Roth conversion worth it

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dillrob
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Roth conversion worth it

Post by dillrob »

I have a somewhat unique situation that has me questioning whether to do a roth conversion next year. I am an early retiree (currently 58) and am managing my MAGI to qualify for low cost healthcare via the ACA. I ran some numbers and have to decide whether converting $44,000 of my taxable IRA is worth the estimated additional $8,000 in federal and state taxes, and healthcare costs for 2022 ($9,600 vs $1,600). Assuming a higher federal tax bracket in the future (which is reasonable considering I will have an AGI near $200k once my RMDs start at 72) then the roth conversion certainly makes sense just considering the future after tax returns. However, I will probably not have to withdraw from my Roth as I will need to start spending down my taxable IRA and 401k starting at 65 (post ACA) and will have RMDS starting at 72. These post-65 withdraws will provide me with significantly more income than needed. Also, even if I did the roth conversion I project to be in the same IRMAA income band. With that in mind, it seems that the primary and maybe only reason to do the Roth convert is for the tax benefit of my heirs. I would appreciate any additional consideration or insights to what I may be missing with this analysis. Thanks.
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cowdogman
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Re: Roth conversion worth it

Post by cowdogman »

Assuming in 2035:

You'll be 72
You're filing as MFJ
2017 tax rates escalated at 3% pa
$200,000 AGI (I'm also assuming you have reduced your projected SS income to its taxable amount, not 100%)

Then in 2035 (Fed taxes only):

The top of the 15% bracket will be $129,214.67.

Standard deduction, over 65 deduction and exemptions will be, in the aggregate, $33,210.25.

Your taxable income will be $166,789.80.

$37,575 will be in the 25% bracket ($9,393.77).

Also keep in mind that if you are getting ACA credits/subsidies this year, you should add 8.5% to your effective tax rate this year--because for every dollar of increased AGI, your ACA subsidy reduces by $0.085 (assuming you're over the 400% FPL).
marcopolo
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Re: Roth conversion worth it

Post by marcopolo »

we are in a similar situation.

We convert to near the top of the 12% bracket.
For the next 2 years, that equates to a 20.5% marginal rate when considering reduced tax credits. After 2022,:the ACA tax credit loss will be closer to 10%, so 22% marginal rate.

Since tax rates in the future will be either 22% or 25%, that makes a lot of sense.

Converting in the 22% bracket is less clear. The marginal rate becomes 30.5% (32% after 2022). As a couple we are unlikely to have marginal rates that high when RMDs hit. No significant pensions, we keep lid on TDA growth by keeping only fixed income assets in those accounts.

With the small conversions we are doing for many years, and will do to top of 22% after Medicare age, we should be able to get the TDA down to the point where even as a single filer, we will not hit the 32% bracket.

Now if one of us passes well before RMDs (less time to convert) then the survivor may hit 32% for a small portion of income. But, you can't optimize for every situation.

Good luck to you. I wish our tax code was not so complicated.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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Marmot
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Re: Roth conversion worth it

Post by Marmot »

dillrob wrote: Sat Jul 24, 2021 8:16 am I have a somewhat unique situation that has me questioning whether to do a roth conversion next year. I am an early retiree (currently 58) and am managing my MAGI to qualify for low cost healthcare via the ACA. I ran some numbers and have to decide whether converting $44,000 of my taxable IRA is worth the estimated additional $8,000 in federal and state taxes, and healthcare costs for 2022 ($9,600 vs $1,600). Assuming a higher federal tax bracket in the future (which is reasonable considering I will have an AGI near $200k once my RMDs start at 72) then the roth conversion certainly makes sense just considering the future after tax returns. However, I will probably not have to withdraw from my Roth as I will need to start spending down my taxable IRA and 401k starting at 65 (post ACA) and will have RMDS starting at 72. These post-65 withdraws will provide me with significantly more income than needed. Also, even if I did the roth conversion I project to be in the same IRMAA income band. With that in mind, it seems that the primary and maybe only reason to do the Roth convert is for the tax benefit of my heirs. I would appreciate any additional consideration or insights to what I may be missing with this analysis. Thanks.
I might have missed this, but one since the IRMAA income band is adjusted every year, if you do something in a particular year, it doesn't necessarily affect the following years. Also - do the math on the difference cost for an increased IRMAA expense. It might not be too bad.

One other small point (if I may) - we get caught up in the IRA/Roth tax deductible world a lot. Do you intend to leave 100% to heirs? The reason I ask that is because of our particular situation/strategy. We are doing a 65% Charity/35% heirs split when we pass. In our situation we have 5 properties outside our main residence which add up to about 50% of our total net worth. When you look at it from a total net worth point of view, we have easily 35% in taxable funds to pass on the heirs. For us, the only real reason to do a Roth conversion is to reduce future RMD's. The existing tax protected funds will likely go to charity. Our estate attorney asked why we were doing Roths? Her statement was "why would you pay taxes early".
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Lee_WSP
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Re: Roth conversion worth it

Post by Lee_WSP »

It is a tax arbitrage calculation.

Treat the ACA subsidy phase out as a tax and run the numbers.

With an RMD of 200k, you definitely should be doing some Roth conversions up to the bracket below your estimated marginal tax rate at RMD's staying away from any IRMAA cliffs.
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samsoes
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Re: Roth conversion worth it

Post by samsoes »

Don't forget about the loss of cost sharing subsidies in addition to the payback of the premium tax credits when calculating the marginal tax rate for the conversion process.

Remember, also you're required to report changes to your income as they happen to your ACA exchange. If you start doing large Roth conversions and this is reported to your ACA exchange, your cost sharing subsidies (co-payments, deductibles, max out of pocket, etc.) will grow quite large.

Since the ACA requires that the participant re-apply each year, the large income you realized in the year doing Roth conversions will be used as the basis for your ACA MAGI in the new year, and thus also increase the deductibles, copays, max out of pocket, etc.

I am FIREd, now 58, and I consider myself to be in a ACA/MAGI prison, engineering my MAGI to be about $21,000 until I'm able to go on Medicare in 7 years. Once I'm 65, the Roth conversions can then begin. (Assuming, of course, I'm still living above grass.)
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Lee_WSP
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Re: Roth conversion worth it

Post by Lee_WSP »

I'm not sure what the ACA subsidy is actually worth, but if it's somehow actually worth the effort, you could do conversions every other year. It'd be essentially the same as splitting the difference.
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cowdogman
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Re: Roth conversion worth it

Post by cowdogman »

Agree with marcopolo above.

Keep in mind when you are doing your calculations that not the entire RMD will be taxed at the top rate and so it is helpful to look at the effective rate.

Using the numbers I set forth above (including using 2017 brackets as escalated):

Taxable Income $166,789.80

Tax at 10%: $3,175.04
Tax at 15%: $14,619.64
Tax at 25%: $9,393.78

Total Tax: $27,188.46
Effective Tax Rate: 16.30%
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WoodSpinner
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Re: Roth conversion worth it

Post by WoodSpinner »

OP,

Some good advice already but here are a few other things to consider.

How big is your TDA portfolio? The larger the portfolio the more valuable the tax arbitrage will be.

How much are you relying on the portfolio for your expenses. The more you need it the less valuable the Roth Conversion arbitrage will be (e.g. you will naturally be spending it down),

Are you charitably inclined? If so, larger QCDs can reduce the tax arbitrage and the less valuable Roth Conversions will be.

Are your LTC needs well covered? If not, having funds in the TDA can help pay for medical costs and may be deductible. This reduces the value of Roth Conversions.

Are your beneficiaries in a higher bracket than you expect during RMDs? This can make conversions more valuable by improving the tax arbitrage.

How much of your equity allocation do you hold in your TDA? The more equities you have the more valuable Roth Conversions become since they move you towards a more tax optimized portfolio (equities grow in Roth Tax Free).

Your question is best answered by modeling using a deterministic model (e.g. RPM or Pralana Gold etc) and then a probabilistic model (E.g. Firecalc, Flexible Retirement Planner etc.) to understand the impact of the expected changes in spending (e.g. higher taxes for conversions, higher medical costs).

Best of luck,

WoodSpinner
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Topic Author
dillrob
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Re: Roth conversion worth it

Post by dillrob »

Thanks for the replies.

Considering everything, the additional 2022 $8,100 cost (fed taxes, state taxes and ACA costs (both PTC and CSR based on estimated costs from healthcare.gov website) will conservatively yield about $7,000 more when I'm 75 (2% growth over inflation, 24% fed and 6% state). Clearly good from a pure dollar perspective.

Our heirs will likely be in a lower bracket so leaving funds in a roth is not going to be as beneficial to them. As a matter of fact, we'll be spending down our ira/401k starting at 65 and increasingly at 72. If all goes well, we will have allot of this spent or gifted before our demise leaving the untouched roth (and other assets) to our heirs.

I am leaning heavily toward the $8,100 bird in the hand as the future potential benefit is unlikely to be realized by me and not as material to my heirs.

Thanks again for the thoughtful input.
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dillrob
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Re: Roth conversion worth it

Post by dillrob »

Woodspinner -


"How big is your TDA portfolio? The larger the portfolio the more valuable the tax arbitrage will be.

How much are you relying on the portfolio for your expenses. The more you need it the less valuable the Roth Conversion arbitrage will be (e.g. you will naturally be spending it down),"

It's not that I will need the TDA portfolio but that I will have to use it. As you note, this reduces the arbitrage. My relatively large tax deferred position actually acts against doing the conversion since my RMDs from the TDA portfolio (in addition to social security) will more than cover my future expenses. This means I will not have to tap the roth rendering the arbitrage useless to me. Again, good for my heirs, but not beneficial for me.

Thanks
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cowdogman
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Re: Roth conversion worth it

Post by cowdogman »

dillrob wrote: Sat Jul 24, 2021 4:30 pm Woodspinner -


"How big is your TDA portfolio? The larger the portfolio the more valuable the tax arbitrage will be.

How much are you relying on the portfolio for your expenses. The more you need it the less valuable the Roth Conversion arbitrage will be (e.g. you will naturally be spending it down),"

It's not that I will need the TDA portfolio but that I will have to use it. As you note, this reduces the arbitrage. My relatively large tax deferred position actually acts against doing the conversion since my RMDs from the TDA portfolio (in addition to social security) will more than cover my future expenses. This means I will not have to tap the roth rendering the arbitrage useless to me. Again, good for my heirs, but not beneficial for me.

Thanks
OP: You hit on one of the big issues (IMO) in considering Roth conversions. My plan is to use taxable investments for retirement (and pay cap gains taxes) and not touch retirement accounts--other than for RMDs. I came the conclusion that if the only reason I am doing Roth conversions is to reduce RMDs, then I am making two bets: (1) that the taxes I pay ICW the conversion will be less than the taxes I pay later (plus I'll be able to make up the lost investment income on the taxes paid early) and (2) that RMDs will continue to required/not delayed again beyond 72. And when I calculate how little my year-by-year RMDs will be impacted by Roth conversions, making those two bets just does not seem worth it to me (at least above 12%--and maybe at 12%).

The above ignores the benefit to heirs of Roth conversions, but my goal is to maximize our assets for me and my wife.
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FiveK
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Re: Roth conversion worth it

Post by FiveK »

cowdogman wrote: Sat Jul 24, 2021 2:45 pm Keep in mind when you are doing your calculations that not the entire RMD will be taxed at the top rate
True, but any conversions now will affect the "top end" of the RMD, e.g., change it from $200K to, say, $190K.
and so it is helpful to look at the effective rate.
The effective rate is irrelevant. The marginal rate for the $10K difference between $200K and $190K is what will matter.
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FiveK
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Re: Roth conversion worth it

Post by FiveK »

dillrob wrote: Sat Jul 24, 2021 4:22 pm I am leaning heavily toward the $8,100 bird in the hand as the future potential benefit is unlikely to be realized by me and not as material to my heirs.
Based on a quick read of your situation, that makes sense. It also appears you have analyzed things well - nicely done!

While it doesn't address the Cost Sharing Reduction (CSR) amounts, Roth Conversion and Capital Gains On ACA Health Insurance may be of interest for others in this situation. Might be of interest to you also, if only to confirm what you have figured.
MikeG62
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Re: Roth conversion worth it

Post by MikeG62 »

marcopolo wrote: Sat Jul 24, 2021 1:33 pm we are in a similar situation.

We convert to near the top of the 12% bracket.
For the next 2 years, that equates to a 20.5% marginal rate when considering reduced tax credits. After 2022,:the ACA tax credit loss will be closer to 10%, so 22% marginal rate.

Since tax rates in the future will be either 22% or 25%, that makes a lot of sense.

Converting in the 22% bracket is less clear. The marginal rate becomes 30.5% (32% after 2022). As a couple we are unlikely to have marginal rates that high when RMDs hit. No significant pensions, we keep lid on TDA growth by keeping only fixed income assets in those accounts.

With the small conversions we are doing for many years, and will do to top of 22% after Medicare age, we should be able to get the TDA down to the point where even as a single filer, we will not hit the 32% bracket.

Now if one of us passes well before RMDs (less time to convert) then the survivor may hit 32% for a small portion of income. But, you can't optimize for every situation.

Good luck to you. I wish our tax code was not so complicated.
Came upon this interesting white paper on the payback period for early Roth converting, in which the author concludes that if one were expecting to be in a similar tax bracket pre-RMD's and once taking RMD's, the payback period for early Roth converting is indeed very long.

https://papers.ssrn.com/sol3/papers.cfm ... id=3860359

I built a model, based upon our very specific facts and circumstances, and that model indicated we would not breakeven with the early Roth conversions until I reach the age of about 88-89 (despite the fact that a larger portion of our RMD's would be taxed above the 12% bracket in the future if we don't Roth convert).

We are in a similar position to you (retired with room to the top of the 12% bracket). I've recently decided (again based upon our specific facts and circumstances) to harvest LT capital gains to the top of the 0% LTCG's tax bracket instead of Roth converting. While it is possible that we'd have the same result if these unrealized gains were left in place indefinitely (and inherited by our daughters with a basis step up), it is hard to model this with much precision as there are so many unknowns. I accept that reasonable minds could probably debate this for a very long time, but that's what I am currently planning to do.
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cowdogman
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Re: Roth conversion worth it

Post by cowdogman »

FiveK wrote: Sun Jul 25, 2021 12:59 am
cowdogman wrote: Sat Jul 24, 2021 2:45 pm Keep in mind when you are doing your calculations that not the entire RMD will be taxed at the top rate
True, but any conversions now will affect the "top end" of the RMD, e.g., change it from $200K to, say, $190K.
Correct, but I have noticed that when people start to look at RMD risk that there is a tendency to do back of the envelope calculations with the marginal rate applying to the whole RMD, when of course that is not the case.

As to the $10,000 in your example, assuming it is all taxed at the margin, it is is still very worthwhile when doing a Roth conversion analysis to look at the effective tax rate and actual tax savings during the RMD years with and without Roth conversions. This allows you to see what the real $ effect is of the Roth conversion--and compare it to the cost of the conversions. Because keep in mind that the benefit of Roth conversions is spread out over the whole RMD table from ages 72 to 115 and so almost none of us are likely to see a 100% benefit to any Roth conversion.

For example, if I do $400,000 of Roth conversions between 64 and 71 ($50,000/year) with approx $120K of incremental taxes on the conversions, my effective rate on taxable income when I'm 72 (first RMD year) goes from 16.65% to 16.20% and my taxes are reduced by $3,382. if I do $800,000 of Roth conversions between 64 and 71 ($100,000/year) with approx $234K of incremental taxes on the conversion, my effective rate on taxable income when I'm 72 goes from 16.65% to 15.72% and my taxes are reduced by $7,092.75.
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Re: Roth conversion worth it

Post by afan »

I will need to start spending down my taxable IRA and 401k starting at 65 (post ACA) and will have RMDS starting at 72. These post-65 withdraws will provide me with significantly more income than needed
Why will you need to take out more than you need from age 65 to 72?
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Eagle33
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Re: Roth conversion worth it

Post by Eagle33 »

Why is no consideration is given for the tax rate at the time of tax deferral? The tax rates were higher in the 90's than they were this century. If we decided to defer money at 28% tax rate in the 90's and now convert or withdraw it at 22% today, then why is that not a good decision? True converting at 12% is better than at 22%, but if we determine the lowest tax rate we will be in the future is 22% (increasing to 25% in 2026) then would it not be wise to take what tax savings we can get now? Once one of us passes, then single rate becomes 24% (28% in 2026). What are we not considering in our calculations?
Topic Author
dillrob
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Re: Roth conversion worth it

Post by dillrob »

afan -

At 65 I plan to withdraw from IRA/401(k) up to the top of the then current base IRMAA band to spend down these accounts since in the future (SS at 70 and RMDs at 72) I should be in a higher tax bracket. At this point the base IRMAA tops out around $176,000. This is more than I plan to need but worth the additional withdraw to spend down these accounts somewhat. At 72 RMDs may require larger withdraws.
Topic Author
dillrob
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Re: Roth conversion worth it

Post by dillrob »

Eagle33 -

Yes, I considered the tax effects on the decision. Even assuming current brackets the conversion makes sense from a purely financial perspective. However, since we may not need the Roth in the future (due to large tax deferred accounts that have to be exhausted and will meet our needs), the financial benefit will likely not be realized by us. Thus, the present cost may not be worthwhile unless (1) we fully use QCDs in the future and thus require some roth and brokerage funds to meet our needs or (2) we incur this present cost for the benefit of our heirs. At this point we don't anticipate QCDs in the full amount of our RMD. We'll will do some but not at 100%. Also, our heirs should be in a lower tax bracket and would not benefit from the present cost as much anyway. So, financially, yes it makes sense if we'd have to use the roth but less so if we don't intend to do so.
bradpevans
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Re: Roth conversion worth it

Post by bradpevans »

Eagle33 wrote: Sun Jul 25, 2021 10:23 pm Why is no consideration is given for the tax rate at the time of tax deferral? The tax rates were higher in the 90's than they were this century. If we decided to defer money at 28% tax rate in the 90's and now convert or withdraw it at 22% today, then why is that not a good decision? True converting at 12% is better than at 22%, but if we determine the lowest tax rate we will be in the future is 22% (increasing to 25% in 2026) then would it not be wise to take what tax savings we can get now? Once one of us passes, then single rate becomes 24% (28% in 2026). What are we not considering in our calculations?
That calculus relates to the initial choice: should i put $ into my tax deferred account?
While many people look at "tax savings (i.e. marginal rate at the time), I look at it more
like "money that was never taxed yet"

The Roth / no Roth conversion compares:
leave it in tax deferred .. and eventually pay some unknown tax rate later
vs.
convert to Roth and pay some known tax rate now
VanGar+Goyle
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Re: Roth conversion worth it

Post by VanGar+Goyle »

cowdogman wrote: Sat Jul 24, 2021 9:57 am Assuming in 2035:

You'll be 72
You're filing as MFJ
2017 tax rates escalated at 3% pa
$200,000 AGI (I'm also assuming you have reduced your projected SS income to its taxable amount, not 100%)

Then in 2035 (Fed taxes only):

The top of the 15% bracket will be $129,214.67.

Standard deduction, over 65 deduction and exemptions will be, in the aggregate, $33,210.25.

Your taxable income will be $166,789.80.

$37,575 will be in the 25% bracket ($9,393.77).

Also keep in mind that if you are getting ACA credits/subsidies this year, you should add 8.5% to your effective tax rate this year--because for every dollar of increased AGI, your ACA subsidy reduces by $0.085 (assuming you're over the 400% FPL).
I like the precision for 14 years in the future, if not the accuracy. :happy
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cowdogman
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Re: Roth conversion worth it

Post by cowdogman »

VanGar+Goyle wrote: Tue Jul 27, 2021 9:45 am
cowdogman wrote: Sat Jul 24, 2021 9:57 am Assuming in 2035:

You'll be 72
You're filing as MFJ
2017 tax rates escalated at 3% pa
$200,000 AGI (I'm also assuming you have reduced your projected SS income to its taxable amount, not 100%)

Then in 2035 (Fed taxes only):

The top of the 15% bracket will be $129,214.67.

Standard deduction, over 65 deduction and exemptions will be, in the aggregate, $33,210.25.

Your taxable income will be $166,789.80.

$37,575 will be in the 25% bracket ($9,393.77).

Also keep in mind that if you are getting ACA credits/subsidies this year, you should add 8.5% to your effective tax rate this year--because for every dollar of increased AGI, your ACA subsidy reduces by $0.085 (assuming you're over the 400% FPL).
I like the precision for 14 years in the future, if not the accuracy. :happy
Given the assumptions, I'm curious what you find inaccurate. Of course what the actual rates will be in 2035 I have no idea, but all I have to by is current law.
bradpevans
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Re: Roth conversion worth it

Post by bradpevans »

MikeG62 wrote: Sun Jul 25, 2021 10:26 am
marcopolo wrote: Sat Jul 24, 2021 1:33 pm we are in a similar situation.

We convert to near the top of the 12% bracket.
For the next 2 years, that equates to a 20.5% marginal rate when considering reduced tax credits. After 2022,:the ACA tax credit loss will be closer to 10%, so 22% marginal rate.

Since tax rates in the future will be either 22% or 25%, that makes a lot of sense.

Converting in the 22% bracket is less clear. The marginal rate becomes 30.5% (32% after 2022). As a couple we are unlikely to have marginal rates that high when RMDs hit. No significant pensions, we keep lid on TDA growth by keeping only fixed income assets in those accounts.

With the small conversions we are doing for many years, and will do to top of 22% after Medicare age, we should be able to get the TDA down to the point where even as a single filer, we will not hit the 32% bracket.

Now if one of us passes well before RMDs (less time to convert) then the survivor may hit 32% for a small portion of income. But, you can't optimize for every situation.

Good luck to you. I wish our tax code was not so complicated.
Came upon this interesting white paper on the payback period for early Roth converting, in which the author concludes that if one were expecting to be in a similar tax bracket pre-RMD's and once taking RMD's, the payback period for early Roth converting is indeed very long.

https://papers.ssrn.com/sol3/papers.cfm ... id=3860359

I built a model, based upon our very specific facts and circumstances, and that model indicated we would not breakeven with the early Roth conversions until I reach the age of about 88-89 (despite the fact that a larger portion of our RMD's would be taxed above the 12% bracket in the future if we don't Roth convert).

We are in a similar position to you (retired with room to the top of the 12% bracket). I've recently decided (again based upon our specific facts and circumstances) to harvest LT capital gains to the top of the 0% LTCG's tax bracket instead of Roth converting. While it is possible that we'd have the same result if these unrealized gains were left in place indefinitely (and inherited by our daughters with a basis step up), it is hard to model this with much precision as there are so many unknowns. I accept that reasonable minds could probably debate this for a very long time, but that's what I am currently planning to do.
In terms of tax rate arbitrage, favorable LTCG could/would shift a 15% to a zero%
Roth more typically would shift 22% to 12%, hence good reason to do cap gains.

Also, with cap gains you pay tax only on the gain but of course you get to spend all of it.
An investment of almost 80K now worth 160K (spendable) could be "cashed in" at 0% (assuming MFJ, no other income)

Or, given enough cash, the basis could be stepped up 80K without a tax hit (assuming MFJ, no other income but other money/cash to pay expenses)
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