Missed Roth conversion

[Chardo]

A friend of mine intended to do Roth conversions a few years ago, but never did them. Her IRA was about 20k then. It's now close to 30k. I'm thinking this mistake cost her over 1k. She would have paid tax on 20k, now she'll pay tax on 10k more. Am I right or am I missing something?

[tonyclifton]

You would need a lot more details about the person’s tax situation and tax rates to know. Could be zero tax. Could be more.

[Mrbogleheads]

A friend of mine intended to do Roth conversions a few years ago, but never did them. Her IRA was about 20k then. It's now close to 30k. I'm thinking this mistake cost her over 1k. She would have paid tax on 20k, now she'll pay tax on 10k more. Am I right or am I missing something?

She was able to use the money that would have been used for the roth conversion to do other things with. Like invest. She had a zero % interest loan from the gov.

[terran]

Yes, it will probably cost her over $1000 if she's above the 10% bracket, on ACA health insurance, has capital gains near the change from the 0% to 15% bracket, or pays state tax. If those things aren't true then it might cost less to convert the extra $10k. If she was in higher tax bracket a few years ago it might have saved her money even though she now has more to convert. Does it matter? What's done is done, the only thing to do now is to make a decision based on the current situation.

[Chardo]

A friend of mine intended to do Roth conversions a few years ago, but never did them. Her IRA was about 20k then. It's now close to 30k. I'm thinking this mistake cost her over 1k. She would have paid tax on 20k, now she'll pay tax on 10k more. Am I right or am I missing something?

She was able to use the money that would have been used for the roth conversion to do other things with. Like invest. She had a zero % interest loan from the gov.

Seems like the value of that "use of money" is small in comparison to the additional tax that would now be paid on converting a higher amount.

[cas]

A friend of mine intended to do Roth conversions a few years ago, but never did them. Her IRA was about 20k then. It's now close to 30k. I'm thinking this mistake cost her over 1k. She would have paid tax on 20k, now she'll pay tax on 10k more. Am I right or am I missing something?

As tonyclifton said, we don't have enough information to know whether the Roth conversion would have been better then, now, or never.

However, you want to make sure you aren't falling into Common Misconception #2 about any Traditional -vs- Roth decision.

[Rocinante Rider]

A Roth conversion is simply tax arbitrage. There's no lost opportunity for growth on the money by paying the taxes now rather than later. And if marginal tax rates are the same now as they were in the past, there's no extra cost to paying a larger amount of taxes now.

Simplified example, assuming your friend's 20k had no non-deductible basis, her marginal tax rate is the 10% that you mentioned both now and in the past, and she pays the tax out of the conversion amouint:
1. Converts 20k a few years ago, pays 2k in taxes, the 18k grows 50%: Roth balance now is 27k
2. Converts 30k now after the 20k has grown 50%, pays 3k in taxes, and the Roth balance now is 27k

Of course, using taxable funds if you have them to pay the conversion tax is preferred as that lowers the break-even tax rate on conversions.
https://investor.vanguard.com/investor- ... n-equation

[Chardo]

A Roth conversion is simply tax arbitrage. There's no lost opportunity for growth on the money by paying the taxes now rather than later. And if marginal tax rates are the same now as they were in the past, there's no extra cost to paying a larger amount of taxes now.

Simplified example, assuming your friend's 20k had no non-deductible basis, her marginal tax rate is the 10% that you mentioned both now and in the past, and she pays the tax out of the conversion amouint:
1. Converts 20k a few years ago, pays 2k in taxes, the 18k grows 50%: Roth balance now is 27k
2. Converts 30k now after the 20k has grown 50%, pays 3k in taxes, and the Roth balance now is 27k

Of course, using taxable funds if you have them to pay the conversion tax is preferred as that lowers the break-even tax rate on conversions.
https://investor.vanguard.com/investor- ... n-equation

So in your 2 examples, waiting (number 2) cost an extra thousand in tax. Am I missing something?

[Young Boglehead]

A Roth conversion is simply tax arbitrage. There's no lost opportunity for growth on the money by paying the taxes now rather than later. And if marginal tax rates are the same now as they were in the past, there's no extra cost to paying a larger amount of taxes now.

Simplified example, assuming your friend's 20k had no non-deductible basis, her marginal tax rate is the 10% that you mentioned both now and in the past, and she pays the tax out of the conversion amouint:
1. Converts 20k a few years ago, pays 2k in taxes, the 18k grows 50%: Roth balance now is 27k
2. Converts 30k now after the 20k has grown 50%, pays 3k in taxes, and the Roth balance now is 27k

Of course, using taxable funds if you have them to pay the conversion tax is preferred as that lowers the break-even tax rate on conversions.
https://investor.vanguard.com/investor- ... n-equation

So in your 2 examples, waiting (number 2) cost an extra thousand in tax. Am I missing something?

Do you not see how they have the same amount of money after tax even though it "cost another thousand in tax"? That's why it doesn't matter. You should aim to have the highest after-tax account value, which may or may not be affected by paying a higher amount of gross taxes depending on the marginal tax rates.

In this example, paying 1k more in taxes didnt matter if we assume they were at the same tax bracket. They're left with the same amount of money.

[Rocinante Rider]

So in your 2 examples, waiting (number 2) cost an extra thousand in tax. Am I missing something?

Yes, you're missing something as Young Boglehead points out above.

Here's another way to think about it that might help. Think about your tIRA as a business that has a silent partner - your Uncle Sam. Let's say that you're in a marginal 25% tax bracket. This means that your Uncle Sam owns 25% of your business (i.e., your tIRA). If you buy out your Uncle Sam now by giving Uncle Sam his 25% of the business or you wait X years to buy him out by giving him his 25% after the business has increased in value, you will end up with exactly the same value in the remaining portion of the "business" that you own. By waiting, you get to keep 75% of the growth in Uncle Sam's 25% ownership piece, but he gets to keep 25% of the growth in your 75% ownership piece of the business. It's a complete wash either way.

As I stated previously, a Roth conversion is simply tax arbitrage. In the example already given, your friend has lost absolutely nothing by paying 3k in taxes now instead of paying 2k in taxes a few years ago.

See the wiki, especially the section on the commutative property of multiplication described in the "Simplest Situation" section, for a simple mathematical explanation:
https://www.bogleheads.org/wiki/Traditional_versus_Roth

[Chardo]

I thought I was reasonably smart, but I'm still not understanding. Anyone have another explanation of how she is no worse off despite paying more in tax?

[TomatoTomahto]

I thought I was reasonably smart, but I'm still not understanding. Anyone have another explanation of how she is no worse off despite paying more in tax?

Being reasonably smart and being good with numbers are not always the same thing. Run through the numbers that Rocinante Rider put forward as an example again. It’s called the commutative property of multiplication.

[FatefulTanker]

Yes, it will probably cost her over $1000 if she's above the 10% bracket, on ACA health insurance, has capital gains near the change from the 0% to 15% bracket, or pays state tax. If those things aren't true then it might cost less to convert the extra $10k. If she was in higher tax bracket a few years ago it might have saved her money even though she now has more to convert. Does it matter? What's done is done, the only thing to do now is to make a decision based on the current situation.

Family members in similar situation, 10% bracket, both on Social Security, one on ACA. Their marginal "tax" rate is 30%. 10% bracket, 5% more due to extra Social Security being taxed, 15% in lost ACA subsidy. Next year they will we have to decide to do a Roth conversion as they will be in the 0% bracket, but still losing 15%+ in ACA subsidy.

[Darth Vanguard]

I thought I was reasonably smart, but I'm still not understanding. Anyone have another explanation of how she is no worse off despite paying more in tax?

You are focusing only on the initial variables - the $20,000 conversion amount and the $2,000 in taxes. The variables have now changed to $30,000 and $3,000, so you are comparing apples and oranges on the input side.

If she wanted to, she could still convert $20,000 and pay $2,000 in taxes. She is paying "more" in taxes, because she is now converting a larger amount.

As others have pointed out her end result is still the same. That is the number to focus on.

[Chardo]

I thought I was reasonably smart, but I'm still not understanding. Anyone have another explanation of how she is no worse off despite paying more in tax?

You are focusing only on the initial variables - the $20,000 conversion amount and the $2,000 in taxes. The variables have now changed to $30,000 and $3,000, so you are comparing apples and oranges on the input side.

If she wanted to, she could still convert $20,000 and pay $2,000 in taxes. She is paying "more" in taxes, because she is now converting a larger amount.

As others have pointed out her end result is still the same. That is the number to focus on.

Right, she is now converting a larger amount and paying more in taxes. So how is the result still the same?

[Chardo]

I thought I was reasonably smart, but I'm still not understanding. Anyone have another explanation of how she is no worse off despite paying more in tax?

Being reasonably smart and being good with numbers are not always the same thing. Run through the numbers that Rocinante Rider put forward as an example again. It’s called the commutative property of multiplication.

I have a degree in finance. I still don't get it.

[Rocinante Rider]

I have a degree in finance. I still don't get it.

Reread the Calculations section of the wiki entry until it clicks for you.
https://www.bogleheads.org/wiki/Traditional_versus_Roth
Most people make the opposite, but equally incorrect, assumption to the one that you're making. Those folks mistakenly believe that by paying the 2k in taxes earler, they will lose all the growth they would have made if they had kept that tax money invested in their tIRA until some date in the future. They are wrong and you are wrong.
Commutative property of multiplication: if the marginal withdrawal tax rate on tIRA in the future is the same as the marginal tax rate paid for the Roth conversion in the past, then it's six of one and half a dozen of the other.

[tgallag]

How is this?

You have $20,000 in an IRA in 2022. With the benefit of a crystal ball you know it will increase to $30,000 in 2025. You want to do a roth conversion, either in 2022 or in 2025. You want to pick which is going to leave you the most money AFTER the conversion.

Choice #1. In 2022 covert the $20,000. $2,000 goes to taxes. The remaining $18,000 grows to $27,000 by 2025

Choice #2: Do nothing until 2025. The IRA has grown to $30,000. You do the conversion which results in $3,000 in taxes. You have $27,000 remaining. Same place you would be had you converted the $20,000 in 2022.

I hope I didn't make it more confusing

[Darth Vanguard]

You are focusing only on the initial variables - the $20,000 conversion amount and the $2,000 in taxes. The variables have now changed to $30,000 and $3,000, so you are comparing apples and oranges on the input side.

If she wanted to, she could still convert $20,000 and pay $2,000 in taxes. She is paying "more" in taxes, because she is now converting a larger amount.

As others have pointed out her end result is still the same. That is the number to focus on.

Right, she is now converting a larger amount and paying more in taxes. So how is the result still the same?

Because she is paying 50% more, but converting 50% more. It is a wash.