Roth Conversion

I seem to be obsessed with Roth conversion.  I’ve analyzed it 68 ways to Sunday, and written articles on that.   My take away was to develop a scheme of the most efficient conversion.  What I discovered is to convert at best efficiency and you have a fair pile to convert you need to be living on cash and it works best if you are married.

Love and Conversion

The tax law is such that being single kills conversion.  A married couple filing jointly can convert much more at a lower rate


Here is a list of maxed out contributions for married and the tax on an equivalent contribution for a single.  Notice the tax bracket creep.  Being married helps to the tune tens of thousands or more.  ALWAYS CHECK THE SINGLE V MARRIED CALCULATION!  In this calculation the deductible is the sum of my over 65 and my wife’s under 65 rates.  If you die your wife will be taxed at single rates and have a single deductible which means her taxes will be far higher than while married for a similar income.  You have to plan your portfolio deflation accordingly because Uncle Sam will happily take her dough.  In addition after your death her SS will decrease so taxes go up and SS goes down meaning a bigger strain on portfolio deflation.  Filling only to the 12% level doesn’t convert enough money to dent the tax burden of bigger TIRA.  

The Time of the season

Till 2025 taxes are favorable, but the tax cuts are temporary!  If you can, make hay while the sun shines.  I spent months optimizing the most efficient conversion strategy.  It turns out best conversion is in the years just prior to RMD, or when you can live off cash and are no longer funding IRA’s.  If you planned for conversion, you can free up some cash to live on while using all of your tax bracket to convert.  The number of years and amount you need is based on IRA size.  If your going to convert the whole shootin’ match of say a 1.7M IRA your best conversion is 340K over 5 years.  Your tax bill will be $321,000.  Past the top of the 24% bracket things start getting drained by the tax man pretty quickly.  If you plan to live on 100K per year you will need 821000 in available cash to effect your conversion.  You would need 500K anyway to live on so the extra risk is only 321K or an extra 64K per year.  You plan for that during accumulation, and if you do it right part of that 321K will be from interest,

If you put 10K per year away for 20 years at 4% that’s 320K at the end of 20 years, 34% of which is interest.  But wait there’s more!   If you start at age 30 and put an extra 14K per year away for 20 years at 4% that will virtually pay for the entire 5 year Roth conversion including 100K/year living expense and 64K taxes/year starting at age 65.  14k/yr for 20 years @ 4% grows to 450K.   34% of that money is interest.  450K for an additional 15 years @ 4% with no added money is 820K meaning your Roth conversion would only cost 280K,  (20 x 14k) including 5 years of living expense.  If that isn’t magic, nothing is!  Essentially your 820K Roth conversion would be paid with 2/3 interest and 1/3 principal, and your non Roth conversion portfolio would continue for 5 more years of compounding untouched.  As long as you’re married filing jointly you can pull 100K/yr out of a taxable account with no cap gains tax.  In the mean time since you don’t need SS because you saved and have all this interest to spend, you can let SS ride to age 70 when you will get a bigger payout.  I hear people call SS gravy.  Not this daddyo, I call it red meat.  A larger SS means my therefore smaller WR becomes bullet proof.  

You can fund over longer or shorter periods but it’s hard to live on cash for say 10 years while doing funding.  Longer periods of funding tends to be in smaller amounts per year so you do save some taxes.  Part of the reason I retired was so I would have adequate time to do my Roth conversions efficiently.  Best choice ever!

Discovery is in the Details

My Original plan was to convert 100%.  I consider those taxes already belonging to Uncle Sam.  The problem with waiting is Uncle Sam controls the tax rate and RMD forces you to withdraw.  If you’re forced to withdraw A LOT and taxes go up you pay A LOT in taxes.  Taxes are low till 2025 so my inclination is to get them out of the way.

This is an image of how RMD works the red line is ROI with RMD.  The black line is ROI with Roth conversion.  RMD continually increases and therefore taxes continually increase causing the slope of the red line to fall off as time goes on.  The black line however shows what happens when you pay a chunk to start and then let the ROI recover.  Eventually black beats red.  It takes some time but if you live long enough it pays, and when it pays is significant.  If you don’t live long enough you die with less than if you didn’t do the conversion, but your wife will reap that black line benefit.  It starts paying just when you might need assisted living or some significant medical expense.  This is a kind of sustainable self insurance.  Yes you may need to forgo yet another trip around the world to pay for the conversion but when you need memory care that trip around the world will be long forgotten.  (it turns out the black and red lines are also a pictorial of what mildly bad SORR looks like).  The above pic dramatizes the differences between early SORR (black) and late SORR.  In my own portfolio I ran actual quantitative curves,  holding all other return risk stresses constant, the early SORR portfolio (black) outperformed the late SORR portfolio (red) by close to 1M over a 30 year horizon but it took something like 15 years for the lines to cross.  

As I was working through conversion it became obvious the highest risked assets needed to be converted first, and lower risked assets each succeeding year.  In other words convert the AMZN before you convert VBMFX.  VBMFX is the last to go.  I have virtually all of my bonds at Vanguard in IRAs except for some LTIPS in a  FIDO IRA.  As I was reading through the tax code I found out there is a 3.8% surtax attached to income above 250K jointly.  Homey don’t like surtax so I re-evaluated max conversion.  In addition there is an increase in monthly medicare expense.  Regular folks (170K jointly income) pay 134/mo.  170K to 214K folks pays 187.50/mo, I pay 348/mo because I made too much money in 2015 (267K to 320K range).  I can save over $1500 per year in medicare expense.  Over 5 years that’s 7500.  In addition by limiting my conversion to 250K,  I save the 3.8% surtax and quite a bit of taxes upfront from not converting at 340K/yr.  What I discovered is by converting 250K x 2 and then 214K x 3 I can convert about 1.1M of risky assets, take advantage of medicare savings the last few years before RMD and avoid a 3.8% surtax.  My total tax bill drops about 150K.  What I am left with is 600K of bonds in the IRA.  If bonds pay 3% my RMD is about 25K/yr on the average. The Roth will continue to compound during conversion so with 1.1M converted over 5years as described at 4% return I will have 1.6M in the Roth when I turn 70.  I have the rest in a taxable account with a big chunk of LT cap loss to pair against cap gains.

Our combined SS will be a little over 50K and my RMD about 25K,  My living expense averages 109K/yr so I only need tap my taxable account for 35K per year plus taxes.  Taxes look like they will be $4600 and once I get this rigmarole done medicare will drop back to 134/mo.  I will never have need to touch the Roth so it will just sit in the background peculating, and my 150K tax savings also sits in my taxable account gathering interest.

One other small detail.  I don’t recommend using “timing” but if the market happens to be down, it’s an excellent time to convert.  A smaller portfolio generates fewer taxes, and the conversion can recover in the Roth as easily  as if left in the TIRA.  Roth conversion can no longer be re-characterized so once you do it, it be done.

Angels (not devils) are in the details

This post demonstrates what happens on the other side of accumulation.  Your goal becomes all about efficiency and what I call parsimony, making the best value out of what you have.  You don’t want to let the air out of the portfolio balloon too soon and you certainly don’t want Uncle Sam letting it out for you!  This is my present Roth conversion strategy.  Convert the stocks, RMD the bonds, compound the tax savings from not converting the bonds, avoid extra taxes and Medicare penalties as much as possible.  Efficient conversion however depends on planning during accumulation.  If you can make it happen, that accrued interest can’t be beat. 

FWIW here is an article

5 Replies to “Roth Conversion”

  1. Great article. I had to read three times because so much information. 1 question. I am 62 and plan to retire in 2021 at 65. $1700k in TIRA, $250k in Roth and $300k taxable and $200k in 457b. I want to take advantage of pre-2025 tax brackets for Roth conversions. I have a 3 year window post retirement and pre tax changes. I can take out 457 in lump sum of $200k or over 5 years. That lump sum would eat into conversion plans but 5 years seems like a long time, straddling the probable tax change and the fact that my employer owns the money. I may have answered my own question because 40k per year shouldn’t have a big tax bite. I plan to wait to 70 to collect Social Security. Suggestions? Thanks for the relevant article.

    1. Hey DK. I hoped to provide a framework on how to think through conversion. My general feeling is convert as much as you can. In the first article on DDD’s site I show 3 scenarios small middle and big. The problem with small is you pay small taxes early but the accounts grow again and pretty soon you’re in the next tax bracket/s. Also RMD is graduated. Each year they force a bigger withdrawal amount by percentage (meaning it’s multiplied not just added) than the year before and a bigger withdrawal means a bigger tax bill. The way I look at it is you owe the taxes. Putting them off causes the taxes to compound so it’s like paying off a mortgage early if you can afford it, you save the interest. That’s my rap and I’m sticking to it. To really understand the consequence you almost have to go through it year by year.

      I used the schwab RMD calc and this tax calculator The tax calculator calculates savings between the old plan and the new plan so you can revert to using old plan data if your conversion extends beyond 2025. Yu don’t need to take symmetric conversions of say 40K per year. It may work out better to graduate or declimate the conversion schedule based on the tax bite. So if you convert to 2027 but run out of tax bill in 2025 convert a lot early and less later. A and you thought it was just 4% x25. Good luck in your endeavor, you’ll be the smartest doobee on the block

  2. MDonfire,
    Just to be clear on the 3,8% surtax :
    The Roth conversion income itself is not subject to the 3.8% tax because it is not treated as investment income. But it can increase MAGI to the point where the 3.8% tax can apply to investment income like the LTCG or interest and dividend income.
    Is that how you see it ? You lowered your conversion amount to avoid the 3.8% due on LTCG/div taxes, not the conversion amount, correct ?

    1. Yes. Things are engineered to provide the lowest tax rate for the highest (conversion rate + living expense). I was originally going to convert 100% of the TIRA/401K to Roth but found it more efficient to leave some TIRA as TIRA and fill those accounts with 15/85 stocks to bonds and RMD the TIRA. I did an analysis of the tax code and found the median TIRA amount at the brokerages was 500K. The tax code is written to give someone with RMD on 500K plus typical SS a relatively low tax rate compared to SS + say a 1M RMD.

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