is the same as an $80k Roth IRA. There's $80k of your tax-free money in that tIRA and $20k of the IRS's money in it as well. So everything being equal in this simple case, a Roth conversion is a total wash. The timing doesn't matter, you're just investing the IRS's money for a longer time if you wait.

An extra benefit of a Roth conversion is that when you withdraw that $100k and pay the IRS their $20k (or maybe it's now $200k and $40k after doubling your investment) you are still eligible to place a full $100k into the Roth, not just your $80k. So you pay the $20k taxes from your taxable account (possibly incurring taxable capital gains before you normally would, so it may not be without some cost), and put the full $100k in the Roth. Now $20k that was in your taxable account is in your Roth account instead, growing tax free. The value of that tax free growth may be nothing to something substantial (if you are highly taxed and leave it to grow tax free for a long time.)

So my financial optimization is to determine how much to withdraw from the tIRA/t401k each year to essentially minimize the tax rate of each dollar withdrawn throughout retirement (I actually try to maximize what I can spend, inflation adjusted, but close enough). I'll use the withdrawal for expenses if necessary (when taxable account dollars dry up) and everything else goes into the Roth for later.

And the exception to my lowest tax rate rule is when the added benefit of moving taxable money into the Roth outweighs a (slightly) higher withdrawal tax rate when all is said and done. It's not a big driver, but favors larger Roth conversions earlier in the process when your money has a longer time to grow in the Roth. About 10 years before Roth withdrawals will start was my cutoff for pushing the tax rate a little bit.

Be sure to consider income tax/credit/subsidy trigger levels that may add to your effective tax rate when converting. And also consider using the 0% capital gains tax rate that may be available to you. Hopefully many of these special cases won't apply or will always apply, simplifying your calculations.

 

[SevenUp]

I modeled three annual scenarios in Flexible Retirement Planner. Blue is no conversion, Red is 20K conversion, Green is 40K conversion. The curves are dependent on our inputs, like IRA total, when we hit RMD age, etc. The program calculated taxes at an effective rate of 15%.

Same rate for all conversion amounts?

Yes, effective tax rate is one rate applied to the total income.

I used 15% effective tax rate: 12% Federal and 3% State.

If that's how FRP works, it's not a good recommendation for the tool.

The trick with Roth IRA conversions is how to navigate the non-flat US tax code in which higher conversion amounts usually incur higher marginal tax rates but not always. It's the marginal rates on the extra conversion amounts compared with the marginal rates on the decreased RMD amounts that matters.

 

[target2019]

FRP is not a tax-planning tool. I mentioned that in another thread, and repeat it here for the curious. I added a graph which shows how taxes would increase if WE do nothing. It is teaching moment. Don't like it, fine.

The chart was not meant to be anything other than a depiction of how conversions can change the tax, you can use different conversion amounts, and so on.

These discussions are all analytical to some degree. Every tool I've seen can't predict the future. But tools can show how options you select may impact the long run.

The short story is convert enough to stay in the 12% now. Going further requires more analysis.

The long story is about how you might shift invested dollars from your tax-deferred pile to your tax-free pile.

YMMV.

 

[G-Man]

Don't worry about paying the taxes "early", or the dollar amount. Only the percent of each dollar withdraw taken in taxes counts. By converting gradually you minimize the tax brackets the withdrawals fall into. By converting too much you may leave potential low tax brackets unfilled late in retirement. Also consider that one spouse may die and the surviving spouse would be taxed as a single tax payer, with effectively higher tax rates for the same income.

A good way to think of your tIRA is this: Assume everything will come out at a 20% tax rate (for simplification). Then 20% of your tIRA belongs to the IRS. Pay them now or invest it for them and pay it later, 20% of every dollar withdrawn is theirs and they always own 20% of your tIRA balance. There is no advantage (if you can't change your tax rate) in delaying taxes like there is in a taxable account. Your advantage comes if you can reduce that 20% for at least some of the money. Then you get to take some of the IRS's money as your own.

At a fixed 20% tax rate your $100k tIRA is the same as an $80k Roth IRA. There's $80k of your tax-free money in that tIRA and $20k of the IRS's money in it as well. So everything being equal in this simple case, a Roth conversion is a total wash. The timing doesn't matter, you're just investing the IRS's money for a longer time if you wait.

An extra benefit of a Roth conversion is that when you withdraw that $100k and pay the IRS their $20k (or maybe it's now $200k and $40k after doubling your investment) you are still eligible to place a full $100k into the Roth, not just your $80k. So you pay the $20k taxes from your taxable account (possibly incurring taxable capital gains before you normally would, so it may not be without some cost), and put the full $100k in the Roth. Now $20k that was in your taxable account is in your Roth account instead, growing tax free. The value of that tax free growth may be nothing to something substantial (if you are highly taxed and leave it to grow tax free for a long time.)

So my financial optimization is to determine how much to withdraw from the tIRA/t401k each year to essentially minimize the tax rate of each dollar withdrawn throughout retirement (I actually try to maximize what I can spend, inflation adjusted, but close enough). I'll use the withdrawal for expenses if necessary (when taxable account dollars dry up) and everything else goes into the Roth for later.

And the exception to my lowest tax rate rule is when the added benefit of moving taxable money into the Roth outweighs a (slightly) higher withdrawal tax rate when all is said and done. It's not a big driver, but favors larger Roth conversions earlier in the process when your money has a longer time to grow in the Roth. About 10 years before Roth withdrawals will start was my cutoff for pushing the tax rate a little bit.

Be sure to consider income tax/credit/subsidy trigger levels that may add to your effective tax rate when converting. And also consider using the 0% capital gains tax rate that may be available to you. Hopefully many of these special cases won't apply or will always apply, simplifying your calculations.

I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?

 

[TheWizard]

I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?

This is an excellent time to do Roth conversions.
Convert 5% of your 401k balance this year, ok?

 

[SevenUp]

I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?

Definitely not too late! As a guess, converting this year would not be good because the conversion amount would be taxed "on top of" (i.e., at a higher marginal rate) your work income.

At a minimum, start by understanding the marginal tax rate(s) you'll pay on various Roth conversion amounts for the next several years (i.e., after retirement and before IRMAA and/or SS effects kick in).

Then estimate your RMDs, assuming some growth rate for your traditional balance, and no conversions, between now and age 72.

Then estimate what your marginal tax rate will be on those RMDs (including all other expected income as the base upon which the RMDs will be taxed).

As a start, look at doing Roth conversions up to the point the conversion marginal tax rate doesn't exceed the "no conversion RMD" rate. But then you need to re-estimate the RMD amount because doing conversions will lower it, and repeat.

A couple of tools that can help are mentioned in the Using a spreadsheet section of the Roth IRA conversion wiki in Bogleheads.

If that is more than you want to take on yourself (but if you have any spreadsheet ability it may be easier to do than it looks), whoever you might pay to do it for you should explain things in similar terms.

As target2019 rightly implied, predicting the future (e.g., what will your investments returns be? what will tax law be?) is part of this, so don't agonize over details. But for any tool to be much more useful than a Magic 8 Ball, that tool should have a least a rudimentary understanding that in general the higher the Roth conversion this year, the higher the tax rate on the conversion amounts.

 

[Dash man]

I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?

Be aware that since you are 56, if you have tax withheld from your conversions, you’ll also have to pay a 10% penalty for the portion used to pay taxes. This will be the case until you turn 59 1/2.

I remember in your Roth IRA thread you mentioned most of your money is in your retirement accounts. So if you don’t have funds to fully contribute your $7k to a Roth, you may not have funds to pay the tax. In this case, wait until you’re 59 1/2.

 

[TheWizard]

I wouldn't do Roth conversions while still pulling down a decent working salary for the entire year.
Plug all the details into your spreadsheet and see what it says...

 

[Exchme]

Don't worry about paying the taxes "early", or the dollar amount. Only the percent of each dollar withdraw taken in taxes counts. By converting gradually you minimize the tax brackets the withdrawals fall into. By converting too much you may leave potential low tax brackets unfilled late in retirement. Also consider that one spouse may die and the surviving spouse would be taxed as a single tax payer, with effectively higher tax rates for the same income.

A good way to think of your tIRA is this: Assume everything will come out at a 20% tax rate (for simplification). Then 20% of your tIRA belongs to the IRS. Pay them now or invest it for them and pay it later, 20% of every dollar withdrawn is theirs and they always own 20% of your tIRA balance. There is no advantage (if you can't change your tax rate) in delaying taxes like there is in a taxable account. Your advantage comes if you can reduce that 20% for at least some of the money. Then you get to take some of the IRS's money as your own.

At a fixed 20% tax rate your $100k tIRA is the same as an $80k Roth IRA. There's $80k of your tax-free money in that tIRA and $20k of the IRS's money in it as well. So everything being equal in this simple case, a Roth conversion is a total wash. The timing doesn't matter, you're just investing the IRS's money for a longer time if you wait.

An extra benefit of a Roth conversion is that when you withdraw that $100k and pay the IRS their $20k (or maybe it's now $200k and $40k after doubling your investment) you are still eligible to place a full $100k into the Roth, not just your $80k. So you pay the $20k taxes from your taxable account (possibly incurring taxable capital gains before you normally would, so it may not be without some cost), and put the full $100k in the Roth. Now $20k that was in your taxable account is in your Roth account instead, growing tax free. The value of that tax free growth may be nothing to something substantial (if you are highly taxed and leave it to grow tax free for a long time.)

So my financial optimization is to determine how much to withdraw from the tIRA/t401k each year to essentially minimize the tax rate of each dollar withdrawn throughout retirement (I actually try to maximize what I can spend, inflation adjusted, but close enough). I'll use the withdrawal for expenses if necessary (when taxable account dollars dry up) and everything else goes into the Roth for later.

And the exception to my lowest tax rate rule is when the added benefit of moving taxable money into the Roth outweighs a (slightly) higher withdrawal tax rate when all is said and done. It's not a big driver, but favors larger Roth conversions earlier in the process when your money has a longer time to grow in the Roth. About 10 years before Roth withdrawals will start was my cutoff for pushing the tax rate a little bit.

Be sure to consider income tax/credit/subsidy trigger levels that may add to your effective tax rate when converting. And also consider using the 0% capital gains tax rate that may be available to you. Hopefully many of these special cases won't apply or will always apply, simplifying your calculations.

+1

The graph OP posted is not optimizing the right thing. So OP seems to be set up to make an expensive mistake. As Animorph says, you want to avoid high tax brackets, the way to do that is to keep your tax bracket level through the years with Roth Conversions, with the caveat that if you need ACA premium credits, those are top priority.

The important thing to optimize is the after tax value at end of life (or to heirs after they withdraw any money left in the tIRA). OP should do some more reading about the program capability, it would be very disappointing if OP's graph is the kind of thing a commercial program is guiding the user to do.

 

[G-Man]

+1

The graph OP posted is not optimizing the right thing. So OP seems to be set up to make an expensive mistake. As Animorph says, you want to avoid high tax brackets, the way to do that is to keep your tax bracket level through the years with Roth Conversions, with the caveat that if you need ACA premium credits, those are top priority.

The important thing to optimize is the after tax value at end of life (or to heirs after they withdraw any money left in the tIRA). OP should do some more reading about the program capability, it would be very disappointing if OP's graph is the kind of thing a commercial program is guiding the user to do.

I really appreciate the feedback for everyone. I will do some more reading on this topic. Their is no heirs or children to leave money to. The goal is for my wife and I to spend that dough during retirement.

 

[TheWizard]

+1
The graph OP posted is not optimizing the right thing. So OP seems to be set up to make an expensive mistake. As Animorph says, you want to avoid high tax brackets, the way to do that is to keep your tax bracket level through the years with Roth Conversions, with the caveat that if you need ACA premium credits, those are top priority.

I completely agree on levelizing your retirement income up through start of RMDs by doing Roth conversions, with annual increases in AGI tracking inflation.
That's basically what I did...

 

[Animorph]

I would love to pay something to perform a "Traditional 401k Roth conversion optimization Analysis" to determine the most optimal Roth conversion strategy for my situation.

Any recommendations? I'm 56 and plan to retire next year. Is it too late to execute Roth conversions on my Tradtional 401K funds?

I created my own computer program, unsuitable for use by others (and becoming unsuitable for older me!). Optimization is a tricky thing to program and to run, and taxes (and future taxes) are not far behind. Which is why there aren't any great reasonably priced calculators available. However, I have found, at least for me, that past a certain basic level of complexity I might be optimizing for an extra $100 per year in spending. OK as a hobby, but not worth the time for most people. Follow the advice on the forum that applies to you and you will capture most of the benefits.

That said, I optimize my tIRA/401k withdrawals for each year in order to achieve my best inflation-adjusted yearly spending while leaving a constant final value in the portfolio. Everything else is calculated from those withdrawal numbers. I often see the optimized withdrawals are setting my income exactly at the top of a tax bracket, sometimes even a state tax bracket, or other tax feature like the start of the investment tax. So a spreadsheet that does all the calculations and gives you a final yearly spending amount could be used with manually entered tIRA numbers guided by various tax inflection points. Not too many numbers to try, and I think it would give you 99% of the conversion benefit.

Just like anything in retirement finances there are so many assumptions being made just to get one output number that most fine tuning will be buried in the noise. Get the basics right and you'll be fine.

 

[pb4uski]

What I have done is a projection model of all of our sources of retirement income from now until we are 90. So it includes interest on taxable account money, my small fixed pension, and SS. It also includes a cell for Roth conversions each year and for RMDs once I'm 73. And most importantly, it includes projected standard deductions, taxable income and income taxes based on today's brackets and rates. All values are adjusted for inflation and investment balances like IRAs are adjusted for growth and withdrawals.

With no Roth conversions, we would pay no taxes until I start RMDs but some standard deductions would go unutilized each year and once I start RMDs the effective tax rate on the RMDs would be ~25-27%. So if I do nothing then I'll pay 25-27% of the RMDs in tax.

With Roth conversions to the top of the 12% tax bracket we pay about 11.5% of the convertsion amount in tax now and the effective tax rate on RMDs one they start is ~17%.

I can also look at the total paid in tax from now to age 90... with conversions is $258k and without any future conversions is $326k... not life changing but worth a little effort.