Granularity of Roth Conversion

I’ve decided on a Roth conversion schedule.  

$250,000, $250,000, $250,000, $250,000 for a total of 1M over 4 years.  I’m in process now and I have till Dec 31 to get the first conversion done.  This process has turned out to be more complicated than I thought but once understood very do-able.  This schedule does not eliminate some of the cliffs of conversion like excess medicare costs but minimizes them over 4 years.  

The considerations are 

  1. Volatility of tax law.  Since the present tax law expires and the politicos seem hell bent on changing the law again it’s time to make hay while the sun shines.  This is why the first conversion are $250K.  No matter what that much will be converted and likely no matter what $750K will be converted before anything could legislatively be done to ruin the plan.  What could ruin the plan you ask?  They could eliminate the ability to convert.  Hopefully gridlock will protect me on all 4 conversions.  By sticking to $250K, as a couple we avoid the extra 3.8% medicare surcharge, but still get 1M converted in 4 years.  
  2. My wife and I both own IRA’s which were funded with post tax dollars.  It turns out the government only expects you to pay once, so a % of the Roth conversion will be tax free and the rest will be taxed as ordinary income.  I’ve dutifully saved the 8606 IRS forms each year so I have an accurate legal basis.  Something to consider is each spouses IRA gets treated separately since Roth conversions are per spouse.  My IRA is large.  My earliest IRA contributions were only 2000/yr which was the  max contribution till about the year 2000.  The IRS has a formula by which you determine a percentage of already tax paid money which you can subtract from the gross conversion to give you net taxable money.  The formula (from investopedia) : 

“John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2018, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.

Here’s how it works:

Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount) = $100,000 ÷ ($200,000 + $100,000) = $100,000 ÷ $300,000

Tax-Free amount of Conversion = 33.3% (or $33,333)Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate”

That percentage is set each year based on contribution amount, total IRA size and total amount of non deductible assets in the IRA, for each spouse,  once IRA conversion commences.  Because my early IRA contribution was small when I started my percentage is small, about 2%.  When I started the IRS only allowed 2K per year per spouse.  So I will have to pay on 98%.  2% off works for me!  My wife however worked a shorter time and raised our kids as a SAHM so her IRA is much smaller so her % tax relief is much larger, about 9% meaning on every dollar converted she pays, only 91 cents are taxed.  Such a deal!  The 1M conversion is not just my conversion it is OUR conversion but the IRA belong to each of us separately so sequencing the conversions into each spouses Roth accounts matters.  It turns out by converting her entire IRA and by back-filling the remaining from my IRA to reach $250K total we save an additional $4000 in taxes.   So my sequence becomes: convert all of hers then begin to convert mine for a $4000 maximized savings on this years conversion.   I will recalculate next year on a conversion based on my IRA alone.

3. What you convert matters.  You want to convert your highest risk assets first and of those high risk assets convert the ones that are down first.  My TIRA’s are at Fido and Vanguard as are my wife’s and our Roth’s are there as well.  Fido and Vanguard will transfer assets from a IRA to a Roth without a conversion to cash step as long as both IRA and Roth are at their brokerage.  So the funds are transferred and a tax bill generated, slick!  This year Emerging markets and Foreign are down 11% and 9% so these are my first equity’s to convert.  Stocks are property and by transferring the least appreciated highest risk property first you can transfer the most property for the least tax bite.  My conversion order will then be remaining stock, then alternatives, then REIT, then commodities, and finally bonds.  My goal is to end up with most of my bonds still in the TIRA and not in the Roth.  This minimizes the tax bill.  A Roth’s greatest advantage is sheltering capital appreciation as in stocks.  It’s less effective in sheltering assets that don’t appreciate much as in bonds.  The trade off is pay the government now or pay the government later.  Assets with large appreciation potential should be in the Roth ASAP so they can compound over years tax free.  Something like bonds which don’t appreciate much can be RMD’d as an interest bearing annuity, and pay those taxes over time.  BIG NOTE the RMD is still subject to whatever percentage you determine yearly from the non deductible portion when you started conversion so in my case if I RMD $30K I pay on only $29,400 since my percentage is reduced by 2% or so (variable each year).  I’ll take $600 tax free, so it gives me a little Roth like relief even while being a TIRA.  By splitting my assets into TIRA and Roth based on capital appreciation I split my tax bill between paying some now on the aggressive earners with no further tax consequence, and paying some in the future on smaller less aggressive earners as opposed to paying it all at once.  This reduces sequence of return risk early in retirement to some extent.  I am paying my taxes from my post tax account so by having a smaller tax bill for conversion that extra tax money I would pay by converting everything continues to grow in the post tax account.  My goal at RMD is to live on SS + a small RMD which gives me room to grow for quite a while before a jump to a new tax bracket, supplement my income as needed from small donations from my taxable account and let the Roth grow unmolested forever.   

4. By cleaning appreciation out of the IRA you have the ability to control tax brackets for a longer time.  My SS will be about $43K and my wife’s will be about $10K for a total of $53K.  Taxes are paid on 85% of the $53K or  $45K.  The top of the 12% bracket including deductions for age 65+ is 104,000 (26,600 deduction plus 77,400 (top end 12% bracket), so I have $59K of RMD money I can use to fill to the top of the 12% bracket.  If I RMD say $25K my taxable is 45K + 25K or 70K and I have $34K of growth before I hit the next tax bracket.  That probably is 12-15 years of retirement.  Because of the .85% break on SS my spendable income will be 53K+25K or $78K.  I’ll fill in my remaining needs from selling post tax stock or from post tax dividends.  Since I’m in the 12% bracket cap gains are 0%.  A masterpiece in optimization!  (I think).  I’ve run it by my professional adviser and he thinks so also.

Just a snapshot of what post retirement granularity including Roth conversion looks like.  So much for 4% x25, get drunk on the beach.

4 Replies to “Granularity of Roth Conversion”

  1. I like your plan, it’s well thought out. Clearing out $1M from the pre-tax space while in the 24% marginal bracket sounds good to me. Just curious, why not take your conversion up to the max $315K in that bracket? You would get it almost all done in 3 years at an effective tax rate of ~20% .

    I’ve finally found someone else who actually used the after-tax tIRA. None of my colleagues in two different PP groups would use it since it wasn’t pre-tax like their 401k/PSP. Did it religiously every year beginning when I was an intern. Besides forced savings, it was comforting asset protection in a state that had a terrible malpractice climate when I started practice. Added my wife into the mix in 1998 when they allowed the spousal IRA for SAHM w/o earned income. That’s also when the Roth IRA was born but I earned too much to be eligible much to my dismay. I had pretty much the same experience as PoF in his post:
    https://www.physicianonfire.com/megaroth/
    I too thought the opportunity to convert in 2010 was a one time offer so I jumped at it even though I was in the 33% marginal bracket. At least I had a significant basis from my 8606 to lessen the pain. I don’t harbor the same angst as PoF, it’s over and done and I’ve happily backdoor Rothed ever since. Good for you that you can use your basis now to trim the tax load.

    1. It’s a matter of optimization.

      You can convert up to 340K per year in the 24% bracket (314 + 26K deductible). Medicare charges a 3.8% additional surtax on W2’s over 250K filed jointly. and they charge you triple for your monthly premium. So over 4 years to convert 340K (1.36M) as an example is about 350k total taxes and fees. If you convert instead 314K (1.25M) as you suggest it’s not much better about 320K since the surcharge still exists and medicare is still triple so you save 30K. At a 250K conversion the surcharge is eliminated and they charge about 1.5x on medicare. Also most of your taxes are from the 22% bracket with only about half due to what 24% costs so the taxes are less progressive. So on a 1M conversion your cost is only about 190K. That extra 250K conversion costs you an extra 130K in taxes and fees. If you keep that 130K in the bank compounding for 20 years it becomes 400K, more than enough by far to pay the extra taxes on the TIRA you didn’t convert. In addition a small Bond TIRA doesn’t generate a big tax bill because it doesn’t grow much even as an RMD annuity and the same post tax money tax break exists to further reduce the tax. Your going to need some money to live on so a small Bond RMD with a post tax, tax break is ideal. It’s tax consequence is not all that different from a Roth. It’s a high return AA mix in a TIRA that accelerates the RMD taxes. Also by having a small RMD you remain with some flexibility to be in the 12% bracket which has a 0% cap gains rate so you can supplement your income from post tax brokerage accounts tax free (very similar to a Roth).

      So you save 130K on taxes which can compound into the future, you make your accounts very Roth like without spending all those taxes. You can spend down the TIRA + SS + some post tax brokerage for your hamburgers and leave the Roth alone to accumulate untouched as future insurance for say long term care or as a legacy for the kids, or if you happen to go living to age 190. 20 years post conversion a 1M unmolested Roth would be worth about 5M. If you complete your conversion at 70 sitting on an extra 5M might be a nice place to be when you’re 90, you need full time memory care and your wife still needs guaranteed dough for her to live on for another 10-15 years. That’s my story and I’m stickin to it!

      1. Thanks for the education. I hadn’t considered the effects of Medicare tax surcharges and premiums. Deconstructing a portfolio in the retirement or pre-retirement process is certainly a multi-factorial process. I also like the idea of using bonds in your tIRA to generate a small RMD in the low tax bracket. The bond portion of my portfolio is currently munis in the taxable account, but when I approach RMD time that seems like something easy to do with minimal tax consequences. If any post-RMD portfolio growth is to occur, definitely want that to happen in the Roth space.

  2. I think I have the Canadian version of your plan. Seriously. My RMD portion will be almost all laddered GICs guaranteed by the government. And I also plan on using delayed government benefits and my RMD Account. It really is a plan that makes sense. We can allow the government to be the counter party in our own self made annuity.

    I am a bit further away from 70 but I have it planned all the way to 100. You have certainly given a lot of thought to your plan. No wonder you chuckle at the 25 x 4%. Many of us have had to plan much more than that.

    Very nice to see such a detailed plan.

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