Any Red Flags? FIL's decision to convert rationale

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URSnshn
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Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

[Updated with additional info requested]

FIL has now tentatively made his decision to convert some of his tIRA dollars to a Roth. He would like to know if there are any red flags in his thought process? Tax status: MFJ.

After reconsidering, re-reading and using I-ORP and other calculators his tentative decision is to convert $200K dollars to a Roth and in so doing pay the taxes out of the conversion. He realizes that he has to hold it long term for payback to occur. Payback is taxes paid + IRMAA costs in two years. Marginal Tax Rate is about 34%. In early years of RMDS he would be in the 22% Marginal Tax Bracket, this year he is in 12% MTR. He is concerned that the marginal tax rate for this conversion is 34% (which includes the increased IRMAA he will have to pay for in two years) Marginal for conversion breakdown:

• Federal Marginal Tax is 24%,
• State Income Tax is 6%
• IRMAA is additional 3.XX% taking him to a little bit over the $34% Marginal Tax Rate.

Additional info:
* AGE - 71
* MFJ
* TDA - $1,400,000
* Roth - $80,000
* SS + PA: $100,000

Roth Spending: He may have to spend some of the conversion dollars out of the Roth, if this comes to pass, he feels he would have had to withdraw the money anyway from the Traditional IRA and pay taxes. If some of those tax dollars were paid out at the 24%, well then he might have paid a little bit more or less in taxes depending on tax rates in the future. But if he needed the money, he would withdraw it anyway, and anything he doesn’t spend will grow tax free.

SS He realizes a couple of thousand of his SS dollars will be paid for in the 40% range.

IRMAA. The higher IRMAA premiums in two years is something he is going to save for and/or use from some taxable (low interest MM funds).

Plan: With respect to future RMDs, if he feels it is advantageous he would make Roth Conversions - may well be much smaller - in coming years, and will try to pay taxes for those out of taxable. While the Roth Conversions may not keep pace with growth, the monies would grow tax free.

His reasons for doing a Roth Conversion:
- to hold down RMDs and thus taxes and IRMAA surcharges in the future - as best as is possible at this time.
- to invest in long term growth.
- may need access to some of the conversion dollars in next couple of years.
- to have his financial picture be in good shape for a sole survivor issue

Is he missing anything in his thought process? Any red flags? Is 34% Marginal Tax Rate too outrageous?
Last edited by URSnshn on Sat Oct 16, 2021 10:53 am, edited 3 times in total.
123
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Re: Any Red Flags? FIL's decision to convert rationale

Post by 123 »

URSnshn wrote: Fri Oct 15, 2021 4:23 pm ...his tentative decision is to convert $200K dollars to a Roth and in so doing pay the taxes out of the conversion...
If he lacks outside funds to pay the taxes on the conversion to me the cost of conversion is too high.
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Watty
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Re: Any Red Flags? FIL's decision to convert rationale

Post by Watty »

One thing you did not mention was his marital status and if he is filing joint or single tax returns. If he is filing joint tax returns then it might make more sense because it is likely that one of them will survive the other and then be filing tax returns in the higher single tax brackets.

You also did not mention what percent of his net worth this is. I would assume that it is a modest percentage of his retirement accounts.

He could also do a smaller Roth conversion now and another in January to get that on his 2021 taxes. It would be worth playing with the numbers on that.
URSnshn wrote: Fri Oct 15, 2021 4:23 pm Is 34% Marginal Tax Rate too outrageous?
The tax rates are scheduled to revert to the old higher tax rates in 2026 if there are not any tax law changes.

Assuming that happens then even if this turns out to be a mistake then it might only cost him something like 5%(???) in higher taxes. That is likely not a life changing problem if it happens.

I probably would not do it but I have heard of people doing worse things so I don't think that you would have any reason to panic and try to do some sort of intervention.
chemocean
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Re: Any Red Flags? FIL's decision to convert rationale

Post by chemocean »

Why do the conversion in one year? I plan to take 10 years to convert even after I have to take RMDs.
Does he need the RMDs for living expenses? At 72, take the RMDs If not, the RMDs become taxable assets that he then can use to fund the conversions.
BigJohn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by BigJohn »

123 wrote: Fri Oct 15, 2021 4:36 pm
URSnshn wrote: Fri Oct 15, 2021 4:23 pm ...his tentative decision is to convert $200K dollars to a Roth and in so doing pay the taxes out of the conversion...
If he lacks outside funds to pay the taxes on the conversion to me the cost of conversion is too high.
There are few absolutes about this decision, it’s very dependent on individual circumstances. But…. a large part of the benefits comes from maximizing the Roth balance and lowing the taxable account balance by not paying taxes from the conversion. So without more details, I think this is a show stopper if he can’t pay the money from other funds.
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URSnshn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

Watty, Thanks for the question and your thoughts. My FIL's tax status is MFJ, I've changed to post to reflect that.
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URSnshn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

chemocean: Good question! He's planning on doing it this year because his taxable income in 2021 is much lower than usual (in the 12% marginal tax bracket), once he adds on RMD's I think he doubted he could make much of a dent in it over time due to RMD's and the growth factor.
A Random Fellow
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Re: Any Red Flags? FIL's decision to convert rationale

Post by A Random Fellow »

Lots of people smarter than me here, but it would be a slam dunk to me to convert up to the top of the 12% bracket, potentially a little bit of sense to convert up to the 22% bracket, and probably not much sense to convert up to the 24% bracket. Going beyond that just seems like trying to pay a lot of taxes on purpose.

I am a big Roth fan but I don't see the wisdom in lumping a $200k conversion in one year for virtually anyone who doesn't have a Peter Thiel sized traditional retirement account.
Fat Tails
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Re: Any Red Flags? FIL's decision to convert rationale

Post by Fat Tails »

OP,
It is impossible to even take a swag at this question without knowing his age, his projected income (and marginal tax rates) and the current TIRA balance.

Like other replies here, if is goal is to convert only $200k then is is likely not optimal to do it all on one year, unless it is to just take the IRMAA hit for only one year.

Cheers
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TropikThunder
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Re: Any Red Flags? FIL's decision to convert rationale

Post by TropikThunder »

BigJohn wrote: Fri Oct 15, 2021 5:08 pm
123 wrote: Fri Oct 15, 2021 4:36 pm
URSnshn wrote: Fri Oct 15, 2021 4:23 pm ...his tentative decision is to convert $200K dollars to a Roth and in so doing pay the taxes out of the conversion...
If he lacks outside funds to pay the taxes on the conversion to me the cost of conversion is too high.
There are few absolutes about this decision, it’s very dependent on individual circumstances. But…. a large part of the benefits comes from maximizing the Roth balance and lowing the taxable account balance by not paying taxes from the conversion. So without more details, I think this is a show stopper if he can’t pay the money from other funds.
I agree. It's akin to using your Roth as an emergency fund and withdrawing contributions like some advise (not on this thread). You can never put that money back in the Roth.
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URSnshn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

Fat Tails and all, Thank you for your comment. I updated my post with the information requested.

Additional info:
* AGE - 71
* MFJ
* TDA - $1,400,000
* Roth - $80,000
* SS + PA: $100,000
smitcat
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Re: Any Red Flags? FIL's decision to convert rationale

Post by smitcat »

URSnshn wrote: Sat Oct 16, 2021 7:40 am Fat Tails and all, Thank you for your comment. I updated my post with the information requested.

Additional info:
* AGE - 71
* MFJ
* TDA - $1,400,000
* Roth - $80,000
* SS + PA: $100,000
"In early years of RMDS he would be in the 22% Marginal Tax Bracket, this year he is in 12% MTR"
I am curious how you get to the 22% marginal rate in the early 70's with these numbers?
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Watty
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Re: Any Red Flags? FIL's decision to convert rationale

Post by Watty »

URSnshn wrote: Fri Oct 15, 2021 4:23 pm ....his tentative decision is to convert $200K dollars to a Roth and in so doing pay the taxes out of the conversion.
.....
Additional info:
* AGE - 71
* MFJ
* TDA - $1,400,000
* Roth - $80,000
* SS + PA: $100,000
It looks like he will have to take an RMD of around $50K in 2022.

If he does a Roth conversion the taxes will not be due until April 15th when he files his taxes.

I would think that he could take the RMD in January and use that money to pay the taxes on the Roth conversion. That would help prevent having to pay the Roth conversion taxes out of the conversion.

He would need to check the safe harbor rules to make sure that he did not get a penalty for underwithholding.
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URSnshn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

smitcat: He and I calculated the taxes and extrapolated, as well as used various spreadsheets. In addition he had his tax expert calculate next years taxes and next year he is in the 22% bracket and for a few years. Of course in 2026 and/or if tax laws change that might change. Are we in error. $100,000 base SS + PA + RMD.
HomeStretch
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Re: Any Red Flags? FIL's decision to convert rationale

Post by HomeStretch »

On the surface, it doesn’t make sense to me for FIL to do a $200k Roth conversion in one tax year at a marginal tax rate of 34% (which includes IRMAA in 2023) with the taxes being paid from the conversion. It’s possible it makes sense due to some detail about your FIL’s situation. As Watty posted, such as a sole surviving spouse scenario.

If FIL’s marginal tax rate in the early RMD years is 22%, he shouldn’t pay IRMAA premium surcharges in those years. This wouldn’t be true though if he has significant AGI adjustments such as tax-exempt income to arrive at IRMAA MAGI or he has high IRMAA-territory AGI with high deductions that bring him down to the 22% tax bracket.

What is the marginal tax rate/IRMAA impact of doing smaller conversions over multiple years to stay in a lower tax bracket and below IRMAA tier 1 (2021 IRMAA starts on MAGI > $176k)?

If I-ORP supports this large conversion in one year, have you/he reviewed your FIL’s I-ORP assumptions? For example, if he input a high return % for Roth accounts (if he intends to use 100% equity) and low return % for tax deferred accounts (if he holds his bond allocation here), I-ORP might suggest very aggressive Roth conversions. But that scenario would mean that FIL is moving to a more aggressive overall portfolio asset allocation. Which may not be the case and, if it is, an AA change is independent of doing Roth conversions.
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URSnshn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

Thank you everyone - I am sharing your questions and insights with my FIL

HomeStretch - Yes one of FIL's goals is to have his financial picture be in good shape for a sole survivor issue - although personally I am not sure this is much of an issue in that it looks like the survivor will have enough extra to pay the taxes. And yes it does not appear he will pay IRMAA surcharges in early years (five or six as I recall). He has no AGI adjustments at this time. He had thought it best to do a one and done as in a large conversion to begin with given his 12% marginal tax bracket this year - he thought this gave him the best opportunity for meaningful conversion results. His AA allocation is 40 equities / 60 bonds - He is not an aggressive investor.



He didn't think that it would be likely, once RMD's start next year to be able to convert the growth amount of the account each year and that was another reason for doing a large conversion this year. Maybe he should re-look at this.
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URSnshn
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Re: Any Red Flags? FIL's decision to convert rationale

Post by URSnshn »

My FIL took a look at doing smaller conversions up to the 22% tax bracket rather than 24%. He found he could do a Roth Conversions in 2022 - 2025 totalling approx $200K but his marginal tax rate is still rather high. For example, in 2022 with the Roth Conversion + RMD the marginal tax rate would be 29.2% (including marginal tax increase in IRMAA into Tier 2). One of the reasons is the state income tax doesn't change.

Even if he were to use the RMD taxable dollars too pay for the taxes on the conversion, the marginal tax rates still look to be too high. He is thinking that this year may be his best bet, but to lower the conversion amount to the top of the 22% marginal tax bracket and see where things fly each year and / see if he find a way to swing paying the taxes out of taxable for this year's conversion ... possibly using the taxable RMD dollars he'd have to take in 2022.
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