Roth Conversion and Marginal Vs Effective

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SarahS
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Roth Conversion and Marginal Vs Effective

Post by SarahS » Wed Jan 09, 2019 10:39 am

Hi Bogleheads

I am currently a resident of OR (high state income tax of 9%) but will be moving to WA soon (no state income tax). Between this, and the lower federal tax rates currently in effect (husband and I are in 24% bracket), we’re considering doing some conversions of tIRA to Roth after we move to WA. But I struggle a bit with whether it makes sense to convert at 24% rate. (Note: I would pay the taxes with savings held in taxable accounts.) I realize each dollar I convert would be taxed at my marginal rate today, but how should I be thinking of this in terms of future taxes on the tIRA if I don’t convert: marginal rate vs effective rate?

02nz
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Re: Roth Conversion and Marginal Vs Effective

Post by 02nz » Wed Jan 09, 2019 11:19 am

This is a perennial debate but I think people are tripped up by semantics, because neither word (effective and marginal) is fully accurate/precise in this case. You need to look at the effective tax rate on that chunk, including growth, when withdrawn during retirement. That may or may not equal your overall effective tax rate (it does if you have no other income). It also may or may not equal your marginal rate (it does so only if the withdrawal falls entirely within one tax bracket).

To give an example, let's say you defer $10,000 this year through 401k contributions, which grows to $50K, and you withdraw that in a year with no other income. At current* tax rates for married filing jointly, you'd pay just $2,684 in taxes (effective tax rate on the withdrawal is 5.4%). But if you already had $50K of other income**, and took the $50K withdrawal in addition, then you're paying $8,684 in taxes on $100K total income. The $50K withdrawal increases your tax bill that year by $6,000 - this chunk was all taxed at the 12% rate.

Whether it makes sense to convert depends a lot on your holdings (how much, and proportion of tax-deferred to Roth), whether you expect to have pensions or other income in retirement, and whether you plan to retire early (doesn't mean at 40, but rather early enough to have years of low or no income). I wouldn't convert at 24%, because it takes massive 401k/IRA balances to reach a 24% effective withdrawal tax rate, but we don't know enough about you to say whether it makes sense for you. Generally, converting in years of no to low income - say after retiring but before taking Social Security, is the best strategy, as it allows you to "fill up" your standard deduction and low tax brackets to withdraw at very favorable tax rates.

* The tax brackets and standard deduction are indexed for inflation, but I've ignored that here. This means if tax rates stay the same, you'll pay less than in my examples.
** Taxation of SS benefits is a little tricky - see the wiki.

Ben Mathew
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Re: Roth Conversion and Marginal Vs Effective

Post by Ben Mathew » Wed Jan 09, 2019 12:27 pm

The correct comparison is between marginal tax rate now vs marginal tax rate in the future. You just have to be careful to do that comparison with each dollar. So on the first dollar, you might say marginal tax rate now is 24% vs future is 12%. So you go traditional on the first dollar. Second dollar, again marginal tax rate is 24% vs future is 12%. So again, traditional for the second dollar. At some point, after you've put a bunch into traditional, the current marginal tax rate might drop to 22%. And because you've put so much in traditional, the future expected marginal tax rate might increase to 24%. At that point, you switch to Roth. This sounds complicated, but once you get the idea it's not that hard. The hard part is predicting future savings, investment returns, tax structure, career trajectories, retirement age, retirement expenses, and large medical expenses--all of which affect marginal tax rates in the future. For most people, traditional will probably work better because they are likely to be in a lower tax bracket in retirement than in their working years. So unless you expect to have a very large traditional balance (I would say more than $2 million @ age 70, others might set the threshold at higher at $3 or 4 million), just go with traditional. But if you do expect to enter retirement with a very large traditional balance, you'll need to think harder. Consider a mix of traditional and Roth--each year you contribute to traditional till you drop into a low bracket, then put the rest in Roth. You could come up with a cutoff marginal tax rate:

$ whose marginal tax rate is >= X%: traditional
$ whose marginal tax rate is < X%: Roth

If you had perfect foreknowledge, X would be constant over your lifetime. But because of uncertainty, X would have to be updated when new information comes in--income change, new plan to retire early, etc.

The math is cumbersome. But, on the plus side, people considering Roth contributions in their working years are expecting to be in a very good financial position in retirement.

hushpuppy
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Re: Roth Conversion and Marginal Vs Effective

Post by hushpuppy » Wed Jan 09, 2019 4:50 pm

delete
Last edited by hushpuppy on Fri Feb 15, 2019 8:23 pm, edited 1 time in total.
Two dogs are better than one. One dog needs to have at least one companion that can consistently measure up to standards. Humans need not apply. Consider Ecclesiastes 10-2.

02nz
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Re: Roth Conversion and Marginal Vs Effective

Post by 02nz » Wed Jan 09, 2019 5:04 pm

hushpuppy wrote:
Wed Jan 09, 2019 4:50 pm
02nz wrote:
Wed Jan 09, 2019 11:19 am
I wouldn't convert at 24%, because it takes massive 401k/IRA balances to reach a 24% effective withdrawal tax rate, but we don't know enough about you to say whether it makes sense for you.
I know this has been noted many times before, but the death of one spouse makes the 24% effective withdrawal tax rate (or at least a 24% marginal rate) much easier to reach. When trying to plan for taxes (or life), it is easy to forget that bad things can happen to good (or any other kind of) people. It may be worthwhile to move more toward Roth to limit this possible future detrimental taxation effect. However, I am only speaking from one, necessarily biased, point of view.

Regards,

hushpuppy
A valid point, but the 24% bracket doesn't start for singles until $96,400 of income (including the standard deduction). Starting RMDs on a $2.5 million pre-tax balance wouldn't even touch this bracket. And for many people the better way to mitigate this risk is to aggressively draw down pre-tax balances in the early years of retirement (withdrawals and Roth conversions), ideally before taking Social Security, rather than doing Roth conversions while they still have substantial other income. This is also an argument for retiring a bit earlier. Of course individual circumstances will vary, there's no one best answer for everyone.

retiredjg
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Re: Roth Conversion and Marginal Vs Effective

Post by retiredjg » Wed Jan 09, 2019 5:08 pm

SarahS wrote:
Wed Jan 09, 2019 10:39 am
Hi Bogleheads

I am currently a resident of OR (high state income tax of 9%) but will be moving to WA soon (no state income tax). Between this, and the lower federal tax rates currently in effect (husband and I are in 24% bracket), we’re considering doing some conversions of tIRA to Roth after we move to WA. But I struggle a bit with whether it makes sense to convert at 24% rate. (Note: I would pay the taxes with savings held in taxable accounts.) I realize each dollar I convert would be taxed at my marginal rate today, but how should I be thinking of this in terms of future taxes on the tIRA if I don’t convert: marginal rate vs effective rate?
Marginal rate now vs marginal later....except that marginal later may cover more than 1 tax bracket so it could end up being the effective rate of just those two brackets.*** It is also possible that "marginal now" could cross over a tax bracket line but that does not seem to be very common.

If you will be in a higher tax bracket for the rest of your careers, I think converting (a moderate amount) now at 24% is reasonable. The lack of state tax helps too.

The argument against that is that it is not uncommon for a couple to be in a lower bracket in retirement. 15% (12% under current law) is very common. However, when one of you dies, the other will quite likely be in the 25% bracket or some new tax bracket we don't yet know about and it is hard to imagine rates being lower. That said, it was hard to imagine rates dropping recently either so who knows what will happen.


***I see that O2nz worded it well - "effective rate on that chunk" which could be your marginal rate in retirement or a somewhat smaller number if you cross over a bracket line.

randomguy
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Re: Roth Conversion and Marginal Vs Effective

Post by randomguy » Wed Jan 09, 2019 8:18 pm

02nz wrote:
Wed Jan 09, 2019 5:04 pm
hushpuppy wrote:
Wed Jan 09, 2019 4:50 pm
02nz wrote:
Wed Jan 09, 2019 11:19 am
I wouldn't convert at 24%, because it takes massive 401k/IRA balances to reach a 24% effective withdrawal tax rate, but we don't know enough about you to say whether it makes sense for you.
I know this has been noted many times before, but the death of one spouse makes the 24% effective withdrawal tax rate (or at least a 24% marginal rate) much easier to reach. When trying to plan for taxes (or life), it is easy to forget that bad things can happen to good (or any other kind of) people. It may be worthwhile to move more toward Roth to limit this possible future detrimental taxation effect. However, I am only speaking from one, necessarily biased, point of view.

Regards,

hushpuppy
A valid point, but the 24% bracket doesn't start for singles until $96,400 of income (including the standard deduction). Starting RMDs on a $2.5 million pre-tax balance wouldn't even touch this bracket. And for many people the better way to mitigate this risk is to aggressively draw down pre-tax balances in the early years of retirement (withdrawals and Roth conversions), ideally before taking Social Security, rather than doing Roth conversions while they still have substantial other income. This is also an argument for retiring a bit earlier. Of course individual circumstances will vary, there's no one best answer for everyone.
SS and any after tax income drops that number. IRMAA is at 85k (note that these numbers have been frozen for the past decade. Who knows if they will start adjusting them up or not). You really need to do a lot more math than just tax bracket rate versus tax bracket rate.

Seems to me that there are 2 questions that really matter:
a) odds of moving back to OR or other high tax state? Hitting 22%+9% seems pretty likely in that case and even the best case of 9+12% is pretty close.
b) Retirement date. Retiring at say 55 or 60 gives you 10+ years to convert a lot of money at rates less than 24%.

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grabiner
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Re: Roth Conversion and Marginal Vs Effective

Post by grabiner » Wed Jan 09, 2019 8:22 pm

02nz wrote:
Wed Jan 09, 2019 11:19 am
I wouldn't convert at 24%, because it takes massive 401k/IRA balances to reach a 24% effective withdrawal tax rate, but we don't know enough about you to say whether it makes sense for you.
If you are young, and are paying the tax with money from a taxable account, converting at a 24% marginal tax rate and withdrawing at a 22% marginal tax rate is a net benefit, as you effectively tax-defer more money. (If you are close to retirement, you could wait until you retire and then fill up the lower brackets with conversions.)

Another reason you might want to convert at 24% is that the 22% bracket is scheduled to become a 25% bracket in 2026.
Wiki David Grabiner

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FiveK
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Re: Roth Conversion and Marginal Vs Effective

Post by FiveK » Thu Jan 10, 2019 7:36 pm

02nz wrote:
Wed Jan 09, 2019 11:19 am
This is a perennial debate but I think people are tripped up by semantics, because neither word (effective and marginal) is fully accurate/precise in this case. You need to look at the effective tax rate on that chunk, including growth, when withdrawn during retirement.
AKA the marginal rate as defined in Marginal tax rate - Bogleheads: "the amount of additional taxes that will be due (or reduced) by the amount of income involved."

A rose by any other name.... :)

02nz
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Re: Roth Conversion and Marginal Vs Effective

Post by 02nz » Thu Jan 10, 2019 8:28 pm

FiveK wrote:
Thu Jan 10, 2019 7:36 pm
02nz wrote:
Wed Jan 09, 2019 11:19 am
This is a perennial debate but I think people are tripped up by semantics, because neither word (effective and marginal) is fully accurate/precise in this case. You need to look at the effective tax rate on that chunk, including growth, when withdrawn during retirement.
AKA the marginal rate as defined in Marginal tax rate - Bogleheads: "the amount of additional taxes that will be due (or reduced) by the amount of income involved."

A rose by any other name.... :)
You're correct that the BH wiki definition of "marginal" is the same as my wordier version. The issue is that another common definition of "marginal tax rate" is the rate applied to the next dollar of income (e.g., https://www.investopedia.com/terms/m/ma ... axrate.asp). That rate may not be the same as the rate on a chunk of money withdrawn.

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FiveK
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Re: Roth Conversion and Marginal Vs Effective

Post by FiveK » Thu Jan 10, 2019 9:06 pm

02nz wrote:
Thu Jan 10, 2019 8:28 pm
You're correct that the BH wiki definition of "marginal" is the same as my wordier version. The issue is that another common definition of "marginal tax rate" is the rate applied to the next dollar of income (e.g., https://www.investopedia.com/terms/m/ma ... axrate.asp). That rate may not be the same as the rate on a chunk of money withdrawn.
Yes.

Differential calculus devotees mislead themselves by looking at that very last dollar. If they would stop at the "capital delta" difference equation instead of squeezing down to the differential, all would be well.

One can be misled by the "last dollar" view, and also by the "tax rate on all income" view - but I'm just agreeing with what you've already said. :sharebeer

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Re: Roth Conversion and Marginal Vs Effective

Post by Ben Mathew » Thu Jan 10, 2019 10:31 pm

If we define marginal tax rate as the extra tax on an extra dollar (the standard definition), there is only one case where the use of the term "marginal tax rate" has to be qualified. That's the perverse case where marginal tax rates decline with income. In that case, comparing marginal tax rates on the last dollar is not enough. One would have to look at the "effective/marginal tax rates" on larger chunks. The Wiki gives an example:
One should also recognize that marginal rates don't always increase as income increases, nor always decrease as pre-tax contributions increase. In those cases, one should look at different values of "some amount" to determine the best strategy.

E.g., take a couple making $54K/yr with two young children. In 2016, that puts them in the "15% bracket." Yet, due to various combinations of the saver's and earned income credits, as they increase 401k contributions from $0 to $18,000 their marginal savings rates (calculated a dollar at a time) go through regions of 25%, 46%, 36%, 31%, and 21% - plus some spikes due to tiers in the saver's credit. Their maximum marginal savings rate of 33.4% comes when "some amount" of 401k contribution is $14,000. In graphical form:
But the case where the total amount under consideration spans multiple increasing brackets can still be handled by the term "marginal tax rate" without qualification because if you compare "extra tax on an extra dollar" for each dollar, the calculations will come out right. Using "effective" instead of "marginal" tax rates in this situation would, in my opinion, be misleading because there is no need to chunk. The calculations can and should be done dollar by dollar (conceptually of course, not literally). The right answer will often take the form "traditional till the marginal rates flip, and Roth thereafter." Chunking here would suggest that you have to consider the effective rate on the full amount under consideration, when that is not the case.

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