Understanding Roth Optimization

Hi Retiree, that's a good question but PRC's optimization algorithm simply tests every possible marginal tax rate over the one or two time periods you specify (using the same rate every year) and then reports the ones that yield the best long-term result. I don't think you can safely draw conclusions from looking at the tax rates alone because growth rates (and other things) also matter, and these may be different for your tax-deferred and Roth accounts. With that said, PRC cannot select the best tax rate on a year-by-year basis (because there are way too many combinations to test within any reasonable timeframe), so it may very well be true that you can start with the recommended settings and then adjust them manually and achieve better results.

Stuart

One additional question, does the optimization take into account ACA PTC? That is, for every dollar of additional IRA2ROTH that I convert, in addition to paying taxes on that, I also get my PTC lowered, adding an additional (effectively) 8.5% tax on the conversion, which should be taken into account when doing the optimal conversion amount.

Even so, intuition tells me that, since I am modeling the same overall asset allocation throughout retirement, then optimizing conversions would probably just mean evening out (minimizing) marginal tax rates. I was just wondering if there were any specific examples that would counter my intuition, and explain why paying less % now and more % later might actually be beneficial.

The Roth optimization algorithm determines the optimum marginal tax bracket to use for conversions given the constraints you've specified for IRMAA brackets and FPL multiples (which are relevant to ACA PTC). This is all based on the selection that results in the highest savings balance at the end of the modeling period. So, yes, this takes into account ACA PTC. I don't have any specific examples that counter your intuition. With that said, if you think PRC is giving you an incorrect result, you can send me an export file (to mail@pralanaconsulting.com) and I'll be happy to investigate.

Stuart

@kellyj

Roughly it's true that you should even out marginal tax rates. However, because of the strangeness of the tax code, that may not mean always staying in the same tax bracket for ordinary income. From phase-outs of ACA premium credits to phase-ins of long term capital gains taxes, phase-in of taxes on Social Security, to IRMAA tiers, there are lots of places where you face high marginal tax rates even when your ordinary income tax bracket is low or moderate.

That said, I use the optimizer as a starting point and then try year by year experiments, say limiting income for a large ACA premium credit to 3 or 4 x FPL vs. Roth converting to the top of the 0% LTCG range and getting a moderate ACA premium credit. Or do no Roth Conversions one year to get and ACA premium credit and then do a large conversion a different year. Or going up an IRMAA tier in early years and going down one tier in later ones. The year by year experimentation will generally produce a more beneficial and more refined plan than the optimizer can as the optimizer is only varying the ordinary income bracket. Pralana's approach of using selectors where you can try different things with just one click makes this experimentation as painless as possible.

The other thing you may be overlooking is your heirs' tax bracket. If you have enough that your planning shows you will have money left over and you plan to give your IRA to heirs (as opposed to charities), then the heirs will have to pay taxes at their marginal rate as they withdraw the money from the IRA inherited from you. You can tell Pralana your heirs' tax rate under Financial Assets-Management - Effective Tax Rate for Converting Absolute Dollars to Effective Dollars. Then on the Roth Conversion sheet, on the graph, select effective dollars. You will get markedly larger benefits of Roth Conversions when you account for heirs taxes.

@ricke Thanks for the information!

To be clear, I am looking at the marginal tax rate, not the overall tax rate. Still, I guess what Pralana calls marginal is not your true marginal - I've already mentioned the additional 8.5% (effective) additional 'tax' that gets applied if you're getting an ACA PTC, and you mention a few more.

I do get your point about heirs' bracket, though as a first step I'm ignoring heirs and trying to maximize spending, to get an optimization strategy that I believe and understand. Then I'll worry about legacy 🙂

@ricke provides good insight. There are reasons to accelerate conversions, despite perhaps sacrificing some health care premium subsidy through ACA or IRMAA. One is that the Tax Cuts and Jobs Act may expire at the end of 2025 and jack tax brackets up.

This is the time of year that CPAs freak out because clients did Roth conversions. Most CPAs are tax PREPARERS not tax PLANNERS. They're laser focused on one year - the past one, and saving you the most on your taxes in that one year. They fail to look forward, to PLAN and STRATEGIZE, and see that perhaps paying more taxes this year will save you many fold over the years to come.

Ok, for example you gave up some ACA premium tax credit. Watch the growth of that thousand or two dollars over the next decade, tax free, and tell me it was a mistake. PRC verifies that by optimizing your overall savings rate, which factors all that in implicitly.

Now, there are reasons not to do the conversion, or at least all of it, despite the math saying "go for it." For example, if you plan on using $100k for long-term care in old age, leave that in your IRA, because that expense is tax free. You don't want to pay for that with money you paid taxes on! Same thing for itemized deductible healt care expenses, which can be high later in life. If you're planning on leaving money to charities, don't convert that. Give it from your IRA as a Qualified Charitable Distribution, because the charities don't pay taxes on it.

@hines202 Interesting observation on taxes and long term care Ins. This is from IRS Pub 554:

Long-Term Care Insurance Contracts

In most cases, long-term care insurance contracts are treated as accident and health insurance contracts. Amounts you receive from them (other than policyholder dividends or premium refunds) are generally excludable from income as amounts received for personal injury or sickness. However, the amount you can exclude may be limited. Long-term care insurance contracts are discussed in more detail in Pub. 525.

@pizzaman Yes, my post was talking about self-insuring. Those expenses are tax-free, so keep it in the IRA, don't convert. I'm not a fan of the insurance either. The whole waiting period thing is ridiculous. Why not be able to use it when you *need* it? Because they hope you die in the interim, big win for them. As well, they're very hesitant to cover the thing you are most *likely* to need *long* term care for - dementia/alzheimers.

I'm with you. Plan ahead, self-fund. Everyone should have that section of the expenses tab filled out (bottom of the healthcare section).

I guess I misunderstood something. If I self-insure I mean you pay medical expenses like for a nursing home out-of-pocket. Are you saying out-of-pocket expenses are tax exempt?? 🤔

I did a little research and you are correct sir. I did not know nursing home costs were mostly deductible. I assume you must itemize and only expenses above 7.5% of your adjusted gross income are deductible (see below). Good catch on the PRC health care costs page (at the bottom), I never really looked at that before, thanks @hines202. I am still a little foggy on why you would want to keep money in your rIRA to pay the expenses. The medical expenses are deductible, not tax free. The deductions are below the line (on form 1040) so as soon as you take money out of the rIRA it's taxed. So what's the difference between that and Roth? What am I missing? 😯

Nursing home costs are tax deductible if the primary reason for residence in a nursing home is to receive medical care. The following costs are tax deductible:

• Medical care
• Meals
• Lodging

Note: If the primary reason for entering the nursing home isn't to obtain medical care, only the portion of the fees directly spent on medical treatment are deductible. Meals and lodging wouldn't be deductible.

Assisted living expenses are deductible when a doctor has certified a patient can't care for themselves. These individuals are unable to perform two or more activities of the following daily living activities:

• Eating
• Toileting
• Transferring
• Bathing
• Dressing
• Managing incontinence

Assisted living expenses may also be deductible if an individual requires supervision due to a cognitive impairment, such as Alzheimer’s or another form of dementia. https://ttlc.intuit.com/turbotax-support/en-us/help-article/medical-tax-credits-deductions/nursing-home-assisted-living-costs-tax-deductible/L8GyxIquG_US_en_US

If you itemize your deductions for a taxable year on Schedule A (Form 1040), Itemized Deductions, you may be able to deduct expenses you paid that year for medical and dental care for yourself, your spouse, and your dependents. You may deduct only the amount of your total medical expenses that exceed 7.5% of your adjusted gross income. You figure the amount you're allowed to deduct on Schedule A (Form 1040). https://www.irs.gov/taxtopics/tc502

If you are going to pay a lot for healthcare, and it's deductible, you want to make sure you have income to deduct it from, or the deduction goes to waste. Funds taken from tIRA are income. If your only source of funding was the Roth, you might not be able to use the healthcare deduction.

@hines202 Regarding..."Everyone should have that section of the expenses tab filled out (bottom of the healthcare section)".... Can you explain this further? I have long term care insurance (and you and @Pizzaman are correct about the cost and problems associated with LTC) but I think you guys are saying self-insurance gives you a greater use and control of your funds. How should this section be filled out if someone eliminates LTC cost and goes self-insured?

This is from the PRC Gold 2023 users manual: Moving farther down the page, there are several other rows in which you can specify any expected long term care (LTC) expenses. There are separate columns for you and your spouse, and you can specify the amount in today’s dollars, the start age and duration of the care period. PRC assumes that all LTC expenses are tax-deductible. So I assume this is saying this section is NOT for long term care insurance as you indicated @patton525. Saying all LTC expenses are tax-deductible is a little generous as I think only expenses above 7.5% of your adjusted gross income are deductible. I think what we are suppose to do is say, for example, at age 85 I will go into a nursing home and stay there for 3 years at a cost of say $90,000/yr. PRC then takes that into account when running scenarios. Sound right everyone??

@pizzaman You may be correct. The amount shown in the table from the manual uses $36,000 in cost, so this sounds like it is right up your alley. I had always thought this section was for insurance cost. Now, I wonder how to capture insurance costs - Misc expenses I assume.

So, if a person has LTC insurance, the benefits from the insurance are not modeled by PRC to offset the budgeted expenses it seems.