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

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

Post by WoodSpinner »

FiveK wrote: Tue Aug 03, 2021 5:31 pm
WoodSpinner wrote: Tue Aug 03, 2021 5:09 pm Not sure if anyone took a look at the Tax Drag Example spreadsheet posted upthread. Reposting to provide support for McQ that the drag is real and will be more noticeable over time.
WoodSpinner wrote: Sun Aug 01, 2021 6:50 pm To see a demonstration of the Tax Drag in action, you can inspect this simple Excel model. The size and impact of the drag will depend on a variety of the variables (in addition to time).

https://drive.google.com/file/d/1RRNghh ... sp=sharing

WoodSpinner
Looked at it but it wasn't "intuitively obvious" how to use it. Instructions?
Here goes:
  • Conversions over 2 10 year Time periods are compared:
  • Enter Conversion Amounts in Column in O3:13 or O18:28
  • Tax Rates are held Constant and can be entered in Cells B32:33
  • Expected Returns for Equities, Bonds & Cash can be entered in Cells B42:44
  • Asset Mix for Taxable, Roth, and TDA can be entered in Cells C36:E38
  1. Weighted Expected Growth Rates for Taxable, Roth and TDA are calculated in B36:38 based on Expected Returns and Asset Mix
  2. Totals (for Taxable, Roth, and IRA) are calculated in S3:13 and S18:28
  3. Tax Drag is calculated in S30
You can play with time periods for Conversions, growth rates, Asset mixes to gain a better understanding of their impact on Tax Drag.

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

Post by FiveK »

^Thanks, that made it clear.

You might take a look at this post regarding assumptions that need to be specified, and the two tools mentioned in the More complicated situations of the t vs. R wiki.

The tax drag in a taxable account manifests itself in two ways:
1) annual taxes on interest, dividends, etc.
2) capital gain taxes when withdrawn

The two existing tools get it right (AFAIK) for optional traditional vs. Roth contributions and conversions. That is, "get it right" meaning they each tell the withdrawal marginal rate at which current traditional and Roth contributions (or a conversion choice) provide the same spendable after-tax amount. That future marginal rate has been called the break-even tax rate (BETR).

McQ has introduced another wrinkle: the forced removal of traditional funds due to RMDs when the after-tax amount of the RMD is invested instead of spent.

Presumably that would have a qualitatively similar effect on one's BETR: Roth becomes favorable even if one's future withdrawal tax rate is "somewhat" below the current rate, due to the tax drag imposed by the enforced conversion of traditional to taxable funds. The unanswered question is the quantification of "somewhat" for the invested RMD case.

Preferably, the answer would come via a tool with similar simplicity to the ones noted above, as there are many moving parts that will vary from person to person. See this post for a few of the variables. At his point, even a few well documented examples would be a good start at answering diy60's question in the above post.
hvaclorax
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by hvaclorax »

Question,
If my heirs are known to be in the 35+% tax (Fed+State) and I won’t touch the Roth during my or DW lifetime, should I go higher than the McQ recommend Roth conversion amounts? IE convert to 24% bracket even though I otherwise should only go to top of 22% bracket?
Thanks HVAC
McQ
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by McQ »

hvaclorax wrote: Sun Aug 15, 2021 2:22 pm Question,
If my heirs are known to be in the 35+% tax (Fed+State) and I won’t touch the Roth during my or DW lifetime, should I go higher than the McQ recommend Roth conversion amounts? IE convert to 24% bracket even though I otherwise should only go to top of 22% bracket?
Thanks HVAC
Hello hvaclorox: remember, I don't actually "recommend" any particular stopping rate beyond which you should not convert. My goal is an analytic procedure that can rank order conversions by what might be called robustness and also, by relative advantage. In my analysis, all undisturbed Roth conversions are expected to have a positive return *eventually*, but even then, that return may be exceedingly modest. Other conversion scenarios are likely to pay off early, and in spades.

Woodspinner asked my advice for his very specific case, and my answer might be paraphrased as, "a conversion up to the first IRMAA boundary is about where robust outcomes begin to give way to chancy outcomes, in my judgment, in your highly specific case."

Turning now to your different, highly specific case: the greater the certainty that you won't touch the funds, and that your heirs will be in the 35% bracket, the more robust a conversion *for you* will be up through the 24% bracket, and its several IRMAA cliffs (if you have to convert into IRMAA, always convert to the top of the IRMAA bracket in which you otherwise fall.) On the other hand, although a conversion all the way through the 32% bracket might be considered, and would often pay off, I believe it would be chancy.

In short: large gaps between future and current tax rates (11% in your case) are among the factors that make a conversion robust. That's why conversions through the 12% bracket are generally robust for affluent middle class savers, who may easily find themselves in the 22 or 24% bracket when RMDs begin.
You can take the academic out of the classroom by retirement, but you can't ever take the classroom out of his tone, style, and manner of approach.
McQ
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by McQ »

FiveK wrote: Tue Aug 03, 2021 8:47 pm
McQ has introduced another wrinkle: the forced removal of traditional funds due to RMDs when the after-tax amount of the RMD is invested instead of spent.

Presumably that would have a qualitatively similar effect on one's BETR: Roth becomes favorable even if one's future withdrawal tax rate is "somewhat" below the current rate, due to the tax drag imposed by the enforced conversion of traditional to taxable funds. The unanswered question is the quantification of "somewhat" for the invested RMD case.

Preferably, the answer would come via a tool with similar simplicity to the ones noted above, as there are many moving parts that will vary from person to person. See this post for a few of the variables. At his point, even a few well documented examples would be a good start at answering diy60's question in the above post.
Hello FiveK: I'm a little more than halfway to that tool, or rather to a 'proof of concept' spreadsheet demonstration of exactly how tax drag works, following up on some numbers upthread. It will document exactly how constant tax rates can still lead to a Roth conversion payoff, and how much lower future tax rates might be and still have the conversion payoff. But, not ready for primetime yet.

Just a word to all about why I believe it is important to consider the case where RMDs 'force' removal of funds from the tax shelter in excess of spending needs. I argue for reinvesting the after-tax amount to maintain comparability with the Roth conversion scenario. As has been stated again and again in the DBSH and Woodspinner threads, many converters expect to leave the Roth funds to heirs--to not spend from the Roth. If Roth funds are not being spent, than the counterfactual TDA funds, had there been no conversion, must also not be spent, excepting the haircut from taxes. So they get reinvested in taxable, where a new source of tax drag commences.

If regular withdrawals were to be made from the Roth funds, up to the after-tax value of the forced RMD from the counterfactual TDA, then all the counterfactual RMD could be spent as well; comparability would still be maintained.
You can take the academic out of the classroom by retirement, but you can't ever take the classroom out of his tone, style, and manner of approach.
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WoodSpinner
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by WoodSpinner »

hvaclorax wrote: Sun Aug 15, 2021 2:22 pm Question,
If my heirs are known to be in the 35+% tax (Fed+State) and I won’t touch the Roth during my or DW lifetime, should I go higher than the McQ recommend Roth conversion amounts? IE convert to 24% bracket even though I otherwise should only go to top of 22% bracket?
Thanks HVAC
Wondering what you want to accomplish through your Conversions? What is Important to you?

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

Post by FiveK »

McQ wrote: Sun Aug 15, 2021 4:29 pm Hello FiveK: I'm a little more than halfway to that tool, or rather to a 'proof of concept' spreadsheet demonstration of exactly how tax drag works, following up on some numbers upthread...But, not ready for primetime yet.
Excellent news! And if summer days lead you to pursuits other than typing away at a keyboard...join the crowd. :) Don't know if more volunteer work of this type gets done when outdoor conditions are unfavorable, but it would not be surprising.
It will document exactly how constant tax rates can still lead to a Roth conversion payoff, and how much lower future tax rates might be and still have the conversion payoff.
That does seem the best approach. Whenever a distribution is assumed to come from a converted Roth account, whether voluntary or enforced by inherited RMD rules, that provides a "spendable after tax amount".

Whether spent at that time or invested taxably, the question becomes "what tax rate would withdrawal from an unconverted traditional account have to incur at the same time to provide the same "spendable after-tax amount." When only traditional and Roth accounts are pertinent, the answer is simple: the same rate as imposed on the original Roth conversion.

When taxable accounts enter the fray, that's when "somewhat" lower rates on future withdrawals (compared with current contribution/conversion marginal rates) can still favor the Roth path.
Just a word to all about why I believe it is important to consider the case where RMDs 'force' removal of funds from the tax shelter in excess of spending needs. I argue for reinvesting the after-tax amount to maintain comparability with the Roth conversion scenario. As has been stated again and again in the DBSH and Woodspinner threads, many converters expect to leave the Roth funds to heirs--to not spend from the Roth. If Roth funds are not being spent, than the counterfactual TDA funds, had there been no conversion, must also not be spent, excepting the haircut from taxes. So they get reinvested in taxable, where a new source of tax drag commences.

If regular withdrawals were to be made from the Roth funds, up to the after-tax value of the forced RMD from the counterfactual TDA, then all the counterfactual RMD could be spent as well; comparability would still be maintained.
No argument about the potential utility of this analysis.

For what it's worth, the use of the word counterfactual may be more distracting than worthwhile. Note that for a person considering whether to convert or not, neither choice is yet "factual". ;)
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by smitcat »

FiveK wrote: Sun Aug 15, 2021 11:10 pm
McQ wrote: Sun Aug 15, 2021 4:29 pm Hello FiveK: I'm a little more than halfway to that tool, or rather to a 'proof of concept' spreadsheet demonstration of exactly how tax drag works, following up on some numbers upthread...But, not ready for primetime yet.
Excellent news! And if summer days lead you to pursuits other than typing away at a keyboard...join the crowd. :) Don't know if more volunteer work of this type gets done when outdoor conditions are unfavorable, but it would not be surprising.
It will document exactly how constant tax rates can still lead to a Roth conversion payoff, and how much lower future tax rates might be and still have the conversion payoff.
That does seem the best approach. Whenever a distribution is assumed to come from a converted Roth account, whether voluntary or enforced by inherited RMD rules, that provides a "spendable after tax amount".

Whether spent at that time or invested taxably, the question becomes "what tax rate would withdrawal from an unconverted traditional account have to incur at the same time to provide the same "spendable after-tax amount." When only traditional and Roth accounts are pertinent, the answer is simple: the same rate as imposed on the original Roth conversion.

When taxable accounts enter the fray, that's when "somewhat" lower rates on future withdrawals (compared with current contribution/conversion marginal rates) can still favor the Roth path.
Just a word to all about why I believe it is important to consider the case where RMDs 'force' removal of funds from the tax shelter in excess of spending needs. I argue for reinvesting the after-tax amount to maintain comparability with the Roth conversion scenario. As has been stated again and again in the DBSH and Woodspinner threads, many converters expect to leave the Roth funds to heirs--to not spend from the Roth. If Roth funds are not being spent, than the counterfactual TDA funds, had there been no conversion, must also not be spent, excepting the haircut from taxes. So they get reinvested in taxable, where a new source of tax drag commences.

If regular withdrawals were to be made from the Roth funds, up to the after-tax value of the forced RMD from the counterfactual TDA, then all the counterfactual RMD could be spent as well; comparability would still be maintained.
No argument about the potential utility of this analysis.

For what it's worth, the use of the word counterfactual may be more distracting than worthwhile. Note that for a person considering whether to convert or not, neither choice is yet "factual". ;)
"Whether spent at that time or invested taxably, the question becomes "what tax rate would withdrawal from an unconverted traditional account have to incur at the same time to provide the same "spendable after-tax amount." When only traditional and Roth accounts are pertinent, the answer is simple: the same rate as imposed on the original Roth conversion."
Yes, exactly.
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by hvaclorax »

Woodspinner,
My goal is to give all Roth proceeds to my higher tax bracket children. As such DW and I would still have enough in tIRA and SS to carry us through our time left on Earth.
HVAC
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by FiveK »

FiveK wrote: Sun Aug 15, 2021 11:10 pm Whether spent at that time or invested taxably, the question becomes "what tax rate would withdrawal from an unconverted traditional account have to incur at the same time to provide the same "spendable after-tax amount." When only traditional and Roth accounts are pertinent, the answer is simple: the same rate as imposed on the original Roth conversion.

When taxable accounts enter the fray, that's when "somewhat" lower rates on future withdrawals (compared with current contribution/conversion marginal rates) can still favor the Roth path.
It appears Michael Kitces addressed exactly this issue 12 years ago: https://www.kitces.com/wp-content/uploa ... y-2009.pdf

The law change regarding a 10 year distribution for inherited IRAs may change the RMD math somewhat, but the article appears pertinent nonetheless.
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by Exchme »

McQ wrote: Sun Aug 15, 2021 4:12 pm
hvaclorax wrote: Sun Aug 15, 2021 2:22 pm Question,
If my heirs are known to be in the 35+% tax (Fed+State) and I won’t touch the Roth during my or DW lifetime, should I go higher than the McQ recommend Roth conversion amounts? IE convert to 24% bracket even though I otherwise should only go to top of 22% bracket?
Thanks HVAC
Hello hvaclorox: remember, I don't actually "recommend" any particular stopping rate beyond which you should not convert. My goal is an analytic procedure that can rank order conversions by what might be called robustness and also, by relative advantage. In my analysis, all undisturbed Roth conversions are expected to have a positive return *eventually*, but even then, that return may be exceedingly modest. Other conversion scenarios are likely to pay off early, and in spades.

Woodspinner asked my advice for his very specific case, and my answer might be paraphrased as, "a conversion up to the first IRMAA boundary is about where robust outcomes begin to give way to chancy outcomes, in my judgment, in your highly specific case."

Turning now to your different, highly specific case: the greater the certainty that you won't touch the funds, and that your heirs will be in the 35% bracket, the more robust a conversion *for you* will be up through the 24% bracket, and its several IRMAA cliffs (if you have to convert into IRMAA, always convert to the top of the IRMAA bracket in which you otherwise fall.) On the other hand, although a conversion all the way through the 32% bracket might be considered, and would often pay off, I believe it would be chancy.

In short: large gaps between future and current tax rates (11% in your case) are among the factors that make a conversion robust. That's why conversions through the 12% bracket are generally robust for affluent middle class savers, who may easily find themselves in the 22 or 24% bracket when RMDs begin.
One other point hvaclorax should consider is how certain is it that hvaclorax's heirs really will end up in such high brackets. Many people have financial setbacks, pull the plug on their careers when they think they have "enough", move to lower tax states, get married, divorced, have children with high expenses, etc. Or hvaclorax might not last so long and the inheritance happens sooner rather than later and the heirs retire as a result. The point being conversions into higher and higher brackets become less and less certain to work out as you have to take on the impossible job of evaluating risks and choices of your heirs too.
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FiveK
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by FiveK »

FiveK wrote: Fri Aug 27, 2021 10:43 pm
FiveK wrote: Sun Aug 15, 2021 11:10 pm Whether spent at that time or invested taxably, the question becomes "what tax rate would withdrawal from an unconverted traditional account have to incur at the same time to provide the same "spendable after-tax amount." When only traditional and Roth accounts are pertinent, the answer is simple: the same rate as imposed on the original Roth conversion.

When taxable accounts enter the fray, that's when "somewhat" lower rates on future withdrawals (compared with current contribution/conversion marginal rates) can still favor the Roth path.
It appears Michael Kitces addressed exactly this issue 12 years ago: https://www.kitces.com/wp-content/uploa ... y-2009.pdf

The law change regarding a 10 year distribution for inherited IRAs may change the RMD math somewhat, but the article appears pertinent nonetheless.
The tool described in How do RMDs affect Roth conversion choices? may shed some light. I've looked at it without finding any obvious errors, but am not to that stage of life so someone for whom the question is less theoretical (or the various spreadsheet mavens who post here) might have more insight.

Some quotes from that thread below.
Some observations:
- If the original owner had lived to age 94, it would have been slightly better to do the Roth conversion even if the heir had been a tax-exempt charity.
- With the default scenario, not converting is slightly better for the heir if the heir would use the inheritance within two years. If the heir would let the money grow for the full 10 years, an age 71 conversion by the original owner would give the heir more spendable after-tax income after the 10 years.

Disclaimers:
- None of this should be interpreted to be an unqualified "Roth is better" or "traditional is better." As always, it depends....
- At the time of this post, the spreadsheet has not been checked for errors by anyone other than the author. It has passed several self-checking reasonableness tests, but any good tool developer knows that the original developer is not the best reviewer....
hvaclorax
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by hvaclorax »

Exchme wrote: Sat Aug 28, 2021 12:03 pm
McQ wrote: Sun Aug 15, 2021 4:12 pm
hvaclorax wrote: Sun Aug 15, 2021 2:22 pm Question,
If my heirs are known to be in the 35+% tax (Fed+State) and I won’t touch the Roth during my or DW lifetime, should I go higher than the McQ recommend Roth conversion amounts? IE convert to 24% bracket even though I otherwise should only go to top of 22% bracket?
Thanks HVAC
Hello hvaclorox: remember, I don't actually "recommend" any particular stopping rate beyond which you should not convert. My goal is an analytic procedure that can rank order conversions by what might be called robustness and also, by relative advantage. In my analysis, all undisturbed Roth conversions are expected to have a positive return *eventually*, but even then, that return may be exceedingly modest. Other conversion scenarios are likely to pay off early, and in spades.

Woodspinner asked my advice for his very specific case, and my answer might be paraphrased as, "a conversion up to the first IRMAA boundary is about where robust outcomes begin to give way to chancy outcomes, in my judgment, in your highly specific case."

Turning now to your different, highly specific case: the greater the certainty that you won't touch the funds, and that your heirs will be in the 35% bracket, the more robust a conversion *for you* will be up through the 24% bracket, and its several IRMAA cliffs (if you have to convert into IRMAA, always convert to the top of the IRMAA bracket in which you otherwise fall.) On the other hand, although a conversion all the way through the 32% bracket might be considered, and would often pay off, I believe it would be chancy.

In short: large gaps between future and current tax rates (11% in your case) are among the factors that make a conversion robust. That's why conversions through the 12% bracket are generally robust for affluent middle class savers, who may easily find themselves in the 22 or 24% bracket when RMDs begin.
One other point hvaclorax should consider is how certain is it that hvaclorax's heirs really will end up in such high brackets. Many people have financial setbacks, pull the plug on their careers when they think they have "enough", move to lower tax states, get married, divorced, have children with high expenses, etc. Or hvaclorax might not last so long and the inheritance happens sooner rather than later and the heirs retire as a result. The point being conversions into higher and higher brackets become less and less certain to work out as you have to take on the impossible job of evaluating risks and choices of your heirs too.
Exchme
Sorry I didn’t see you answer till today. Your points are absolutely needed. I haven’t thought about the gotcha issues. Will give this some thought. Had been planning to swing for the fences but maybe I should be more conservative. Will share with my advice guru.
Hvac
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Re: [**Update] - Metrics to Compare Roth Conversion Scenarios ??

Post by Wiggums »

Great thread. I found the examples with numbers to be very helpful.

I can summarize our situation by saying:

1) “Wish I had found BH sooner and learned more about this issue. I am working with the portfolio I have, not the one I wish I had.”

2) Wish I had better understood our complex’s tax system earlier.

3) We have adopted “the sooner (and larger) you convert early on, the more compounding can make that Roth grow.” Take Roth conversion taxes into account, but then get that Roth growing.

4) There are many unknowns, so you have to make reasonable assumptions. Tax laws can and do change. Balancing tax deferred and Roth is not a bad strategy for those who cannot decide what to do.

Thanks again for sharing your detailed thoughts on this subject.
"I started with nothing and I still have most of it left."
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