To Roth? What if future max tax rates ARE less?
Sorry, I basically asked this question a few weeks ago (“What if a 9-9-9 tax code is ever adopted”) but did not get an answer. It seems really important…
I have been Roth converting for the past 4 years, usually at chunks just large enough to bring my marginal tax rate to 25%. As mentioned before, this puts my overall tax rate at about 16%.
Let’s not make this thread an issue of whether to Roth convert or not. Suffice it to say, I have decided to take a mid-point solution and Roth convert about half my TIRA. Ed Slott tends to recommend 100% and others recommend 0%. My own tax attorney says she still hasn’t been able to decide which is better and she’s a very smart lady…
So here’s the issue: Since income limits for Roth conversions have been removed, we can continue to Roth convert past age 70.5 (previously not allowed for most because of RMD income). So I can now Roth convert much smaller amounts each year (for a smaller marginal tax rate) or I can continue with larger chunks.
If the max tax rate is reduced in the future to something like 9% (with a 9% consumption tax), then smaller chunks is better.
If the max tax rate actually goes above 35%, then larger chunks are better.
No one can predict political events, but is there a germ of wisdom out there that can suggest one option is better?
BTW, my IRAs are a modest $1.5mm and I’ve converted about $600k so far.
Kind regards
Permalink Submitted by Peter Lingane on Mon, 2011-10-31 16:38
It is the marginal tax rate on conversion, not the overall tax rate, that matters. The rate of conversion matters because “smaller chunks” are likely associated with lower marginal rates on conversion.
You do not mention whether you plan to spend the Roth IRA in retirement. If you plan to spend the Roth IRA in retirement, you are not likely to benefit from late in life conversions unless the conversion premium – the difference between the marginal tax rate that you pay on the conversion less the marginal rate that you would pay on required distributions – is negative.
You need to estimate the marginal tax rate on IRA distributions in retirement. With $40K in required distributions from a traditional IRA plus Social Security and some investment income, it could be a blend of the 15 and 25% brackets if the tax rules do not change. With more income, it might be 25% or more. Your strategy of converting only so much as to pay less than 25% on conversion is reasonable because you avoid a positive premium so long as tax rates stay about the same.
Suppose future tax rates are 9%. If your marginal rate on conversion is 15% and you would pay tax at 9% if you do not convert, you are paying a 6% premium to convert. This is steep but conversion might still be profitable (not for you but for your heirs) if you take no distributions from the Roth IRA. If your marginal rate on conversion is 25%, you would be paying a 16% premium and conversion is unlikely to be profitable unless you are many years from death.
Suppose future tax rates are 35% and you pay only 15% on conversion. You are ahead even if you need to spend the Roth IRA a few years later.
My guess is that you will require some of the IRA, meaning that it would be unwise to convert your entire IRA late in life unless you can convert at a negative premium and are convinced that tax rates will not decline.
Your goal of converting half your IRA is probably optimum. You will have $750K in your Roth IRA (which you don’t intend to spend) to hedge against tax rate increases and $750K in your traditional IRA (which you do intend to spend) to hedge against tax rate declines.
Post death “stretch” benefits are potentially so large as to skew the decision towards conversion. I tend to discount stretch benefits because I expect the rules to change. I can think of no public good which is served by a special tax treatment for non spouses who inherit large traditional or Roth IRAs.
Permalink Submitted by James Mitchell on Mon, 2011-10-31 17:11
Peter,
What an excellent discussion! Thank you so much.
You are correct in thinking we plan to spend our TIRAs in the next 10 to 30 years and hope to leave the RIRAs to our children.
We obviously can not predict what Congress will do with tax rates and whether a flat tax of some kind will ever be introduced. Perhaps lowering the conversion “chunk” size to attain a MTR of 20% would be a good compromise. This would especially true if my assumption of being able to convert after age 70.5 is correct. If not, then I should continue with the larger “chunks” so I achieve my 50% conversion in the next two years.
Sooo… can you comment on the problems associated with planning to convert after age 70.5?
Thanks again.
Permalink Submitted by Peter Lingane on Wed, 2011-11-02 19:33
The primary disadvantage of converting after age 70.5 is greater risk because of a shortened time horizon. Market upsets or early death have a larger effect than if the conversion were effected at a younger age. The marginal tax rate for conversion may also be higher than at a younger age because of RMDs.
You are interested in optimizing the conversion decision. That is fine in the abstract or as a hobby but other issues can have a greater impact on your financial wellbeing and of these close to you.
Are you restricting your lifestyle in order to provide an inheritance for your children? I’m not challenging your decision but please consider whether your children might benefit more from gifts while you are alive.
Do you have long term care insurance to protect your children’s inheritance?
Should you have different investment strategies for the traditional IRA which is intended for your support and for the Roth IRA which is intended for your children?
Permalink Submitted by James Mitchell on Wed, 2011-11-02 20:22
Thanks again, Peter.
You raise three very good points, each of which is worthy of its own thread. These are the types of questions everyone should either be considering or asking their Financial Advisor.
Regarding my investment strategies for Roth vs. TIRA, I am using the same, very conservative approach for both. I made most of my present worth by exploiting equities in the 90’s; my understanding then was that longer-term investments should be more invested in equities (I actually held no bonds then). However, I now know that equity risk increases with time so the rule of thumb I grew up with has been tossed. I’m keeping my horizon at 20 years (my family has a history of fairly long life so that’s how I plan) and my equity holding in all my qualified accounts is only 30%. Even in today’s up-and-down world, I’m sleeping nicely at night. 😀
Thanks for clarifying the issues associated with post-70.5 Roth conversions.
Kind regards