IRA to Roth Conversion: looking for good modeling tools

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InvestorThom
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IRA to Roth Conversion: looking for good modeling tools

Post by InvestorThom » Wed Dec 05, 2018 2:31 pm

I'm in a year where my taxable income is really low and have decided to convert part of an IRA to a Roth IRA. The IRA includes funds from both rollover 401k's and deductible contributions (I have the basis on previously filed forms 8606). The basic question is how much to convert.

Here's what I have tried:
1. Modeling in Excel to get a sense for how much each scenario will impact taxes due and the effective tax rates using 2018 state and federal tax brackets

2. Using Schwab's Roth conversion calculator. This tool helps users determine the financial impacts of leaving money in an IRA vs converting to a Roth IRA based on assumptions input by the user. The tool also provides approximate state and federal tax implications. I found the tax numbers to be somewhat higher than my back of the envelop Excel model -- but not way out of line

3. I downloaded Turbo Tax for 2018 and started to create a test tax return. I got stuck at inputing information from a 1099-R because I don't have one. I was unable to find an example via google search that I felt comfortable using -- i.e., which boxes on the form should be checked given the scenario

This should be fairly easy given the simple tax year but I'm stumbling. Here's what I'm trying to determine:

How much should I convert based on how much in taxes I'm willing to pay this year. This may not be the most tax efficient method. I'm targeting within the 24% federal bracket.

Here are the questions I have:

1. Can someone recommend a good modeling tool(s)?

2. Given the simple tax year, Turbo Tax should be a decent modeling tool. Can someone help me out with how the 1099-R will appear so that I can answer the questions Turbo Tax presents correctly?

3. A lot of folks talk about marginal tax rates and "how much room" they have within the tax brackets. While I don't want to exceed the 24% bracket I'm also looking at the effective tax rate. Is this also something I should be considering? Why/why not? And if so, how do I think about a target effective rate?

Math and tax calculations are not my strengths. :) Thanks in advance for your help!

retiredjg
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by retiredjg » Wed Dec 05, 2018 2:44 pm

InvestorThom wrote:
Wed Dec 05, 2018 2:31 pm
I'm in a year where my taxable income is really low and have decided to convert part of an IRA to a Roth IRA. The IRA includes funds from both rollover 401k's and deductible contributions (I have the basis on previously filed forms 8606). The basic question is how much to convert.
Is that what you meant to say? There should not be any basis if all that money came from rolling over 401ks or from deductible contributions.

How much should I convert based on how much in taxes I'm willing to pay this year. This may not be the most tax efficient method. I'm targeting within the 24% federal bracket.
Why did you choose the 24% bracket? That's a fairly high bracket to do Roth conversions.

Are you over 59.5? If not, do you have money in savings to pay the taxes?

3. A lot of folks talk about marginal tax rates and "how much room" they have within the tax brackets. While I don't want to exceed the 24% bracket I'm also looking at the effective tax rate. Is this also something I should be considering? Why/why not? And if so, how do I think about a target effective rate?
The effective tax rate is not relevant. Here's why.

Not all of your income is taxed at the same rate. Some is not taxed, some at 10%, some at 12%, and so on.

But all of the conversion will be taxed at the same rate, your marginal rate, unless you just happen to cross a tax bracket line when you do the conversion. If you are in the 24% bracket, each "next dollar" of income will be taxed at 24% (assuming you are not in some kind of phase out).

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munemaker
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by munemaker » Wed Dec 05, 2018 2:54 pm

By far, the most comprehensive modeling tool for Roth conversions is "Retirement Portfolio Model" or RPM for short. Developed and provided without charge by our fellow Boglehead Bigfoot48.

https://www.bogleheads.org/wiki/Retiree_Portfolio_Model

InvestorThom
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by InvestorThom » Wed Dec 05, 2018 4:55 pm

retiredjg wrote:
Wed Dec 05, 2018 2:44 pm

Is that what you meant to say? There should not be any basis if all that money came from rolling over 401ks or from deductible contributions.
==> No. Thanks. I read it three times and still missed it. It should read, "The IRA is comprised of rollovers from 401k's and non-deductible contributions."

Why did you choose the 24% bracket? That's a fairly high bracket to do Roth conversions.
==> It is lower than the expected bracket in next few years of working -- 35%. And may be lower than tax bracket when I start drawing from tax advantaged accounts, ~age 68.

Are you over 59.5? If not, do you have money in savings to pay the taxes?
==> No, 55. Yes.

The effective tax rate is not relevant. Here's why.

Not all of your income is taxed at the same rate. Some is not taxed, some at 10%, some at 12%, and so on.
==> Understand.

But all of the conversion will be taxed at the same rate, your marginal rate, unless you just happen to cross a tax bracket line when you do the conversion. If you are in the 24% bracket, each "next dollar" of income will be taxed at 24% (assuming you are not in some kind of phase out).
==> Understand.
==> However, current earnings are in the 10% bracket this tax year -- i.e., up to $9525. A conversion of any significance would throw me into the next bracket -- i.e., 12%. Why would I not contribute more, i.e., up to the 22% bracket or into the 24% bracket vs leaving in tax advantaged account until ~68? (I'm also in a HCOL state and will be factoring in state tax.)

retiredjg
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by retiredjg » Sat Dec 08, 2018 9:56 am

InvestorThom wrote:
Wed Dec 05, 2018 4:55 pm
However, current earnings are in the 10% bracket this tax year -- i.e., up to $9525. A conversion of any significance would throw me into the next bracket -- i.e., 12%. Why would I not contribute more, i.e., up to the 22% bracket or into the 24% bracket vs leaving in tax advantaged account until ~68? (I'm also in a HCOL state and will be factoring in state tax.)
InvestorThom, sorry about the delay.

I agree you should convert, maybe a good portion. Up to the top of the 22% seems like a no brainer to me and up to the top of the 24% bracket might be reasonable too. This last part sort of depends, maybe on whether you see yourself being married when you take the money out.

Sounds nuts, but you appear to be single right now. If you are single when you retire (and no new tax laws occur) you will almost certainly be at least in the 22% tax bracket and that 22% bracket is set to revert to 25% in a few years.

If you are married when you retire, your tax bracket may dip to 12% (set to revert to 15%).

Either way, it is not the effective rate that will matter if that is what you are still thinking of. You will pay 10% on some of your conversion, 12% on some of your conversion, and so on. It is the tax rate of the very last dollar that will matter. I think paying 22% on the last dollar is a very good bet. Paying 24% on the last dollar is not as clear to me, but it certainly seems like it might be a good bet.

Keep a couple of things in mind. In your low current rate, you have the ability to sell long term capital gains at 0% tax. You will lose that when you go above $38,600 taxable income. So keep in mind if you sell in taxable to pay the taxes, you need to add that to your income.

Second, if you are converting that large an amount, you will need to pay or withhold tax in some manner so as not to be subject to penalties for underpayment of tax. You will need to figure out how to handle that.

Do you know how to handle the pre-tax/non-deductible contribution ratio on that IRA? Assume you already have the Forms 8606 for the non-deductible contributions?

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FiveK
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by FiveK » Sat Dec 08, 2018 2:32 pm

InvestorThom wrote:
Wed Dec 05, 2018 2:31 pm
Here are the questions I have:

1. Can someone recommend a good modeling tool(s)?

2. Given the simple tax year, Turbo Tax should be a decent modeling tool. Can someone help me out with how the 1099-R will appear so that I can answer the questions Turbo Tax presents correctly?

3. A lot of folks talk about marginal tax rates and "how much room" they have within the tax brackets. While I don't want to exceed the 24% bracket I'm also looking at the effective tax rate. Is this also something I should be considering? Why/why not? And if so, how do I think about a target effective rate?

Math and tax calculations are not my strengths. :) Thanks in advance for your help!
1) The variety of credits, phaseouts, etc., plus the graphical output one can get, makes the personal finance toolbox spreadsheet more useful to us than other tools. YMMV.

2) Do you have a 1099-R from a previous year? Or does http://www.wolterskluwerfs.com/article/ ... 1099r.aspx make enough sense?

3) As retiredjg notes, ignoring effective and using marginal is likely best. Assuming no "humps" (e.g., see Taxation of Social Security benefits) in your marginal rates, once you reach a new, higher, marginal rate, all dollars converted beyond that will be taxed at that rate.

Makes no sense to convert at high marginal rates this year if you can convert (or will be forced to take RMDs) at lower marginal rates in future years. But if you can avoid higher marginal rates later by converting now, it does make sense.

InvestorThom
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by InvestorThom » Tue Dec 11, 2018 12:14 am

retiredjg wrote:
Sat Dec 08, 2018 9:56 am
Do you know how to handle the pre-tax/non-deductible contribution ratio on that IRA? Assume you already have the Forms 8606 for the non-deductible contributions?
Thanks.

Forms 8606 were filed when non-deductible contributions were made.

My understanding is that when I convert to a Roth, the non-deductible contributions will be decremented by a proportional amount — e.g., if total IRA balances (non-deductible contributions + tax deferred contributions + growth) is $100,000 and total non-deductible contributions is $10,000 then 1/10 of the converted amount will be considered from non-deductible contributions and therefore $90,000 will be considered taxable income. Correct?

My understanding is that when I file my tax returns I will again file Form 8606 to update my non-deductible contributions. I assume Turbo Tax is intuitive in walking through this. If not, tips are appreciated.

Yes, I am aware I need to file and pay estimated taxes to avoid penalties.

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FiveK
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by FiveK » Tue Dec 11, 2018 1:11 am

InvestorThom wrote:
Tue Dec 11, 2018 12:14 am
My understanding is that when I file my tax returns I will again file Form 8606 to update my non-deductible contributions. I assume Turbo Tax is intuitive in walking through this.
A reasonable assumption but there are many threads describing a form 8606 prepared using Q&A software (whether TurboTax or H&RBlock or...) turned out incorrect, because the Qs were ambiguous enough that the As were incorrect.

Consequently, doing a draft 8606 by hand, and perhaps with a "transparent" tool such as the 'Form8606' tab in the personal finance toolbox spreadsheet, can help you understand if the forms generated by a "black box" tool such as TurboTax are correct.

retiredjg
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by retiredjg » Tue Dec 11, 2018 9:28 am

It sounds like you have the general idea of how it works. Agree that doing a form 8606 by hand is helpful because you will know what it is supposed to look like.

That said....some software does not fill in lines 6 - 12. Instead it goes to grandmother's house and back using the back curvy roads and does the calculations in private on a worksheet found in one of the publications. If you get the right answer on line 14 and the right amount on line 18, don't worry that lines 6 - 12 are blank.

InvestorThom
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Re: IRA to Roth Conversion: looking for good modeling tools

Post by InvestorThom » Tue Dec 11, 2018 1:30 pm

Thanks everyone for the help!

InvestorThom
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Joined: Sun May 07, 2017 12:10 pm

Re: IRA to Roth Conversion: looking for good modeling tools

Post by InvestorThom » Tue Dec 11, 2018 1:48 pm

munemaker wrote:
Wed Dec 05, 2018 2:54 pm
By far, the most comprehensive modeling tool for Roth conversions is "Retirement Portfolio Model" or RPM for short. Developed and provided without charge by our fellow Boglehead Bigfoot48.

https://www.bogleheads.org/wiki/Retiree_Portfolio_Model
Thanks. However, on the Read Me tab, Limitation 1 is "Non-deductible (after-tax) contributions to your traditional IRAs are not considered in calculating taxes on withdrawals. All traditional IRAs are assumed to have been "tax-deductible" when funded."

Regardless, I should be able to ballpark it with a back of the envelope calculation.

Thanks again.

InvestorThom
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Joined: Sun May 07, 2017 12:10 pm

Re: IRA to Roth Conversion: looking for good modeling tools

Post by InvestorThom » Wed Dec 12, 2018 1:55 am

FiveK wrote:
Sat Dec 08, 2018 2:32 pm

1) The variety of credits, phaseouts, etc., plus the graphical output one can get, makes the personal finance toolbox spreadsheet more useful to us than other tools. YMMV.

2) Do you have a 1099-R from a previous year? Or does http://www.wolterskluwerfs.com/article/ ... 1099r.aspx make enough sense?

3) As retiredjg notes, ignoring effective and using marginal is likely best. Assuming no "humps" (e.g., see Taxation of Social Security benefits) in your marginal rates, once you reach a new, higher, marginal rate, all dollars converted beyond that will be taxed at that rate.

Makes no sense to convert at high marginal rates this year if you can convert (or will be forced to take RMDs) at lower marginal rates in future years. But if you can avoid higher marginal rates later by converting now, it does make sense.
Thanks. #2 was helpful in working through what the 1099-R may look like. (I did not have one from a previous year.)

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