How good can it get?
A few posts back I identified “plausible best cases” for outcomes from converting to Roth at a tax rate of 22%. These were:
1. Avoiding a post-TCJA tax rate of 25%
2. Avoiding a future rate of 28% (next bracket up, post TCJA)
3. Avoiding an IRMAA penalty combined rate (post-TCJA) of 32%
4. Avoiding an SS tax torpedo of 40.7% (or 46.25% post-TCJA).
The benchmark for these will be conversion at a constant tax rate of 22%. And the comparison case will be the “plausible worst case” outcome of converting at 22% to avert RMDs that were only going to be taxed at 12%, also known as a doing a Bob-and-Barb (i.e., failing to adjust future tax brackets for inflation).
I also introduced several metrics for evaluation, explained upthread; and I said I would stick to outcomes likely to be achieved while alive. That will be defined here as the outcome achieved at age 85 or 95.
If you want to follow along at home, the spreadsheet used to generate these outcomes can be downloaded here: [edit 12-8-2021]
https://github.com/emcquarrie/Roth-conv ... readsheets
Here is the first code block showing outcomes at a constant rate of 22%.
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Real Ratio Tax Wealth
Roth to tax debit Wealth ratio
Age surplus debit ROI ratio ROI
------------------------------------------------
85 $ 7,629 0.35 2.15% 1.04 0.28%
95 $42,190 1.92 4.56% 1.13 0.49%
Consistent with my initial posts on this thread, even when rates stay constant a Roth conversion can pay off. But it’s a slow process, with not much return after fourteen years; only out in the 90s does the payoff start to amount to something.
The most likely “win”
The statute says that the 22% rate will lapse and return to its pre-TCJA value of 25% in 2026. Here are the metrics:
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Real Ratio Tax Wealth
Roth to tax debit Wealth ratio
Age surplus debit ROI ratio ROI
------------------------------------------------
85 $14,868 0.68 3.76% 1.08 0.57%
95 $55,103 2.50 5.36% 1.17 0.66%
This small change in future rate has a noticeable impact: the real Roth surplus at age 85 doubles relative to constant rates. Interestingly, the incremental impact is comparatively less at age 95, and this “not that much better” result at 95 holds across metrics. I’ll interpret it later.
A somewhat less likely but sweeter outcome
If you are converting during a temporary valley in your income, and you have been a doughty saver, you may reasonably fear that absent a conversion at 22%, you will be in the next bracket up on retirement, and post-TCJA that will be at 28% (we’ll ignore IRMAA, see my thread on pensions). That’s a six point rate hike, double the three points just investigated. Here are the metrics.
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Real Ratio Tax Wealth
Roth to tax debit Wealth ratio
Age surplus debit ROI ratio ROI
------------------------------------------------
85 $22,106 1.00 5.09% 1.13 0.86%
95 $68,017 3.09 6.05% 1.22 0.83%
Well, nothing has doubled since the prior scenario. And the improvement again is comparatively less at age 95 than at age 85, where it is up 50% from the 22-->25 case. Interestingly, the most stringent metric, the rightmost column, actually decreases slightly at age 95. Translation: the improvement in wealth in the ten years after 85 isn’t coming fast enough.
A not much less likely but sweeter still outcome
Post TCJA, IRMAA penalties might add 4% to the income tax rate. Who wouldn’t want to convert at 22% to save 32%? Here are the metrics.
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Real Ratio Tax Wealth
Roth to tax debit Wealth ratio
Age surplus debit ROI ratio ROI
------------------------------------------------
85 $31,757 1.44 6.59% 1.19 1.27%
95 $85,235 3.87 6.82% 1.29 1.07%
Hmmh. Results have improved once more, but the numbers are hardly … striking. Good news: the pattern at age 95 now has an explanation. Each 1% increase in tax rate relative to the base case of constant rates adds about $4333 to the age 95 real Roth surplus.* By this point the rate is up 10 points, and the age 95 surplus is up about $43,000 relative to the constant case. Bad news: according to the most stringent metric on the right, the ROI is noticeably lower at age 95 than 85.
*At 85, it is about $2400 per point of rate increase; remember, these are real dollars.
The Big One: Dodging the SS Tax Torpedo
Using post-TCJA rates, if you have enough social security, and just the right amount of other income, each dollar of income gets taxed itself plus brings $0.85 of your social security payment into the taxable fold. Your marginal tax rate becomes 1.85X the income tax rate of 25%, or 46.25% in all. Owww….
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Real Ratio Tax Wealth
Roth to tax debit Wealth ratio
Age surplus debit ROI ratio ROI
------------------------------------------------
85 $66,139 3.01 10.42% 1.51 2.99%
95 $146,574 6.66 8.86% 1.63 2.07%
And no surprise, these are the best results thus far. To put them in context, here is a summary of the raw portfolio values that generate the metrics (these are nominal values while the tables above gave real values).
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Roth TDA pretax TDA post-tax
balance balance Taxable balance
22% constant $296,205 $204,335 $125,284 $159,381
22% --> 46.25% $296,205 $204,335 $ 86,333 $109,830
As can be seen, the Roth and pretax TDA values don’t change. Rather, the taxable balance is lower because so much more of each RMD is lost to tax and not available for reinvestment. Likewise, the post-tax value of the TDA is that much lower under higher rates of tax.
I should point out that these tax torpedo results are probably overly rosy. They assume you stay in the tax torpedo even as you liquidate hundreds of thousands of dollars of TDA for the evaluation—which is highly unlikely, because the torpedo is generally a window that gets exited once income hits a certain point.
Summary
Looking over the entire set, I draw the following conclusions about the expected payoff from Roth conversions under various tax rate scenarios:
1. If future rates move higher, the payoff becomes substantial much sooner, in the 80s.
2. But at later ages, 95 and up, the gain is less, because tax drag has had a chance to grow large even under the constant rate case. Tax drag on the reinvested RMDs is an independent source of payoff.
3. The payoff in the 80s remains modest even if future rates jump ten points. The wealth ratio (2nd column from the right) is still less than 1.2. Likewise, focusing on the tax debit ratio, to earn the debit as young as 85 requires a jump of 6 points in the rate.
Glass half full, or half empty?
In many cases a Roth conversion amounts to a simple bookkeeping change plus a check made out to the IRS. The VTI in one account is translated into a VTI in another account, minus a debit. Not a lot of effort, nor much in the way of risk other than the tax debit, which itself is just a change in the timing of tax. Almost any positive impact might be judged sufficient to motivate these bookkeeping and timing changes.
On the other hand, many folks contemplating a Roth conversion might look at these numbers and find themselves humming,
Is that all there is? Yes there is a payoff; but in the context of income levels of $110,000 plus—the floor of the 22% bracket—and TDA assets of $1 million to $4 million, depending on pension—is the payoff from a $100,000 conversion enough to get excited about? Only you can decide.
Another way to approach the metrics would be to calculate the risk/reward matrix across the three most likely outcomes: 1) no change in rates; 2) post-TCJA increase to 25%; 3) miscalculation, where future rates drop to 12%. Here it is at age 85, sticking to the metric of the real dollar surplus.
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Real Roth surplus
Rates at age 85:
22 --> 12 -$16,499
22 --> 22 $ 7,629
22 --> 25 $14,868
If you are careful about tax brackets and inflation, you can be reasonably certain of not doing a Bob-and-Barb, and thus not ending up in the 12% bracket and losing $16,499 on the conversion. Or you can say, “this conversion is risky, because on my current projection RMDs are only just barely going to lift me into the 22% bracket. Just a few tweaks downward in the variables, and I’m going to find myself like Bob and Barb.” In which case, don’t do the conversion.
If the negative outcome can be ruled out as unlikely, then the conversion decision is straightforward: in the not unlikely case of no change in rates, the $100,000 conversion will put you $7000 ahead after fourteen years; best probable case, $14,000; even as there is always the small chance that it could be $20,000 or $30,000, if the markets prove unexpectedly rewarding and you do get pushed into the next tax bracket up.
Likewise, the SS Tax Torpedo requires that you be comfortably into the 22% tax bracket. If the amount of your social security can be projected reasonably well, along with your expected pension if any, and those two are going to bring you to the 22% floor, then almost any non-zero amount of RMDs might fall into the tax torpedo, with a big payoff from the conversion.
But before you start licking your lips, remember: if your social security as a couple is too low (<$35,000 or so), it will hit the 85% taxation ceiling before other income gets you to the 22% bracket. You won’t be in the top half of the torpedo. And if your total income is too high, you’ll exit the torpedo on the other side and again, will not be paying a marginal rate that begins with 4.
Run the numbers.
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.