I recently retired and have started to use but not a power user yet of Pralana Gold.
I have been researching the blogs and the manual to see if there is anything on modeling the payment of the taxes due from a Roth conversion from the 401k money converted. For example, converting $50K with tax of $11K, which leaves $39K as total converted.
It is not an ideal situation, but I will probably be faced with paying the Roth conversion taxes from a portion of the original amount. The Roth Conversion modeling of Pralana is very good and shows the taxes as part of the expenses. This is well and good if I have enough taxable/tax-free non-qualified funds to cover the taxes due.
Again, this is not ideal as but as most of my assets are in 401k and any cash that I have I want to save for any immediate or emergency use.
If it is in the manual, please direct me and if not, can someone provide some guidance please?
Thank you very much in advance,
Emilio
Emilio,
I don't think the manually specifically addresses this question, so I'll try to explain how it works here. The Roth conversion algorithm takes money from a tax-deferred account and deposits 100% of that into the Roth account. In the course of doing that, the conversion amount is included as ordinary income in the AGI for the corresponding year. The taxes on the converted amount aren't treated separately from your other taxes in that year, and they simply roll into your total expenses for that year. Expenses are subtracted from your income in that year to determine your annual cash flow. If it's negative, then the deficit spending will be covered by your cash account if it has enough funds and, if not, by your other accounts based on the withdrawal order specified on the Financial Assets > Management page. If there are insufficient funds in your cash account and your regular taxable account, it's possible that the taxes on the conversion could result in further withdrawals from your tax-deferred account, or your Roth account. So, if you don't want those taxes to be paid from your cash account, regular taxable account or with further withdrawals from your tax-deferred account, I'd recommend setting the Roth account at top priority in the Withdrawal Order table on the Financial Assets > Management page. This will, in effect, take the taxes out of the stream of money being converted from tax-deferred to Roth.
Stuart
Thanks, Stuart - will definitely try it out.
Emilio
I know this thread is dated, but I am still struggling to understand how PRC handles taxes in the situation where there are insufficient funds in taxable and cash accounts to pay taxes on a Roth conversion. I am in the situation where most of my funds are in a taxed deferred (TD) accounts, but I am exploring Roth conversions. Stuart, you stated above that if a conversion is done, and withdrawal order is Taxed > tax-deferred > Roth, then “it's possible that the taxes on the conversion could result in further withdrawals from your tax-deferred account, or your Roth account.” However, if additional funds are needed from the tax-deferred account, this should add to the taxable income for the year, so the total amount of taxes paid should increase, compared to if the tax from the conversion were paid from cash, taxed accounts or Roth. Conversely, if the withdrawal order were set to Roth having priority, the taxes from the original conversion would be paid from the Roth, which would not add additional tax for the year, but would reduce the Roth balance or effectively reduce the value of the original conversion.
I tested PRC by setting up a large single year Roth conversion, such that the tax for the conversion would exceed the available funds in cash and taxed accounts. Then under the scenarios I set up various withdrawal priorities. In the first case the priority order was Roth, Regular, TD (Case 1). In the second case it was Regular, TD, Roth (Case 2). In the last case it was TD, Regular, Roth (Case 3). In Cases 1 where Roth had priority for withdrawal, the Roth balance was lowest and the TD was highest. This would be expected. In the Cases 2 and 3 where the priority was withdrawal from Taxable and TD, the Roth balance was the same and higher than the Roth balance for Case 1. Again, this would be expected. However, what was unexpected was that for all cases the Federal Income Tax was the same. My expectation would be that for Cases 2 and 3 where funds had to be withdrawn from the TD account to cover the tax from the Roth conversion, this additional TD withdrawal should have triggered a larger tax bill.
The above leads me to believe that when looking at Roth Conversion optimization the only appropriate way to setup the withdrawal priority in PRC when funds from cash or taxable accounts are not sufficient to pay for the conversions is to make the Roth account the top priority. Please verify my assumption.
I can send the the Excel based PRC file privately that explores the above.
Thanks
@lmolino The explanation for what you're seeing is on p125 of the user manual in the section entitled "Handling of Taxes on Unplanned Withdrawals from Tax-Deferred and Regular Savings". The taxes on the Roth conversion amount are always paid in the year the conversion is done; however, if that results in an additional withdrawal from the tax-deferred account to cover those taxes, that constitutes an unscheduled withdrawal, and that amount is added to the AGI for the subsequent year because PRC does not perform iterative tax calculations. I have not specifically studied the impact of this on Roth optimization but I do know that, in general, its effects are minor.
Stuart
Thank you for your response. I guess my concern with the taxes being handled in the next year would be that the AGI would be inaccurate, thus making the proposed Roth conversion estimate from the optimization for any particularly year inaccurate. This might be more of a concern with trying to optimize on IRMAA. Either way, it is good to know what the program is doing.
Thanks again.
Lou.
@lmolino True. I'm always telling clients that Pralana is a long-range calculator, so take these kinds of things as 'guidelines' and leave a fudge factor if things like ACA subsidies, IRMAA, etc are concerns. Better yet, find someone that uses Holistiplan, which is an excellent, surgical precision tool that will show you this data precisely, as well as all the relevant guardrails in those things and phase out of other tax breaks, etc. I use it with clients in early December usually. We load up the previous year's return, then create a baseline for current year and plug in the deltas. By early Dec, you know those pretty well, so not much guessing. I love how Pralana Online will export the projected 1040 and other tax forms so I can hold them up to the real ones as a check to see if something is egregiously off in the plan!
@lmolino True. I'm always telling clients that Pralana is a long-range calculator, so take these kinds of things as 'guidelines' and leave a fudge factor if things like ACA subsidies, IRMAA, etc are concerns. Better yet, find someone that uses Holistiplan, which is an excellent, surgical precision tool that will show you this data precisely, as well as all the relevant guardrails in those things and phase out of other tax breaks, etc. I use it with clients in early December usually. We load up the previous year's return, then create a baseline for current year and plug in the deltas. By early Dec, you know those pretty well, so not much guessing. I love how Pralana Online will export the projected 1040 and other tax forms so I can hold them up to the real ones as a check to see if something is egregiously off in the plan!
@lmolino I think at one point I found a consumer tax tool that allows this kind of current-year tinkering before 12/31 moves have to be made. It might have been on the dinkytown.net site. By then I think a lot of the tax software is out, at least in preliminary form.
@hines202 I will take a look at that website. I'm hoping I can do a reasonable job at estimating my AGI/MAGI before the end of the year. We'll see.
