Rethinking Roth Conversions in a Down Market
With everything down across the board, I began reconsidering whether doing some Roth conversions might now be a good move. Most endorse the idea (and warn on taxes), and we all know to take the money from another account and not the IRA to pay the taxes. BUT, one article stood out, making the case that depending on the source of the funds to pay the taxes is invested, it may not produce the tax savings you're hoping for in doing the conversion in the first place. Would be interested in 1) to hear from others as to what they think of the reasoning presented, and 2) do you know of a really solid calculator for planning a conversion (PRC indicates "no benefit," but its also looking at my portfolio as of 1/1 and not not where it stands as of today)
I read the article and I think his assessment is correct. However, I don't think his case is too relevant to most retires who plan to do a Roth conversion in any given year. I think most would have enough money in cash to pay the taxes. I don't know what you are trying to calculate. I have made one Roth conversion this year when the markets were down and I just look at it as converting more "shares" at the same cost when the market is down assuming the markets recover. I don't use Pralana for that calculation.
@golich428 Is there a particular tool you use instead do gauge whether to convert or not?
@nc-cpl I use Pralana to evaluate the benefits over time but then for any given year I take a much closer look at my tax situation. I am going to convert a significant amount of my traditional IRA over the next few years as I am living off of savings that is not taxable. I think Pralana does a good job evaluating the benefit of conversions.
@golich428 So Greg - I'm still curious if you're using a specific tool to determine how much to convert to a roth (as you did this year), or if you are just "go for it" because the market is down without a guide as to how much to convert.
The overall process of determining how much to convert is complicated. For example, the results will depend on the ROR assumptions for the Roth vs traditional IRA accounts. There other factors as well. I don't plan on taking distributions from my ROTH for a long time or ever, so I assume it will be invested in 100% equities and will have a higher ROR than my other accounts.
I look at what taxes Pralana projects in the future and what the benefit is for converting at each tax bracket today so that is my starting point. Because the jump in tax rates is not linear, there will be a sweet spot for most I think. For example, moving from the 10% bracket to the 12% is only a 2% increase compared to moving into the next bracket which is 22% (a 10% increase). This same thing happens as you move through the tax brackets.
To determine the individual years conversion amount, I use a spreadsheet I created that calculates my taxes to stay within a lower tax bracket today compared to the future. It calculates both my Federal and State taxes including capital gains, NIT and IRMMA. I then look at how much I can convert at each tax bracket (10%, 12%, 22%, 24%, 32%). My focus now is on the 22% and 24% brackets.
This year I have made on conversion when markets were down and will likely do the same throughout the year.
Hope this is related to your question.
@golich428 Did you find that the roth conversion (optimize) feature in PRC agreed with your own calculations? If not, how so? If yes, to what degree did they match? I'm curious because mine always results in "no conversions recommended," yet I feel like I'm missing an opportunity with the markets as down as they are these days.
@nc-cpl The answer depends on my asset allocation I use in each one of my accounts. Since my base case assumes that I allocate 100% equities in my Roth account, so if I use the optimization algorithm, it will convert most if not all my traditional IRA account to Roth but this results in a very high equity allocation for my overall portfolio because the ROR for equities is much higher than bonds. So I use the option of picking a maximum tax bracket (22%) then to keep my asset allocation for my overall portfolio in a reasonable range, I go to my asset allocation page and adjust the allocation in the non-Roth accounts to keep my overall allocation to about 50% equities through time. I am probably over complicating things to keep it more in line with what I will do in real life.
To answer your question a different way, I changed all my allocations to be the same in the Regular, tax deferred and Roth. Now when I run the optimization, it converts at the 24% bracket which gives me a higher end of life net worth than if I convert using a maximum tax bracket of 22% for the same number of years. This makes sense and I believe the algorithm is doing exactly what it should, however, am about 90 years old when the net worth of the optimization case surpasses the 22% maximum tax bracket case. So for me, doing the extra conversions is not that attractive.
Hope this helps.
An easy way to help determine if it would be advantageous to do Roth conversions is to first determine what your required minimum distribution (RMD) will be when you turn 72 ( https://smartasset.com/retirement/rmd-table) :
- Figure out the balance of your IRA account.
- Find your age on the table and note the distribution period number.
- Divide the total balance of your account by the distribution period. This is your required minimum distribution.
So at age 72 you divide you IRA balance (all your regular IRA's combined if you have more then one) by 27.4. One million in IRA's is a RMD of $36,496, 1.5 million in IRA's is $54,744 and so on.
Next, determine what the likely amount of money you will need to live on when you are 72. If your RMD is larger than what you need, do Roth conversions.
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@giovanelli766 Thanks Pizzaman , I'll run the numbers based on your guidance and see what I get! Appreciated!
@nc-cpl I think you're looking for something like the below calculators. You can use them toward year-end to figure out what marginal bracket you will end up in and approx how much headroom you have in that bracket to do conversions:
I think there's also one at the bogleheads.org site in their resources as well.
When I first looked at the math of Roth IRA conversions, they made little economic sense to me. Then at some point it dawned on me that funds held in tax deferred accounts are not usable unless one pays taxes on the amounts distributed. That led to the development of the attached spreadsheet to help me determine under what circumstances a Roth IRA conversion might make sense. My conclusion is that Roth IRA conversions offer little economic benefit unless the taxes / tax rate paid on the conversion is less than the taxes / tax rate that would be owed if the funds were retained in an IRA and distributed at a future date.
The key is to understand whether one's tax rate could be headed higher, lower or is likely to remain the same. It might be wise to retain funds in a tax deferred account to pay for long term care expenses since it may be possible to withdrawal funds for Medical expenses from tax deferred accounts at reduced tax rates. It might make sense to do Roth IRA conversions to avoid future increases in income taxes or IRRMA. It may also make sense to do some Roth IRA conversions to diversify ones holdings. Having a tax free source of funds in a Roth IRA account may help one avoid high taxes if one needs funds for some unexpected event.
I am a fan of doing Roth IRA Conversion of in-kind shares which are likely experiencing temporary declines in price. Roth IRA conversions are done at a tax discount which equal to the percentage investment drawdown / decline. I will attach a second spreadsheet abut this in a subsequent reply.
I don't think I agree with the conclusions made in the advisorperspectives article referenced above. The article does not appear to take into account the income tax obligations on the capital gains of funds held in a taxable account. In the Roth IRA account there are no taxes on the gains once the distributions are "qualified".
Im sorry, but I am not able to load either spreadsheet.
@morlock103 Put it out in Google Drive or Dropbox and share the link only.
@morlock103 Another advantage to Roth conversions is it may reduce taxes on your social security income once it starts. In terms of medical expenses the best way to go is to fully fund your Health Saving Account (HSA), it is an above the line tax deduction, so you can convert more to Roth while staying in the same tax bracket.