But what if I convert before age 71?
Back to more pragmatic, actionable concerns in this and the next post.
Claim: that converting before age 71 won’t make any difference to the level of payoff from a Roth conversion, after proper adjustment.
Way upthread I made that claim in response to a query from Woodspinner. I reasoned as follows: prior to taking RMDs, the performance of an asset in a TDA account must be exactly the same as performance of that asset in a Roth account—if it is the identical asset, here taken to be stocks returning 10% when inflation is 3%. Both accounts are equally tax deferred prior to RMDs; each account’s value appreciates by exactly the asset’s appreciation.
For example, if, a few years earlier at age 65, one had converted $100,000 at 22%, and paid tax out of the conversion, then there will be $100,000 to start in the counterfactual no-conversion TDA, and $78,000 in the Roth account. Six years later, after compounding at 10%, there will be about $177,000 in the TDA (pretax) and about $138,000 in the Roth. The ratio is the same: 177/138 ~ 100/78. My point: the ratio 100/78 will be maintained at all points until RMDs begin, with that ratio understood to have the general form of [conversion / (conversion – tax)].
Only when RMDs begin can the Roth conversion, which was intended to reduce RMDs and the tax burden they incur, start to pay off.
That was the claim; now here is the spreadsheet. The first iteration looks at a Roth conversion aged 65, six years earlier than the base case. The second iteration will look at a conversion at age 59.51, twelve years early. The ss shows the constant tax rate case 22%-->22%.
To focus discussion, here is a table with a few key values from the ss.
(age 85)
Code: Select all
Real Roth Age 71 Inflation Wealth
surplus TDA divisor ratio
--------------------------------------------------------
Convert at 71: $ 7,629 $100,000 1.51 1.0405
Convert at 65: $11,319 $177,156 1.81 1.0405
The real dollar payoff for early conversion is greater, now up to $11,319. Natch—the age 71 TDA and Roth values are $177,156 and $138,182, not $100,000 and $78,000. Converting early is the close equivalent of converting a larger dollar amount at age 71. But not quite. The new Roth surplus is
not 1.77X the old surplus recorded for conversion of $100,000 at age 71.
Why not?? Answer: inflation. Early conversion means an early start to the inflation divisor. In this early scenario, for six years there is no difference between TDA and Roth appreciation, because no RMDs. But the inflation divisor, water running underground, is already over 1.2 by the time the first RMD is taken. So even though we have no catch up for the converted funds in the six years after age 65, we do have inflation exposure. When results are evaluated at age 85, now after 20 years rather than 14, the inflation divisor cuts a little deeper and the real Roth surplus is not quite as much as if we had just converted $177,000 at age 71.
In terms of a formula, the real Roth surplus with early conversion, relative to the surplus for conversion at age 71, looks like this:
New surplus =
Old surplus X
[New TDA $ at 71 / old TDA $ at 71] X
inflation divisor at 71 / inflation divisor (early convert).
Using values from the table and ss, you can confirm that:
$11,319 =
$7,629 X
$177,156 / $100,000 X
1.51 / 1.81
In other words: converting early can’t magically produce an additional or larger Roth payoff, nor does it change the underlying operation that produces a payoff from conversion. This can be seen in the wealth ratio, which doesn’t budge.
On the other hand, you can’t convert $177,000 in one year and stay in a single tax bracket (other than the top one). That’s one proper role for a pre-71 conversion: to convert more within a particular bracket by spreading the conversion over multiple years. Likewise, to get a tax rate as low as 22%, conversions may have to be done before Social Security payments begin; and for that matter, before IRMAA begin. In fact, for IRMAA avoidance, 65 may be too late for the optimal conversion, unless one spouse is still working.
Accordingly, here is the spreadsheet for converting 12 years early.
And here is a summary table:
Code: Select all
Real Roth Age 71 Inflation Wealth
surplus TDA divisor ratio
--------------------------------------------------------
Convert at 71: $ 7,629 $100,000 1.51 1.0405
Convert at 59: $16,794 $313,843 2.16 1.0405
A conversion this early might appear to be the approximate equivalent of converting three times as much at age 71. But the real Roth surplus is
not 3X as great as the base case; it is only about 2.2X. Explanation: there are now twelve extra years of inflation. The inflation ratio is about 1.51/2.16, or only 70%. And 3.13 X 0.7 is about 2.2.
Converting early is no magic bullet able to enhance the real dollar wealth surplus generated by a conversion. But it will still be a good idea for many BH to convert before 71, as discussed next.
(Bad) Good reasons to convert early
Expecting a bigger payoff, or a different mechanism underlying the conversion payoff, is the wrong reason to convert early.
Good reasons to convert early include:
1. To get access to a favorably low tax bracket by converting before Social Security, IRMAA, or other impediments arise;
2. To convert larger amounts within a favorable tax bracket than could be done in any single year;
3. To reduce TDA balances by a larger amount and thereby drive down taxable RMDs by a larger amount.
With respect to #3, I commented up thread that it took a big conversion to materially reduce RMDs: in the running example, it took $100,000 to lower the RMD flow by a mere $3650 at age 72. But if you convert at age 59.51, you convert before the TDA records
another twelve years of appreciation. That same $100,000 removes a larger proportion of the TDA, reducing now over $10,000 of RMDs at age 72, because, performed earlier, the conversion removed three times the age 72 TDA value (under the assumed rate of return).
The conjunction of all three good reasons will drive many Roth conversions into the early 60s, after one / both salaries have stopped, and likely before SS has begun, and to avoid IRMAA penalties on the conversion. The same conjunction will lead to spreading conversion activity across multiple years in the early 60s, to the extent affordable.
More fatefully: if one or both of you work until age 65 or beyond, or had earlier arranged for other income in the gap years before social security (i.e., 409A distributions, which are difficult to reschedule), then there may
never be a good opportunity to convert at low tax rates, because you never will be in a low tax bracket. Ever. In which case, you will have to decide whether a high-rate, with-IRMAA conversion makes sense for you.
One good reason not to convert way in advance
Upthread, FiveK and curmudgeon educated me on the nose cone of the social security tax torpedo—an income range of about $8000, where, with the exact right combination of social security, qualified dividends, and unwanted RMDs, your marginal rate would be 49.95%, or 55.5% post-TCJA, on each additional dollar of RMD. A Roth conversion that moved you down in that range could be the most lucrative ever.
But it’s a narrow range. How certain could you be, at age 59.5, that all the stars would align, so that twelve years later the RMDs reduced by conversion would fall into that narrow window and save you 49.95% / 55.5%? Not very. If IRMAA won’t be a problem, better to wait until your late 60s, when forecasts will have less error.
The social security torpedo more generally covers a wider range; but the high explosive compartment occupies a fairly narrow range at the bottom portion of the 22% bracket, where the marginal tax rate will be 40.7% or 46.25% post-TCJA, if you hit that bullseye. Again, a later conversion is more likely to harvest these juicy results because more certain the torpedo will be launched in the expected direction.
These comments are also a way of acknowledging LilyFleur’s concern about rate of return and its uncertainties. Because RMDs are determined by accumulated wealth, which is an exponential function of rate of return, errors in estimating that rate, which become more likely a dozen years out, can play hob with the forecasted return from a conversion. The later the conversion is made, ceteris paribus, the less the risk that forecasted wealth / RMDs are significantly off.
*ceteris paribus is Latin for “I won’t have to worry about IRMAA or other burdensome increases in my tax rate on later conversions.”
In sum: I would expect most real people to convert before age 71. But for purposes of the abstract demonstrations pursued in this thread, age 71 keeps things simple. It also avoids the complications that come with the Everything-on-camera style of spreadsheet used in the SSRN paper. Respondents in the earlier thread on that paper were wont to ask, On what funds did Rob and Sue live, between the conversion at age 65 and when RMDs commence at 72? That was easy enough to answer (TDA withdrawals, SS, savings) but that whole line of thought distracted from the fundamental question: what determines Roth conversion payoffs? What are the underlying operations?
You can take the academic out of the classroom by retirement, but you can't ever take the classroom out of his tone, style, and manner of approach.