Roth Conversion

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• #8342
haroldml
Participant

Happy Thanksgiving.
I’m considering converting the amount that would normally be required for our RMDs this year to a Roth account. I realize that this is an individual choice so you can’t advise me what to do. The additional taxes required for the conversion would be about \$4,900 so, at our ages (both 86), we may not live long enough to recover those taxes. I know that they need to be paid from other sources & I’ll probably have to make that payment as a quarterly tax payment. What makes the tax computation complicated is that we made some small non-deductible contributions many years ago & we each have a small basis in our accounts. The 2020 8606 isn’t available yet &, obviously, the 2020 year-end values aren’t available. So my question is: If I do the conversion, when & how do I calculate those taxes?

#8345
Kaye Thomas
Moderator

And a happy Thanksgiving to you.

Let’s back up and look at how this strategy is a win for you (or not).

First, you’ve made some nondeductible contributions, creating basis. So long as they remain in the traditional retirement account, investment earnings on these amounts will be deferred but ultimately taxable. Earnings on any portion you move to a Roth account will be permanently free of tax. Because you pay no tax on this portion of your conversion, it is a clear win. It sounds like this is a minor consideration in your case because you have only a small amount of basis, but this is at least a small point in favor of the conversion.

Second, assuming you have funds available from another source to pay the conversion tax, this strategy effectively increases the amount you hold in a tax-favored retirement account. The tax that applies to withdrawals from traditional accounts reduces the amount of usable wealth they provide. A \$200,000 account that is really worth just \$150,000 if a 25% tax will apply to withdrawals. When you convert \$20,000 from that account and pay \$5,000 in tax from other sources, you decrease the value of the traditional account by \$15,000 (the \$20,000 withdrawal minus \$5,000 in tax) but increase the value of the Roth account by \$20,000. The net effect is a \$5,000 increase in tax-favored retirement savings.

The third thing that’s going on is a potential shift in tax rates. Suppose you have to pay 25% on the conversion, but anticipate that if you skip the conversion, you (or your beneficiary) will end up paying a lower rate when these dollars eventually come out of the retirement account. In this case, your conversion makes sense only if the funds remain invested in the account long enough (including the withdrawal period for your beneficiary as well as your lifetime) for the first two benefits to outweigh the disadvantageous shift in tax rates.

On the other hand, if you expect the eventual tax rate to be the same or perhaps even higher, prospects for the conversion are favorable without regard to how long the funds will remain invested.

All these considerations require a crystal ball for any certainty, but understanding how the different factors interact is helpful in making an informed decision.

Now to your specific question. It appears you have an estimate of the tax cost that is usable for planning purposes; that is, for purposes of determining whether to go forward with the conversion, and figuring the amount of estimated tax to pay. You don’t need terribly precise numbers for these purposes. You’ll figure the actual tax when you receive the tax form from your IRA provider.

#8347
haroldml
Participant

Thanks for your thoughtful analysis. If I do the conversion, 85% of our social security will be taxable but if I don’t do the conversion, income will be much lower so taxes on social security will be lower. Currently, we’re in the 12% tax bracket.

Regards,

Harold

#8348
Alan S.
Participant

Your taxable SS income increases as your other income including conversions also increases. If 85% of your SS income is taxable, the effective marginal rate in the 12% bracket is 22.2%, and if you enter the 22% bracket, it is 40.7%.

Once 85% of your SS income is absorbed, your marginal rate then drops back to 22% in many cases. Because of the complexity of these calculations, the best way to determine how much to convert is to use a tax program, and get your total tax for different conversion amounts. The amount of increase from one conversion amount to the next higher one you model divided by the additional amount converted generates your marginal rate for the additional conversion amount.

Here is a fairly simple calculator for 2020 you could use to determine the effect of different conversion amounts this year:
https://www.mortgagecalculator.org/calcs/1040-calculator.php

• This reply was modified 1 year, 1 month ago by Alan S..
#8357
haroldml
Participant

Thanks Alan. I’ve been doing my calculations in Excel 2010 so it’s not easy. I’ll definitely try the calculator you mentioned.

#8358
haroldml
Participant

In my Excel calculations, I didn’t account for the reduced amount of taxable SS since I didn’t know how to calculate it. Eliminating the 40K Roth conversion & with the reduced taxable SS amount, the additional tax for a Roth conversion becomes approx. \$7,295 & that doesn’t account for the opportunity cost. At this point I’m having a tough time justifying a Roth conversion even considering what Kaye indicated. Perhaps I’m missing something.

Thanks,
Harold

#8364
haroldml
Participant

I think what I’m overlooking is the non taxable growth of the 40K Roth conversion.

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