We have been using Pralana for a few years now which has given us some great insights for our plans. As we continue to plan, one item which we do not understand is the best scenario amount of Roth conversions for with our numbers and goals. When we use Pralana for the Roth conversions we always get a plan that has us converting to a higher % of marginal taxes than what will occur in all of the post Roth conversions years. This is also seen in the "effective" tax report columns as well as the “marginal tax” report columns. This situation occurs when we do manual Roth conversions with Pralana as well as when we use the optimize feature for Roth conversions.
Some inputs from our runs…
- we pay our Roth conversions taxes from taxable accounts
- we set these runs for zero inflation
- we do not spend any Roth funds (saved for heirs)
- the results are the same/similar with very conservative returns up thru more historical returns
Questions ….
- In every article we read and every financial site we visit it is stated that Roth conversions are only valuable when the conversion tax rates are more or less equal to the converted tax rates, but never higher. Pralana is calling for us to convert at a higher tax rate, which leaves the converted amount at a much lower tax rate. Why would that be?
- The metric we use is spendable dollars (not taxes) and we see larger spendable dollars with Roth conversions at the portfolio end. Even with higher Roth conversion marginal and effective tax rates there is an increase in spendable dollars so how can this happen?
- Are there any articles or places to read where they talk about making Roth conversions at higher marginal rates pay off?
Theoretically it is possible that paying higher taxes on conversion now compared to future lower taxes is beneficial. For example, if your Roth return is much higher than your IRA return (higher than the tax difference) then conversion may be a good deal. This is especially possible if you are using Asset Allocation Mode-1 and let the conversion increase your overall risk/return allocation.
Karen:
I think Gaby has nailed it. In allocation Mode 1, you need to keep the allocations in all your accounts the same or your results are dominated by switching from bonds in your IRA to stocks in Roth, not of the Roth Conversions themselves.
It is sometimes a possible to that Roth Conversions could be favored at higher marginal rates due to effects like reduction tax drag in taxable, converting prior to age 63 to avoid IRMAA costs, converting prior to claiming SS to minimize taxation of SS benefits. Here it sounds like you are not properly controlling your asset allocation when you test Roth Conversions.
@kkrupka here are some links about Roth conversions:
https://www.marottaonmoney.com/will-roth-conversion-affect-my-estimated-tax-payments/
https://www.fool.com/retirement/plans/roth-ira/5-year-rule/
https://finance.yahoo.com/news/roth-ira-conversion-everything-know-221852053.html
https://arnoldmotewealthmanagement.com/roth-conversions-guide/
Thank you. I had previously tested for that, I allocated 100% bonds in tIRA and 100% bonds in Roth and it still comes out to doing conversions at a higher tax rate with a resulting lower tax rate after we've stopped converting. And then obviously the account balances are way lower at EOL. So I don't know.
@kkrupka I've struggled with this a lot. I will say I've used a couple other tools that also front load the conversions. (although, Pralana seems to be more aggressive). One of the tools - seems to keep some of the traditional IRA around... to take advantage of the deduction each year (i.e. zero tax), which is what I'd expect.
This article is interesting...
A BETR approach to Roth conversions (vanguard.com)
Mike
Thanks, I will take a look at this. It's good to know that other people have come across the same scenarios. Hopefully some others will also chime in here. I really like Pralana, just trying to cover all bases to make sure I'm not doing something incorrectly to skew the results.
It can happen to some degree, particularly if you are young due to reduction in tax drag when you pay taxes out of your taxable account, you reduce future taxes on that account. Like saving investment fees, that starts very small but grows fast.
Other things that you may be seeing-
On the Home tab are you telling it that TCJA will expire? That raises taxes in future years.
It may avoid a phase-in of LTCG taxes, the phase-in is an effective 27% tax rate during the phase-in range.
It may allow less than 85% of your SS benefit to be taxed, the SS tax phase-in can be 1.85 x your normal tax rate, so a 22% bracket can have nearly a 40% marginal rate during the phase-in range..
You may avoid a string of IRMAA charges in subsequent years, IRMAA adds about 5% to the marginal rate.
You may avoid the higher marginal rate when one spouse passes.
Also, Pralana allows you to set the tax rate on the IRA residual in tax-deferred, a lot of programs miss that, so they may understate the benefit.
Pralana slightly undercounts the value as it doesn't give credit for the average of an extra 5 years after you pass that Roths keep the money out of taxable vs. an IRA.
Pralana slightly over-counts the value as it does not give a step-up in cost basis in taxable when one spouse passes (half your unrealized gains and losses fly away to heaven when your spouse passes), so Pralana may understate the lifetime tax cost of doing conversions.
The BETR article is interesting, but I am not sure that PRC knowingly uses these techniques when calculating the conversion. Here is another article: Tax Diversification Limits And Roth Optimization Benefits (kitces.com)
I believe that the standard rule of thumb (compare current tax margin to future margin) is the right approach for most people. If you plan to save the Roth for heirs, then you should consider your heirs tax margin in the first 10 years after they inherent the money. If your current tax margin is higher than their future margin, then it is better to keep the money in IRA (not converting it).
Karen, try Asset Allocation Mode-2 and see if PRC still recommends Roth conversion.
@hecht790 Thank you, I will read through that and also try Mode-2
@ricke Thanks. That is interesting. I do have it set to change tax rates so I will check these things out.
@hecht790 I tried mode 2 and yes it still recommends roth conversions but it does reduce the amount to be converted. It still doesn't spread the taxes out evenly though.
Here is a quote from Kitces article:
“Mathematically, the Roth-versus-traditional IRA decision will actually be the same, regardless of growth rates and time horizon, as long as both accounts remain intact and tax rates don’t change. If future tax rates do change, though, the Roth IRA will result in more wealth when tax rates rise in the future, while the traditional IRA will benefit when tax rates are lower in the future.”
If your future tax rate is higher and you still gain from Roth conversion it means that something else is changing in your accounts.
