Author Topic: Fill 0% tax bracket with Roth conversion ladder income to save on taxes later?  (Read 598 times)

Ursus Major

  • Stubble
  • **
  • Posts: 154
  • Location: Silicon Valley, CA
Hi,

I'm currently looking at the option to start Roth Conversions next year with the idea of paying a (hopefully) smaller tax now to save on a bigger tax later (at RMD time).

Some facts about me:
Age: 50 (18 months FIRE'd)
Tax Status: Single, no dependents

Assets in taxable accounts: $2.3M (almost all in individual stocks) + $90k cash reserve
Assets in 401(k): $770k
Assets in traditional IRA: $0
Assets in Roth IRA: $160k

Projected annual expenses: ca. $60k-$65k (depending on medical costs)

Annual income (all from taxable accounts):
Qualified dividends: $43k
Non-qualified dividends (from REITs) and interest: $4k
LT capital gains: ca. $10k - $15k (to make up difference between expenses and dividend/interest income; in bad market years, I'll tap into my cash reserve instead).


State of Residence: California (9.3% marginal tax rate, no lower tax rate on qualified dividends or LT cap gains)

As you can see from the data above, I FIRE'd last year and luckily I have sufficient assets in taxable accounts, so I do not need to access any assets in my Roth to fund my living expenses.

However I was wondering, if it would make sense to roll my 401(k) over into an IRA and then start a Roth Conversion ladder in order to save on my total taxation in the long run. If I were to fill out the 0% tax bracket (exemption + standard deductible) I could convert about $6.5k ($10.5k - $4k non-qualified dividends and interest). That would cost me 15% of that in federal taxes (since some qualified dividends are getting pushed out of the 0% tax bracket and would be taxed at 15%) and 9.3% in state taxes for about 24.3% in total taxes.

Since I do not anticipate that I'll leave the state of California (my girl-friend has family here), I am assuming to be stuck with CA state taxes for the foreseeable future. The RMD at 70 1/2 comes to about $28k on a $770k retirement account (still in the 15% federal bracket and will stay in that bracket for at least another 10 years). However if I (conservatively) assume annual real portfolio growth of about 4% over the next 20 years and no Roth Conversions, my 401(k)/IRA portfolio would be about $1.7M, when I'm 70 1/2 and the RMD for that is about $62k, so an ever-increasing chunk of that money would be taxed at 25% federal + 9.3% state (assuming the same tax rate).

I realize that I never will be able to drain my 401(k)/IRA completely, so this is only an attempt of tax optimization at the margins.

So would it be worth it to pay 24.3% in taxes now and going forward in order to avoid a higher tax rate at RMD time in 20+ years?

MMbergmann

  • 5 O'Clock Shadow
  • *
  • Posts: 28
What is your opinion on doing a side hustle? Your space to fill (6500) is ironically the contribution limit for someone 50 and older. It would be too bad if you dont have a side hustle to allow you to make the contribution to your roth since that is easier math than a conversion.

Also I think it would depend on your opinion of the time value of money and if you are capital gain harvesting  or just getting enough out of taxable to pay expenses.

MDM

  • Walrus Stache
  • *******
  • Posts: 7214
So would it be worth it to pay 24.3% in taxes now and going forward in order to avoid a higher tax rate at RMD time in 20+ years?
Yes.

Also, congratulations on getting the marginal rates correct.

One thing that might make it worth doing even more conversions now: SS benefits and the way those are taxed.

If you can pay taxes on the Roth conversions with money from taxable accounts, in effect you are converting the tax amount from taxable to Roth.  That makes Roth conversion favorable even for marginal rates equal now and at withdrawal.

Ursus Major

  • Stubble
  • **
  • Posts: 154
  • Location: Silicon Valley, CA
What is your opinion on doing a side hustle? Your space to fill (6500) is ironically the contribution limit for someone 50 and older. It would be too bad if you dont have a side hustle to allow you to make the contribution to your roth since that is easier math than a conversion.

MMbermann,

Thanks so much for your response. I wouldn't mind doing a side hustle, though I'm not exactly entrepreneurial or know how about going finding something suitable.

Quote
Also I think it would depend on your opinion of the time value of money and if you are capital gain harvesting  or just getting enough out of taxable to pay expenses.

I'm not sure, how you apply the time value of money to this. Certainly the "utility value" of money is a bit higher now, since (assuming all goes well) I'll have plenty of money to pay the extra taxes, whereas now I'd need to sell a few more shares. FWIW I'm not capital gain harvesting (since my marginal capital gains rate is 24.3% for federal + state taxes), I'm just getting enough out to pay expenses.

Ursus Major

  • Stubble
  • **
  • Posts: 154
  • Location: Silicon Valley, CA
So would it be worth it to pay 24.3% in taxes now and going forward in order to avoid a higher tax rate at RMD time in 20+ years?
Yes.

Also, congratulations on getting the marginal rates correct.

One thing that might make it worth doing even more conversions now: SS benefits and the way those are taxed.

If you can pay taxes on the Roth conversions with money from taxable accounts, in effect you are converting the tax amount from taxable to Roth.  That makes Roth conversion favorable even for marginal rates equal now and at withdrawal.

MDM, thanks for your response.

I don't think I understand your argument regarding paying taxes with money from taxable accounts.  Even if I were not do the Roth conversions I would still pay all taxes on RMDs from my taxable account. Of course I understand that $6500 in a Roth is worth more than $6500 in a traditional IRA, but I've already paid for that being worth more (through my taxes in the conversion).
It would be great, if you could elaborate a bit on this point, so that I may understand it better.

Also if the Roth conversion is favorable even for the same marginal tax rates, shouldn't I be also filling the 10% federal tax bracket with my Roth conversion? Because then my tax rate on the conversions would be 25% federal + 9.3% state now, exactly what my marginal rate at RMD time would be (based on the assumptions in my original post).


MDM

  • Walrus Stache
  • *******
  • Posts: 7214
I don't think I understand your argument regarding paying taxes with money from taxable accounts.  Even if I were not do the Roth conversions I would still pay all taxes on RMDs from my taxable account. Of course I understand that $6500 in a Roth is worth more than $6500 in a traditional IRA, but I've already paid for that being worth more (through my taxes in the conversion).
It would be great, if you could elaborate a bit on this point, so that I may understand it better.
Assume you start with $10K in a tIRA, $2500 in a taxable account, $0 in a Roth, and pay 25% tax on conversions.  You could
a) withhold $2500 from your tIRA->Roth conversion, ending with $2500 in taxable and $7500 in Roth, or
b) withhold $0 from your tIRA->Roth conversion, pay the $2500 tax from taxable, ending with $0 in taxable and $10000 in Roth.
Option 'b' is more favorable to you because there is no tax drag in the Roth account.

Quote
Also if the Roth conversion is favorable even for the same marginal tax rates, shouldn't I be also filling the 10% federal tax bracket with my Roth conversion? Because then my tax rate on the conversions would be 25% federal + 9.3% state now, exactly what my marginal rate at RMD time would be (based on the assumptions in my original post).
See https://www.bogleheads.org/wiki/Traditional_versus_Roth#Maxing_out_your_retirement_accounts for more details.  It's not only that "$6500 in a Roth is worth more than $6500 in a traditional IRA," but also $X in Roth is worth more (at least to those who pay tax on capital gains and dividends) than $X in taxable.  So yes, if your marginal tax rate won't change, getting the money into Roth ASAP is best.

Of course, the more you convert now, the greater the chance that your marginal rate later will be lower.... ;)

MMbergmann

  • 5 O'Clock Shadow
  • *
  • Posts: 28
I don't think I understand your argument regarding paying taxes with money from taxable accounts.  Even if I were not do the Roth conversions I would still pay all taxes on RMDs from my taxable account. Of course I understand that $6500 in a Roth is worth more than $6500 in a traditional IRA, but I've already paid for that being worth more (through my taxes in the conversion).
It would be great, if you could elaborate a bit on this point, so that I may understand it better.
Assume you start with $10K in a tIRA, $2500 in a taxable account, $0 in a Roth, and pay 25% tax on conversions.  You could
a) withhold $2500 from your tIRA->Roth conversion, ending with $2500 in taxable and $7500 in Roth, or
b) withhold $0 from your tIRA->Roth conversion, pay the $2500 tax from taxable, ending with $0 in taxable and $10000 in Roth.
Option 'b' is more favorable to you because there is no tax drag in the Roth account.

Quote
Also if the Roth conversion is favorable even for the same marginal tax rates, shouldn't I be also filling the 10% federal tax bracket with my Roth conversion? Because then my tax rate on the conversions would be 25% federal + 9.3% state now, exactly what my marginal rate at RMD time would be (based on the assumptions in my original post).
See https://www.bogleheads.org/wiki/Traditional_versus_Roth#Maxing_out_your_retirement_accounts for more details.  It's not only that "$6500 in a Roth is worth more than $6500 in a traditional IRA," but also $X in Roth is worth more (at least to those who pay tax on capital gains and dividends) than $X in taxable.  So yes, if your marginal tax rate won't change, getting the money into Roth ASAP is best.

Of course, the more you convert now, the greater the chance that your marginal rate later will be lower.... ;)

@MDM I don't think it's that simple for the first part of your post. He would have to sell stock to get the 2500 accessible in taxable. Therefore his gain would be 2,500 less cost basis.

MDM

  • Walrus Stache
  • *******
  • Posts: 7214
I don't think I understand your argument regarding paying taxes with money from taxable accounts.  Even if I were not do the Roth conversions I would still pay all taxes on RMDs from my taxable account. Of course I understand that $6500 in a Roth is worth more than $6500 in a traditional IRA, but I've already paid for that being worth more (through my taxes in the conversion).
It would be great, if you could elaborate a bit on this point, so that I may understand it better.
Assume you start with $10K in a tIRA, $2500 in a taxable account, $0 in a Roth, and pay 25% tax on conversions.  You could
a) withhold $2500 from your tIRA->Roth conversion, ending with $2500 in taxable and $7500 in Roth, or
b) withhold $0 from your tIRA->Roth conversion, pay the $2500 tax from taxable, ending with $0 in taxable and $10000 in Roth.
Option 'b' is more favorable to you because there is no tax drag in the Roth account.

Quote
Also if the Roth conversion is favorable even for the same marginal tax rates, shouldn't I be also filling the 10% federal tax bracket with my Roth conversion? Because then my tax rate on the conversions would be 25% federal + 9.3% state now, exactly what my marginal rate at RMD time would be (based on the assumptions in my original post).
See https://www.bogleheads.org/wiki/Traditional_versus_Roth#Maxing_out_your_retirement_accounts for more details.  It's not only that "$6500 in a Roth is worth more than $6500 in a traditional IRA," but also $X in Roth is worth more (at least to those who pay tax on capital gains and dividends) than $X in taxable.  So yes, if your marginal tax rate won't change, getting the money into Roth ASAP is best.

Of course, the more you convert now, the greater the chance that your marginal rate later will be lower.... ;)

@MDM I don't think it's that simple for the first part of your post. He would have to sell stock to get the 2500 accessible in taxable. Therefore his gain would be 2,500 less cost basis.
Or just use $2500 out of the $90K cash reserve.