Roth Conversions and Safe Withdrawal Rate

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mikedm
Posts: 16
Joined: Thu Feb 27, 2014 9:18 pm

Roth Conversions and Safe Withdrawal Rate

Post by mikedm » Wed Oct 09, 2019 6:19 pm

I've now run extended I-ORP under 2 scenarios - no Roth conversions, and Roth conversions up to the 22% Tax Bracket Ceiling. I currently have no Roth accounts, but have sizeable balances in tax deferred IRA's. I plan for both me and DW to delay SS until 70. I set our stock/bond allocation at 50/50 across the board, and I set stock return rates at 5% and bond return rate at 3%. I set retirement spending at Constant Spending. Both DW and I are retired, I'm 65 and she's 62.

I downloaded the results into an Excel spreadsheet and compared several key things for both maintaining status quo (no Roth Conversions) and doing Roth Conversions, and over a 30 year period found a total tax savings of 24% and total spending dollars increasing 1.5% if I convert, both confirming the benefits of Roth Conversions.

I then computed the actual withdrawal percentage of the prior year end total investment balance for each year to determine what the withdrawal rate was, and to summarize here's what I found:

For no Roth Conversions, the withdrawal rate for the 1st 20 years holds pretty steady at 4.5%/year, and then jumps to an average of 20.7%/year for the final 10 years. I suppose this isn't too surprising, as the accounts are being depleted in the final years.

But for Roth Conversions, the withdrawal rate is extremely high at an average of 13.7%/year for the 1st 3 years when taxes are owed on the large amounts that are being converted to Roth. It then settles down over the remaining 27 years at an average annual rate not vastly different than not doing Roth conversions.

I never planned to specifically follow the 4% rule, but do use it as a frame of reference for what is safe to withdraw. In both scenarios the average annual withdrawal rate is quite a bit higher than the 4% rule that is considered "safe", but I believe that's because the program assumes growth based on what is input into the program. I'm ok with that. But now that I'm considering Roth conversions, the prospect of these huge withdraws early in retirement as a percent of investment balances is concerning.

Am I being "over-thinking" this? Pretty much everything I've read here seems to be in favor of Roth Conversions, but I want to be sure I'm not missing anything. Thanks!

ExitStageLeft
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Re: Roth Conversions and Safe Withdrawal Rate

Post by ExitStageLeft » Wed Oct 09, 2019 6:48 pm

I don't think you're overthinking the conversions. At least, not yet.

If you're looking at large RMDs at age 70 then it's almost a slam dunk to do Roth conversions in order to minimize taxes. The problem is that doing so in the first few years accentuates your sequence of return risk.

Another thing to keep in mind is the Medicare premium surcharge (IRMAA) kicks in as gross income increases. DW and I are a year or two away from retiring and are going through the same calculations. For us it will be simple - never go above the first IRMAA tier when doing conversions. Keeping our MAGI below $170k will allow us to do enough conversions that the subsequent RMDs should allow us to remain in the same tax bracket.

Uncle will get his slice of the pie, one way or another.

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FiveK
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Re: Roth Conversions and Safe Withdrawal Rate

Post by FiveK » Thu Oct 10, 2019 12:55 am

mikedm wrote:
Wed Oct 09, 2019 6:19 pm
I never planned to specifically follow the 4% rule, but do use it as a frame of reference for what is safe to withdraw. In both scenarios the average annual withdrawal rate is quite a bit higher than the 4% rule that is considered "safe", but I believe that's because the program assumes growth based on what is input into the program. I'm ok with that. But now that I'm considering Roth conversions, the prospect of these huge withdraws early in retirement as a percent of investment balances is concerning.

Am I being "over-thinking" this? Pretty much everything I've read here seems to be in favor of Roth Conversions, but I want to be sure I'm not missing anything. Thanks!
In the context of the "4% safe withdrawal rate" a "withdrawal" implies spending on food, clothing, shelter, taxes, etc. Converting from traditional to Roth is not a withdrawal in that sense (although the tax on the conversion is).

Not sure if that is at issue here, but just in case....

Topic Author
mikedm
Posts: 16
Joined: Thu Feb 27, 2014 9:18 pm

Re: Roth Conversions and Safe Withdrawal Rate

Post by mikedm » Thu Oct 10, 2019 11:38 am

I understand that the withdrawal only applies to the additional taxes owed due to the Roth conversion, not the actual dollars converted.

I think the way I'll look at it is this. My plan, before considering Roth conversions, was to keep my spending at 3.5% of investments each year, not adjusting to inflation each year like the 4% rule stipulates. The 3.5%, in addition to other income, is to cover all of my expenses including taxes if I DID NOT do any Roth conversions. I felt that this is a safe and conservative plan.

Then the question becomes, how much in additional withdrawals in early retirement am I willing to make in order to pay taxes on Roth conversions? Does this make sense?

Although I-ORP is a good tool, I'm beginning to realize that this is more of an art than it is a science. As ExitStageLeft said, Uncle will get his slice of the pie one way or the other. I just want to keep as much of the pie to myself as I can!

Silk McCue
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Re: Roth Conversions and Safe Withdrawal Rate

Post by Silk McCue » Thu Oct 10, 2019 11:56 am

We are 58/60 and we have been converting for 4 years. If you are paying the taxes due on the Roth Conversion from a Taxable account then you are simply shifting those Taxable funds into a more efficient vehicle for long term growth.

Our goal is to reduce the slice of the pie that Uncle Sam will get over our lifetimes and possibly to the heirs receiving any remaining funds.

Cheers

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FiveK
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Re: Roth Conversions and Safe Withdrawal Rate

Post by FiveK » Thu Oct 10, 2019 12:16 pm

mikedm wrote:
Thu Oct 10, 2019 11:38 am
Then the question becomes, how much in additional withdrawals in early retirement am I willing to make in order to pay taxes on Roth conversions? Does this make sense?
Yes.

At some point RMDs will require you to incur taxes. If you can incur a lower marginal tax rate now than what you will be forced to incur later, a conversion now will be favorable. As Silk M. noted, if you pay the conversion tax from cash on hand, converting now at the same - or even a little higher - marginal rate than you will be forced to incur later will be favorable. See Traditional versus Roth - Bogleheads for more.
Although I-ORP is a good tool, I'm beginning to realize that this is more of an art than it is a science. As ExitStageLeft said, Uncle will get his slice of the pie one way or the other. I just want to keep as much of the pie to myself as I can!
Yes, this does require predictions about future events. Also, i-orp's tax calculations are decent but not rigorous. E.g., it ignores the phase-in of SS benefit taxation on the low end and NIIT on the high end. In the middle it's pretty good, so it may or may not be accurate enough for a given individual.

Admiral
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Re: Roth Conversions and Safe Withdrawal Rate

Post by Admiral » Thu Oct 10, 2019 12:20 pm

mikedm wrote:
Thu Oct 10, 2019 11:38 am
I understand that the withdrawal only applies to the additional taxes owed due to the Roth conversion, not the actual dollars converted.

I think the way I'll look at it is this. My plan, before considering Roth conversions, was to keep my spending at 3.5% of investments each year, not adjusting to inflation each year like the 4% rule stipulates. The 3.5%, in addition to other income, is to cover all of my expenses including taxes if I DID NOT do any Roth conversions. I felt that this is a safe and conservative plan.

Then the question becomes, how much in additional withdrawals in early retirement am I willing to make in order to pay taxes on Roth conversions? Does this make sense?

Although I-ORP is a good tool, I'm beginning to realize that this is more of an art than it is a science. As ExitStageLeft said, Uncle will get his slice of the pie one way or the other. I just want to keep as much of the pie to myself as I can!
I like i-ORP, but it's more of a hammer. If you really want the screwdriver, and your focus is on RMDs and conversion, I suggest you download Retiree Portfolio Model. It takes some effort to set up, but it's well worth your time, and specifically for granular data on Roth conversions, RMDs, and taxes. Do a search for a link to the spreadsheet.

ByThePond
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Joined: Thu Dec 31, 2015 11:21 am

Re: Roth Conversions and Safe Withdrawal Rate

Post by ByThePond » Thu Oct 10, 2019 5:07 pm

Admiral wrote:
Thu Oct 10, 2019 12:20 pm

I like i-ORP, but it's more of a hammer. If you really want the screwdriver, and your focus is on RMDs and conversion, I suggest you download Retiree Portfolio Model. It takes some effort to set up, but it's well worth your time, and specifically for granular data on Roth conversions, RMDs, and taxes. Do a search for a link to the spreadsheet.
+1 on all points.

GAAP
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Joined: Fri Apr 08, 2016 12:41 pm

Re: Roth Conversions and Safe Withdrawal Rate

Post by GAAP » Fri Oct 11, 2019 11:42 am

mikedm wrote:
Wed Oct 09, 2019 6:19 pm
But for Roth Conversions, the withdrawal rate is extremely high at an average of 13.7%/year for the 1st 3 years when taxes are owed on the large amounts that are being converted to Roth. It then settles down over the remaining 27 years at an average annual rate not vastly different than not doing Roth conversions.

I never planned to specifically follow the 4% rule, but do use it as a frame of reference for what is safe to withdraw. In both scenarios the average annual withdrawal rate is quite a bit higher than the 4% rule that is considered "safe", but I believe that's because the program assumes growth based on what is input into the program. I'm ok with that. But now that I'm considering Roth conversions, the prospect of these huge withdraws early in retirement as a percent of investment balances is concerning.
Or maybe underthinking it -- the 4% rule would have an inflation adjustment each year that would change the nominal rate that you're using for comparison. Since that method is designed to deplete the portfolio, it should generally increase the nominal withdrawal rate each year -- not keeping a steady 4%.
“Adapt what is useful, reject what is useless, and add what is specifically your own.” ― Bruce Lee

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