Latest Roth conversion paper

[McQ]

Some may remember that I joined the forum in June 2021 because I stumbled across a discussion of my first Roth piece, a working paper published on ssrn.com. https://papers.ssrn.com/sol3/papers.cfm ... id=3860359

Since then I’ve started several threads on the forum on the topic of Roth conversions, and published a paper in the Journal of Financial Planning on the arithmetic of Roth conversions.

That journal has just published my latest effort, which I don’t believe is as yet behind a paywall: https://www.financialplanningassociatio ... sions-OPEN.

The title is self-explanatory: Net Present Value Analysis of Roth Conversions.

Here is the Executive Summary

• In most conventional treatments, the advisability of a Roth conversion hinges on a comparison of present to future tax rates. If future tax rates will be higher, conversion is indicated.

• This paper argues that future tax rates are unknowable, and that this uncertainty needs to be incorporated into the decision process around Roth conversions.

• The time course over which tax savings accrue has also been ignored. For the mass affluent, conversions typically serve to reduce required minimum distributions. Because RMDs continue for life, tax savings from reducing future RMDs may take decades to accumulate.

• RMD-reducing Roth conversions fit the classic model for net present value analyses. There is a large one-time tax payment at conversion, followed by years and years of tax savings. Savings postponed until the distant future must be discounted. The conversion pays off only if the discounted value of future savings exceeds the cost to convert.

• This paper develops the implications of the long, slow, uncertain payoff for conversions. Clients need to be comfortable with a payoff that may not be complete until 20 or 30 years have passed, and which may be comparatively small in present value terms.

Here is a key passage that will convey the implications of the NPV analysis:

Discounting Future Tax Savings

The proper discount rate must be the expected annualized rate of appreciation on the portfolio targeted for conversion. That is the rate that makes the client indifferent to paying tax now versus later (assuming constant tax rates throughout the distribution period). Here is an example: Suppose a $10,000 portfolio in a tax-deferred account is invested in stocks returning 10 percent and that the tax rate on withdrawals is 25 percent. If the account is converted today, tax of $2,500 will be due. If the account is liquidated after one year of appreciation, $11,000 will be withdrawn, and the tax due will be $2,750. Discounted at the portfolio rate of appreciation, paying $2,750 after one year is no different from paying $2,500 today.

If any lower rate of discount were to be applied to future tax savings (whether inflation, the risk-free rate, or no discount at all), then Roth conversions would always pay off spectacularly if held for long enough. Left in stocks for 30 years, that $10,000 portfolio has an expected future value of about $175,000; undiscounted, the future tax savings would be about $43,625. Absent any discounting, a rational taxpayer would always convert immediately, paying only $2,500 in tax today to save tens of thousands of dollars in future tax.

Clients in the top bracket are particularly vulnerable to this form of money illusion. In the top bracket, clients can convert an arbitrarily large amount at a single tax rate, say, $10 million at 37 percent, paying $3.70 million in tax today. Again, invested in stocks at 10 percent for 30 years, that conversion avoids a future distribution of $175 million, thus averting tax of $64.75 million. Who could resist saving over $60 million in tax through an immediate conversion?

By contrast, the rational taxpayer not subject to money illusion will discount tax savings not received until some future date, and will discount more heavily the more distant that future.

Last, I append a sample of some of the recommendations, all of which are presented as rules of thumb.

Here is a set of circumstances where a Roth conversion becomes a high-risk, low-payoff bet.

1. In general, the earlier the conversion, the more risky the bet; the future is necessarily uncertain, and the more distant the future the more so. Too much can change, legislatively or personally. No one who converted at the first opportunity in 1998, after the creation of Roth accounts, at the then 28 percent rate, had any reason to expect that income in that bracket would see a rate reduction first to 25 percent under EGTRRA and then to 22 percent under TCJA.

2. The higher the tax rate paid on conversion, the bigger the loan made to the government and the greater the vulnerability to a change in personal circumstances or in the legislative environment.

3. Conversions that represent a pure bet on future legislation—as in the baseline example of converting at 22 percent to avoid tax at 25 percent post-TCJA—typically have small payoffs, high uncertainty, and considerable downside risk. The taxpayer has to get both future congressional action and their own future tax situation correct, to win a modest payoff; if they get both wrong, the cost may be steep. Interestingly, converting at 24 percent to avert 28 percent post-TCJA is a somewhat safer bet. If this client gets both predictions wrong, they paid 24 percent to avert tax of 22 percent, a smaller downside. [assumes no IRMAA]

4. Conversions intended to reduce RMDs and deliver a payoff during the client’s life are almost certain to be disappointing unless the conversion tax rate is in single digits and the tax gap is a multiple of it and in double digits. The base case in this paper violated both conditions. The middle bracket converter has to live long enough, with no untoward personal events or unexpected legislation, for a payoff to be received while alive. Most of the time, these conversions will represent a loan to the government not fully paid off even at the taxpayer’s demise, with any payoff from the conversion going to the heirs.

In short: the new paper reverts to a more jaundiced view of the prospects for a Roth conversion in the 22% or 24% bracket, as in the initial working paper.

[Parkinglotracer]

Thank you for sharing. Like your paper states, many of us are converting in the 22% tax bracket in our 60’s anticipation it will save us some money on taxes … ie help when one of us dies and the other is taking RMDs in the single tax bracket at 35% or if our kids inherit it in their high tax bracket years. I take it from your analysis I should just be happy I am loaning the gov money I owe them later and we may never recoup a savings. It does make me feel good to have more in our Roth’s free of the taxman but it’s great to see your analysis showing the error in our ways.

[BetaTracker]

Very interesting research paper! Mike Piper, the CPA and author of the Oblivious Investor blog, recently wrote that "Roth conversions simply do not tend to increase retirement safety." He added: "And that has been my experience with a broad range of clients — ranging from super financially secure to more borderline, with varying ages upon retirement, and with a wide variety of portfolio sizes and compositions."
https://obliviousinvestor.com/what-roth ... o-achieve/

[dcabler]

Very interesting research paper! Mike Piper, the CPA and author of the Oblivious Investor blog, recently wrote that "Roth conversions simply do not tend to increase retirement safety." He added: "And that has been my experience with a broad range of clients — ranging from super financially secure to more borderline, with varying ages upon retirement, and with a wide variety of portfolio sizes and compositions."
https://obliviousinvestor.com/what-roth ... o-achieve/

Interesting. I don't think I've ever seen anybody imply that Roth conversions would increase retirement safety. I assume that, like many folks, Piper's definition of safety means not running out of money prematurely. And that usually implies some sort of SWR withdrawal method when doing the analysis. As he states in the link, you can't run out of money with RMD since it's always a percentage of the remaining balance and never hits 100%. Other withdrawal methods like amortization based withdrawals (VPW, ABW, TPAW for example) have a similar feature, though usually they end up at 100% at some point, although that point in time is at the discretion of the person making the withdrawals.

I look at Roth conversions as a way to possibly increase lifetime, after-tax income primarily for two of us while we're still around, then for the survivor after one is gone and, finally, for a tax-free inheritance after we're both gone. As McQ indicates, there are a lot of possible permutations regarding possible futures.

Cheers

[FiveK]

In short: the new paper reverts to a more jaundiced view of the prospects for a Roth conversion in the 22% or 24% bracket....

Unless by doing so, the 32% bracket is avoided?

Looking at "spendable after-tax amount" instead of "taxes paid" may also be helpful.

[Cyclesafe]

In short: the new paper reverts to a more jaundiced view of the prospects for a Roth conversion in the 22% or 24% bracket....

Unless by doing so, the 32% bracket is avoided?

Looking at "spendable after-tax amount" instead of "taxes paid" may also be helpful.

+1

[sc9182]

Their disinclination "for the reluctant types" to Roth convert may be well-founded; leave them be.
LOL - almost feel like I am "targeted"

Prof. McQ - you've been kind/nice to say - by pre-paying Roth-conversion taxes -- one may be loaning the Govt -- taxes/monies which were otherwise NOT due yet (and some of which you may never owe - due to familial circumstances, and/or large-medical deductible expenses, SORR, large bouts of inflation and/or poor-market returns and such). I might say - you are being too nice and kind with your choice word "loan" ; As far I am concerned - those taxes pre-paid, are NEVER going to be returned - gone, poof -- forever! (BTW - thanks to all aggressive Roth-converters -- for being highly patriotic) I "almost" compare those pre-paid taxes to equivalent of paying "short-term capital gains" due to heavy-penchant for trading in their brokerage accounts. After a sufficiently long-enough time such traders realize that -- the "taxes-paid" were infact much larger portion than the net-monies they made over their high-trading stint. If they traded good stocks - they might be better off keeping those stocks (or ETFs) for long enough term to: 1) realize more gains by being in the market (than trading) 2) their taxes owed be much lower .. (and also, their net-monies in their pockets be larger too). I don't hate traders/betters - just don't want to be one

We do have Roths, do MBR (Mega Backdoor Roth), and in-future., may (or not) opportunistically convert some tIRA amounts to Roths. Not going to be overly optimistic, nor greedy for making all-in-to Roths however! Nor, fearful of future RMDs or single-brackets - even if IRMAAs impacts us - we plan to deal accordingly (then)

[kd2008]

I agree with the gist of the study. Having run various emoney scenarios, our only reason to do Roth conversions would be reducing RMDs for spouse while I am on ACA subsidy. The marginal rates may justify a Roth conversion but the dollar amounts are a rounding error for us. YMMV.

[Tom_T]

I look at Roth conversions as a way to possibly increase lifetime, after-tax income primarily for two of us while we're still around, then for the survivor after one is gone and, finally, for a tax-free inheritance after we're both gone.

Agreed. I've run the analysis using Pralana, with and without conversions. For us, it's not a rounding error: doing Roth conversions increases the final portfolio size by $200K to $300K depending on how I tweak the life expectancy. The breakeven point is when I'm 77. Of course it won't be that precise, but it's not a nothing burger.

[WoodSpinner]

Very interesting research paper! Mike Piper, the CPA and author of the Oblivious Investor blog, recently wrote that "Roth conversions simply do not tend to increase retirement safety." He added: "And that has been my experience with a broad range of clients — ranging from super financially secure to more borderline, with varying ages upon retirement, and with a wide variety of portfolio sizes and compositions."
https://obliviousinvestor.com/what-roth ... o-achieve/

Personally, I think Mike is incorrect about this BUT it may depend on individual circumstances and priorities.

In my case, I retired with 95% of assets in a Traditional IRA, 1% in Roth, 4% in Taxable.

By executing early Roth Conversions I was able to significantly shift this ratio and reduce the Risks to Retirement through various levels of Spending Shock. For me, unplanned changes in spending represent both a significant market and tax risk that is magnified based on Asset Location.

In essence having assets in a Roth provides a set of better options to deal with the inherent uncertainty in life.

Lastly, one key metric for Roth Conversions executed for tax savings is an estimated Break Even Age (e.g. how old would you be before you actually saw a net reduction in Taxes over doing no conversions). Lots of uncertainty in the analysis but my results generally showed it happens well into my 80s. Given expected longevity and the uncertainties of the future this was a much poorer driver for Conversions than reducing the risks of spending shocks.

WoodSpinner

[ThankYouJack]

In short: the new paper reverts to a more jaundiced view of the prospects for a Roth conversion in the 22% or 24% bracket....

Unless by doing so, the 32% bracket is avoided?

Looking at "spendable after-tax amount" instead of "taxes paid" may also be helpful.

+1

+2.

I plan on converting @ 24% (~29% with state) this year, even though it's a banner year income wise. A number of factors come into play with the decision.


The paper says:

RMD-reducing Roth conversions are a risky bet. Payoff can be minimal as well as slow.

However not converting can also be a risky bet...if one defers @ X% and is later taxed @ X+Y%. This is what I want to avoid

[Tom_T]

Lastly, one key metric for Roth Conversions executed for tax savings is an estimated Break Even Age (e.g. how old would you be before you actually saw a net reduction in Taxes over doing no conversions). Lots of uncertainty in the analysis but my results generally showed it happens well into my 80s. Given expected longevity and the uncertainties of the future this was a much poorer driver for Conversions than reducing the risks of spending shocks.

My breakeven is 77 under one set of Roth conversion possibilities. Given that my wife is four years younger, then she would only be 73 at that time, potentially giving her many years of reduced taxes.

[WoodSpinner]

I look at Roth conversions as a way to possibly increase lifetime, after-tax income primarily for two of us while we're still around, then for the survivor after one is gone and, finally, for a tax-free inheritance after we're both gone.

Agreed. I've run the analysis using Pralana, with and without conversions. For us, it's not a rounding error: doing Roth conversions increases the final portfolio size by $200K to $300K depending on how I tweak the life expectancy. The breakeven point is when I'm 77. Of course it won't be that precise, but it's not a nothing burger.

Interesting, I had about the same magnitude of difference in our Tax Adjusted Portfolio and felt it was a nothing burger (under 10% of starting portfolio size). Given the levels of uncertainty in the modeling it wasn’t enough to make me want to take the risk.

WoodSpinner

[tibbitts]

I look at Roth conversions as a way to possibly increase lifetime, after-tax income primarily for two of us while we're still around, then for the survivor after one is gone and, finally, for a tax-free inheritance after we're both gone.

Agreed. I've run the analysis using Pralana, with and without conversions. For us, it's not a rounding error: doing Roth conversions increases the final portfolio size by $200K to $300K depending on how I tweak the life expectancy. The breakeven point is when I'm 77. Of course it won't be that precise, but it's not a nothing burger.

What's the current portfolio size where you're seeing that difference, and how many years until "the end" are there? Certainly with the size of many Bogleheads portfolios at retirement, that amount would indeed be a rounding error after a couple of decades.

[teen persuasion]

I find that looking at marginal tax rate is more useful than tax bracket.

We've always been in a low bracket, but credit phaseouts make for a high marginal rate, approaching 50% at times - we obviously tax deferred at that rate.

Now we are in a semi retired phase - DH is retired, I'm still working part-time, and have a dependent in college (AGI limitations due to aid considerations). Still have relatively high marginal rate, yet can do limited conversions, only tax cost is state tax 4-5%.

Next phase is no earned income, no dependent, ACA subsidies to consider. Our only taxable income will be Roth conversions. I'm planning conversions up to about the top of the 10% bracket (no changes expected)/top of expected state zero bracket (standard deduction + 2 $20k retirement withdrawal exemptions)/<250% FPL to be eligible for Essential plan coverage (zero premiums).

At 70 when we start SS, reduce conversions a bit to keep taxation level, compensating for the SS taxation algorithm.

When RMDs begin at 75, hopefully RMDs will be no larger than desired for supplementing SS for spending (don't need to be shifted to a taxable account, creating more unneeded income), and taxes are still relatively level. If any extra room, continue converting.

The goal is to leave the surviving spouse with mostly Roth assets, and manageable RMDs and taxes, not a big jump in taxes. Hardest part is guessing when that might happen - will we have many years to convert at MFJ rates, or few?

The stacking of ACA considerations and the SS taxation algorithm using non-indexed factors again leads us to a high marginal tax rate.

[bsteiner]

Probably the largest benefit of the Roth conversion is that by paying the tax on the conversion out of other money, you're efffectively making a substantial additional contribution.

People in states with state estate (or inheritance) taxes avoid the double tax problem as to the state estate tax since the Section 691(c) income tax deduction for estate taxes only applies to the Federal estate tax, but not to the state estate tax. That benefit is substantial for IRA owners in a high state estate tax bracket.

Our clients almost always provide for their children in trust rather than outright in their Wills. In the case of a traditional IRA, the trustees have to choose between making distributions to save income taxes (which throws the distributions into the child's estate and exposes them to the child's creditors and spouses) or retaining the IRA distributions (and usually paying more income tax). The Roth conversion avoids that tradeoff.

The tax bracket savings is often just a bonus. But note that in addition to reducing tax rates a few points, the Tax Cuts and Jobs Act also doubled the width of additional joint return brackets for 2018-2025. The 24% bracket on a joint return goes up to $383,900 in 2024. So many married IRA owners can do substantial conversions in 2024 and 2025 without going into one of the high brackets.

[Tom_T]

I look at Roth conversions as a way to possibly increase lifetime, after-tax income primarily for two of us while we're still around, then for the survivor after one is gone and, finally, for a tax-free inheritance after we're both gone.

Agreed. I've run the analysis using Pralana, with and without conversions. For us, it's not a rounding error: doing Roth conversions increases the final portfolio size by $200K to $300K depending on how I tweak the life expectancy. The breakeven point is when I'm 77. Of course it won't be that precise, but it's not a nothing burger.

What's the current portfolio size where you're seeing that difference, and how many years until "the end" are there? Certainly with the size of many Bogleheads portfolios at retirement, that amount would indeed be a rounding error after a couple of decades.

The ending portfolio size is $2.3 million. The reason the difference is so large is that it really accelerates after my breakeven age. Our Social Security plus pension will cover just about all our expenses, so without conversions, the IRAs continue to grow and throw off large RMDs, and our SS gets taxed more. With this one particular conversion strategy, basically all of the tax-deferred balance is converted by age 77, so the savings (which include lower SS taxes) add up quickly when there are no RMDs for 15 years

Now, I may not choose to follow this Pralana plan, since it involves doing conversions into our 70s to cover both my account and my wife's.

[loadba:lanced]

Probably the largest benefit of the Roth conversion is that by paying the tax on the conversion out of other money, you're efffectively making a substantial additional contribution.

Yes this is a big justification for me to Roth convert at 22% up to top of IRMAA tier 1. My assets are approximately 50% taxable, 35% pre-tax, and 15% Roth. Very easy for me to pay for the conversion out of my taxable.

[dcabler]

I look at Roth conversions as a way to possibly increase lifetime, after-tax income primarily for two of us while we're still around, then for the survivor after one is gone and, finally, for a tax-free inheritance after we're both gone.

Agreed. I've run the analysis using Pralana, with and without conversions. For us, it's not a rounding error: doing Roth conversions increases the final portfolio size by $200K to $300K depending on how I tweak the life expectancy. The breakeven point is when I'm 77. Of course it won't be that precise, but it's not a nothing burger.

In my case I always target a final $0 with amortization, though that's not required by amortization math. So anything that shows up as a benefit does so by increasing available after-tax spending. In terms of cumulative tax paid vs. my baseline no-conversion plan, my breakeven is around age 78.

Cheers.

[Jack FFR1846]

Something to be aware of is that the very common assertion that in retirement, you will, of course be in a much lower tax bracket can be completely wrong. I know in my case, for my entire working career, every 401k seminar at work at lunch time has said that. Not said that it MAY be lower but that it absolutely WILL be lower. Being a typical, oversaving Boglehead, this has turned out to not be true in my own retirement. Looking farther ahead than retirement day is no upon me and I've done my calculations, noting that my pre-tax nest egg is way too big and without dealing with it, 3 things happen.
1) beyond 2025, the tax brackets, thus my tax goes up.
2) Social security at 70 and RMDs at 73 will skyrocket both my income and taxes (much beyond any ever paid while working)
3) IRMAA crashes out of that nest egg, breaking the shell and taking more from me.

One potential solution is Roth conversions and I'm doing them up to just under the IRMAA limit as I am on Medicare now. Don't forget inheritance of pre-tax IRAs because those can reduce what you can Roth convert. We're running into that this year.

I've met some of my former co-workers and I've expressed to all of them that they really should consider the Roth 401k option. Some already have. Looking back, I honestly believe that I should have done the 401k only to the top needed to get the match from my employer, which in about half my employers was zero anyways. Direct Roth and Roth conversions, had they been started decades earlier with money going into a taxable account and maybe more iBonds would have been better in my opinion. I will be going to a Cars and Coffee this weekend, hoping to find that DeLorean that I might test drive and get to 88 mph and do it all over again.

[jeffyscott]

4. Conversions intended to reduce RMDs and deliver a payoff during the client’s life are almost certain to be disappointing unless the conversion tax rate is in single digits and the tax gap is a multiple of it and in double digits. The base case in this paper violated both conditions. The middle bracket converter has to live long enough, with no untoward personal events or unexpected legislation, for a payoff to be received while alive. Most of the time, these conversions will represent a loan to the government not fully paid off even at the taxpayer’s demise, with any payoff from the conversion going to the heirs.

In short: the new paper reverts to a more jaundiced view of the prospects for a Roth conversion in the 22% or 24% bracket, as in the initial working paper.

Do you really mean "digits" there (single digits being 9% or less) or do you mean tax rates that start with a 1 (or less) as in the "easy no-bake" rules of thumb that you gave in a discussion here some time ago?

I am wondering because in the "good bets" section, #3 indicates that conversion at 12% can be a good bet:

Clients who can convert at 12 percent or less today and have every reason to expect at least moderate amounts of taxable income in the future that might be taxed at 12 percent or more, as from a combination of Social Security, pension, and RMD income. Here the attractiveness lies not in the certainty of payoff, but in the low risk of loss: future income could fall a little short of expectation, of course, and be taxed at only 10 percent; or future tax legislation could further lower the 12 percent rate. But any drop is likely to be small, even as the odds are good that the future tax rate on the marginal dollar in RMDs will be higher than 12 percent.

[Gaston]

In short: the new paper reverts to a more jaundiced view of the prospects for a Roth conversion in the 22% or 24% bracket, as in the initial working paper.

Thank you for sharing this paper. I've used various tools to assess the benefits of Roth conversions. Each showed that in my case, the benefit would be marginal. But so much is said in favor of Roth conversions, that I felt I must have been doing something wrong in my own analyses. Your paper helps me understand why Roth conversions likely are not the best answer for me.

[Random Musings]

McQ,

Very interesting read. I have done some prelim analysis with Roth conversions, and have also come to the conclusion that right now before retirement it is more of a wash (which surprised me a but), but if current tax rates hold (fingers crossed), their may be opportunities during the retirement phase before taking SS at 70 and change.

RM

[Pickles_Ice_Cream]

If the client fails to predict correctly the direction of future tax legislation and/or misjudges their own income trajectory, substantial losses may be on tap.

Conversely, if assumptions about tax rate and income trajectory are incorrect, substantial gains may be on tap. Seems disingenuous to mention possible losses without mentioning possible gains.

In my case studies, biggest variable is the assumption on rate of return. 6% real return vs 2% real return can result in very different final results.

Another argument against Roth Conversions is that large Conversions early in Retirement increases Sequence of Returns Risk (SORR.) Might be worth avoiding conversions even if it reduces expected final net worth if it also reduces risk of ruin.

Good paper, though.

[9-5 Suited]

I have ended up filing Roth Conversions in a low importance tier for our own personal situation. We have no real bequest motive, and during life the benefits accrue under the condition that one's tIRA expands significantly in value by late life. RMDs just aren't that onerous pre-85 unless the tIRA is gigantic. But I like to think about risk in terms of consequences - that's a hugely successful situation to be in, and not something I worry much about. I actually wouldn't even mind paying a little extra in taxes at that point if it came to that. Part of returning some of my good fortune back to society.

We are doing some tax location optimization to have more of our TIPS ladder in the t-IRA, though, which I consider a reasonable protective measure. Any charitable giving we do later in life would also be in the form of QCDs, another simple solution. Also, as many have mentioned on the forum before, long-term care costs can be funded by tIRA dollars with very little tax cost if you're about the AGI threshold, so that's yet another plausible outlet for the funds.

I'll likely do conversions in the 10%-15% brackets (unless I just opt not to care enough), but higher than that I'm just skeptical of the value of the upfront tax cost in our situation.

[jeffyscott]

In my case studies, biggest variable is the assumption on rate of return. 6% real return vs 2% real return can result in very different final results.

The conversions, themselves, can change what you might expect. If you selectively convert stocks and are left with only bonds in the traditional account, then a 2% (or less) real return would seem to be a reasonable assumption based on current TIPS yields. The range of possible returns is also much smaller once there are only fixed income assets remaining in accounts that will be subject to RMDs.

[Billy C]

Roth conversions can be an effective strategy for reducing federal estate taxes, particularly since the estate exemption limit is set to be cut approximately in half beginning January 1, 2026. Income tax rates are also set to increase on that date. The estate tax can be as high as 40%.

Another benefit of Roth conversions is creditor protection, which could come into play with a devastating automobile accident for example. By making a Roth conversion one is increasing the amount of money which is protected. This scenario is unlikely to occur if one has umbrella insurance, but not impossible.

My biggest investing regret is not starting Roth conversions sooner, particularly after the Tax Cuts and Jobs Act was passed in 2017. That was a missed opportunity on my part.

[tibbitts]

Roth conversions can be an effective strategy for reducing federal estate taxes, particularly since the estate exemption limit is set to be cut approximately in half beginning January 1, 2026. Income tax rates are also set to increase on that date. The estate tax can be as high as 40%.

Another benefit of Roth conversions is creditor protection, which could come into play with a devastating automobile accident for example. By making a Roth conversion one is increasing the amount of money which is protected. This scenario is unlikely to occur if one has umbrella insurance, but not impossible.

My biggest investing regret is not starting Roth conversions sooner, particularly after the Tax Cuts and Jobs Act was passed in 2017. That was a missed opportunity on my part.

I had thought creditor protection for IRAs of any kind was mostly based on state law but I'm not an expert. I also thought all IRAs were afforded equal protection within a state, although you might be referring to the fact that after a conversion you'll have less unprotected money to lose, having used it to pay taxes. So maybe you're "increasing the amount of money which is protected", but you're decreasing the amount of money that isn't protected..? Of course a significant judgement might change your financial situation enough that the Roth conversion would have been entirely unnecessary in the first place.

[Billy C]

Roth conversions can be an effective strategy for reducing federal estate taxes, particularly since the estate exemption limit is set to be cut approximately in half beginning January 1, 2026. Income tax rates are also set to increase on that date. The estate tax can be as high as 40%.

Another benefit of Roth conversions is creditor protection, which could come into play with a devastating automobile accident for example. By making a Roth conversion one is increasing the amount of money which is protected. This scenario is unlikely to occur if one has umbrella insurance, but not impossible.

My biggest investing regret is not starting Roth conversions sooner, particularly after the Tax Cuts and Jobs Act was passed in 2017. That was a missed opportunity on my part.

I had thought creditor protection for IRAs of any kind was mostly based on state law but I'm not an expert. I also thought all IRAs were afforded equal protection within a state, although you might be referring to the fact that after a conversion you'll have less unprotected money to lose, having used it to pay taxes. So maybe you're "increasing the amount of money which is protected", but you're decreasing the amount of money that isn't protected..? Of course a significant judgement might change your financial situation enough that the Roth conversion would have been entirely unnecessary in the first place.

Correct.

I’m not an expert either. It’s my understanding that the asset protection of Roth accounts varies depending on the type of account (401k vs IRA), circumstances, and state law. People would need to check for themselves whether this strategy would help or harm them, depending on where they live.

By paying the taxes in advance for a Roth conversion you are increasing the amount of money which is protected since the entire amount in the Roth is yours and not subject to taxes, unlike a traditional IRA or 401k. In other words $100,000 in a Roth is more valuable than $100,000 in a traditional IRA.

Or as better said by bsteiner earlier in the thread, by paying the tax on the Roth conversion out of other money, you're efffectively making a substantial additional contribution.

[tibbitts]

Roth conversions can be an effective strategy for reducing federal estate taxes, particularly since the estate exemption limit is set to be cut approximately in half beginning January 1, 2026. Income tax rates are also set to increase on that date. The estate tax can be as high as 40%.

Another benefit of Roth conversions is creditor protection, which could come into play with a devastating automobile accident for example. By making a Roth conversion one is increasing the amount of money which is protected. This scenario is unlikely to occur if one has umbrella insurance, but not impossible.

My biggest investing regret is not starting Roth conversions sooner, particularly after the Tax Cuts and Jobs Act was passed in 2017. That was a missed opportunity on my part.

I had thought creditor protection for IRAs of any kind was mostly based on state law but I'm not an expert. I also thought all IRAs were afforded equal protection within a state, although you might be referring to the fact that after a conversion you'll have less unprotected money to lose, having used it to pay taxes. So maybe you're "increasing the amount of money which is protected", but you're decreasing the amount of money that isn't protected..? Of course a significant judgement might change your financial situation enough that the Roth conversion would have been entirely unnecessary in the first place.

Correct.

I’m not an expert either. It’s my understanding that the asset protection of Roth accounts varies depending on the type of account (401k vs IRA), circumstances, and state law. People would need to check for themselves whether this strategy would help or harm them, depending on where they live.

By paying the taxes in advance for a Roth conversion you are increasing the amount of money which is protected since the entire amount in the Roth is yours and not subject to taxes, unlike a traditional IRA or 401k. In other words $100,000 in a Roth is more valuable than $100,000 in a traditional IRA.

Or as better said by bsteiner earlier in the thread, by paying the tax on the Roth conversion out of other money, you're efffectively making a substantial additional contribution.

Absolutely $1 in Roth is almost always worth more than $1 in deferred (unless the deferred ends up being donated or used for deductible expenses.) However the "pay out of taxable" "other money" option can still involve taxes. 70-80% of my taxable accounts represent deferred capital gains for example, and for many of us any large conversion would trigger NIIT on top of capital gains tax.

[Billy C]

Roth conversions can be an effective strategy for reducing federal estate taxes, particularly since the estate exemption limit is set to be cut approximately in half beginning January 1, 2026. Income tax rates are also set to increase on that date. The estate tax can be as high as 40%.

Another benefit of Roth conversions is creditor protection, which could come into play with a devastating automobile accident for example. By making a Roth conversion one is increasing the amount of money which is protected. This scenario is unlikely to occur if one has umbrella insurance, but not impossible.

My biggest investing regret is not starting Roth conversions sooner, particularly after the Tax Cuts and Jobs Act was passed in 2017. That was a missed opportunity on my part.

I had thought creditor protection for IRAs of any kind was mostly based on state law but I'm not an expert. I also thought all IRAs were afforded equal protection within a state, although you might be referring to the fact that after a conversion you'll have less unprotected money to lose, having used it to pay taxes. So maybe you're "increasing the amount of money which is protected", but you're decreasing the amount of money that isn't protected..? Of course a significant judgement might change your financial situation enough that the Roth conversion would have been entirely unnecessary in the first place.

Correct.

I’m not an expert either. It’s my understanding that the asset protection of Roth accounts varies depending on the type of account (401k vs IRA), circumstances, and state law. People would need to check for themselves whether this strategy would help or harm them, depending on where they live.

By paying the taxes in advance for a Roth conversion you are increasing the amount of money which is protected since the entire amount in the Roth is yours and not subject to taxes, unlike a traditional IRA or 401k. In other words $100,000 in a Roth is more valuable than $100,000 in a traditional IRA.

Or as better said by bsteiner earlier in the thread, by paying the tax on the Roth conversion out of other money, you're efffectively making a substantial additional contribution.

Absolutely $1 in Roth is almost always worth more than $1 in deferred (unless the deferred ends up being donated or used for deductible expenses.) However the "pay out of taxable" "other money" option can still involve taxes. 70-80% of my taxable accounts represent deferred capital gains for example, and for many of us any large conversion would trigger NIIT on top of capital gains tax.

Yes, I’m in a similar position as most of my taxable accounts also consist of deferred capital gains. I’ve never sold a share of anything I’ve purchased, and certainly wouldn’t do that to fund a Roth conversion. I’ve been living off dividends since I retired early (in 2012), and using any excess dividends, beyond what I need to pay for living expenses, to fund Roth conversions. But I waited too long to do so. Like I said, definitely my biggest investing regret. I was too conservative and worried about SORR.

[Exchme]

The winning strategy won't change whether you do the analysis in today's $ using some deflator to reduce future values to NPV or whether you use the traditional approach of simply look at terminal values and correct for remaining embedded tax liability.

While there are certainly people that will always be in the 12% or lower bracket that won't benefit much from Roth Conversions and folks in the top couple of brackets that also won't benefit much, there is a cohort in between that benefits from them, especially if they pay the taxes on the conversion out of taxable.

The examples in the paper are unconvincing since they vastly oversimplify the tax code, especially given that there are tools that are low cost (like Pralana) and even free (like RPM) that include vastly more of the tax code. Relevant parts of the tax code omitted from the paper include IRMAA, LTCG tax phase-in, NIIT, SS benefit tax phase-in, AMT, reduction of tax drag in taxable, capital gains taxes, and a step-up basis when spouses pass. The available tools like RPM and Pralana are not perfect, but will produce a much better answer. Obviously all analysis of the future is subject to the usual assumptions about life expectancy, constancy of the tax code, future returns, etc.

Since identifying the source and magnitude of the benefits of Roth Conversions is clearly a passion of Prof McQ, my suggestion is that McQ work with the developer of one of the tools, build out any missing parts of the tax code and test what happens if you start removing parts of the tax code to see which things are the real drivers.

In our case, the tools show that Roth Conversions will generate hundreds of thousands of $ of inflation-adjusted additional value to heirs in our case by converting into the 22 and 24% bracket while paying taxes out of taxable. My impression, based on lots of hours of running various cases in RPM and Pralana (and my own modfications to RPM to look at capital gains, step up basis on death and heirs' taxes) is that the sources of return are reduction in tax drag, minimizing IRMAA, minimizing SS benefit taxation, reducing income after expiration of TCJA and avoidance of high brackets later, especially if one spouse passes early.

[986racer]

The winning strategy won't change whether you do the analysis in today's $ using some deflator to reduce future values to NPV or whether you use the traditional approach of simply look at terminal values and correct for remaining embedded tax liability.

While there are certainly people that will always be in the 12% or lower bracket that won't benefit much from Roth Conversions and folks in the top couple of brackets that also won't benefit much, there is a cohort in between that benefits from them, especially if they pay the taxes on the conversion out of taxable.

The examples in the paper are unconvincing since they vastly oversimplify the tax code, especially given that there are tools that are low cost (like Pralana) and even free (like RPM) that include vastly more of the tax code. Relevant parts of the tax code omitted from the paper include IRMAA, LTCG tax phase-in, NIIT, SS benefit tax phase-in, AMT, reduction of tax drag in taxable, capital gains taxes, and a step-up basis when spouses pass. The available tools like RPM and Pralana are not perfect, but will produce a much better answer. Obviously all analysis of the future is subject to the usual assumptions about life expectancy, constancy of the tax code, future returns, etc.

Since identifying the source and magnitude of the benefits of Roth Conversions is clearly a passion of Prof McQ, my suggestion is that McQ work with the developer of one of the tools, build out any missing parts of the tax code and test what happens if you start removing parts of the tax code to see which things are the real drivers.

In our case, the tools show that Roth Conversions will generate hundreds of thousands of $ of inflation-adjusted additional value to heirs in our case by converting into the 22 and 24% bracket while paying taxes out of taxable. My impression, based on lots of hours of running various cases in RPM and Pralana (and my own modfications to RPM to look at capital gains, step up basis on death and heirs' taxes) is that the sources of return are reduction in tax drag, minimizing IRMAA, minimizing SS benefit taxation, reducing income after expiration of TCJA and avoidance of high brackets later, especially if one spouse passes early.

Agreed with you.

I felt the 2021 paper from Prof McQ was better as it mentioned those other moving parts that make this a difficult calculation, such as paying taxes from outside the TDA, effects of conversions on IRMAA brackets, and a mention that tax brackets adjust up by inflation (but slower than the normal expected return of the equity market).

Without covering all of those complexities, I'm not sure of the point of the new publication.

As far as I can tell, it seems like it is making a point that the additional NPV that is brought to the portfolio is mostly seen by the heirs and not by the original Roth converter (provided we ignore all of the complexities). But so what? The way the exercise is done, it's assumed that the original Roth converter doesn't need that money anyhow and so must have type of legacy intention. If it were any other way, then the exercise would show some unexpected expense in the later years that causes the Roth converter to need to pull a large lump sum from the account. Then there could be an analysis that perhaps the Roth converter does better by locking a guaranteed tax rate now as opposed to hoping for a good tax rate later.

[sc9182]

The tax optimization is a bit more complicated than one “such” tool provides. ACA credits, low-income various breaks/credits, FAFSA, Medicaid eligibility etc on low-income/low-assets side. Betcha your preferred software ain’t account for many of these scenarios!?

If someone mentions IRMAA and social-security taxation optimization in one single sentence - it sounds incongruous to me (then again I may have failed to account for that single/widowed mom in West-Virginia — sorry)

Also, many a folks happily aggressively Roth-convert paying taxes out of taxable/brokerage accounts; nice and all, got couple of Qs: 1) do they ever need living expenses to live-on 2) mysteriously for such folks how come they never have/show latent/built-in capital-gains on their brokerage sales and tax on those on top of Roth-conversion taxes !? (may be they got their investments wrong thus not to have cap-gains - which is worse of the symptoms than Roth tax-optimization they are trying to achieve)

At higher end - some folks are NOT (or in some cases., not-yet) affected by IRMAA — so, their Roth conversion brackets could get bigger. Also, TLH, limited portfolio margin, QBI, 1031 exchanges, evaporated depreciation recapture at death, carried-interest, using HSAs as tax-deferred & Tax-free amp'ed up Roths, large 529s for generational wealth-transfer, gifting LTCG assets to low-bracket kin/family, Donating LTCG assets to your household favorite charity or alma-mater (likely, getting Corporate $1 to $1 matched donation on-top) and limited amount of term-life may be able to add some value for such HHNI folks. Geo-arbitrage also a potential winner for many a folks. But, many BH’er forgoe this benefit mostly due to comforts/familial reasons — but, then, don’t come around to claim Roth conversions even in high-taxed states made sense to them - no matter. Also - many family situations are hard to predict/control: disability, health, large-deductible medical expenses, divorce, re-marriage and such;

As for taxation and future tax-rates going to be higher (citing TCJA sunset) - for the past 20–30-40 some years, as I understood about taxes/tax-rates., they mostly went down or remained steady — rather than sudden spikes of increase. Add to that some additional tax-rebates such as increased child tax credit, Solar and/or EV, and energy tax-rebates/credits and such — our overall taxes (and effective rate) have gone down over the decades - rather than going UP.

Then: there are market gyrations, SORR, bouts of inflation, pandemics and such - which causes much more portfolio/withdrawals volatility — than one can anticipate/control.

For almost of everything else., there are nice "tools" to help optimize Roth-conversions.

Yes - having diversification of accounts helps; and also never touching and leaving Roth monies for legacy reasons; but "all-in on Roth" — ain’t appeal to us ..

[jeffyscott]

As for taxation and future tax-rates going to be higher (citing TCJA sunset) - for the past 20–30-40 some years, as I understood about taxes/tax-rates., they mostly went down or remained steady — rather than sudden spikes of increase. Add to that some additional tax-rebates such as increased child tax credit, Solar and/or EV, and energy tax-rebates/credits and such — our overall taxes (and effective rate) have gone down over the decades - rather than going UP.

Yes, going back at least 40 years I have heard over and over again that tax rates will have to go up, yet ours have done nothing but go down. I think at higher income levels they've gone up and down in various periods during that time, but for those who have lived in tax brackets between 0-25%, I don't think that there has been anything but decreases.

I don't know what the software includes, but one thing it is certainly missing is that it cannot know the future. So to me, it's not worth the effort to enter everything in order to generate more guesses about what might or might not pay off. While I'm sure you can vary the parameters, in the end it's still going to uncertain whether or not conversions will pay off.

The paper helps me realize that I am betting about 18% of about 1/3 of our assets (so around 6% of those financial assets) that converting in the 12% bracket will pay off (most likely for my kids). I've completed about 85% of that already and will do the last increment next year as planned.

I'd decided on my own that going into the next tax bracket was not worth it for a number of reasons, but now I can look at it as a decision that it was not worth wagering 28% of any additional conversion amounts on a less likely to pay off bet.

[Exchme]

The tax optimization is a bit more complicated than one “such” tool provides. ACA credits, low-income various breaks/credits, FAFSA, Medicaid eligibility etc on low-income/low-assets side. Betcha your preferred software ain’t account for many of these scenarios!?

ACA premium credits are covered in the commercial tool, including the current ramps. The free tool calculates whether are eligible and since it is modifiable, you can write you own code in the year-by-year expenses if you wish. For Medicaid, I presume the cost is zero, so that is trivial to set up in either program. Like other low income benefits, in some cases the best answer is to get low income benefits each year, for others the best might be to yo-yo up and down and for others worrying about low income benefits would have been pennywise and pound foolish.

Our kids were long out of school, so FAFSA wasn't relevant to us, was it important to you? My impression, which could of course be mistaken is that it would be a relatively rare combination of wealthy enough to retire and considering conversions at the 22-24% bracket (remember we are talking about McQ's paper), have children in college, but not enough time to wait until the kids are out and also be poor enough that other taxpayers will pay for their children's schooling.

If someone mentions IRMAA and social-security taxation optimization in one single sentence - it sounds incongruous to me (then again I may have fail to
account for that single/widowed mom in West-Virginia — sorry)

Our plan benefits from both. Who knows, maybe stocks will skyrocket and we'll be over the phase-in, but using my return forecast, it looks like getting Roth Conversions done in the years between claiming SS and RMD start in order to avoid full taxation of SS benefits is the winner.

Also, many a folks happily aggressively Roth-convert paying taxes out of taxable/brokerage accounts; nice and all, got couple of Qs: 1) do they ever need living expenses to live-on 2) mysteriously for such folks how come they never have/show latent/built-in capital-gains on their brokerage sales !? (may be they got their investments wrong - which is worse of the symptoms than tax-optimization they are trying to achieve)

Tracking capital gains and having you pay taxes on them when you sell is built in to the commercial tool I mentioned, though that tool doesn't cover the step-up basis on death. I added capital gains and the step-up basis to the free tool and it didn't make that much difference in our case (we had a misadventure with an advisor a number of years ago that reset the basis of a lot of things and we have some shares with relatively low gains). Since my modification of the free tool was unwieldy to maintain, I went back to the commercial tool, but just upped the minimum improvement that a Roth conversion must make before I consider doing it. I have bugged the developer to try to get him to add the step-up basis. I also noted in my comment that if McQ really wants to get to the bottom of things, he should work with the developers to incorporate this.

[chemocean]

Probably the largest benefit of the Roth conversion is that by paying the tax on the conversion out of other money, you're efffectively making a substantial additional contribution.

People in states with state estate (or inheritance) taxes avoid the double tax problem as to the state estate tax since the Section 691(c) income tax deduction for estate taxes only applies to the Federal estate tax, but not to the state estate tax. That benefit is substantial for IRA owners in a high state estate tax bracket.

Our clients almost always provide for their children in trust rather than outright in their Wills. In the case of a traditional IRA, the trustees have to choose between making distributions to save income taxes (which throws the distributions into the child's estate and exposes them to the child's creditors and spouses) or retaining the IRA distributions (and usually paying more income tax). The Roth conversion avoids that tradeoff.

The tax bracket savings is often just a bonus. But note that in addition to reducing tax rates a few points, the Tax Cuts and Jobs Act also doubled the width of additional joint return brackets for 2018-2025. The 24% bracket on a joint return goes up to $383,900 in 2024. So many married IRA owners can do substantial conversions in 2024 and 2025 without going into one of the high brackets.

Your analysis does not seem to apply if the Roth's are intended to be inherited by adult children.
As Bruce mentioned, Squeaking direct distribution into the 10-years of an inherited IRA will likely cause even higher taxes than at the conversion rate if the children are fairly successful. Distributing the traditional IRA into a Trust for control or asset protection produces even higher taxes.

The OP's next paper could address this issue. The future analysis would include a whole new set of variables that could be modeled under various scenarios (early death of original owners, income of adult children (and their spouses), their filing status of adult children, inheritance directly or through a trust, etc.). Probably can get several papers out this analysis. Make sure you acknowledge my suggestion in the acknowledgement section.

[Svensk Anga]

Also, many a folks happily aggressively Roth-convert paying taxes out of taxable/brokerage accounts; nice and all, got couple of Qs: 1) do they ever need living expenses to live-on 2) mysteriously for such folks how come they never have/show latent/built-in capital-gains on their brokerage sales and tax on those on top of Roth-conversion taxes !? (may be they got their investments wrong thus not to have cap-gains - which is worse of the symptoms than Roth tax-optimization they are trying to achieve)

I have met a lot of living expenses including substantial Roth conversion taxes while liquidating taxable brokerage at the 0% LTCG rate. For a couple MFJ, there is a good bit of space available at 0%. I would sell a bunch one year to the top of the 0% bracket, then live on the proceeds for 2 or 3 years, doing conversions in the years when I did not realize capital gains. Depending on how low the basis is, there can be a good bit of sales proceeds relative to the bracket space consumed.

The first funds to go were the old active funds where I declined to realize gains while working. Being active, they distributed a lot of their gains along the way. Thus, there was a good ratio of sales proceeds to 0% bracket space consumed. There wasn't much pain in selling international index funds either, due to poor recent performance. Using specific ID can help capture more spending money per bracket space.

I have also liquidated I-series savings bonds. I was late to the I-bond party so these also had a good ratio of sales proceeds to bracket space consumed.

The taxable equity I have left is just VTI, with a rather low basis. I'm thinking one more sale in the 0% bracket to fund living expenses and conversion taxes, which will wipe out the bulk of it. I don't know that I would trust the step up in basis on death to endure and anyway, we accumulated these assets to fund our own retirement and so it makes sense to use them given 0 tax cost when well planned.

Edit to add. It is really easy to meet the IRS safe harbor withholding rules in the year after using most of one's bracket space for LTCG at 0%. Taxes in the gain years were minimal, so quarterly payments the next year were minimal as well.

[celia]

Prof. McQ - you've been kind/nice to say - by pre-paying Roth-conversion taxes -- one may be loaning the Govt -- taxes/monies which were otherwise NOT due yet (and some of which you may never owe - due to familial circumstances, and/or large-medical deductible expenses, SORR, large bouts of inflation and/or poor-market returns and such). I might say - you are being too nice and kind with your choice word "loan" ; As far I am concerned - those taxes pre-paid, are NEVER going to be returned - gone, poof -- forever!

I see it different than both of you. When you chose to tax-defer your contributions, it was as if the taxes you would have owed were being invested in the tax-deferred account too. The account is not all yours but part of it belongs to your Uncle Sam and possibly your state too. But you are investing the money for all of you. If you do well, all of you get more than the original taxes owed. In effect, the government is loaning YOU some money and eventually they want to get it back. And you need to pay them "interest", which is the growth that their part earned.

And you can still cover "familial circumstance" or medical expenses from other sources and still get the medical deduction. Just as we like to say that money is fungible, I say that the medical deduction is fungible too. You can pair it with taxes from a withdrawal from tax-deferred, some of your wages, or some of your taxable SS (as examples). The taxes on any one of these categories can be cancelled out by the medical deduction. It's just a mental accounting.

(BTW - thanks to all aggressive Roth-converters -- for being highly patriotic) I "almost" compare those pre-paid taxes to equivalent of paying "short-term capital gains" due to heavy-penchant for trading in their brokerage accounts.

Those taxes are not pre-paid because they were always owed ever since you started tax-deferring. You just get to decide when to pay them, now or at RMD time (or give the withdrawal to charity). The longer you wait and your account balance goes up, the more taxes you will have to pay. And if you withdraw from tax-deferred before your RMDs start, you pay the same taxes whether you put the assets in Roth, in a taxable account, or spend it. Once RMDs start, you can no longer put the RMD in Roth.

One side effect of delaying the withdrawals that is rarely mentioned is that as the RMD gets larger, it risks running out of room in the current tax bracket and part of the withdrawal becomes taxed at a higher rate.

After a sufficiently long-enough time such traders realize that -- the "taxes-paid" were infact much larger portion than the net-monies they made over their high-trading stint.

That would be like saying the taxes on your wages are more than your wages, when your taxes really reflect all the income sources shown on your tax return. The "taxes paid" can't be more than the investment itself.

--or did I misunderstand something?

[JamesSFO]

always love your posts, thoughtful and insightful!

[sc9182]

Also, many a folks happily aggressively Roth-convert paying taxes out of taxable/brokerage accounts; nice and all, got couple of Qs: 1) do they ever need living expenses to live-on 2) mysteriously for such folks how come they never have/show latent/built-in capital-gains on their brokerage sales and tax on those on top of Roth-conversion taxes !? (may be they got their investments wrong thus not to have cap-gains - which is worse of the symptoms than Roth tax-optimization they are trying to achieve)

I have met a lot of living expenses including substantial Roth conversion taxes while liquidating taxable brokerage at the 0% LTCG rate. For a couple MFJ, there is a good bit of space available at 0%. I would sell a bunch one year to the top of the 0% bracket, then live on the proceeds for 2 or 3 years, doing conversions in the years when I did not realize capital gains. Depending on how low the basis is, there can be a good bit of sales proceeds relative to the bracket space consumed.

The first funds to go were the old active funds where I declined to realize gains while working. Being active, they distributed a lot of their gains along the way. Thus, there was a good ratio of sales proceeds to 0% bracket space consumed. There wasn't much pain in selling international index funds either, due to poor recent performance. Using specific ID can help capture more spending money per bracket space.

I have also liquidated I-series savings bonds. I was late to the I-bond party so these also had a good ratio of sales proceeds to bracket space consumed.

The taxable equity I have left is just VTI, with a rather low basis. I'm thinking one more sale in the 0% bracket to fund living expenses and conversion taxes, which will wipe out the bulk of it. I don't know that I would trust the step up in basis on death to endure and anyway, we accumulated these assets to fund our own retirement and so it makes sense to use them given 0 tax cost when well planned.

Edit to add. It is really easy to meet the IRS safe harbor withholding rules in the year after using most of one's bracket space for LTCG at 0%. Taxes in the gain years were minimal, so quarterly payments the next year were minimal as well.

Good points - may be I should have prepended saying - the "hyper aggressive Roth-conversion goal seekers" with "IRMAA approaching/bursting-at-seems range. Not applicable to LTCG cap-gain harvesting folks in 0%-12% brackets .. if you are doing 0% LTCG gain-harvesting - kudos -- taxable is almost like Roth (even without the need for emptying it within 10-year post-TCJA rule - but 10-year post-death tax-free may help with Roth still);

In your case - it almost sounds like you have decent chunk in Taxable, with embedded gains; prolly not much in tIRAs ? (even if you have large tIRAs., may not be worried about RMDs and/or IRMAA impact .. ?).

You sure seem to be in sweet-spot for what you are doing - Kudos!

[sc9182]

The tax optimization is a bit more complicated than one “such” tool provides. ACA credits, low-income various breaks/credits, FAFSA, Medicaid eligibility etc on low-income/low-assets side. Betcha your preferred software ain’t account for many of these scenarios!?

ACA premium credits are covered in the commercial tool, including the current ramps. The free tool calculates whether are eligible and since it is modifiable, you can write you own code in the year-by-year expenses if you wish. For Medicaid, I presume the cost is zero, so that is trivial to set up in either program. Like other low income benefits, in some cases the best answer is to get low income benefits each year, for others the best might be to yo-yo up and down and for others worrying about low income benefits would have been pennywise and pound foolish.

Our kids were long out of school, so FAFSA wasn't relevant to us, was it important to you? My impression, which could of course be mistaken is that it would be a relatively rare combination of wealthy enough to retire and considering conversions at the 22-24% bracket (remember we are talking about McQ's paper), have children in college, but not enough time to wait until the kids are out and also be poor enough that other taxpayers will pay for their children's schooling.
..

Also, many a folks happily aggressively Roth-convert paying taxes out of taxable/brokerage accounts; nice and all, got couple of Qs: 1) do they ever need living expenses to live-on 2) mysteriously for such folks how come they never have/show latent/built-in capital-gains on their brokerage sales !? (may be they got their investments wrong - which is worse of the symptoms than tax-optimization they are trying to achieve)

Tracking capital gains and having you pay taxes on them when you sell is built in to the commercial tool I mentioned, though that tool doesn't cover the step-up basis on death. I added capital gains and the step-up basis to the free tool and it didn't make that much difference in our case (we had a misadventure with an advisor a number of years ago that reset the basis of a lot of things and we have some shares with relatively low gains). Since my modification of the free tool was unwieldy to maintain, I went back to the commercial tool, but just upped the minimum improvement that a Roth conversion must make before I consider doing it. I have bugged the developer to try to get him to add the step-up basis. I also noted in my comment that if McQ really wants to get to the bottom of things, he should work with the developers to incorporate this.

Exchme - first of all, thank you for your valuable posts and tooling work; We all benefit from that! I sure trust - what you said is correct in your case, hence did NOT quote "your thread" in my previous response.

My, if any, ire is to soothe-out aggressive-Roth converters - suggesting to do at just about any cost, RMDs fear-mongers (in 40 years your tIRA will grow to 3-5 millions etc), and/or in-future your taxes (and tax-rates) always goes-up -- kind of crowd.

Like someone oft mentions - aggressive Roth conversions, and/or leaving not much in tIRA -- may post asymmetric risk (Esp., if one needs withdrawals from tIRA towards their living/other expenses; if they designate/intend Roths, orall-in-Roths., those Roth amounts mainly for legacy purposes - yes, it could provide long-enough runway of joint-life+10years for Roths to start delivering slight advantage assuming all favorable outcomes fall in our favor)

We contribute to Roth (top-up), and then try to top MBR on top; We do like Roths (no-state-tax state)., just NOT the: do/convert-to Roths at just about any cost philosophy. Also, the tool-set is ever improving - like that, but, we prolly (long aways) intend to use them as a guideline - than gospel.

Again - keep it chugging!! We do like your value-addition - keep'em coming!

[sc9182]

Prof. McQ - you've been kind/nice to say - by pre-paying Roth-conversion taxes -- one may be loaning the Govt -- taxes/monies which were otherwise NOT due yet (and some of which you may never owe - due to familial circumstances, and/or large-medical deductible expenses, SORR, large bouts of inflation and/or poor-market returns and such). I might say - you are being too nice and kind with your choice word "loan" ; As far I am concerned - those taxes pre-paid, are NEVER going to be returned - gone, poof -- forever!

I see it different than both of you. When you chose to tax-defer your contributions, it was as if the taxes you would have owed were being invested in the tax-deferred account too. The account is not all yours but part of it belongs to your Uncle Sam and possibly your state too. But you are investing the money for all of you. If you do well, all of you get more than the original taxes owed. In effect, the government is loaning YOU some money and eventually they want to get it back. And you need to pay them "interest", which is the growth that their part earned.

And you can still cover "familial circumstance" or medical expenses from other sources and still get the medical deduction. Just as we like to say that money is fungible, I say that the medical deduction is fungible too. You can pair it with taxes from a withdrawal from tax-deferred, some of your wages, or some of your taxable SS (as examples). The taxes on any one of these categories can be cancelled out by the medical deduction. It's just a mental accounting.

(BTW - thanks to all aggressive Roth-converters -- for being highly patriotic) I "almost" compare those pre-paid taxes to equivalent of paying "short-term capital gains" due to heavy-penchant for trading in their brokerage accounts.

Those taxes are not pre-paid because they were always owed ever since you started tax-deferring. You just get to decide when to pay them, now or at RMD time (or give the withdrawal to charity). The longer you wait and your account balance goes up, the more taxes you will have to pay. And if you withdraw from tax-deferred before your RMDs start, you pay the same taxes whether you put the assets in Roth, in a taxable account, or spend it. Once RMDs start, you can no longer put the RMD in Roth.

One side effect of delaying the withdrawals that is rarely mentioned is that as the RMD gets larger, it risks running out of room in the current tax bracket and part of the withdrawal becomes taxed at a higher rate.

After a sufficiently long-enough time such traders realize that -- the "taxes-paid" were infact much larger portion than the net-monies they made over their high-trading stint.

That would be like saying the taxes on your wages are more than your wages, when your taxes really reflect all the income sources shown on your tax return. The "taxes paid" can't be more than the investment itself.

--or did I misunderstand something?

If one has decent tIRA, and mostly tIRA -- and that is needed to living-expenses in retirement (ie., no side-income, such as double-max pensions, or business, rental income and such) -- it takes fairy large amount of tIRA account to cause a concern. RMDs have been a feature, not a bug; they've been instituted nearly 40 years since (1986 ?) -- and when one contributes to tIRA/401k/tax-deferred such ., they ought to know from very beginning that RMDs are going to be impacting 10-20-30..50+ years hence. Its NOT like RMDs were instituted recently - also, if any, with TCJA changes and recent life-expectancy updates., the RMDs affect is mitigated decently until typical life-span.

If someone has ample monies, and double-max pensions, and add-to-that with max+delayed double SS -- yes, agree RMDs and tIRA may appear a nuisance (and in some cases, may be less tax-efficient too). Most of the RMD bashers appear to be self-proclaimed financial gurus - who made (and conitnue to make) their significant income/wealth/book/speaking-tours-money in their late 60s or 70s; Obviously, now those folks are in a stiff, can't easily convert their good-ole tIRA in their current/now higher bracket, let alone without going over IRMAA tiers 1-2-3 on so forth. In-a-way, they, themselves, of their own fate/success -- they, themselves couldn't predict/project as late as their 65th birthday!! Now, time to go on complaining tour. If one such guru proclaims tIRAs are bad, and RMDs are monsters -- I got news to tell'em -- they ain't Gurus at all -- because they've been numb all those many decades, and suddenly claims to have smarten'ed up; really !?

I look at how much we could get monies out of one large'ish tIRA account - in multiple angles:

• living expenses
  ability to handle SORR
  Better Asset protection
  Life's and markets un-expected turns
  Geo tax-arbitrage
  to take-care of families large un-reimbursed medical expenses
  FIRE, retire earlier - and enjoy the life a bit more freely
  to help/pay towards any LTC needs down the line
  Charity, QCDs
  Legacy - especially passing tIRAs amounts to needier or lower-bracket lineage
  We also try to make a bit of Brokerage bonus monies using our tIRAs; Ref: viewtopic.php?t=196884&start=8900

If any/lot more tIRA funds left - yes, I am ready to suffer dignity of paying slightly more taxes upon withdrawals if/when I buy our Yacht with those monies

If someone has lots more accounts, income-streams, assets that fill-up almost to IRMAA brackets -- yes, tIRA could be a bit of a nuisance - but, there are ways to minimize pains if you take any/some of the above mentioned points.

As for final point about - loan from/to Govt etc ., in many a cases., (if you don't have lot of side monies/incomes) -- some/good-bit-of tIRA withdrawals could be tax-efficient or may tax-free altogether! No - there is no pre-set loan/percentage deal with Govt on a set tax% as loan on your tIRA amounts.

[Walkure]

The proper discount rate must be the expected annualized rate of appreciation on the portfolio targeted for conversion. That is the rate that makes the client indifferent to paying tax now versus later (assuming constant tax rates throughout the distribution period). Here is an example: Suppose a $10,000 portfolio in a tax-deferred account is invested…

If any lower rate of discount were to be applied to future tax savings (whether inflation, the risk-free rate, or no discount at all), then Roth conversions would always pay off spectacularly if held for long enough.

As others have alluded, this is only the correct discount rate if the taxes are being paid out of the conversion. The easy way to account for the value of the added Roth “contribution” when paying with outside money is to use a discount rate equal to the after tax drag return on the same investment if it were being held in a taxable account.

[Phil DeMuth]

We are extremely fortunate to have Prof. McQuarrie as a contributor to this forum.

I was recently at the accountant's AICPA Engage convention and noticed that many luminaries were still recommending Roth conversions based on the blanket rules from the pre-McQuarrie period. It will be interesting to see how long it takes for these ideas to filter down. In the meantime, participants in the discussion here are at the cutting edge of the topic.

[smitcat]

The winning strategy won't change whether you do the analysis in today's $ using some deflator to reduce future values to NPV or whether you use the traditional approach of simply look at terminal values and correct for remaining embedded tax liability.

While there are certainly people that will always be in the 12% or lower bracket that won't benefit much from Roth Conversions and folks in the top couple of brackets that also won't benefit much, there is a cohort in between that benefits from them, especially if they pay the taxes on the conversion out of taxable.

The examples in the paper are unconvincing since they vastly oversimplify the tax code, especially given that there are tools that are low cost (like Pralana) and even free (like RPM) that include vastly more of the tax code. Relevant parts of the tax code omitted from the paper include IRMAA, LTCG tax phase-in, NIIT, SS benefit tax phase-in, AMT, reduction of tax drag in taxable, capital gains taxes, and a step-up basis when spouses pass. The available tools like RPM and Pralana are not perfect, but will produce a much better answer. Obviously all analysis of the future is subject to the usual assumptions about life expectancy, constancy of the tax code, future returns, etc.

Since identifying the source and magnitude of the benefits of Roth Conversions is clearly a passion of Prof McQ, my suggestion is that McQ work with the developer of one of the tools, build out any missing parts of the tax code and test what happens if you start removing parts of the tax code to see which things are the real drivers.

In our case, the tools show that Roth Conversions will generate hundreds of thousands of $ of inflation-adjusted additional value to heirs in our case by converting into the 22 and 24% bracket while paying taxes out of taxable. My impression, based on lots of hours of running various cases in RPM and Pralana (and my own modfications to RPM to look at capital gains, step up basis on death and heirs' taxes) is that the sources of return are reduction in tax drag, minimizing IRMAA, minimizing SS benefit taxation, reducing income after expiration of TCJA and avoidance of high brackets later, especially if one spouse passes early.

Agreed with you.

I felt the 2021 paper from Prof McQ was better as it mentioned those other moving parts that make this a difficult calculation, such as paying taxes from outside the TDA, effects of conversions on IRMAA brackets, and a mention that tax brackets adjust up by inflation (but slower than the normal expected return of the equity market).

Without covering all of those complexities, I'm not sure of the point of the new publication.

As far as I can tell, it seems like it is making a point that the additional NPV that is brought to the portfolio is mostly seen by the heirs and not by the original Roth converter (provided we ignore all of the complexities). But so what? The way the exercise is done, it's assumed that the original Roth converter doesn't need that money anyhow and so must have type of legacy intention. If it were any other way, then the exercise would show some unexpected expense in the later years that causes the Roth converter to need to pull a large lump sum from the account. Then there could be an analysis that perhaps the Roth converter does better by locking a guaranteed tax rate now as opposed to hoping for a good tax rate later.

Agreed - we get similar results to the both of you.

[Walkure]

We are extremely fortunate to have Prof. McQuarrie as a contributor to this forum.

I was recently at the accountant's AICPA Engage convention and noticed that many luminaries were still recommending Roth conversions based on the blanket rules from the pre-McQuarrie period. It will be interesting to see how long it takes for these ideas to filter down. In the meantime, participants in the discussion here are at the cutting edge of the topic.

I get the sense that it is hard enough to find an accountant who can see past a single year’s return and understand the value of strategically sequencing the recognition of income across multiple years for planning purposes. As such, it’s not surprising that even the “luminaries” are still struggling to convey the blanket first-order benefits of Roth conversions. The good professor’s ideas have a long road ahead to mainstream adoption.

[tibbitts]

We are extremely fortunate to have Prof. McQuarrie as a contributor to this forum.

I was recently at the accountant's AICPA Engage convention and noticed that many luminaries were still recommending Roth conversions based on the blanket rules from the pre-McQuarrie period. It will be interesting to see how long it takes for these ideas to filter down. In the meantime, participants in the discussion here are at the cutting edge of the topic.

I get the sense that it is hard enough to find an accountant who can see past a single year’s return and understand the value of strategically sequencing the recognition of income across multiple years for planning purposes. As such, it’s not surprising that even the “luminaries” are still struggling to convey the blanket first-order benefits of Roth conversions. The good professor’s ideas have a long road ahead to mainstream adoption.

But is - or should that be - the role of an accountant? I don't know, but we've had some threads where there seems to be support for a separation between accounting and planning roles.

[Tundrama]

We are all gambling in one form or another. Market risk, taxes, health/longevity…on and on. If/how much of our pretax IRA is donated to charity, etc, matters regarding Roth conversions.

Life would be less fun if simple Roth conversions were absolutely black and white…but they aren’t.

I’ll make this call…Babe Ruth pointing to the bleachers, fifteen years from now, the RMD rules will have changed. The age requirement will change and maybe the RMDs requirement itself could fade.

Why/how, because simply putting fifteen years on a generation of fat 401k/IRA account owners will impact the stench of RMDs, IMO. Yup, gambling.

If RMDs were a non issue, would the steadfast Roth conversion folks alter their decisions in any way?

[Harry Livermore]

Professor McQ,
Thanks for another insightful article. I've yet to try and model conversions, beyond a cursory look with Pralana and the RPM spreadsheet. I wonder if a case could be made for folks who fit the following profile:

• retiring around age 60, with only a few years of a potential low-income (pre-Medicare) window for conversions
• having income streams in retirement such that their tax rates will stay pretty steady throughout
• have relatively equal percentages in funds subject to, and free of, RMDs (taxable/ deferred/ Roth: say, 25%/ 50%/ 25%)

... upon retiring, rather than a few years of conversions, to begin withdrawing from tax deferred right away, and thus smooth the consumption of the tax-deferred portion, and leaving taxable and Roth alone, to grow. Besides not being subject to RMDs, taxable and Roth are (currently) more favorable in regards to taxes.
This (crude) example would seem to benefit the least from conversions, but also still run the risk of single-taxpayer torpedo and IRMAA later. Why not spend down the IRAs earlier and thus lower RMDs later? Or perhaps there is a sweet spot of conversions coupled with consumption (I suspect that's true for this edge case)?
I'm sure this question has been asked on the forum but I figured it might be a good point of debate in this thread. I also assume it's possible to model this, but I have just not yet devoted the time.
Cheers