[**Update] - Metrics to Compare Roth Conversion Scenarios ??

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marcopolo
Posts: 8411
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by marcopolo »

WoodSpinner wrote: Sun Jul 25, 2021 8:58 pm
Lee_WSP wrote: Sun Jul 25, 2021 8:01 pm It's a question of paying today what may be put off until tomorrow or even ten years or more after death.

If you're able to defer it until after death, then you only care if you care about your heirs. If you do care, it is still a tax rate today vs tax rate for them comparison.

I do not believe there is any rate of return on such a decision as it is a tax arbitrage decision and the only "return" is in paying a lower tax rate.
By paying taxes early and moving assets to a more optimal location (at least in my situation) it is more than a tax arbitrage. I am reducing the overall tax bill and increasing the tax adjusted portfolio value.

The tax arbitrage aspect is important but it isn’t a metric that will help me select among the alternatives I am considering. They all have positive tax arbitrage.

WoodSpinner
Do you tax adjust your asset allocation?
If not, I think the perceived benefit might just be a mirage from actually taking on more risk by having a higher equity allocation when tax-adjusted.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

marcopolo wrote: Sun Jul 25, 2021 9:36 pm
WoodSpinner wrote: Sun Jul 25, 2021 8:58 pm
Lee_WSP wrote: Sun Jul 25, 2021 8:01 pm It's a question of paying today what may be put off until tomorrow or even ten years or more after death.

If you're able to defer it until after death, then you only care if you care about your heirs. If you do care, it is still a tax rate today vs tax rate for them comparison.

I do not believe there is any rate of return on such a decision as it is a tax arbitrage decision and the only "return" is in paying a lower tax rate.
By paying taxes early and moving assets to a more optimal location (at least in my situation) it is more than a tax arbitrage. I am reducing the overall tax bill and increasing the tax adjusted portfolio value.

The tax arbitrage aspect is important but it isn’t a metric that will help me select among the alternatives I am considering. They all have positive tax arbitrage.

WoodSpinner
Do you tax adjust your asset allocation?
If not, I think the perceived benefit might just be a mirage from actually taking on more risk by having a higher equity allocation when tax-adjusted.
Tell me more about a Tax adjusted Asset Allocation? Not sure what you mean….
WoodSpinner
marcopolo
Posts: 8411
Joined: Sat Dec 03, 2016 9:22 am

Re: Metrics to Compare Roth Conversion Scenarios ??

Post by marcopolo »

WoodSpinner wrote: Sun Jul 25, 2021 9:55 pm
marcopolo wrote: Sun Jul 25, 2021 9:36 pm
WoodSpinner wrote: Sun Jul 25, 2021 8:58 pm
Lee_WSP wrote: Sun Jul 25, 2021 8:01 pm It's a question of paying today what may be put off until tomorrow or even ten years or more after death.

If you're able to defer it until after death, then you only care if you care about your heirs. If you do care, it is still a tax rate today vs tax rate for them comparison.

I do not believe there is any rate of return on such a decision as it is a tax arbitrage decision and the only "return" is in paying a lower tax rate.
By paying taxes early and moving assets to a more optimal location (at least in my situation) it is more than a tax arbitrage. I am reducing the overall tax bill and increasing the tax adjusted portfolio value.

The tax arbitrage aspect is important but it isn’t a metric that will help me select among the alternatives I am considering. They all have positive tax arbitrage.

WoodSpinner
Do you tax adjust your asset allocation?
If not, I think the perceived benefit might just be a mirage from actually taking on more risk by having a higher equity allocation when tax-adjusted.
Tell me more about a Tax adjusted Asset Allocation? Not sure what you mean….
There is a fairly good description on the wiki page (https://www.bogleheads.org/wiki/Tax-adj ... allocation), so i will not try to repeat it hear, other than to quote one sentence from that entry:

"Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value."
Once in a while you get shown the light, in the strangest of places if you look at it right.
curmudgeon
Posts: 2630
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by curmudgeon »

Finding an appropriate Figure Of Merit to use in complex analysis can be surprisingly hard. Often there is not a single figure which will adequately describe the impacts of various decisions.

It's possible to create scenarios which will have high levels of variation due to unpredictable life events; a classic example would be leaving a significant amount of your estate to charity. If you were to optimize Roth conversions based on living to age 90, they they might be significantly sub-optimal if you died at age 80.

I don't try to find the single best plan, but rather one of a set of reasonable plans that will do limited harm and have a good likelihood of a positive improvement under a range of reasonable scenarios. In our case this is helped by having the simplifying situation of our heirs being kids and grandkids who would be expected to be in similar or higher tax brackets.

I do expect that tax rates and provisions will change during my retirement, possibly in significant ways. I don't try to go too far in predicting how taxes will change, as the whims of congress and public opinion are far too unpredictable. I consider the possibility of significant medical deductions (for long term care), but I don't treat that as the expected path. I consider the possibility that we might want to withdraw a large lump sum at some point.

In our case, without any pensions, a big question that comes into play is whether the current model of taxation of SS benefits will persist. If it does, then large conversions will give us the potential of avoiding all or nearly all of tax on those benefits. This gives a pretty substantial tax rate arbitrage. But the payoff for that depends on how long we live and collect SS.

I consider a plan based on optimizing total post-tax account value for the exact current tax laws and standard life expectancies to be a reasonable starting point, but it needs to still work reasonably for a variety of plausible tax changes and lifespans.
is50xenough
Posts: 323
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by is50xenough »

WoodSpinner wrote: Sun Jul 25, 2021 3:23 pm
is50xenough wrote: Sun Jul 25, 2021 3:00 am
Woodspinner, I’d like to see total portfolio just to better understand total tax adjusted portfolio. Not sure what other metrics get you. Love to see some of your results.

Good luck
Hypothetical …

At age 90:
Taxable $700,000
Roth $3,000,000
IRA $900,000
Total $4,600,000

Marginal rate at 90, 28% Fed, 9.3% State (37.3% Marginal)
Tax Adjusted Portfolio
Taxable $700,000
Roth $3,000,000
IRA $564,300
Total $4,264,000

Does this help?

WoodSpinner
No, because there is no comparison here of no conversions versus say convert to top of 24% bracket. Also if doing tax adjusted wouldn’t you want to adjust taxable for cap gains hit?
markcoop
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Joined: Fri Mar 02, 2007 7:36 am

Re: Metrics to Compare Roth Conversion Scenarios ??

Post by markcoop »

marcopolo wrote: Sun Jul 25, 2021 10:06 pm "Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value."
I have always tax-adjusted my AA and believed this point to be true. However, I believe this has been one of the bigger mistakes I have made. It is true just looking at the return of the investment. However, when I factor in things like extra SS taxed due to higher RMDs, then asset placement becomes critical even if you tax-adjust your AA.

For example, If I wanted a 50/50 AA in a 25% tax bracket, in the past I did not care if I had either of the following cases:
1) $4,000 equity in my 401K and $3,000 fixed income in Roth
2) $4,000 fixed income in my 401K and $3,000 equity in my Roth.

However, case 1 will cause my RMDs to be higher. Again, from an investment after-tax return, both cases are the same. But the higher RMD can cause more SS to be taxed, meaning both cases are not the same. Not even close to the same.
Last edited by markcoop on Mon Jul 26, 2021 8:39 am, edited 1 time in total.
Mark
MikeG62
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by MikeG62 »

curmudgeon wrote: Sun Jul 25, 2021 10:21 pm Finding an appropriate Figure Of Merit to use in complex analysis can be surprisingly hard. Often there is not a single figure which will adequately describe the impacts of various decisions.

It's possible to create scenarios which will have high levels of variation due to unpredictable life events; a classic example would be leaving a significant amount of your estate to charity. If you were to optimize Roth conversions based on living to age 90, they they might be significantly sub-optimal if you died at age 80.

I don't try to find the single best plan, but rather one of a set of reasonable plans that will do limited harm and have a good likelihood of a positive improvement under a range of reasonable scenarios.
This is well said. I view the situation very similarly.
Real Knowledge Comes Only From Experience
markcoop
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by markcoop »

I am like many here who have made my own spreadsheet. In my case, I plan to convert to the top of the 12% bracket from retirement till SS begins. In modeling this stuff out, playing around with many assumptions affects the outcome. I assumed stocks returned 6% nominal to be conservative. However, using an 8% return changed my results. For my case, the simplest best metric I used was marginal tax-rate. My goal, therefore, was to always stay in the 12% bracket after SS began till I die. At 6% stock return, my model shows success (12% tax bracket in all years). At 8% stock return I hit the 22% bracket in many years. I then realized that sensitivity is a big issue. So I added a column for how far away from the 22% bracket I am in every year. I have found that useful. I also added a second table for the single survivor case. In that table, the single survivor is always in the 22% tax bracket. My initial goal there was to avoid IRMAA level 1. Again, I made a column for how close I am to that point. In order for me to get the single survivor into the 12% tax-bracket, I need to cut my TDA quite a bit. The only way that could happen is if stock/bond returns drop significantly, not something I am rooting for.
Last edited by markcoop on Mon Jul 26, 2021 9:51 am, edited 3 times in total.
Mark
Exchme
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by Exchme »

WoodSpinner wrote: Sun Jul 25, 2021 8:52 pm
Exchme wrote: Sun Jul 25, 2021 7:37 pm
WoodSpinner wrote: Sun Jul 25, 2021 3:35 pm I have also found significant benefit to the optimization of asset location and plan to post in this in a separate thread. Not only is the the IRA growth slowed but the equities moved to Roth are now growing tax free. I am still trying to figure out how to quantify the benefit— did you do any work along those lines?

I found the same thing in my case, combining asset location optimization with doing Roth Conversions provided more benefit and cut the optimum amount of Roth Conversions, in my case the optimum amount of conversions was cut in half.

The wiki suggests that asset location optimization looks good due to a stealth increase in stock allocation since tax deferred is being filled with bonds (so the government's share becomes bonds not stocks, leaving your share more stocks and less bonds). I checked that effect between my 1st and 2nd place contenders and the stealth asset allocation effect was real, but much smaller than the differences between cases, so I think I found the right optimum (given the many life, tax and return assumptions!).

I do all my evaluations from the perspective of maximizing my estate if my heirs' were my financial clone, so evaluate after heir liquidation. That at least sets a metric that I can use. For comparison purposes, I converted those future values back to present values and compare to the total of the Roth Conversions.
Could you tell me more? Or provide some examples? I want to make sure I understand your approach!

Thanks

WoodSpinner
I think the discussion of IRR and ROI clouds the issue in your case where you expect to pass money to your heirs and want to do it in the best way. What matters is the final portfolio value in the hands of heirs after the 10 year liquidation period. That requires estimates of the heirs finances at that time to get a feel for their expected tax rates.

In my own case, we are planning for say 30 years more life, which would bring the kids to about our age. I've already projected our portfolio growth to that point, so I figure that the inheritance will cause them to retire, so they will then have their assets + ours + their SS. So I can run an estimated year by year simulation of their case for the 10 year liquidation period.

I see some folks just using the taxes on the heir conversions of the t-IRA, trying to simplify the heir liquidation calculation, but that misses an important effect. Our paying taxes on our Roth Conversions from taxable reduced the taxable account tax drag during the 10 year liquidation. Also, as the inherited t-IRA gets converted, that money lands in the heirs' taxable account several years earlier on average than the Roth money, so less in the t-IRA means less tax drag due to that money as well. In our case, over the range of Roth Conversions of 0 - 60% of initial t-IRA account value, that extra drag from taxable varied from 60% to 110% the size of the taxes on the inherited IRA conversion itself.

To compare cases to ensure we're not moving big money for small benefit and also allow studies of the effect of us living more or less time, I did a present value calculation, discounting the final liquidated portfolio value to say 4 or 5 years from now, as that will be the $ weighted average date of our Roth Conversions. I used the inflation adjusted portfolio growth rate as the discount rate for the PV calculation. Then I can compare each increment of Roth Conversions to the change in PV.
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

marcopolo wrote: Sun Jul 25, 2021 10:06 pm
WoodSpinner wrote: Sun Jul 25, 2021 9:55 pm
marcopolo wrote: Sun Jul 25, 2021 9:36 pm
WoodSpinner wrote: Sun Jul 25, 2021 8:58 pm
Lee_WSP wrote: Sun Jul 25, 2021 8:01 pm It's a question of paying today what may be put off until tomorrow or even ten years or more after death.

If you're able to defer it until after death, then you only care if you care about your heirs. If you do care, it is still a tax rate today vs tax rate for them comparison.

I do not believe there is any rate of return on such a decision as it is a tax arbitrage decision and the only "return" is in paying a lower tax rate.
By paying taxes early and moving assets to a more optimal location (at least in my situation) it is more than a tax arbitrage. I am reducing the overall tax bill and increasing the tax adjusted portfolio value.

The tax arbitrage aspect is important but it isn’t a metric that will help me select among the alternatives I am considering. They all have positive tax arbitrage.

WoodSpinner
Do you tax adjust your asset allocation?
If not, I think the perceived benefit might just be a mirage from actually taking on more risk by having a higher equity allocation when tax-adjusted.
Tell me more about a Tax adjusted Asset Allocation? Not sure what you mean….
There is a fairly good description on the wiki page (https://www.bogleheads.org/wiki/Tax-adj ... allocation), so i will not try to repeat it hear, other than to quote one sentence from that entry:

"Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value."
Marcopolo,

Thanks for the link….

I am not Tax adjusting the Asset Allocation!

From my perspective, shifting my Portfolio from a less optimized Asset Location (e.g. most equities in my TDA) to a more optimized location (Equities only in Roth or Taxable) is a major benefit of Roth Conversions in our situation.

WoodSpinner
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

curmudgeon wrote: Sun Jul 25, 2021 10:21 pm Finding an appropriate Figure Of Merit to use in complex analysis can be surprisingly hard. Often there is not a single figure which will adequately describe the impacts of various decisions.

It's possible to create scenarios which will have high levels of variation due to unpredictable life events; a classic example would be leaving a significant amount of your estate to charity. If you were to optimize Roth conversions based on living to age 90, they they might be significantly sub-optimal if you died at age 80.

I don't try to find the single best plan, but rather one of a set of reasonable plans that will do limited harm and have a good likelihood of a positive improvement under a range of reasonable scenarios. In our case this is helped by having the simplifying situation of our heirs being kids and grandkids who would be expected to be in similar or higher tax brackets.

I do expect that tax rates and provisions will change during my retirement, possibly in significant ways. I don't try to go too far in predicting how taxes will change, as the whims of congress and public opinion are far too unpredictable. I consider the possibility of significant medical deductions (for long term care), but I don't treat that as the expected path. I consider the possibility that we might want to withdraw a large lump sum at some point.

In our case, without any pensions, a big question that comes into play is whether the current model of taxation of SS benefits will persist. If it does, then large conversions will give us the potential of avoiding all or nearly all of tax on those benefits. This gives a pretty substantial tax rate arbitrage. But the payoff for that depends on how long we live and collect SS.

I consider a plan based on optimizing total post-tax account value for the exact current tax laws and standard life expectancies to be a reasonable starting point, but it needs to still work reasonably for a variety of plausible tax changes and lifespans.
I agree with your approach. Not easy to do but it aligns with what I am trying to do.

WoodSpinner
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

is50xenough wrote: Mon Jul 26, 2021 3:15 am
WoodSpinner wrote: Sun Jul 25, 2021 3:23 pm
is50xenough wrote: Sun Jul 25, 2021 3:00 am
Woodspinner, I’d like to see total portfolio just to better understand total tax adjusted portfolio. Not sure what other metrics get you. Love to see some of your results.

Good luck
Hypothetical …

At age 90:
Taxable $700,000
Roth $3,000,000
IRA $900,000
Total $4,600,000

Marginal rate at 90, 28% Fed, 9.3% State (37.3% Marginal)
Tax Adjusted Portfolio
Taxable $700,000
Roth $3,000,000
IRA $564,300
Total $4,264,000

Does this help?

WoodSpinner
No, because there is no comparison here of no conversions versus say convert to top of 24% bracket. Also if doing tax adjusted wouldn’t you want to adjust taxable for cap gains hit?
To be clearer ….

I compare the Tax adjusted Portfolio Value of No Conversions to the value of each conversion scenario (see posts above).

You are correct about not including a Capital Gains discount in Taxable. I omitted this for 2 reasons:

- I won’t have any Taxable until RMDs begin at 72 (in 10 years)
- I don’t have a clue on how to model it

If you have some suggestions for modeling I would be very interested. See viewtopic.php?t=353100 for a discussion on the approach.

Thanks

WoodSpinner
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

Exchme wrote: Mon Jul 26, 2021 8:25 am
WoodSpinner wrote: Sun Jul 25, 2021 8:52 pm
Exchme wrote: Sun Jul 25, 2021 7:37 pm
WoodSpinner wrote: Sun Jul 25, 2021 3:35 pm I have also found significant benefit to the optimization of asset location and plan to post in this in a separate thread. Not only is the the IRA growth slowed but the equities moved to Roth are now growing tax free. I am still trying to figure out how to quantify the benefit— did you do any work along those lines?

I found the same thing in my case, combining asset location optimization with doing Roth Conversions provided more benefit and cut the optimum amount of Roth Conversions, in my case the optimum amount of conversions was cut in half.

The wiki suggests that asset location optimization looks good due to a stealth increase in stock allocation since tax deferred is being filled with bonds (so the government's share becomes bonds not stocks, leaving your share more stocks and less bonds). I checked that effect between my 1st and 2nd place contenders and the stealth asset allocation effect was real, but much smaller than the differences between cases, so I think I found the right optimum (given the many life, tax and return assumptions!).

I do all my evaluations from the perspective of maximizing my estate if my heirs' were my financial clone, so evaluate after heir liquidation. That at least sets a metric that I can use. For comparison purposes, I converted those future values back to present values and compare to the total of the Roth Conversions.
Could you tell me more? Or provide some examples? I want to make sure I understand your approach!

Thanks

WoodSpinner
I think the discussion of IRR and ROI clouds the issue in your case where you expect to pass money to your heirs and want to do it in the best way. What matters is the final portfolio value in the hands of heirs after the 10 year liquidation period. That requires estimates of the heirs finances at that time to get a feel for their expected tax rates.

In my own case, we are planning for say 30 years more life, which would bring the kids to about our age. I've already projected our portfolio growth to that point, so I figure that the inheritance will cause them to retire, so they will then have their assets + ours + their SS. So I can run an estimated year by year simulation of their case for the 10 year liquidation period.

I see some folks just using the taxes on the heir conversions of the t-IRA, trying to simplify the heir liquidation calculation, but that misses an important effect. Our paying taxes on our Roth Conversions from taxable reduced the taxable account tax drag during the 10 year liquidation. Also, as the inherited t-IRA gets converted, that money lands in the heirs' taxable account several years earlier on average than the Roth money, so less in the t-IRA means less tax drag due to that money as well. In our case, over the range of Roth Conversions of 0 - 60% of initial t-IRA account value, that extra drag from taxable varied from 60% to 110% the size of the taxes on the inherited IRA conversion itself.

To compare cases to ensure we're not moving big money for small benefit and also allow studies of the effect of us living more or less time, I did a present value calculation, discounting the final liquidated portfolio value to say 4 or 5 years from now, as that will be the $ weighted average date of our Roth Conversions. I used the inflation adjusted portfolio growth rate as the discount rate for the PV calculation. Then I can compare each increment of Roth Conversions to the change in PV.
Very interesting…. Will study on this a bit, thanks for getting me thinking….

WoodSpinner
WoodSpinner
is50xenough
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by is50xenough »

WoodSpinner wrote: Mon Jul 26, 2021 10:25 am
is50xenough wrote: Mon Jul 26, 2021 3:15 am
WoodSpinner wrote: Sun Jul 25, 2021 3:23 pm
is50xenough wrote: Sun Jul 25, 2021 3:00 am
Woodspinner, I’d like to see total portfolio just to better understand total tax adjusted portfolio. Not sure what other metrics get you. Love to see some of your results.

Good luck
Hypothetical …

At age 90:
Taxable $700,000
Roth $3,000,000
IRA $900,000
Total $4,600,000

Marginal rate at 90, 28% Fed, 9.3% State (37.3% Marginal)
Tax Adjusted Portfolio
Taxable $700,000
Roth $3,000,000
IRA $564,300
Total $4,264,000

Does this help?

WoodSpinner
No, because there is no comparison here of no conversions versus say convert to top of 24% bracket. Also if doing tax adjusted wouldn’t you want to adjust taxable for cap gains hit?
To be clearer ….

I compare the Tax adjusted Portfolio Value of No Conversions to the value of each conversion scenario (see posts above).

You are correct about not including a Capital Gains discount in Taxable. I omitted this for 2 reasons:

- I won’t have any Taxable until RMDs begin at 72 (in 10 years)
- I don’t have a clue on how to model it

If you have some suggestions for modeling I would be very interested. See viewtopic.php?t=353100 for a discussion on the approach.

Thanks

WoodSpinner
Understood but you haven't posted base case with say 24% conversion and show portfolio and tax corrected portfolio in one table. If you do that I can comment on usefulness and if so why.

I would stay simple initially and with current tax code including planned reversion in 2026 and figure capital gains when money needs to be taken out of tax deferred. Would approximate first year either as current capital gains total or if not first year would correct for anticipated growth per year and use current basis as starting point----if that makes sense.
marcopolo
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by marcopolo »

markcoop wrote: Mon Jul 26, 2021 8:07 am
marcopolo wrote: Sun Jul 25, 2021 10:06 pm "Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value."
I have always tax-adjusted my AA and believed this point to be true. However, I believe this has been one of the bigger mistakes I have made. It is true just looking at the return of the investment. However, when I factor in things like extra SS taxed due to higher RMDs, then asset placement becomes critical even if you tax-adjust your AA.

For example, If I wanted a 50/50 AA in a 25% tax bracket, in the past I did not care if I had either of the following cases:
1) $4,000 equity in my 401K and $3,000 fixed income in Roth
2) $4,000 fixed income in my 401K and $3,000 equity in my Roth.

However, case 1 will cause my RMDs to be higher. Again, from an investment after-tax return, both cases are the same. But the higher RMD can cause more SS to be taxed, meaning both cases are not the same. Not even close to the same.
You are correct. I keep all fixed income in TDA account for this reason.

My point is that it goes back to a tax arbitrage benefit, as you describe. I provided my comment and the link in response to Woodspinner's assertion that there where return benefits to having equities in Roth instead of TDA in addition to the tax arbitrage benefit of keeping a lid on TDA growth. That is a common myth that gets repeated often.

Limiting growth of TDA is a great reason to keep equities out of TDA to the extent possible. But, any perceived return benefit from moving them to Roth without tax adjusting comes from taking on added risk, not from asset location.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

marcopolo wrote: Mon Jul 26, 2021 11:42 am
markcoop wrote: Mon Jul 26, 2021 8:07 am
marcopolo wrote: Sun Jul 25, 2021 10:06 pm "Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value."
I have always tax-adjusted my AA and believed this point to be true. However, I believe this has been one of the bigger mistakes I have made. It is true just looking at the return of the investment. However, when I factor in things like extra SS taxed due to higher RMDs, then asset placement becomes critical even if you tax-adjust your AA.

For example, If I wanted a 50/50 AA in a 25% tax bracket, in the past I did not care if I had either of the following cases:
1) $4,000 equity in my 401K and $3,000 fixed income in Roth
2) $4,000 fixed income in my 401K and $3,000 equity in my Roth.

However, case 1 will cause my RMDs to be higher. Again, from an investment after-tax return, both cases are the same. But the higher RMD can cause more SS to be taxed, meaning both cases are not the same. Not even close to the same.
You are correct. I keep all fixed income in TDA account for this reason.

My point is that it goes back to a tax arbitrage benefit, as you describe. I provided my comment and the link in response to Woodspinner's assertion that there where return benefits to having equities in Roth instead of TDA in addition to the tax arbitrage benefit of keeping a lid on TDA growth. That is a common myth that gets repeated often.

Limiting growth of TDA is a great reason to keep equities out of TDA to the extent possible. But, any perceived return benefit from moving them to Roth without tax adjusting comes from taking on added risk, not from asset location.
As long as my overall AA remains the same I am fine with the risk profile — that is how I have managed the portfolio for many years.

I will be happy to spend the extra money earned from optimizing the asset location.

WoodSpinner
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marcopolo
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by marcopolo »

WoodSpinner wrote: Mon Jul 26, 2021 3:53 pm
marcopolo wrote: Mon Jul 26, 2021 11:42 am
markcoop wrote: Mon Jul 26, 2021 8:07 am
marcopolo wrote: Sun Jul 25, 2021 10:06 pm "Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value."
I have always tax-adjusted my AA and believed this point to be true. However, I believe this has been one of the bigger mistakes I have made. It is true just looking at the return of the investment. However, when I factor in things like extra SS taxed due to higher RMDs, then asset placement becomes critical even if you tax-adjust your AA.

For example, If I wanted a 50/50 AA in a 25% tax bracket, in the past I did not care if I had either of the following cases:
1) $4,000 equity in my 401K and $3,000 fixed income in Roth
2) $4,000 fixed income in my 401K and $3,000 equity in my Roth.

However, case 1 will cause my RMDs to be higher. Again, from an investment after-tax return, both cases are the same. But the higher RMD can cause more SS to be taxed, meaning both cases are not the same. Not even close to the same.
You are correct. I keep all fixed income in TDA account for this reason.

My point is that it goes back to a tax arbitrage benefit, as you describe. I provided my comment and the link in response to Woodspinner's assertion that there where return benefits to having equities in Roth instead of TDA in addition to the tax arbitrage benefit of keeping a lid on TDA growth. That is a common myth that gets repeated often.

Limiting growth of TDA is a great reason to keep equities out of TDA to the extent possible. But, any perceived return benefit from moving them to Roth without tax adjusting comes from taking on added risk, not from asset location.
As long as my overall AA remains the same I am fine with the risk profile — that is how I have managed the portfolio for many years.

I will be happy to spend the extra money earned from optimizing the asset location.

WoodSpinner
As long as it works for your situation that is all that matters.

Just to clarify, the extra money comes from asset allocation, not asset location. As long as you are ok with the added risk associated with the higher allocation, that is fine. But, in that case there is no need to wait to move the money to the Roth account. If you want the extra money from the higher equity allocation (and ok with attendant risk) then you could go ahead and do that in your taxable of TDA account. Other than the possibility of higher RMDs pushing you into a higher tax bracket, the placement does not provide any better risk adjusted return.

EDIT: You said "as long as my overall AA stays the same". That is the main issue. The overall AA does not stay the same. Since a dollar in Roth is worth more to you than a dollar in TDA due to your outstanding tax obligations on the TDA dollars, the same dollar amount in each type of account does not produce the same overall AA.
Just something to think about, not trying to change how you manage your accounts.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by FiveK »

Any metric that uses "amount of tax paid" as a standalone input (as opposed to "marginal tax rate", where the tax paid is divided by the income in question) is liable to mislead.

Simple example (same investment in traditional vs. Roth; no taxable account present):
a) Convert $10K at a 32% tax rate now and withdraw after the investment quadruples, vs.
b) Don't convert. Instead, wait while the investment quadruples and then withdraw at a 12% rate.

Tax paid:
a) $3,200
b) $4,800

Spendable amount remaining:
a) $27,200
b) $35,200

Seems clear that "b" is the better choice, even though 50% more tax is paid.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by McQ »

WoodSpinner wrote: Sun Jul 25, 2021 3:23 pm
is50xenough wrote: Sun Jul 25, 2021 3:00 am
Woodspinner, I’d like to see total portfolio just to better understand total tax adjusted portfolio. Not sure what other metrics get you. Love to see some of your results.

Good luck
Hypothetical …

At age 90:
Taxable $700,000
Roth $3,000,000
IRA $900,000
Total $4,600,000

Marginal rate at 90, 28% Fed, 9.3% State (37.3% Marginal)
Tax Adjusted Portfolio
Taxable $700,000
Roth $3,000,000
IRA $564,300
Total $4,264,000

Does this help?

WoodSpinner
Hello all: Woodspinner asked me to comment on his metrics here. Apologies to those who also participated in the earlier thread; it is not likely I will say anything new here.

First, as to metrics, I generally agree with the line by line response by FiveK. See especially his/her concise demonstration earlier today that tax paid cannot be the metric.

Next, if I may put the “how to measure outcomes” question in my own language: there is no substitute for preparing a year by year spreadsheet. Results will always be better for Roth conversions over longer time frames. Since you have a bequest motive, I think you should run the spreadsheet out to your age 110. I know you don’t think you will live past 90, but … I’m somewhat older than you, and my mother is still going strong at 96. There can be no final age from which IRR calculations are done. That’s not given to us humans to know.

Next, the absolute most crucial spreadsheet to construct is the “do nothing” spreadsheet: all your current portfolios, no conversions, how do you like the disposable income each year and the bequest? If there is clearly surplus—you can’t / won’t spend it all—then Roth conversions become attractive, up to the surplus amount.

Second, in version two of the spreadsheet you must create an exact counterfactual for, say, the first year’s conversion amount. You segregate the unconverted amount, invest it the same as the Roth, take RMDs from it, subtract taxes, reinvest the RMDs, and track how the Roth conversion slowly then quickly catches up and surpasses the counterfactual. Because it will, eventually.

You can also test after-tax liquidation values year by year; the Roth is ahead from the first RMD here, but gets farther ahead the longer you live. I always test both, pretax value and post-tax liquidation value, per the several comments upthread, re charitable donations, LTC and deductible medical expenditures, etc.

Wrinkle: when I adapted my spreadsheet to my own situation, I had some low return short term bond funds as well as some stock funds available to convert—let’s say $24,000 of the one and $76,000 of the other. My counterfactual now has two columns, one for each asset, which stay invested as they had been. For the Roth account, I assumed that I liquidated the bond funds to pay the tax, and had the $76,000 of stock now in the Roth. This asset location strategy will generally boost Roth outcomes; but it presumes you want to increase your stock allocation relative to your current AA, again as described up thread.

PS: after the first conversion you must never, ever leave California for Nevada, Washington, Texas, or Florida. Your spreadsheet will blow up. Not a problem for me; I’m never leaving California except feet first.

PPS: It is my understanding that California does not tax social security. Be sure your state tax calculations post age 70 reflect that fact.

Last, and to cut to the chase: I think you are converting too much. I would run an alternative scenario where you convert only up short of the first IRMAA level (near top of the 22% bracket in AGI terms).

Instead of your current max-convert plan, if it were me, I would pay the taxes on the RMDs (from the portion you failed to convert), and with the remainder, each year take your daughter and family to New Zealand or other bodacious destination, and leave her a much lower Roth balance as an inheritance (the future value of that New Zealand trip, if the expense was instead invested in VTI within the Roth… breathtaking!). But you see how quickly personal values supplant rational calculation once bequests come into the picture, and your values may not be the same as mine.

And, with this last recommendation I stand revealed as far more hedonistic, or Epicurean, than the typical BH. Imagine…spending money on pleasure today rather than scheming how to pass the future value of those funds on to heirs tax-free. Might get me placed on Boglehead probation!

PPPS: since Celia got you started on this path, would love to see her response to the dollar level of conversions that you currently intend in your plan.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by marcopolo »

McQ wrote: Mon Jul 26, 2021 10:58 pm
WoodSpinner wrote: Sun Jul 25, 2021 3:23 pm
is50xenough wrote: Sun Jul 25, 2021 3:00 am
Woodspinner, I’d like to see total portfolio just to better understand total tax adjusted portfolio. Not sure what other metrics get you. Love to see some of your results.

Good luck
Hypothetical …

At age 90:
Taxable $700,000
Roth $3,000,000
IRA $900,000
Total $4,600,000

Marginal rate at 90, 28% Fed, 9.3% State (37.3% Marginal)
Tax Adjusted Portfolio
Taxable $700,000
Roth $3,000,000
IRA $564,300
Total $4,264,000

Does this help?

WoodSpinner
Hello all: Woodspinner asked me to comment on his metrics here. Apologies to those who also participated in the earlier thread; it is not likely I will say anything new here.

First, as to metrics, I generally agree with the line by line response by FiveK. See especially his/her concise demonstration earlier today that tax paid cannot be the metric.

Next, if I may put the “how to measure outcomes” question in my own language: there is no substitute for preparing a year by year spreadsheet. Results will always be better for Roth conversions over longer time frames. Since you have a bequest motive, I think you should run the spreadsheet out to your age 110. I know you don’t think you will live past 90, but … I’m somewhat older than you, and my mother is still going strong at 96. There can be no final age from which IRR calculations are done. That’s not given to us humans to know.

Next, the absolute most crucial spreadsheet to construct is the “do nothing” spreadsheet: all your current portfolios, no conversions, how do you like the disposable income each year and the bequest? If there is clearly surplus—you can’t / won’t spend it all—then Roth conversions become attractive, up to the surplus amount.

Second, in version two of the spreadsheet you must create an exact counterfactual for, say, the first year’s conversion amount. You segregate the unconverted amount, invest it the same as the Roth, take RMDs from it, subtract taxes, reinvest the RMDs, and track how the Roth conversion slowly then quickly catches up and surpasses the counterfactual. Because it will, eventually.

You can also test after-tax liquidation values year by year; the Roth is ahead from the first RMD here, but gets farther ahead the longer you live. I always test both, pretax value and post-tax liquidation value, per the several comments upthread, re charitable donations, LTC and deductible medical expenditures, etc.

Wrinkle: when I adapted my spreadsheet to my own situation, I had some low return short term bond funds as well as some stock funds available to convert—let’s say $24,000 of the one and $76,000 of the other. My counterfactual now has two columns, one for each asset, which stay invested as they had been. For the Roth account, I assumed that I liquidated the bond funds to pay the tax, and had the $76,000 of stock now in the Roth. This asset location strategy will generally boost Roth outcomes; but it presumes you want to increase your stock allocation relative to your current AA, again as described up thread.

PS: after the first conversion you must never, ever leave California for Nevada, Washington, Texas, or Florida. Your spreadsheet will blow up. Not a problem for me; I’m never leaving California except feet first.

PPS: It is my understanding that California does not tax social security. Be sure your state tax calculations post age 70 reflect that fact.

Last, and to cut to the chase: I think you are converting too much. I would run an alternative scenario where you convert only up short of the first IRMAA level (near top of the 22% bracket in AGI terms).

Instead of your current max-convert plan, if it were me, I would pay the taxes on the RMDs (from the portion you failed to convert), and with the remainder, each year take your daughter and family to New Zealand or other bodacious destination, and leave her a much lower Roth balance as an inheritance (the future value of that New Zealand trip, if the expense was instead invested in VTI within the Roth… breathtaking!). But you see how quickly personal values supplant rational calculation once bequests come into the picture, and your values may not be the same as mine.

And, with this last recommendation I stand revealed as far more hedonistic, or Epicurean, than the typical BH. Imagine…spending money on pleasure today rather than scheming how to pass the future value of those funds on to heirs tax-free. Might get me placed on Boglehead probation!

PPPS: since Celia got you started on this path, would love to see her response to the dollar level of conversions that you currently intend in your plan.
As I discussed above, this asset location does not really boost the Roth outcome relative to the baseline case. The benefit, as you seem to agree, comes from the higher equity allocation of the portfolio. If one is willing to have that higher equity allocation, why would they not do that to begin with in the baseline case? An apple to apple comparison should compare the same tax adjusted asset allocation. Otherwise, you are confounding the benefit of the Roth Conversions with the benefit of higher equity allocation.

PS: I like your suggestion to spend more now rather than leave a large inheritance. Sending your RMDs, as opposed to re-imvesting them, also weakens the case for Roth Conversions, particularly in the equal marginal rate scenario.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

FiveK wrote: Mon Jul 26, 2021 5:45 pm Any metric that uses "amount of tax paid" as a standalone input (as opposed to "marginal tax rate", where the tax paid is divided by the income in question) is liable to mislead.

Simple example (same investment in traditional vs. Roth; no taxable account present):
a) Convert $10K at a 32% tax rate now and withdraw after the investment quadruples, vs.
b) Don't convert. Instead, wait while the investment quadruples and then withdraw at a 12% rate.

Tax paid:
a) $3,200
b) $4,800

Spendable amount remaining:
a) $27,200
b) $35,200

Seems clear that "b" is the better choice, even though 50% more tax is paid.
First, thanks for your reply and insights. I am not sure we will align on our thinking but I deeply respect your experience and insights.

FWIW, I very well might have chosen A if I was concerned about the Cashflow implications (which I am) and the uncertainties involved.

Not considering the Delta Tax costs for the various scenarios is missing a key part of the data metrics (IMHO). For instance I would consider spending $100 to gain a $10,000 increase in Spendable amount a good investment but would probably pass on spending $5,000 to gain a $10,000 increase. For me the question involves the Return on Investment vs. Internal Rate of Return metric and which one should have more weight.

Not sure if you saw this up-thread, these are actual results from the various scenarios I am considering (reposting for consideration)

[/quote]
So let's put some real numbers and see if it helps. The numbers reflect the deltas of the Total Tax Adjusted Portfolio Value which is the same as "spendable after taxes" at 90.

Image

I would certainly eliminate No Conversions and Balance Effective Taxes based on your suggestions..

This leaves the other scenarios in-play and the variance between them is fairly small (under 2%). I don't think this metric is enough to make a decision on.

If you then look at Return on Investment (ROI) it helps highlights the tax costs of getting the Tax adjusted Portfolio Value and can provide an insight into the efficiency of the tax payments versus spendable wealth.

Image.

RoI does provide some meaningful variance and if I stopped here, I have a clear answer to convert to the Top of the 24% Marginal bracket.

However, I think (and certainly could be wrong) that the Internal Rate of Return (IRR) is a better financial metric for evaluating expenses versus returns.

Image.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

McQ wrote: Mon Jul 26, 2021 10:58 pm Hello all: Woodspinner asked me to comment on his metrics here. Apologies to those who also participated in the earlier thread; it is not likely I will say anything new here.
Thank you very much for taking the time and thought in your reply. Its much appreciated and I have been pondering it (and FiveK's) input for the last day or so.
First, as to metrics, I generally agree with the line by line response by FiveK. See especially his/her concise demonstration earlier today that tax paid cannot be the metric.

Next, if I may put the “how to measure outcomes” question in my own language: there is no substitute for preparing a year by year spreadsheet. Results will always be better for Roth conversions over longer time frames. Since you have a bequest motive, I think you should run the spreadsheet out to your age 110. I know you don’t think you will live past 90, but … I’m somewhat older than you, and my mother is still going strong at 96. There can be no final age from which IRR calculations are done. That’s not given to us humans to know.

Next, the absolute most crucial spreadsheet to construct is the “do nothing” spreadsheet: all your current portfolios, no conversions, how do you like the disposable income each year and the bequest? If there is clearly surplus—you can’t / won’t spend it all—then Roth conversions become attractive, up to the surplus amount.
WoodSpinner wrote: So let's put some real numbers and see if it helps. The numbers reflect the deltas of the Total Tax Adjusted Portfolio Value which is the same as "spendable after taxes" at 90.

Image

I would certainly eliminate No Conversions and Balance Effective Taxes based on your suggestions..

This leaves the other scenarios in-play and the variance between them is fairly small (under 2%). I don't think this metric is enough to make a decision on.
I have run full Year-by-Year scenarios for each alternative including the Do Nothing. I have presented the actual Deltas from the Do Nothing up thread for consideration. I hesitate to post the details for each scenario since I don't want to overwhelm the members and wanted to focus the discussion more on the metrics to use rather than the specifics.

There should be plenty of disposable income based on any of the scenarios under consideration. Pension(s) + SS(s) will cover most of our expenses and our WR is expected to be under 2% (including Health Care, Taxes, Travel etc.). Bequests and Charitable giving goals will also be met by any of these plans.

That said, I do want to be wise in my choices and choose to incur additional taxes carefully.
Second, in version two of the spreadsheet you must create an exact counterfactual for, say, the first year’s conversion amount. You segregate the unconverted amount, invest it the same as the Roth, take RMDs from it, subtract taxes, reinvest the RMDs, and track how the Roth conversion slowly then quickly catches up and surpasses the counterfactual. Because it will, eventually.

You can also test after-tax liquidation values year by year; the Roth is ahead from the first RMD here, but gets farther ahead the longer you live. I always test both, pretax value and post-tax liquidation value, per the several comments upthread, re charitable donations, LTC and deductible medical expenditures, etc.
I think I am doing the same thing although I am using a different approach. What I do is run a full model for each Scenario, copy it to a spreadsheet and then compare the results between each scenario. For instance this allows me to compare No Conversions to Convert to top of 24% Bracket on a year by year basis. This allows me to compare scenarios using the same Cashflows, Inflation, Tax Rates, IRMAA etc. Taxes are always paid from the Conversion itself since there are no funds currently in Taxable (Taxable starts building when RMDs begin at 72).

Here is a sample (fictitious data) of a model run:
Image
Image

This is then loaded into another spreadsheet which allows me to compare across the scenarios:
Image
Wrinkle: when I adapted my spreadsheet to my own situation, I had some low return short term bond funds as well as some stock funds available to convert—let’s say $24,000 of the one and $76,000 of the other. My counterfactual now has two columns, one for each asset, which stay invested as they had been. For the Roth account, I assumed that I liquidated the bond funds to pay the tax, and had the $76,000 of stock now in the Roth. This asset location strategy will generally boost Roth outcomes; but it presumes you want to increase your stock allocation relative to your current AA, again as described up thread.
To be clear, my overall Portfolio Allocation (non Tax Adjusted) remains the same througout all of my scenarios (60/40, 45% VTI, 15% VXUS, 40% VGIT). The Asset Location does change but the model handles the rebalancing to insure that the overall Portfolio Allocation remains constant.

The idea of a Tax-Adjusted Portfolio allocation is not something I have dealt with before (its amazing what is in the Wiki!) and I am comfortable with the notion that this may indeed be changing as assets are moved from the IRA to Roth or Taxable. I will continue to think on this.....

That said, I do see Roth Conversions as a way to better optimize my Asset Location and in general will be better off if they are in Roth (via Conversions) versus Taxable (via RMDs). This provides a great deal more resilancy to our Retirement plan--the question comes down to how much does it cost in Taxes.
PS: after the first conversion you must never, ever leave California for Nevada, Washington, Texas, or Florida. Your spreadsheet will blow up. Not a problem for me; I’m never leaving California except feet first.

PPS: It is my understanding that California does not tax social security. Be sure your state tax calculations post age 70 reflect that fact.
I think we will likely be in CA for the rest of our lives as well. Moving elsewhere is financially attractive but I believe family, friends and social networks are more important. That said, you do have a good point, the 9.3% Marginal Tax Rate hit for Conversions by CA is painful.

My modeling does account for how CA handles SS taxes (which is a nice benefit), thanks for the reminder.
Last, and to cut to the chase: I think you are converting too much. I would run an alternative scenario where you convert only up short of the first IRMAA level (near top of the 22% bracket in AGI terms).

Instead of your current max-convert plan, if it were me, I would pay the taxes on the RMDs (from the portion you failed to convert), and with the remainder, each year take your daughter and family to New Zealand or other bodacious destination, and leave her a much lower Roth balance as an inheritance (the future value of that New Zealand trip, if the expense was instead invested in VTI within the Roth… breathtaking!). But you see how quickly personal values supplant rational calculation once bequests come into the picture, and your values may not be the same as mine.

And, with this last recommendation I stand revealed as far more hedonistic, or Epicurean, than the typical BH. Imagine…spending money on pleasure today rather than scheming how to pass the future value of those funds on to heirs tax-free. Might get me placed on Boglehead probation!
To be clear, I am still deciding on my approach for Roth Conversions/ Focusing on the a foundation in modeling and metrics to use each year to review and course correct.

I appreciate your thoughts on being too aggressive in Conversions given there are so many unknowns involved and will keep them in the forefront of my consideration.

I will add a IRMA Tier-1 Scenario as well, now that I have the foundation built adding scenarios is fairly trivial. That should be interesting!

We are definitely travelers and experience enthusiasts -- that is definitely where we have decided to spend our money (although my wife does maintain a significant clothing budget! :shock: ). I totally get that part of the equation.

PPPS: since Celia got you started on this path, would love to see her response to the dollar level of conversions that you currently intend in your plan.
Celia wrote:
Think it would be interesting as well.

This discussion is certainly helping me crystalize my thinking on how to figure out if Roth Conversions are worthwhile and to develop a metric based approach for choosing between scenarios.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by FiveK »

WoodSpinner wrote: Wed Jul 28, 2021 3:12 pm However, I think (and certainly could be wrong) that the Internal Rate of Return (IRR) is a better financial metric for evaluating expenses versus returns.
That's certainly possible, and it could be that I don't understand the details of how you are implementing it. I'm familiar enough with the concept and mechanics of Internal rate of return in general, but perhaps not how you are using it.

When I think of "investment" I think of money I put to some use, with the hope that I will get back not only that money but more in return. With Roth conversions, the "tax paid" doesn't seem to fit that thought.

Instead, I think of the traditional account as being a co-owned "business" between me and the IRS. According to the contract we drew up, the amount the IRS gets when we take money out of the "business" can change, and I can choose when to withdraw that money. My best choice then becomes the times the IRS gets the lowest fractions of those withdrawals, and that matches the metric of "highest spendable after-tax amount".
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by yog »

Our metric is also after-tax disposable income.

ROI & IRR both suffer from the same fatal error. In a progressive tax system, tax costs are lower in lower brackets, and higher as brackets increase. Roth conversions work by accelerating ordinary income, at least to your lifetime tax-equilibrium rate. For a taxpayer firmly in the middle & higher brackets for life, converting at lower brackets is actually an act of deferring income, causing tax drag to increase, and not capturing the full benefit available from conversions. This impact is not captured properly in ROI/IRR, but it is on full display when using after-tax disposable income.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

yog wrote: Wed Jul 28, 2021 9:48 pm Our metric is also after-tax disposable income.

ROI & IRR both suffer from the same fatal error. In a progressive tax system, tax costs are lower in lower brackets, and higher as brackets increase. Roth conversions work by accelerating ordinary income, at least to your lifetime tax-equilibrium rate. For a taxpayer firmly in the middle & higher brackets for life, converting at lower brackets is actually an act of deferring income, causing tax drag to increase, and not capturing the full benefit available from conversions. This impact is not captured properly in ROI/IRR, but it is on full display when using after-tax disposable income.
I don’t follow, can you provide some more insights?

Why would it increase tax drag?

Thanks

WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by yog »

WoodSpinner wrote: Wed Jul 28, 2021 11:52 pm
yog wrote: Wed Jul 28, 2021 9:48 pm Our metric is also after-tax disposable income.

ROI & IRR both suffer from the same fatal error. In a progressive tax system, tax costs are lower in lower brackets, and higher as brackets increase. Roth conversions work by accelerating ordinary income, at least to your lifetime tax-equilibrium rate. For a taxpayer firmly in the middle & higher brackets for life, converting at lower brackets is actually an act of deferring income, causing tax drag to increase, and not capturing the full benefit available from conversions. This impact is not captured properly in ROI/IRR, but it is on full display when using after-tax disposable income.
I don’t follow, can you provide some more insights?

Why would it increase tax drag?

Thanks

WoodSpinner

For those that benefit from Roth conversions, and not everyone will, if you are otherwise in the 22%/24% bracket for life, spending or converting at just the 12% bracket in the current year means you are also deferring ordinary income. If you are deferring ordinary income, your Roth conversions are not as effective as they could be, since you didn't accelerate all the income you should have. This shows up in a reduced after-tax disposable income or lifetime after-tax plan value. It doesn't show up in an ROI calculation.

As rising ordinary income from RMDs inescapably occurs, tax drag is caused from SS taxation, high state income taxes, IRMAA, capital gains bump zones, NIIT, etc., as this ordinary income crowds out more favorably taxed income. When you skip spending or converting at your lifetime tax-equilibrium rate, you are latently increasing this future tax drag even further. In addition, for those with joint longevity risk, this deferral increases any exposure to 32%+ brackets for a surviving spouse.

Here's a good primer on the importance of finding your lifetime tax-equilibrium rate from Kitces.com:
https://www.kitces.com/blog/tax-rate-eq ... nversions/
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by McQ »

WoodSpinner wrote: Wed Jul 28, 2021 4:09 pm
WoodSpinner wrote: So let's put some real numbers and see if it helps. The numbers reflect the deltas of the Total Tax Adjusted Portfolio Value which is the same as "spendable after taxes" at 90.

Image

I would certainly eliminate No Conversions and Balance Effective Taxes based on your suggestions..

This leaves the other scenarios in-play and the variance between them is fairly small (under 2%). I don't think this metric is enough to make a decision on.

To be clear, I am still deciding on my approach for Roth Conversions/ Focusing on the a foundation in modeling and metrics to use each year to review and course correct.

I appreciate your thoughts on being too aggressive in Conversions given there are so many unknowns involved and will keep them in the forefront of my consideration.

I will add a IRMA Tier-1 Scenario as well, now that I have the foundation built adding scenarios is fairly trivial. That should be interesting!

We are definitely travelers and experience enthusiasts -- that is definitely where we have decided to spend our money (although my wife does maintain a significant clothing budget! :shock: ). I totally get that part of the equation.
[Still figuring out nested quoting--apologies if I got this wrong]
Woodspinner, if my reply was thoughtful, yours is somewhere between intellectual and cerebral. It gives me a chance to add some advice for you and make a more general comment to the thread.

First, I observe that all your with-conversions results are only a little bit off your best case results--each is well within the error of estimate, if that concept is meaningful here. I believe you will find that also to be true of the 'convert in the 22% bracket up to the 1st IRMAA boundary' recommendation. That alternative might look even better, under the accounting conventions introduced next. Accordingly, the conservative choice is to convert less, not more.

You indicated that taxes will be deducted from the conversion (I concur). But then, any IRMAA incurred by a post-65 conversion should also be deducted (at least in the spreadsheet). No one ever wants to fall one dollar into an IRMAA bracket--the marginal rate on that dollar is over a hundred thousand percent. Rather, you drive to the ceiling of any IRMAA bracket you enter. At the ceiling, with Medicare B & D, average of 2019-21 IRMAA costs represent about 3.7%, 4.7%, and 4.7% of the IRMAA 1-3 bracket dollar spans.

So as a Californian, if your conversion drives you into IRMAA, your marginal tax rate on conversions into IRMAA is 24% + 9.3% +~4.5%, or 38% (42% if TCJA expiration is confirmed). Not a problem if your daughter is a successful professional in California, post TCJA, paying 28% + 9.3% = 37.3% (or, more successful, paying 33% + 10.3%, or 43.3%).

Oops, guess what--you never leave California, but her spouse has family in Seattle, and she moves there before inheriting. Plus, the lower brackets of TCJA were preserved (or, a decade later, restored); plus further, she/her spouse weren't that successful in their careers, leaving them in the 24% bracket Federal, 0% Washington State (=MFJ income less than $350,000 today, or $800,000 when you die 30 years hence).

Result, on the worst path: you converted at 42% to save her taxes at 24%. Your lifespan + 10 years will not be enough for that conversion to pay out. Ouch.

Everything changes when you convert only up to staying beneath IRMAA #1. Your tax is 22% + 9.3%; your daughter's tax is likely to be the same (moved to Washington) or more (stayed in California and did well).

My conclusion: convert less. But you've read Celia's signature line many a time; let the debate continue.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

yog wrote: Thu Jul 29, 2021 12:33 am
WoodSpinner wrote: Wed Jul 28, 2021 11:52 pm
yog wrote: Wed Jul 28, 2021 9:48 pm Our metric is also after-tax disposable income.

ROI & IRR both suffer from the same fatal error. In a progressive tax system, tax costs are lower in lower brackets, and higher as brackets increase. Roth conversions work by accelerating ordinary income, at least to your lifetime tax-equilibrium rate. For a taxpayer firmly in the middle & higher brackets for life, converting at lower brackets is actually an act of deferring income, causing tax drag to increase, and not capturing the full benefit available from conversions. This impact is not captured properly in ROI/IRR, but it is on full display when using after-tax disposable income.
I don’t follow, can you provide some more insights?

Why would it increase tax drag?

Thanks

WoodSpinner

For those that benefit from Roth conversions, and not everyone will, if you are otherwise in the 22%/24% bracket for life, spending or converting at just the 12% bracket in the current year means you are also deferring ordinary income. If you are deferring ordinary income, your Roth conversions are not as effective as they could be, since you didn't accelerate all the income you should have. This shows up in a reduced after-tax disposable income or lifetime after-tax plan value. It doesn't show up in an ROI calculation.

As rising ordinary income from RMDs inescapably occurs, tax drag is caused from SS taxation, high state income taxes, IRMAA, capital gains bump zones, NIIT, etc., as this ordinary income crowds out more favorably taxed income. When you skip spending or converting at your lifetime tax-equilibrium rate, you are latently increasing this future tax drag even further. In addition, for those with joint longevity risk, this deferral increases any exposure to 32%+ brackets for a surviving spouse.

Here's a good primer on the importance of finding your lifetime tax-equilibrium rate from Kitces.com:
https://www.kitces.com/blog/tax-rate-eq ... nversions/
Yog,

Thanks for the link, no disagreement that Kitces’ advice is well founded.
Which, in practice, usually entails engaging in tax strategies that minimize (or at least defer) taxes as long as possible. Except the caveat is that when it comes to tax deferral, there really is such thing as being “too good” at doing so, given the progressive nature of income tax brackets (with higher tax rates on higher income levels).
Guilty during my accumulation years! Wish I had found BH sooner and learned more about this issue. That said, it’s water under the bridge and I am working with the portfolio I have, not the one I wish I had.

I am going to add a Tax Equilibria to the metric list and use it as an initial screen (along with current Vs. future marginal rates. At least in my case, I don’t think it’s a sufficient metric by itself.

I have been making good use of the 12 and 22% brackets and not continuing to defer while in Retirement.

Thanks

WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by afan »

A few notes:

Since this involves cash flows at different times, it must be evaluated as a present value question.
This requires estimating the discount rate and deciding whether a single discount rate should apply to everything or different rates for different parts of the plan, or changing over time.

For me, the ultimate goal is maximizing the amount to heirs, after accounting for our income taxes, their income taxes and estate taxes. The job is made somewhat simpler since we only need assume they survive 10 years past the second to die of our couple. So each scenario runs through the second to die, then the next 10 years for heirs.

This will produce a present value for each year and the values assuming a short expectancy for us will differ from the values assuming long lives. We don't know how long we will live, so I can just use actuarial life expectancies and assign a value to each outcome based on the likelihood of it happening.

I have not gone through the full exercise yet, since we are far enough away that the unknown tax laws will have a huge effect. But I plan to run the numbers for a variety of survival figures and tax rates then see whether a particular strategy is often among the best.

I am sure I do not want to do any conversions while I am still working, so I will get more serious about modelling as retirement approaches. That lets me avoid years of planning under tax laws that are no longer in force by the time I approach the time when I might consider converting.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by celia »

WoodSpinner wrote: Wed Jul 28, 2021 4:09 pm
McQ wrote: PPPS: since Celia got you started on this path, would love to see her response to the dollar level of conversions that you currently intend in your plan.
Celia wrote:
I haven't participated in this thread since it's gone into a lot of irrelevant topics, in my opinion. I also know that WoodSpinner can easily handle this as he started posting in Roth conversion threads 4 years ago, although he was different in that all his assets were in tax-deferred. (I well-remember his "handle" as someone who has woodworking as a hobby or skill, whether or not that is actually true. :D )

In regards to the primary question, the "metric" or goal is to maximize your spendable money. That is close to his "Total Tax Adjusted Portfolio Value" but the details are in how you define that. Even in your later years or after you are widowed, you may be in the same or a different tax bracket. Or tax law can change the "rules". The markets and inflation can also change your balances. We can't control any of these and thus it makes no sense to look for the "optimal" path to the goal. But IT DOES make sense to try to do some planning. The easiest guess is to figure out what will happen if one does not convert, then make the best-estimate of a Roth conversion plan you can. If you over-convert or under-convert, oh well, at least you tried, and you can always make adjustments each year as you go along.


DIFFERENT PERSPECTIVES
I think it is nonsense to think about how long it takes to "earn the taxes back" since RMDs will be taxed anyways. Are you going to calculate the time to earn back the RMD or it's taxes? I don't know why people keep bringing that up as they only apply it to conversions, not RMDs. (If that bothers you, then don't convert but do large QCDs after 70.5 instead. There, no taxes were paid! You "won" over Uncle Sam.)

And as far as saving some tIRA assets for future health care needs, you could say the same about LTCG and Qualified Dividends in taxable, which could end up being tax-free instead (as you sell taxable assets to free up money for medical expenses).

We're over 70.5 and all our tIRAs were converted before then (although our balances were never as big as those asking for Roth conversion help). DH has an Inherited tIRA, though that can't be converted, so we are QCDing that away. I want to say that even when we were converting, our portfolio still kept on growing, but I can't really prove that since the the inheritance was partly taxable, tax-deferred, and Roth. It impacted our net worth as well as the bull market over the last 10 years. Our Asset Allocation is pretty aggressive as our income in retirement is more than our expenses. But it would be interesting to hear of anyone else whose portfolio kept on growing through the years they did Roth conversions.

I would also like to remind those of you who are planning Roth conversions, that the Roth should be invested in your assets that you expect to grow the fastest. If your Roth is growing twice as fast as your tax-deferred, it won't take as long to "overcome the tax hit". In fact, the sooner (and larger) you convert early on, the more compounding can make that Roth grow. This is the same as when we tell the younger folks just starting out that the biggest factor that impacts their future growth is the amount they invest early on since they have more time to allow compounding to work. The same holds for us older folks. Take Roth conversion taxes into account, but then get that Roth growing.

Once we hit 70, we started to realize how much we needed to simplify things. Many of us won't want to leave a Roth conversion plan for a spouse who doesn't understand it as much as we do. Some of us will probably just set up monthly RMDs to go to our checking accounts so our spouse won't have to think about it. But to keep a Single spouse from going into higher tax brackets, we might want to calculate our "preferred tIRA balance" for the year one of us turns 72. RMDs start at about 4% that year, so if you are MFJ, a million dollar tIRA will give $40K a year. That may be reasonable for a widowed spouse too, especially if there are other income streams. With that as a goal, you can then plan for Roth conversions to convert the excess over the remaining years. For example, it appears WoodSpinner has $2M in tax-deferred. If he wants to move half of that to Roth in his remaining 9 years (before turning 72), that averages $111K a year. But that doesn't take into account the average growth that will occur during those 9 years. If the tIRA has been growing at 7% a year recently, that is an expected growth of $140K this year. So he might want to convert $111K + $140K this year.

Hope some of you enjoy these other perspectives and that I didn't get too far off topic!

celia
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Re: Metrics to Compare Roth Conversion Scenarios ??

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McQ wrote: Thu Jul 29, 2021 12:36 am [Still figuring out nested quoting--apologies if I got this wrong]
Perfect, there is a Preview Button that can also help. I am still learning some tricks in formatting and posting in the forum myself. Its definitely a bit old-school and not a WYSWYG interface. Fortunately the posts and the helpfulness of everyone more than makes up for it.
Woodspinner, if my reply was thoughtful, yours is somewhere between intellectual and cerebral. It gives me a chance to add some advice for you and make a more general comment to the thread.
I have been pondering the meaning of your observations and am not still not quite sure what you intended but I suspect I resemble this remark, :D . As a background, I spent many years working in a MegaCorp helping to build a portfolio of IT projects that had to be estimated, funded, and prioritized. When you ask the Board to spend Hundreds of Millions or Billion(s) of Dollars everyone has an opinion and they never accept -- It seems like a good idea. A big part of the culture was around analytical decision making and trying to quantify the various unknowns.
First, I observe that all your with-conversions results are only a little bit off your best case results--each is well within the error of estimate, if that concept is meaningful here. I believe you will find that also to be true of the 'convert in the 22% bracket up to the 1st IRMAA boundary' recommendation. That alternative might look even better, under the accounting conventions introduced next. Accordingly, the conservative choice is to convert less, not more.
That said, I do hear you on the call to be conservative given the significant unknowns.
You indicated that taxes will be deducted from the conversion (I concur). But then, any IRMAA incurred by a post-65 conversion should also be deducted (at least in the spreadsheet). No one ever wants to fall one dollar into an IRMAA bracket--the marginal rate on that dollar is over a hundred thousand percent. Rather, you drive to the ceiling of any IRMAA bracket you enter. At the ceiling, with Medicare B & D, average of 2019-21 IRMAA costs represent about 3.7%, 4.7%, and 4.7% of the IRMAA 1-3 bracket dollar spans.

So as a Californian, if your conversion drives you into IRMAA, your marginal tax rate on conversions into IRMAA is 24% + 9.3% +~4.5%, or 38% (42% if TCJA expiration is confirmed). Not a problem if your daughter is a successful professional in California, post TCJA, paying 28% + 9.3% = 37.3% (or, more successful, paying 33% + 10.3%, or 43.3%).
Interesting, I have not figured out how to convert the IRMAA costs to a Marginal Rate, that is helpful. How did you calculate that? I would like to include it in my Marginal Tax Rate computations.
Oops, guess what--you never leave California, but her spouse has family in Seattle, and she moves there before inheriting. Plus, the lower brackets of TCJA were preserved (or, a decade later, restored); plus further, she/her spouse weren't that successful in their careers, leaving them in the 24% bracket Federal, 0% Washington State (=MFJ income less than $350,000 today, or $800,000 when you die 30 years hence).

Result, on the worst path: you converted at 42% to save her taxes at 24%. Your lifespan + 10 years will not be enough for that conversion to pay out. Ouch.

Everything changes when you convert only up to staying beneath IRMAA #1. Your tax is 22% + 9.3%; your daughter's tax is likely to be the same (moved to Washington) or more (stayed in California and did well).

My conclusion: convert less. But you've read Celia's signature line many a time; let the debate continue.
Part of the reason I am posting this is that it helps me think through the issues and hopefully provides some insights for others.

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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by diy60 »

Consider that marginal rate is the "sum of costs / related change of income." As such, IRMAA charges get added to the numerator along with your other costs. For most retired folks considering Roth conversions, taxes and IRMAA charges probably make up the bulk of the numerator, but there could be other costs such loss of ACA subsidies, loss of various senior credits, NIIT, etc.. My suggestion would apply the Pareto principle and go enjoy life.
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Re: Metrics to Compare Roth Conversion Scenarios ??

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diy60 wrote: Thu Jul 29, 2021 9:09 pm Consider that marginal rate is the "sum of costs / related change of income." As such, IRMAA charges get added to the numerator along with your other costs.
^Yes, exactly that. As the wiki article says, Marginal tax rate is the tax rate on a change in income (i.e. change in tax/change in income). IRMAA is, in effect, just another tax.

See Worth pushing through the Social Security hump and/or IRMAA cliffs? for the inputs to the chart of marginal rates, including IRMAA spikes, shown below. The personal finance toolbox in Excel will generate those charts.

Image
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by McQ »

WoodSpinner wrote: Thu Jul 29, 2021 8:20 pm
Interesting, I have not figured out how to convert the IRMAA costs to a Marginal Rate, that is helpful. How did you calculate that? I would like to include it in my Marginal Tax Rate computations.

Part of the reason I am posting this is that it helps me think through the issues and hopefully provides some insights for others.

WoodSpinner
Here is how I did it. Each year, a part of the SS/Medicare bureaucracy posts next year's IRMAA calculations. Here is the most recent: https://www.cms.gov/newsroom/fact-sheet ... eductibles

So from that release, you can get the dollar increment for the first IRMAA bracket: $59.40 per person per month Medicare B; and the bracket width of $176K to $222K (couples). So IRMAA dollars = $59.40 x 12 x 2, or $1426 for the couple for the year; add Medicare D of $295, and you've got $1721 for IRMAA #1; divided by the bracket span of $46,000 and you've got ~3.7% as the additional marginal tax rate on MAGI between $176,000 and $222,000, to be added to the Federal rate that applies there (22%-24%) and the CA rate (9.3%).

IRMAA 2 & 3 are a little higher, more like 4.7%; and in the paper, for stability, I averaged the 2019, 2020, and 2021 values all of which are slightly different at second decimal. Given medical cost inflation, these values may reach 4% and 5% within your planning horizon.

So that's how I got your conversion "rate" of 37% plus, and my advice to convert only up to IRMAA #1.

PS: thanks for the Megacorp story, knew you had to be either an engineer or a financial analyst of some kind. 8-)
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by smitcat »

WoodSpinner wrote: Wed Jul 28, 2021 4:09 pm
McQ wrote: Mon Jul 26, 2021 10:58 pm Hello all: Woodspinner asked me to comment on his metrics here. Apologies to those who also participated in the earlier thread; it is not likely I will say anything new here.
Thank you very much for taking the time and thought in your reply. Its much appreciated and I have been pondering it (and FiveK's) input for the last day or so.
First, as to metrics, I generally agree with the line by line response by FiveK. See especially his/her concise demonstration earlier today that tax paid cannot be the metric.

Next, if I may put the “how to measure outcomes” question in my own language: there is no substitute for preparing a year by year spreadsheet. Results will always be better for Roth conversions over longer time frames. Since you have a bequest motive, I think you should run the spreadsheet out to your age 110. I know you don’t think you will live past 90, but … I’m somewhat older than you, and my mother is still going strong at 96. There can be no final age from which IRR calculations are done. That’s not given to us humans to know.

Next, the absolute most crucial spreadsheet to construct is the “do nothing” spreadsheet: all your current portfolios, no conversions, how do you like the disposable income each year and the bequest? If there is clearly surplus—you can’t / won’t spend it all—then Roth conversions become attractive, up to the surplus amount.
WoodSpinner wrote: So let's put some real numbers and see if it helps. The numbers reflect the deltas of the Total Tax Adjusted Portfolio Value which is the same as "spendable after taxes" at 90.

Image

I would certainly eliminate No Conversions and Balance Effective Taxes based on your suggestions..

This leaves the other scenarios in-play and the variance between them is fairly small (under 2%). I don't think this metric is enough to make a decision on.
I have run full Year-by-Year scenarios for each alternative including the Do Nothing. I have presented the actual Deltas from the Do Nothing up thread for consideration. I hesitate to post the details for each scenario since I don't want to overwhelm the members and wanted to focus the discussion more on the metrics to use rather than the specifics.

There should be plenty of disposable income based on any of the scenarios under consideration. Pension(s) + SS(s) will cover most of our expenses and our WR is expected to be under 2% (including Health Care, Taxes, Travel etc.). Bequests and Charitable giving goals will also be met by any of these plans.

That said, I do want to be wise in my choices and choose to incur additional taxes carefully.
Second, in version two of the spreadsheet you must create an exact counterfactual for, say, the first year’s conversion amount. You segregate the unconverted amount, invest it the same as the Roth, take RMDs from it, subtract taxes, reinvest the RMDs, and track how the Roth conversion slowly then quickly catches up and surpasses the counterfactual. Because it will, eventually.

You can also test after-tax liquidation values year by year; the Roth is ahead from the first RMD here, but gets farther ahead the longer you live. I always test both, pretax value and post-tax liquidation value, per the several comments upthread, re charitable donations, LTC and deductible medical expenditures, etc.
I think I am doing the same thing although I am using a different approach. What I do is run a full model for each Scenario, copy it to a spreadsheet and then compare the results between each scenario. For instance this allows me to compare No Conversions to Convert to top of 24% Bracket on a year by year basis. This allows me to compare scenarios using the same Cashflows, Inflation, Tax Rates, IRMAA etc. Taxes are always paid from the Conversion itself since there are no funds currently in Taxable (Taxable starts building when RMDs begin at 72).

Here is a sample (fictitious data) of a model run:
Image
Image

This is then loaded into another spreadsheet which allows me to compare across the scenarios:
Image
Wrinkle: when I adapted my spreadsheet to my own situation, I had some low return short term bond funds as well as some stock funds available to convert—let’s say $24,000 of the one and $76,000 of the other. My counterfactual now has two columns, one for each asset, which stay invested as they had been. For the Roth account, I assumed that I liquidated the bond funds to pay the tax, and had the $76,000 of stock now in the Roth. This asset location strategy will generally boost Roth outcomes; but it presumes you want to increase your stock allocation relative to your current AA, again as described up thread.
To be clear, my overall Portfolio Allocation (non Tax Adjusted) remains the same througout all of my scenarios (60/40, 45% VTI, 15% VXUS, 40% VGIT). The Asset Location does change but the model handles the rebalancing to insure that the overall Portfolio Allocation remains constant.

The idea of a Tax-Adjusted Portfolio allocation is not something I have dealt with before (its amazing what is in the Wiki!) and I am comfortable with the notion that this may indeed be changing as assets are moved from the IRA to Roth or Taxable. I will continue to think on this.....

That said, I do see Roth Conversions as a way to better optimize my Asset Location and in general will be better off if they are in Roth (via Conversions) versus Taxable (via RMDs). This provides a great deal more resilancy to our Retirement plan--the question comes down to how much does it cost in Taxes.
PS: after the first conversion you must never, ever leave California for Nevada, Washington, Texas, or Florida. Your spreadsheet will blow up. Not a problem for me; I’m never leaving California except feet first.

PPS: It is my understanding that California does not tax social security. Be sure your state tax calculations post age 70 reflect that fact.
I think we will likely be in CA for the rest of our lives as well. Moving elsewhere is financially attractive but I believe family, friends and social networks are more important. That said, you do have a good point, the 9.3% Marginal Tax Rate hit for Conversions by CA is painful.

My modeling does account for how CA handles SS taxes (which is a nice benefit), thanks for the reminder.
Last, and to cut to the chase: I think you are converting too much. I would run an alternative scenario where you convert only up short of the first IRMAA level (near top of the 22% bracket in AGI terms).

Instead of your current max-convert plan, if it were me, I would pay the taxes on the RMDs (from the portion you failed to convert), and with the remainder, each year take your daughter and family to New Zealand or other bodacious destination, and leave her a much lower Roth balance as an inheritance (the future value of that New Zealand trip, if the expense was instead invested in VTI within the Roth… breathtaking!). But you see how quickly personal values supplant rational calculation once bequests come into the picture, and your values may not be the same as mine.

And, with this last recommendation I stand revealed as far more hedonistic, or Epicurean, than the typical BH. Imagine…spending money on pleasure today rather than scheming how to pass the future value of those funds on to heirs tax-free. Might get me placed on Boglehead probation!
To be clear, I am still deciding on my approach for Roth Conversions/ Focusing on the a foundation in modeling and metrics to use each year to review and course correct.

I appreciate your thoughts on being too aggressive in Conversions given there are so many unknowns involved and will keep them in the forefront of my consideration.

I will add a IRMA Tier-1 Scenario as well, now that I have the foundation built adding scenarios is fairly trivial. That should be interesting!

We are definitely travelers and experience enthusiasts -- that is definitely where we have decided to spend our money (although my wife does maintain a significant clothing budget! :shock: ). I totally get that part of the equation.

PPPS: since Celia got you started on this path, would love to see her response to the dollar level of conversions that you currently intend in your plan.
Celia wrote:
Think it would be interesting as well.

This discussion is certainly helping me crystalize my thinking on how to figure out if Roth Conversions are worthwhile and to develop a metric based approach for choosing between scenarios.
The chart you attached is labeled "fictituos data" but it shows a growing balance each year. Looking at that and some of your descriptions leads me to believe that there will be a substantial amount of funds going to heirs.
If you make a number of different runs with the most likely future outcomes and there is a substantial amount of funds going to heirs in allor most of them then one of the largest factor for the decisions becomes the heirs future tax rate.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

McQ wrote: Thu Jul 29, 2021 10:53 pm Here is how I did it. Each year, a part of the SS/Medicare bureaucracy posts next year's IRMAA calculations. Here is the most recent: https://www.cms.gov/newsroom/fact-sheet ... eductibles

So from that release, you can get the dollar increment for the first IRMAA bracket: $59.40 per person per month Medicare B; and the bracket width of $176K to $222K (couples). So IRMAA dollars = $59.40 x 12 x 2, or $1426 for the couple for the year; add Medicare D of $295, and you've got $1721 for IRMAA #1; divided by the bracket span of $46,000 and you've got ~3.7% as the additional marginal tax rate on MAGI between $176,000 and $222,000, to be added to the Federal rate that applies there (22%-24%) and the CA rate (9.3%).

IRMAA 2 & 3 are a little higher, more like 4.7%; and in the paper, for stability, I averaged the 2019, 2020, and 2021 values all of which are slightly different at second decimal. Given medical cost inflation, these values may reach 4% and 5% within your planning horizon.

So that's how I got your conversion "rate" of 37% plus, and my advice to convert only up to IRMAA #1.

PS: thanks for the Megacorp story, knew you had to be either an engineer or a financial analyst of some kind. 8-)
Thanks for the approach….

I can make this work in my model without too much trouble.

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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

smitcat wrote: Fri Jul 30, 2021 7:22 am The chart you attached is labeled "fictituos data" but it shows a growing balance each year. Looking at that and some of your descriptions leads me to believe that there will be a substantial amount of funds going to heirs.
If you make a number of different runs with the most likely future outcomes and there is a substantial amount of funds going to heirs in allor most of them then one of the largest factor for the decisions becomes the heirs future tax rate.
This is an accurate observation, if all goes well there will be substantial funds for my heirs and for Charitable donations. At the moment, my model doesn’t handle the finances after the second-to-die. Addressing this is on my short-term enhancement list.

Our clear priority is to Enjoy Our Retirement with Heirs and Charity as 2nd and 3rd priorities.

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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by RetiredCSProf »

celia wrote: Thu Jul 29, 2021 5:44 pm
In regards to the primary question, the "metric" or goal is to maximize your spendable money. ... The easiest guess is to figure out what will happen if one does not convert, then make the best-estimate of a Roth conversion plan you can. If you over-convert or under-convert, oh well, at least you tried, and you can always make adjustments each year as you go along.

I want to say that even when we were converting, our portfolio still kept on growing, but I can't really prove that since the the inheritance was partly taxable, tax-deferred, and Roth. ... But it would be interesting to hear of anyone else whose portfolio kept on growing through the years they did Roth conversions.
My tax-deferred portfolio has continued to grow in retirement while taking partial Roth conversions, which I started in 2015, at age 67. I had nothing in Roth when I retired at age 64. My TDA at the end of 2012 (when I stopped contributing to TDA) had a balance of about $400K. I think my AA was about 70/30, but I would need to review my records to check. I have converted about $200K and plan to continue making partial conversions for a few more years.

My current TDA balance is about $600K; AA of 56/39/5. I withdrew $12K from TDA in 2013 to fill gap between pension and expenses, spread Roth conversions over several years, and withdrew RMDs/QCDs at age 70, 71, and 73 (this year). I could have slowed the growth in TDA more by starting sooner (in 2013), adjusting sooner to a more conservative AA in TDA, and by converting bigger chunks.

I am not sure how to measure the growth in TDA, given that not all withdrawals were for Roth conversions, my conversions were spread unevenly across multiple years, and my AA fluctuated.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by Leif »

celia wrote: Thu Jul 29, 2021 5:44 pmAnd as far as saving some tIRA assets for future health care needs, you could say the same about LTCG and Qualified Dividends in taxable, which could end up being tax-free instead (as you sell taxable assets to free up money for medical expenses).
I like the idea of having my tIRA as my self funded long term care insurance if needed for that. The side benefit is reduced RMDs and less tax for my beneficiaries. My taxable equities may well get a step up in basis.
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WoodSpinner
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

All,

I decided to take a step back and look at a smaller set of Conversion Scenarios and focus on 3 Simple Metrics:

- Does the Scenario achieve a reasonable Tax Equilibrium?
- Cumulative Taxes Paid over Time
- Tax Adjusted Portfolio Value

Scenarios Compared:
- No Conversions
- IRMAA Tier1
- IRMAA Tier2
- IRMAA Tier3

Note: Data is fictitious, all amounts are Nominal

Image

Observations:
1. Roth Conversions as a Tax-Arbitrage scheme won't break even until Spouse1 is about 84-88 years old.
2. No Conversions do not pass the Tax Equilibrium Test (Eliminate this option)

Image
Observations:
1. Roth Conversions deliver a larger Tax Adjusted Portfolio by age 72 (versus No Conversions). I believe this is mainly being driven by the change in Marginal Tax Rates for the Scenarios. improvements in Asset Location as Equities are moved from the IRA to Roth and allowed to grow.
2. There is not a significant Tax Adjusted Portfolio difference between converting at the top of IRMAA Tier2 vs IRMAA Tier3 (Eliminate IRMAA Tier3 option)
3. More equities (e.g. VTI/VXUS) are moved from the IRA to the Roth during Conversions for the IRMAA Tier2 Scenario (overall 60/40 Portfolio allocation is maintained throughout).

Code: Select all

	IRMAA Tier2		IRMAA Tier 1	
Age	Equity	Bond		Equity	Bond
62	52%	48%		54%	46%
72	27%	73%		38%	62%
Spouse2 passes at 71
I then re-ran the model with my spouse (e.g. Spouse2 who is 1 year younger than me) passing at 71. The thinking is that all of the Roth Conversions would have been completed and I could focus on the impacts of one Spouses early passing. In this situation our Income is changed only slightly since Spouse2 has a much smaller SS income -- Spouse1 Pension and SS will continue to 90 when they pass.

Image
Observations:
1. Roth Conversions as a Tax-Arbitrage scheme still won't break even until Spouse1 is about 84-88 years old.
2. There is an increase in Cumulative Taxes (e.g. Widower's Tax) in the 4-7% range depending on the Scenario

Code: Select all

No Conversions 	6.92%
IRMAA Tier 1	7.08%
IRMAA Tier 2	5.98%
IRMAA Tier 3	5.70%
Top 24%		4.44%
Image
Observations:
1. The early passing of Spouse2 leads to a smaller Tax Adjusted Portfolio value (9-14% less) depending on the Scenario

Code: Select all

No Conversions 	-14.23%
IRMAA Tier 1	-12.70%
IRMAA Tier 2	-10.89%
IRMAA Tier 3	-9.27%
Top 24%		-9.26%
Insights:
  • The shift in Metrics and presentation have helped clarify my thinking and narrowed the Scenarios down to 2 choices (IRMAA-Tier1 or IRMAA-Tier2). I find this revised approach easier to understand and interpret.
  • By age 72 IRMAA Tier1 spends significantly less on Taxes ($218,000 and produces a Tax Adjusted Portfolio Value slightly less ($94,000) than IRMAA Tier2
  • By age 90 IRMAA Tier1 spends slightly more on Taxes (about $5000) and produces a Tax Adjusted Portfolio that significantly less (almost $1,000,000) than IRMAA Tier2
  • Roth Conversions are not a large source of Tax Arbitrage in this situation (breakeven is around 84 or after)
  • The Widow(er) tax is real but it will not significantly impact Retirement (under 7% cumulative tax increase) in this situation
Last edited by WoodSpinner on Sun Aug 01, 2021 8:37 pm, edited 1 time in total.
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FiveK
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by FiveK »

WoodSpinner wrote: Fri Jul 30, 2021 6:55 pm 1. Roth Conversions as a Tax-Arbitrage scheme won't break even until Spouse1 is about 84-88 years old.
For equal current and future tax rates, we know Roth conversions are immediately "break even" based on the commutative property of multiplication.

How are you defining "break even" such that it becomes time dependent? It certainly can be - it just isn't clear what assumptions are being used.
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by marcopolo »

WoodSpinner wrote: Fri Jul 30, 2021 6:55 pm All,

I decided to take a step back and look at a smaller set of Conversion Scenarios and focus on 3 Simple Metrics:

- Does the Scenario achieve a reasonable Tax Equilibrium?
- Cumulative Taxes Paid over Time
- Tax Adjusted Portfolio Value

Scenarios Compared:
- No Conversions
- IRMAA Tier1
- IRMAA Tier2
- IRMAA Tier3

Note: Data is fictitious, all amounts are Nominal

Image

Observations:
1. Roth Conversions as a Tax-Arbitrage scheme won't break even until Spouse1 is about 84-88 years old.
2. No Conversions do not pass the Tax Equilibrium Test (Eliminate this option)

Image
Observations:
1. Roth Conversions deliver a larger Tax Adjusted Portfolio by age 72 (versus No Conversions). I believe this is mainly being driven by improvements in Asset Location as Equities are moved from the IRA to Roth and allowed to grow.
2. There is not a significant Tax Adjusted Portfolio difference between converting at the top of IRMAA Tier2 vs IRMAA Tier3 (Eliminate IRMAA Tier3 option)
3. More equities (e.g. VTI/VXUS) are moved from the IRA to the Roth during Conversions for the IRMAA Tier2 Scenario (overall 60/40 Portfolio allocation is maintained throughout).

Code: Select all

	IRMAA Tier2		IRMAA Tier 1	
Age	Equity	Bond		Equity	Bond
62	52%	48%		54%	46%
72	27%	73%		38%	62%
Spouse2 passes at 71
I then re-ran the model with my spouse (e.g. Spouse2 who is 1 year younger than me) passing at 71. The thinking is that all of the Roth Conversions would have been completed and I could focus on the impacts of one Spouses early passing. In this situation our Income is changed only slightly since Spouse2 has a much smaller SS income -- Spouse1 Pension and SS will continue to 90 when they pass.

Image
Observations:
1. Roth Conversions as a Tax-Arbitrage scheme still won't break even until Spouse1 is about 84-88 years old.
2. There is an increase in Cumulative Taxes (e.g. Widower's Tax) in the 4-7% range depending on the Scenario

Code: Select all

No Conversions 	6.92%
IRMAA Tier 1	7.08%
IRMAA Tier 2	5.98%
IRMAA Tier 3	5.70%
Top 24%		4.44%
Image
Observations:
1. The early passing of Spouse2 leads to a smaller Tax Adjusted Portfolio value (9-14% less) depending on the Scenario

Code: Select all

No Conversions 	-14.23%
IRMAA Tier 1	-12.70%
IRMAA Tier 2	-10.89%
IRMAA Tier 3	-9.27%
Top 24%		-9.26%
Insights:
  • The shift in Metrics and presentation have helped clarify my thinking and narrowed the Scenarios down to 2 choices (IRMAA-Tier1 or IRMAA-Tier2). I find this revised approach easier to understand and interpret.
  • By age 72 IRMAA Tier1 spends significantly less on Taxes ($218,000 and produces a Tax Adjusted Portfolio Value slightly less ($94,000) than IRMAA Tier2
  • By age 90 IRMAA Tier1 spends slightly more on Taxes (about $5000) and produces a Tax Adjusted Portfolio that significantly less (almost $1,000,000) than IRMAA Tier2
  • Roth Conversions are not a large source of Tax Arbitrage in this situation (breakeven is around 84 or after)
  • The Widow(er) tax is real but it will not significantly impact Retirement (under 7% cumulative tax increase) in this situation
At the risk of repeating myself and others.

If you are going to do this kind of detailed analysis, it seems really odd to do two things:

1) You are using cumulative taxes paid as a metric. As shown in a previous post cumulative taxes paid is a terrible metric to use to evaluate Roth Conversions.

2) You are correctly using tax adjusted portfolio value. So you clearly understand that portions of your portfolio should be derated by the taxes due. But, for some reason you are still ignoring tax adjusted asset allocation. You seem to be ignoring that most of the perceived gains you are getting is from taking on more risk. To do a consistent comparison (why go through all this detailed analysis If not to compare Apple to Apples scenarios), you would need to use equivalent tax adjusted asset allocation. If you are OK with higher equity allocation, you should have that in the less conversions cases as well.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by MahoningValley »

I guess that I am a very simple man. My only metric re: converting tIRA to Roth was to move as much into the Roth before I turned 71 with minimal tax impact. I've been at it since I was 60. :beer
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

MahoningValley wrote: Sat Jul 31, 2021 6:42 am I guess that I am a very simple man. My only metric re: converting tIRA to Roth was to move as much into the Roth before I turned 71 with minimal tax impact. I've been at it since I was 60. :beer
Simple can be good!

Btw, love the Black Swans on your Avatar!

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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

FiveK wrote: Fri Jul 30, 2021 7:54 pm
WoodSpinner wrote: Fri Jul 30, 2021 6:55 pm 1. Roth Conversions as a Tax-Arbitrage scheme won't break even until Spouse1 is about 84-88 years old.
For equal current and future tax rates, we know Roth conversions are immediately "break even" based on the commutative property of multiplication.

How are you defining "break even" such that it becomes time dependent? It certainly can be - it just isn't clear what assumptions are being used.
FiveK,

Using 2 metrics:
- From a tax Arbitrage perspective the Cumulative Taxes Paid (this occurs in the 84-88 year old range), see 1st graph. My observation is that tax arbitrage is not a strong driver for conversions.
- From a Total After Tax Portfolio Value (this occurs around 72) see second bar chart, all scenarios are now more valuable than the No Conversion.

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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by MahoningValley »

WoodSpinner wrote: Sat Jul 31, 2021 8:44 am

Btw, love the Black Swans on your Avatar!

WoodSpinner
:thumbsup My wife took that picture in Lucerne, Switzerland
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

marcopolo wrote: Sat Jul 31, 2021 3:03 am
At the risk of repeating myself and others.

If you are going to do this kind of detailed analysis, it seems really odd to do two things:

1) You are using cumulative taxes paid as a metric. As shown in a previous post cumulative taxes paid is a terrible metric to use to evaluate Roth Conversions.
Upthread there was a link to the Kitces article on Tax Equilibrium throughout your Retirement. See https://www.kitces.com/blog/tax-rate-eq ... nversions/

A graph of cumulative taxes paid seems to be a pretty useful way to visually see this, see the No Conversion and IRMAA Tier3 lines and notice the slope and bend points that occur when Conversions end and RMDs begin.

Secondly the amount of taxes paid between scenarios is important, it affects Cashflow during different periods.
2) You are correctly using tax adjusted portfolio value. So you clearly understand that portions of your portfolio should be derated by the taxes due. But, for some reason you are still ignoring tax adjusted asset allocation. You seem to be ignoring that most of the perceived gains you are getting is from taking on more risk. To do a consistent comparison (why go through all this detailed analysis If not to compare Apple to Apples scenarios), you would need to use equivalent tax adjusted asset allocation. If you are OK with higher equity allocation, you should have that in the less conversions cases as well.
Perhaps this is a difference between an academic exercise and a real world one (well at least a model of my real world). In my world, I am not going to Tax Adjust my asset allocation but I do acknowledge that there is a risk difference. I am comfortable with keeping my overall Asset Allocation and Rebalancing strategies consistent across all scenarios.

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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

MahoningValley wrote: Sat Jul 31, 2021 9:26 am
WoodSpinner wrote: Sat Jul 31, 2021 8:44 am

Btw, love the Black Swans on your Avatar!

WoodSpinner
:thumbsup My wife took that picture in Lucerne, Switzerland
Cool, mine was from Australia ….
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by FiveK »

WoodSpinner wrote: Sat Jul 31, 2021 8:58 am
FiveK wrote: Fri Jul 30, 2021 7:54 pm
WoodSpinner wrote: Fri Jul 30, 2021 6:55 pm 1. Roth Conversions as a Tax-Arbitrage scheme won't break even until Spouse1 is about 84-88 years old.
For equal current and future tax rates, we know Roth conversions are immediately "break even" based on the commutative property of multiplication.

How are you defining "break even" such that it becomes time dependent? It certainly can be - it just isn't clear what assumptions are being used.
FiveK,

Using 2 metrics:
- From a tax Arbitrage perspective the Cumulative Taxes Paid (this occurs in the 84-88 year old range), see 1st graph. My observation is that tax arbitrage is not a strong driver for conversions.
- From a Total After Tax Portfolio Value (this occurs around 72) see second bar chart, all scenarios are now more valuable than the No Conversion.

WoodSpinner
Others have also commented on why "taxes paid" is not a useful metric.

Why do you think the Total After Tax Portfolio Value (TATPV) is not immediately breakeven? Given equal marginal tax rates for current and future conversions, I would expect "no change" in TATPV when the conversion occurs. But maybe I'm expecting something incorrectly...?
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Re: Metrics to Compare Roth Conversion Scenarios ??

Post by Lee_WSP »

FiveK wrote: Sat Jul 31, 2021 1:24 pm
WoodSpinner wrote: Sat Jul 31, 2021 8:58 am
FiveK wrote: Fri Jul 30, 2021 7:54 pm
WoodSpinner wrote: Fri Jul 30, 2021 6:55 pm 1. Roth Conversions as a Tax-Arbitrage scheme won't break even until Spouse1 is about 84-88 years old.
For equal current and future tax rates, we know Roth conversions are immediately "break even" based on the commutative property of multiplication.

How are you defining "break even" such that it becomes time dependent? It certainly can be - it just isn't clear what assumptions are being used.
FiveK,

Using 2 metrics:
- From a tax Arbitrage perspective the Cumulative Taxes Paid (this occurs in the 84-88 year old range), see 1st graph. My observation is that tax arbitrage is not a strong driver for conversions.
- From a Total After Tax Portfolio Value (this occurs around 72) see second bar chart, all scenarios are now more valuable than the No Conversion.

WoodSpinner
Others have also commented on why "taxes paid" is not a useful metric.

Why do you think the Total After Tax Portfolio Value (TATPV) is not immediately breakeven? Given equal marginal tax rates for current and future conversions, I would expect "no change" in TATPV when the conversion occurs. But maybe I'm expecting something incorrectly...?
Because you could die before it actually breaks even.

Which I suppose segue ways into my suggestion that OP look into expected after tax total withdrawals, where the expected metric is heavily influenced by life expectancy.
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