what if conversion pushes us int to next bracket?
I keep hearing to convert just enough to not go into next bracket. BUT, what if in the end, you are hovering just below a higher bracket (lets say at 208,00 which puts you in 28% and under the 33% bracket)? Do you simply not convert much at all because you’ll almost immediately jump into next bracket?
Permalink Submitted by Alan Spross on Thu, 2010-12-30 20:39
It does make the decision tougher because you would have to take a closer look at whether you should convert when the bulk of it will be in that higher bracket. But perhaps the conversion will prevent an even greater amount of income from being subject to that rate or even higher in the future.
You might want to convert a smaller amount than you otherwise would, and as your Roth value as a percentage of your pre tax retirement account values rises, you would be more selective about conversion amounts. It also depends on what other income you expect to have in retirement, eg rentals, pensions, part time work, inheritance, taxable brokerage accounts etc. If you have these other income producing assets, you would generally remain subject to higher taxable income in retirement, so would have to convert more to reduce your tax rate in retirement than if you had just pre tax retirement accounts.
The whole process is one that needs to be revisited fairly often since both tax rates, and personal financial statements are subject to change due to investment results and expenses. The first dollars you convert tend to be more valuable than conversions you do after you already have considerable assets in your Roth.
Permalink Submitted by Mike Hunt on Fri, 2010-12-31 17:18
Alan – not sure I get this point “But perhaps the conversion will prevent an even greater amount of income from being subject to that rate or even higher in the future.” You clearly get me issue – I might go into higher bracket with just a small conversion based on back of the envelope estimating of AGI for 2010 and tax tables. I really want to convert, but paying 5% more in taxes (plus high state rates – CA) seem to be pushing back on the logic. Particularly if I move to a low or no state income tax state (see recent post)
As for future income sources, it’s all me (no rentals, inheritance, etc.) just what I save between now and then (and SS if around).
Permalink Submitted by Alan Spross on Fri, 2010-12-31 18:41
Point was that whatever amount your tax liability is for the conversion itself, the conversion will reduce your future taxable income due to reduced future RMD obligations.
If your income in retirement was the same as it is now, ie about to spill over to the next higher bracket, every dollar you convert now reduces the dollars of income in the future that will be subject to your marginal rate in that year. Therefore conversion now makes it less likely that when RMDs begin those RMDs will push you into a higher bracket. Over a two decade retirement, the RMD % more than doubles so analysis is very difficult and depends on a highly subjective rate of return on your IRAs as well as dozens of other factors.
In the end, conversions are a hedge against future tax loss due to any combination of higher tax rates and wealth accumulation over time, perhaps with some estate consideration included as well.
Declining to convert is a hedge against the reverse, ie lower tax rates, loss of wealth due to health, natural disasters, financial meltdowns etc. For most people the pain of the latter is more significant than the pain of higher taxes, so for some people who are more spenders than savers and are unlikely to accumulate retirement savings, conversions are unlikely to benefit them.
Returning to the bracket question, right now you are on the cusp of the next bracket, but you cannot assume that this will always be the case. Based on all the factors, it does tend to make it more difficult to convert very much when going into the higher bracket, so perhaps you would put a lid on the conversions using the rationale that each dollar converted makes it less likely that you will enter that higher bracket in retirement even when RMD %s get much higher by your mid 80s. The decision to convert is easier if you are in the middle of the 15% bracket now and you can project that RMDs will push you into the 25% bracket by the time you reach your late 70s.
For lower taxable income people, the SS inclusion also becomes a complicating factor, ie determining what conversion pattern subjects less of your total SS benefit to inclusion in AGI over time if you are in the SS phase in range, ie before 85% of it is included.