Logic of Roth conversion costs

Submitted by Jeff Watkins on Wed, 2013-11-20 16:32

I am 69, wife is 63, both retired, with enough SS and pension income to cover living expenses. We both have sizable TIRAs and small Roths because we rolled 401ks into the TIRAs and got started late on Roths. We understand that a Roth has several advantages over a TIRA, that a Roth conversion will be taxed, and that RMD money is taxed and can’t be converted. RMD money will be re-invested in our taxable account and gains will be taxed.

However, I assume we can make regular, partial conversions of TIRA money (not RMD money) to a Roth, pay the tax, and then enjoy the Roth advantages. It seems that the cost of lost opportunity of staying in a TIRA is greater than the tax cost of conversion. Is this reasonable? I can handle spreadsheet calculations, so how can I model this scenario?

Many thanks!
Jeff



Submitted by Alan - IRA critic on Wed, 2013-11-20 20:59

  • You may have a temporary window before RMDs begin, and even better if you are delaying SS benefits to increase delayed retirement credits, to convert at a lower marginal rate than after age 70. Incremental conversions that do not increase your tax rate is what many people do, because conversions are not beneficial if you pay a higher tax rate for the conversion than you will later if you don’t convert.
  • You need to make many assumptions about the future for such a spreadsheet to address all the variables. For example, who will inherit the bulk of these plans after both spouses are gone? If it will be charity, then why pay the taxes to convert? Also, if you don’t have LT care insurance, you would generally convert less than those that do because major medical expenses are deductible and therefore eliminate a large portion of your tax bill.
  • When setting up a spreadsheet, you have to include all the additional taxes affected by modified AGI. For example, your Part B and D Medicare premiums will be surcharged if you exceed the MAGI amount. The new 3.8% surtax on investment income is also triggered and while the distributions are not taxed directly, those distributions are in MAGI and subject other investment income to the surtax. Most calculators available on the web are superficial and do not incorporate all these variables.
  • To simplify, note that your first dollars of Roth conversions are more valuable to you than the later ones. Each conversion reduces future RMDs and therefore future tax rates from the top down resulting in your future marginal rate being reduced eventually. That makes later conversion more likely to cost more than you would pay if you don’t convert. Once you get your pre tax retirement balance down to a certain point, there is no longer a benefit to convert more. Of course, your other non retirement account income must also be considered.

Submitted by Bruce Steiner on Fri, 2013-11-22 00:21

I suggest you create a spreadsheet for each choice, showing how much money you’ll have in your traditional IRA, how much in your Roth IRA, and how much in your taxable account, making some reasonable assumptions as to tax rates, investment returns in the IRAs and after-tax in the taxable account, and how long you’ll live, and take it through the year your beneficiaries will have to take their last required distribution (the end of their life expectancy as of your death).

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