Planning Roth conversions while having child tax credit

[johnhenry]

Hi All. Been away from the forums for a LONG time.  Good to see so many familiar handles still here.

These are fuzzy questions... I'm obviously expecting fuzzy answers.  Just looking to hash out a broad plan that we can execute over the coming years in years when it makes sense - if it makes sense.

We are around 40 with kids young enough for the child tax credit for 7, 8, 12 more years respectively.  So $6K tax credit for 7 years, $4K for 1 more, $2K for 4 more... as things are now. You never know when you may have to sell a child to the traveling circus.

We are FI now, but not fully RE.  We have a high degree of control over our income.  In the coming 7-12 years (and longer if necessary) it should be easy (I think) for us to have taxable income low enough that we can convert a significant amount of our Trad/401k funds to Roth and have the conversion income completely or mostly shielded.

At this point we are not worried about ACA income thresholds and cliffs.

Based on the tax tables with us MFJ and taking the standard deduction (currently 24,800) it looks like the roughly-estimated thresholds of income that would allow us to cancel out federal income tax with child tax credits are:

MAGI / Taxable / child tax credit
78000 / 54000  /  $6K
61800 / 37000  /  $4K
44800 / 20000  /  $2K

First off, does that look right? 

To get around to a more direct question.  Is there any reason in the coming years when we know or expect our income to be under those shielded thresholds that we should not convert our tax deferred holdings to Roth up to the point of reaching the threshold?

It's possible that in some of these years we will have close to $0 earned/rental/taxable dividend income and can use all of the space for conversion.  Other years we may have income and it could even be just a hair under those thresholds.  As we finished up our careers the last several years we put everything into Trad/401k and nothing into Roth... with this rough plan that we'd have plenty of time for conversions after FI/RE. 

Another direction question would be: In a year when taxable income is just under threshold for being shielded by the tax credits... say taxable income is $48000 and $54000 would be offset, does it make sense to continue funding Traditional IRAs during those years? And then do a Traditional to Roth conversion of $6K to use the shielded space?  In years like those, when a Traditional IRA can be fully deductible, but Roth Conversion still completely shielded from tax, is there a reason to choose 1 over the other?  I'll have to check if and how my state would tax the Roth Conversion.  Or is it best to do the math and only contribute to the Traditional the amount to land exactly on the taxable income threshold and put the rest in a Roth.... avoiding the need/ability for a conversion that year.

A more complicated question would be... what is good way to approximate the value of the timing of the conversion, in terms of returns?

I've been away from the forum for years now and through the forum just recently discovered I-ORP.  I can't believe how much preference it gives to front loading Roth Conversions early in retirement!!  It seems to do so even when it would generate tax... not sure I have all that figured out yet... but I am in overall agreement with its general goal of getting the Conversions done ASAP. Just seeing what others thought.

Front loading certainly seems to make sense in our case just because while we still have 3 kids at home is when we have the "space" afforded by the tax credits to get the conversions knocked out in big chunks.  Not that we can't also do the Conversions slowly over time.  But one of the things I'm trying to hash out is the expected return of doing large amounts of the conversions as early as possible.

We have a significant amount in taxable accounts that are funding living expenses for the moment.

Any feedback appreciated.....

[MDM]

At those income levels, the Child Tax Credit (CTC) may or may not be relevant to your marginal tax rate.  That rate is what matters when deciding Roth conversion timing and amounts.

The CTC is, in general, a fixed amount so that wouldn't affect your tax rate.  Depending on exact income, the split between the non-refundable and refundable portions of the CTC may come into play.

You could use the case study spreadsheet to help with your Roth IRA conversion decisions.

[ender]

At those income levels, the Child Tax Credit (CTC) may or may not be relevant to your marginal tax rate.  That rate is what matters when deciding Roth conversion timing and amounts.

The CTC is, in general, a fixed amount so that wouldn't affect your tax rate.  Depending on exact income, the split between the non-refundable and refundable portions of the CTC may come into play.

+1

I'd also consider the impact on ACA subsidies if you are using that.

Another direction question would be: In a year when taxable income is just under threshold for being shielded by the tax credits... say taxable income is $48000 and $54000 would be offset, does it make sense to continue funding Traditional IRAs during those years?

Will you have earned income to actually use for this?

[johnhenry]

At those income levels, the Child Tax Credit (CTC) may or may not be relevant to your marginal tax rate.  That rate is what matters when deciding Roth conversion timing and amounts.

The CTC is, in general, a fixed amount so that wouldn't affect your tax rate.  Depending on exact income, the split between the non-refundable and refundable portions of the CTC may come into play.

You could use the case study spreadsheet to help with your Roth IRA conversion decisions.

Thanks.  I think I am grasping what you are saying about the marginal rates.  We are at 12% now and expect that will be the same the rest of our years as long as the code doesn't change.

Even though we have a situation where the tax credit leaves us with $0 in federal income tax liability the Roth Conversion is being taxed at 12% before that amount is offset by the credit.

The only way to ensure that the Roth Conversion income is taxed at less than 12% is to create a situation where income for a tax year is below the 12% threshold. Then any Conversion amount up to that amount gets the treatment at 10%, correct?

Am I on the right track thinking about it that way?

[johnhenry]

Will you have earned income to actually use for this?

Yes. I mean this is a broad planning exercise for the next several years.  Some of those years neither of us may work at all and have little or no earned income and less than $5K in taxable dividends, interest, etc.  So in those years we could have some space in the 10% bracket for Roth Conversions.  And other years we may both work and have enough earned income to fully fund Traditional IRAs/employer 401k/solo 401k if we chose. 

[MDM]

At those income levels, the Child Tax Credit (CTC) may or may not be relevant to your marginal tax rate.  That rate is what matters when deciding Roth conversion timing and amounts.

The CTC is, in general, a fixed amount so that wouldn't affect your tax rate.  Depending on exact income, the split between the non-refundable and refundable portions of the CTC may come into play.

You could use the case study spreadsheet to help with your Roth IRA conversion decisions.

Thanks.  I think I am grasping what you are saying about the marginal rates.  We are at 12% now and expect that will be the same the rest of our years as long as the code doesn't change.

Even though we have a situation where the tax credit leaves us with $0 in federal income tax liability the Roth Conversion is being taxed at 12% before that amount is offset by the credit.

The only way to ensure that the Roth Conversion income is taxed at less than 12% is to create a situation where income for a tax year is below the 12% threshold. Then any Conversion amount up to that amount gets the treatment at 10%, correct?

Am I on the right track thinking about it that way?

Yes.

There is a wealth (perhaps a surfeit) of information in the links above, and in the main Traditional versus Roth - Bogleheads article.

[ender]

Will you have earned income to actually use for this?

Yes. I mean this is a broad planning exercise for the next several years.  Some of those years neither of us may work at all and have little or no earned income and less than $5K in taxable dividends, interest, etc.  So in those years we could have some space in the 10% bracket for Roth Conversions.  And other years we may both work and have enough earned income to fully fund Traditional IRAs/employer 401k/solo 401k if we chose.

I'd also consider some of the tax credit ranges such as savers credit/EITC/etc at this point, too, as you will find a lot of them can be pretty seriously optimized with some earned income.

[secondcor521]

(I'm replying here to disagree with MDM, which I usually don't and wouldn't do.  So he's probably right and I'm probably wrong, so mostly this reply is to find out what I'm missing.)

Based on the tax tables with us MFJ and taking the standard deduction (currently 24,800) it looks like the roughly-estimated thresholds of income that would allow us to cancel out federal income tax with child tax credits are:

MAGI / Taxable / child tax credit
78000 / 54000  /  $6K
61800 / 37000  /  $4K
44800 / 20000  /  $2K

First off, does that look right? 

Approximately.  The numbers are a little off when I look at the 2020 tax tables, but you're in the right ballpark and have the right idea here.  (The first row is closer to $78,100 / $53,300.)

To get around to a more direct question.  Is there any reason in the coming years when we know or expect our income to be under those shielded thresholds that we should not convert our tax deferred holdings to Roth up to the point of reaching the threshold?

It's possible that in some of these years we will have close to $0 earned/rental/taxable dividend income and can use all of the space for conversion.  Other years we may have income and it could even be just a hair under those thresholds.  As we finished up our careers the last several years we put everything into Trad/401k and nothing into Roth... with this rough plan that we'd have plenty of time for conversions after FI/RE. 

It's a good idea.  The thing to look out for is other tax effects.  ACA subsidy loss is one.  State income tax effects are another - usually state income taxes start with AGI, and Roth conversions directly increase AGI, so generally speaking you're going to pay state income tax on your Roth conversions.  It still may be a good idea anyway.

Another tax effect is FAFSA EFC.  When those kids start to get college age, the Roth conversions will effectively be taxed at 7% to 8% in less financial aid.  If your kids are in the running for financial aid.  Which they might be if you can manipulate your income and FIRE before they start or while they're in college.

Another direction question would be: In a year when taxable income is just under threshold for being shielded by the tax credits... say taxable income is $48000 and $54000 would be offset, does it make sense to continue funding Traditional IRAs during those years? And then do a Traditional to Roth conversion of $6K to use the shielded space?  In years like those, when a Traditional IRA can be fully deductible, but Roth Conversion still completely shielded from tax, is there a reason to choose 1 over the other?  I'll have to check if and how my state would tax the Roth Conversion.  Or is it best to do the math and only contribute to the Traditional the amount to land exactly on the taxable income threshold and put the rest in a Roth.... avoiding the need/ability for a conversion that year.

In order:  No, No, No, and No.

In case of the first three questions:  You end up in exactly the same place - zero federal tax and the money in the Roth - just with more hassle and more paperwork.

In case of the last question:  You still end up with zero taxes in the current year, but then have created a tax liability for yourself for a future year when you will (likely) end up wanting to Roth convert that portion that you stuck in your traditional IRA.

A more complicated question would be... what is good way to approximate the value of the timing of the conversion, in terms of returns?

It's complicated, but as a rough swag you can compare the marginal rate you would have paid or are thinking about paying to the marginal rate at which you initially deferred the money (times the amount you're looking at).  You can also compare the marginal rate you're thinking about paying compared to the marginal rate at which you might Roth convert at age 75 if you don't do it now (times the amount you're looking at).  Age 75 will have you probably collecting SS and doing RMDs on your traditional IRAs and Roth 401(k)s after they have compounded for a decade or three, and you might be surprised at your tax rate at that age.

I've been away from the forum for years now and through the forum just recently discovered I-ORP.  I can't believe how much preference it gives to front loading Roth Conversions early in retirement!!  It seems to do so even when it would generate tax... not sure I have all that figured out yet... but I am in overall agreement with its general goal of getting the Conversions done ASAP. Just seeing what others thought.

Front loading certainly seems to make sense in our case just because while we still have 3 kids at home is when we have the "space" afforded by the tax credits to get the conversions knocked out in big chunks.  Not that we can't also do the Conversions slowly over time.  But one of the things I'm trying to hash out is the expected return of doing large amounts of the conversions as early as possible.

We have a significant amount in taxable accounts that are funding living expenses for the moment.

Any feedback appreciated.....

I think I-ORP generally calculates that the upfront taxes (and sometimes penalties) on the Roth conversions are offset by the tax free compounded growth and lowered RMD-induced tax rates over the next several decades.  And I believe it's probably right about the math.  It doesn't take into consideration the risks of one person in a marriage dying earlier, or both parties dying earlier, or tax rate changes.  It also used to not take ACA subsidies into account, but I think that's been fixed.  Aside from all of that, it's hard for people to write those big checks early - just human nature.

...

Even though we have a situation where the tax credit leaves us with $0 in federal income tax liability the Roth Conversion is being taxed at 12% before that amount is offset by the credit.

[...]

Am I on the right track thinking about it that way?

I would say no, and this is where I don't see eye to eye with MDM's responses.

The way I see it, in this kind of scenario the marginal tax rate on the Roth conversion is actually 0% when it is shielded by a credit (like the CTC, but could include the others mentioned).  Just talking about federal income taxes, the credit essentially acts like a larger standard deduction, and elsewhere people are very positive - even on this thread perhaps - about doing Roth conversions to fill that space, declaring such conversions to be effectively tax free.

To me, the only way a Roth conversion should be considered to be taxed at a marginal 12% rate is if, by increasing or decreasing that conversion, I see a $12 increase or decrease in the net tax liability or refund.

I'd also consider some of the tax credit ranges such as savers credit/EITC/etc at this point, too, as you will find a lot of them can be pretty seriously optimized with some earned income.

Indeed.  Just note that if you're thinking about the Saver's Credit may be offset by distributions.  See line 4.  Also EITC is hard to get.

[teen persuasion]

If you have earned income, consider EITC.  With 3 children, it can be much bigger than CTC, and it's fully refundable where CTC is partially refundable (max $1400 each child).  When the kids pass age 16, the CTC becomes $500 each nonrefundable.  When they go to college, AOTC can kick in, max $2500 each for 4 years, 40% refundable.

The Stimulus package that was just passed included FAFSA simplification.  The section formerly known as Simplified Needs Test is getting a new name, and the AGI threshold for it is increasing to $60k.  The auto EFC = zero will now be tied to qualifying for max PELL, at a % of federal poverty level (175% for married parents, 225% for single parents).  The income protection chart for calculated EFC (changing name to SAI-student aid index) is also increased, allowing more room for Roth conversions.

So now I'm crunching the numbers again for our situation, to see if we should consider larger Roth conversions in the next 4 years.  Our youngest is 15, a sophomore in HS, so our tax returns from years 2021-2024 will be the ones used on his FAFSAs.  DH is planning on retiring this year, mid year; I want to continue part-time a bit longer.  I'd been targeting keeping our AGI < $27k to qualify for auto EFC =0, which also is close to the MFJ standard deduction and to AGI for max EITC (but we waste lots of nonrefundable tax credits that *could* offset more Roth conversions).  The new FAFSA rules would give us up to $38k AGI for SAI = 0; we could convert more tax free, but the phaseout for EITC is a steep 21% + another 6.3% in state 30% EITC matching and extra state tax of 4%+, so over 30% tax cost in lost refundable credits.

EITC requires earned income, and practically requires child dependents (there is zero child EITC, but it is small and at extremely low income).  It makes sense to me to maximize it while we have both for the next few years.  Once we no longer have dependents our taxes will rise w/o the credits, but conversely our marginal tax rate drops - the EITC pushes that really high.  So the tax cost is less, because we aren't losing the refundable credits we *could* have been eligible for, if that makes sense.  I have to think in windows of tax years - filing FAFSA vs not, filing with dependents vs not, and later filing with SS/RMDs, etc.

EITC also has a phasein as well as a phaseout, and it tests on both w2 wages and AGI.  So I was trying to balance the two against each other.  I could target getting w2 wages on the phasein side equal to AGI on the phaseout side (your EITC will be whichever result is smaller), giving us some room for Roth conversions between the two numbers.  The other option is we both retire, have 0 earned income, conversion is our only taxable income, we withdraw and equivalent amount from prior Roth IRA contributions for living expenses.  Same AGI, but 0 w2 wages, so 0 EITC refunds, but more converted.  This is the plan for after EITC is no longer an option.

The bigger question is how much the tIRA balances grow while we are doing minimal conversions.  Can we later do enough conversions to shrink the tIRA balances over time, to limit RMDs on top of SS to limit taxes?  Will we need to convert more heavily for a few years to reach that tipping point, paying more taxes then to avoid more later?  Or can we successfully thread the needle and pay a small amount each year (or zero) and stay in range?

[MDM]

Even though we have a situation where the tax credit leaves us with $0 in federal income tax liability the Roth Conversion is being taxed at 12% before that amount is offset by the credit.
[...]
Am I on the right track thinking about it that way?

I would say no, and this is where I don't see eye to eye with MDM's responses.

The way I see it, in this kind of scenario the marginal tax rate on the Roth conversion is actually 0% when it is shielded by a credit (like the CTC, but could include the others mentioned).  Just talking about federal income taxes, the credit essentially acts like a larger standard deduction, and elsewhere people are very positive - even on this thread perhaps - about doing Roth conversions to fill that space, declaring such conversions to be effectively tax free.

To me, the only way a Roth conversion should be considered to be taxed at a marginal 12% rate is if, by increasing or decreasing that conversion, I see a $12 increase or decrease in the net tax liability or refund.

I agree with you, so maybe you agree with me also? ;)

If one uses the case study spreadsheet, it shows the marginal rates.  Perhaps someone could posit a scenario and see if it shows 0%, 12%, or whatever, at various conversion amounts.

[secondcor521]

The Stimulus package that was just passed included FAFSA simplification.  The section formerly known as Simplified Needs Test is getting a new name, and the AGI threshold for it is increasing to $60k.  The auto EFC = zero will now be tied to qualifying for max PELL, at a % of federal poverty level (175% for married parents, 225% for single parents).  The income protection chart for calculated EFC (changing name to SAI-student aid index) is also increased, allowing more room for Roth conversions.

Thanks for this paragraph.  It probably has redirected my plans for October 2022. :)

The bigger question is how much the tIRA balances grow while we are doing minimal conversions.  Can we later do enough conversions to shrink the tIRA balances over time, to limit RMDs on top of SS to limit taxes?  Will we need to convert more heavily for a few years to reach that tipping point, paying more taxes then to avoid more later?  Or can we successfully thread the needle and pay a small amount each year (or zero) and stay in range?

What I do is have a spreadsheet that projects IRA balances, RMDs, Social Security, and very basic tax and IRMAA brackets to guestimate what my marginal rate will be when I'm 75.

I Roth convert each year based on whether the marginal rate now is higher or lower than that projected marginal rate at age 75.

Since I'm 51, I can course-correct higher or lower depending on the actual investment performance of my traditional IRA over the next 20 years or so.

What I am planning on doing:

1.  While kids are in college, limit Roth conversions to a maximum of using up refundable tax credits.  Above that point, the combined effect of federal taxes, state taxes, ACA subsidy loss, and EFC increase combine for a very high marginal rate.
2.  After kids are in college through Medicare age, Roth convert to 400% FPL for ACA subsidies.
3.  Medicare age onward, convert up to 22% bracket as long as possible, then up to 24% bracket.

This seems to give me the most after tax spending power, and roughly follows the maxim of leveling taxes and tax brackets through my life.

[secondcor521]

Even though we have a situation where the tax credit leaves us with $0 in federal income tax liability the Roth Conversion is being taxed at 12% before that amount is offset by the credit.
[...]
Am I on the right track thinking about it that way?

I would say no, and this is where I don't see eye to eye with MDM's responses.

The way I see it, in this kind of scenario the marginal tax rate on the Roth conversion is actually 0% when it is shielded by a credit (like the CTC, but could include the others mentioned).  Just talking about federal income taxes, the credit essentially acts like a larger standard deduction, and elsewhere people are very positive - even on this thread perhaps - about doing Roth conversions to fill that space, declaring such conversions to be effectively tax free.

To me, the only way a Roth conversion should be considered to be taxed at a marginal 12% rate is if, by increasing or decreasing that conversion, I see a $12 increase or decrease in the net tax liability or refund.

I agree with you, so maybe you agree with me also? ;)

If one uses the case study spreadsheet, it shows the marginal rates.  Perhaps someone could posit a scenario and see if it shows 0%, 12%, or whatever, at various conversion amounts.

Probably! :)

Here's a scenario:  Tax year 2020.  Single filing with one 10 year old dependent.  Roth conversion of $13,000.  What is the marginal rate on the 13,000th dollar?  Nominally it's 10%, but practically speaking its 0% because of the CTC.

My point to the OP was that if they're in this situation they should look at the "practically speaking 0% rate" rather than the "10% nominal rate" when determining what to do.

(I'd do it myself but I get a runtime error in the 2020 spreadsheet when clicking on the button trying to do the fancy charts.)

[MDM]

Here's a scenario:  Tax year 2020.  Single filing with one 10 year old dependent.  Roth conversion of $13,000.  What is the marginal rate on the 13,000th dollar?  Nominally it's 10%, but practically speaking its 0% because of the CTC.

Need to know all other income to run this.

(I'd do it myself but I get a runtime error in the 2020 spreadsheet when clicking on the button trying to do the fancy charts.)

If not using Excel, that's probably the problem.  If using Excel, are you allowing macros to run?  See https://forum.mrmoneymustache.com/forum-information-faqs/case-study-spreadsheet-updates/msg1879496/#msg1879496 regarding that.

[secondcor521]

Here's a scenario:  Tax year 2020.  Single filing with one 10 year old dependent.  Roth conversion of $13,000.  What is the marginal rate on the 13,000th dollar?  Nominally it's 10%, but practically speaking its 0% because of the CTC.

Need to know all other income to run this.

(I'd do it myself but I get a runtime error in the 2020 spreadsheet when clicking on the button trying to do the fancy charts.)

If not using Excel, that's probably the problem.  If using Excel, are you allowing macros to run?  See https://forum.mrmoneymustache.com/forum-information-faqs/case-study-spreadsheet-updates/msg1879496/#msg1879496 regarding that.

No other income.  I was trying to come up with the simplest scenario.

Not running Excel.

[MDM]

Here's a scenario:  Tax year 2020.  Single filing with one 10 year old dependent.  Roth conversion of $13,000.  What is the marginal rate on the 13,000th dollar?  Nominally it's 10%, but practically speaking its 0% because of the CTC.

Need to know all other income to run this.

(I'd do it myself but I get a runtime error in the 2020 spreadsheet when clicking on the button trying to do the fancy charts.)

If not using Excel, that's probably the problem.  If using Excel, are you allowing macros to run?  See https://forum.mrmoneymustache.com/forum-information-faqs/case-study-spreadsheet-updates/msg1879496/#msg1879496 regarding that.

No other income.  I was trying to come up with the simplest scenario.

Not running Excel.

Assuming HOH filing status, $13K is below the standard deduction of $18,650.

There would be no CTC.  No non-refundable CTC because no tax is owed, and no refundable CTC because there is no earned income (having earned income is a requirement for the refundable CTC, in addition to being a requirement for the Earned Income Credit).

It appears non-Excel tools such as Google Sheets and LibreOffice Calc just don't have the needed functionality.  At least, nobody has ever been able to explain how to get them to do what Excel does.

[secondcor521]

Here's a scenario:  Tax year 2020.  Single filing with one 10 year old dependent.  Roth conversion of $13,000.  What is the marginal rate on the 13,000th dollar?  Nominally it's 10%, but practically speaking its 0% because of the CTC.

Need to know all other income to run this.

(I'd do it myself but I get a runtime error in the 2020 spreadsheet when clicking on the button trying to do the fancy charts.)

If not using Excel, that's probably the problem.  If using Excel, are you allowing macros to run?  See https://forum.mrmoneymustache.com/forum-information-faqs/case-study-spreadsheet-updates/msg1879496/#msg1879496 regarding that.

No other income.  I was trying to come up with the simplest scenario.

Not running Excel.

Assuming HOH filing status, $13K is below the standard deduction of $18,650.

There would be no CTC.  No non-refundable CTC because no tax is owed, and no refundable CTC because there is no earned income (having earned income is a requirement for the refundable CTC, in addition to being a requirement for the Earned Income Credit).

It appears non-Excel tools such as Google Sheets and LibreOffice Calc just don't have the needed functionality.  At least, nobody has ever been able to explain how to get them to do what Excel does.

Ah right.  Make it a $19,000 Roth conversion then.  The point was to get above the SD but stay in a range where the non-refundable portion of the CTC would erase the tax liability.

I'm using LibreOffice.  It does have some notable differences with Excel but serves my needs 99% of the time.

[MDM]

Assuming HOH filing status, $13K is below the standard deduction of $18,650.

There would be no CTC.  No non-refundable CTC because no tax is owed, and no refundable CTC because there is no earned income (having earned income is a requirement for the refundable CTC, in addition to being a requirement for the Earned Income Credit).

It appears non-Excel tools such as Google Sheets and LibreOffice Calc just don't have the needed functionality.  At least, nobody has ever been able to explain how to get them to do what Excel does.

Ah right.  Make it a $19,000 Roth conversion then.  The point was to get above the SD but stay in a range where the non-refundable portion of the CTC would erase the tax liability.

I'm using LibreOffice.  It does have some notable differences with Excel but serves my needs 99% of the time.

Same problem if conversion money is the only income: no CTC due to no earned income.

Assuming $10K W-2 income, and (to make it interesting) a $1000/mo premium tax credit (PTC) with a $12K SLCSP, the marginal rates for Roth conversions are


Without the premium tax credit effects, the chart is very similar but does not have the spikes associated with reaching a different payback limitation for the PTC.

At no point (other than before the standard deduction is reached) is the marginal rate 0%.  Other scenarios may have different results.

[secondcor521]

OK, I fired up TaxSlayer to gin up a scenario to demonstrate what I'm talking about.

Tax year 2020.  Single person filing HOH status with a 10 year old.  W2 wages of $10K.  1099-R $10K from an IRA with distribution code 7.  No other income.  US citizens with SSNs.

This results in AGI of $20K, taxable income of $1,350, tax on line 16 of $136, total tax on line 24 of $0.  It also shows an EITC and additional CTC later on down the 1040, but forget about those because they're not relevant to my point.

One can argue that the $136 on line 16 means a marginal rate of 10%.  One can argue that the $0 on line 24 means effectively a marginal rate of 0%.  My only point in all this back and forth is that when deciding whether to Roth convert a little more or a little less, it's the line 24 0% rate that matters, not the line 16 10% rate.

If the person in this situation increased the 1099-R to $11K, the line 16 tax would go up to $236, but the line 24 remains zero.  (Yes, their EITC would be a bit less.)  To me that means that the additional $1K is effectively at a 0% rate even if it's at a nominal 10% rate, and it's only this effectively 0% rate that matters in decision making.

I'm mildly interested in what the case study spreadsheet shows as the marginal rate for that 20,000th dollar.  I'm far more interested in @johnhenry actually getting accurate information and understanding in order to plan his Roth conversions well, which was how we started down this conversation path.

[MDM]

One can argue that the $136 on line 16 means a marginal rate of 10%.  One can argue that the $0 on line 24 means effectively a marginal rate of 0%.  My only point in all this back and forth is that when deciding whether to Roth convert a little more or a little less, it's the line 24 0% rate that matters, not the line 16 10% rate.

Line 34, and how much it changes as the conversion amount changes, defines the marginal tax rate of interest here.

(4534 - 4438)/(11000 - 10000) = 9.6%

That's an odd number for a couple of reasons:
1) The extra $1000 spans the point (~$10,450) at which the EIC from AGI drops below the EIC from earned income.  Up to that point the marginal rate for Roth conversions is 0%.
2) Using TaxSlayer (or any other "accurate" tax software) the marginal rate calculation is noisy due to both income tax and EIC being calculated by tables in which the amounts change only every $50.

[secondcor521]

^ Right, exactly.  That's how I do my own, although I add in state income tax and FAFSA EFC effects as well.

I think we may be in violent agreement.

I also think I misunderstood your "Yes." in the "surfeit" post on 12/31 above, but I'm going to drop it because I think I was interpreting it incorrectly before and correctly now.

[johnhenry]

Hey all.  Thanks for the feedback.  I have a lot to process here and I think I'm going to have to get my exact current info loaded into the tax software and run some different scenarios to feel out what the real tax advantages would be of the Roth conversions in years with little/no income between now. 

I already use TaxSlayer anyway for filing.  I also use ProConnect from Intuit sometimes for a second opinion, just don't actually file with it.  I haven't had much luck with the case study Excel sheet, but may give it another try.  TaxSlayer is a little clunky for running what-if scenarios.... especially those where state and federal have to be evaluated with every what-if adjustment.

What I have become fairly certain about since making this post, is that my state of KY has a rate that's likely to keep anyone making much income paying  ~6.0% in income tax.  But it looks like they allow an exemption of  ~30K per person on retirement income, including Roth conversions. And 60K in conversions is probably more than we'd ever want to do in one year anyway. So I think it makes sense for me to load up tax deferred to the greatest extent I can just taking the state tax situation into account. We should have plenty of time between 40 and full retirement age to do chunks of conversions each year.

But I still hope to improve my understanding of just the Federal implications.

[MDM]

I haven't had much luck with the case study Excel sheet, but may give it another try.

If not using actual Excel, it may be problematic, but using Excel it should work.  Post here or PM me with questions.  Roth IRA conversion - Bogleheads has some good pictures that may be useful, as does the Finance Buff site liked on the Instructions tab if you have ACA insurance.

[johnhenry]

At those income levels, the Child Tax Credit (CTC) may or may not be relevant to your marginal tax rate.  That rate is what matters when deciding Roth conversion timing and amounts.

The CTC is, in general, a fixed amount so that wouldn't affect your tax rate.  Depending on exact income, the split between the non-refundable and refundable portions of the CTC may come into play.

I'm still having trouble accepting (or understanding?) this broad rule that I've seen here and elsewhere on the forum that the marginal rate now vs. the marginal rate at time of conversion/retirement can always be used to determine Trad vs. Roth.  At the very least it seems like the wording of the advice is either incomplete or not nuanced enough.

I've run about 60 potential scenarios through TaxSlayer (and ProConnect) to see what levels of Fed & state income tax are incurred when different amount of Roth Conversions are done ($20K, $30K, $60K, $80K) for different levels of earned income ranging from $10 up to $90K.  I won't post the whole spreadsheet for now, because I think it will muddy the waters. But I'll post a couple of the scenarios below to help the question make sense.

OK, here are the constants for these scenarios:
Tax Year: 2020
Tax status: MFJ
Children under 16: 3
Net Sch E income: $600
Ord dividends: $2700
Qual dividends: $1700
Taxable interest: $300  (Total of $5300 investment income, which does not disqualify the earned income credit)
Earned income: $10

Note: I believe my state allows the first $30K in retirement income (including conversions) for each person to be done tax free.

Scenario 1:
Roth Conversion of $60K
Fed Marginal Rate: 12%
State Marginal Rate: 0%
AGI: 63610
Taxable Income: 38810
Child Tax Credit: 4060
Earned income credit: 0
Add'l Child Tax Credit: 1
Total Fed Tax: $-1 ($1 refund)
Total State Tax: $0
Fed tax attributable to Roth Conversion:   $10 (.02%) (attributable is higher than actual, because the EIC was lost)
State tax attributable to Roth Conversion: $0   (0%
Total tax attributable to Roth Conversion:  $10 (.02%)
Total tax saved by Conversion: $10,190  on $60K = 16.98%  (assuming original 17% marginal when deferred)

Scenario 2:
Roth Conversion of $80K
Fed Marginal Rate: 12%
State Marginal Rate: 5%
AGI: 83610
Taxable Income: 58810
Child Tax Credit: 6000
Earned income credit: 0
Add'l Child Tax Credit: 0
Total Fed Tax: $460
Total State Tax: $839
Fed tax attributable to Roth Conversion:   $471 (.59%)  (attributable is higher than actual, because the EIC was lost)
State tax attributable to Roth Conversion: $839   (1.05%)
Total tax attributable to Roth Conversion:  $1310 (1.64%)
Total tax saved by Conversion: $12,290 on $80K = 15.36% (assuming original 17% marginal when deferred)


So for the person considering this scenario: (That's me, with 3 kids and the opportunity to have only $10 earned income and do a Roth Conversion in the range of 60-80K)
These things are known:

At the time that we deferred this income into our Traditional IRA/401(k) our Fed marginal rate was 12% and State was around 5-6%

According to both Taxslayer and ProConnect:

Scenario 1: Roth conversion $60K
Fed Marginal rate: 12%
State Marginal rate: 0%

Scenario 2: Roth conversion $80K
Fed Marginal rate: 12%
State Marginal rate: 5%

Extra note: the difference in total tax on Scenario 2 vs Scenario 1 = $1300 (of an extra $20K converted to Roth) = 6.5%
Of that 6.5%, 4.2% is state which is expected because of the first $60K not taxed, and the remaining 2.3% is Federal.
So the additional $20K in conversions only incurred 2.3% in federal tax, despite the marginal rate being listed
as 12% for scenario 1 and scenario 2. 

I think most people heeding the advice about the "marginal tax rate being what matters" would assume that if scenario 1 ($60K conversion) was known to already have a 12% marginal rate, then any additional conversions(or any taxable income) being considered would be expected to incur a 12% (federal) tax.  Obviously, in these 2 scenarios, staying closer to $60K in conversions will be the most "tax efficient" with almost all of it incurring no state or federal tax. And I'm sure it's possible to determine the max amount that can be converted so that all $6K of the child tax credit can be realized.  For a person with enough savings and time, it probably makes sense to stay more efficient.

At this point, I'm not necessarily looking for advice on whether to plan for Roth Conversion in general.  The spreadsheet of scenarios I've built shows me how much I can "save" by doing a certain Roth Conversion amount at a certain earned income level, using the constants above. As others have pointed out, the earned income credit is a factor in some of these scenarios and it's most beneficial with 3 kids... which means it's harder to justify Roth Conversions when it's in play because conversions of any significant size make it unavailable.  Anyway, what I'm looking for is some clarification or update to the general advice about marginal rates being "what matters" in these situations. Is there a general rule that will always be true?  Or will it always be the case that it's always necessary to run the numbers so see?  I only know my situation, which involves the child tax credit x 3.  Maybe there are other credits that have this same effect on the general rule??

[secondcor521]

I think you are misapplying the notion of "marginal tax rate".

I do think that the marginal tax rate is what matters when making Roth conversion decisions.

But the decision needs to be made on a dollar-by-dollar basis, not on $20K chunks.  So if you have already decided to make $60K in Roth conversions, then the next question is whether to do $60,001 in Roth conversions, and that decision is made on the marginal rate on that dollar.

Then if that makes sense, the next question is whether to do $60,002 in Roth conversions, and that decision is made on the marginal rate on that dollar (which may be different from the marginal rate on the $60,001st dollar).

There are cases where the marginal rate is not monotonically increasing (i.e., there is a marginal rate hump).  In that case, I think it does make sense to look at how tall and how wide the hump is compared to the lower marginal rate area after the hump.  In this scenario it may make sense to look at the income level where the marginal rate hump starts and the income level where the lower marginal rate area after the hump ends and consider that income range in aggregate.

...

I think I disagreed [1] elsewhere earlier with someone - maybe it was @MDM? - regarding marginal rates and tax credits.  To me, if I have a non-refundable credit (say the CTC or similar) that I lose if I don't realize income but effectively means I don't pay tax if I do realize income, then I include that aspect of things in my effective marginal rate and in my Roth conversion decision.

So (and using made up numbers here that probably don't work in real life very well) if I have $10,000 in income and a $500 nonrefundable credit that is wasted because I have zero tax liability, but if I make a Roth conversion of $5,000 and that means I have a $500 tax liability but the $500 nonrefundable credit erases it, then in my simple brain it makes sense to think of the marginal rate on that $5000 Roth conversion as 0% (and thus worthwhile to do).  Therefore in general in my own situation, I realize enough income each year via Roth conversions to absorb all nonrefundable credits on my return; above that level I revert to the marginal rate analysis implied above.

But I will add that @MDM (and @terran and @seattlecyclone I think) are all more advanced at tax stuff than I am, so if I were you I'd give more weight to what they say than what I say.

[1] ETA:  It's also possible that @MDM (or whomever it was) and I actually agreed and it was just a matter of definitions and talking past each other.  I forget now.

[MDM]

At those income levels, the Child Tax Credit (CTC) may or may not be relevant to your marginal tax rate.  That rate is what matters when deciding Roth conversion timing and amounts.

I'm still having trouble accepting (or understanding?) this broad rule that I've seen here and elsewhere on the forum that the marginal rate now vs. the marginal rate at time of conversion/retirement can always be used to determine Trad vs. Roth.

Note the definition of marginal tax rate: (change in tax)/(change in income).  See the linked wiki article for more.

I've run about 60 potential scenarios through TaxSlayer (and ProConnect) to see what levels of Fed & state income tax are incurred when different amount of Roth Conversions are done ($20K, $30K, $60K, $80K) for different levels of earned income ranging from $10 up to $90K.  I won't post the whole spreadsheet for now, because I think it will muddy the waters. But I'll post a couple of the scenarios below to help the question make sense.

The case study spreadsheet (CSS) might have saved you some time on that exercise. ;)  If you are using Excel you could try it very quickly....

OK, here are the constants for these scenarios:
Tax Year: 2020
Tax status: MFJ
Children under 16: 3
Net Sch E income: $600
Ord dividends: $2700
Qual dividends: $1700
Taxable interest: $300  (Total of $5300 investment income, which does not disqualify the earned income credit)
Earned income: $10

Note: I believe my state allows the first $30K in retirement income (including conversions) for each person to be done tax free.

I don't think the CSS has that particular wrinkle for any state, but it wouldn't be hard to add.  E.g., see State Income Tax calculations - Crowdsourcing request.

Scenario 1:
Roth Conversion of $60K
Fed Marginal Rate: 12%

Where does this 12% come from?  If this is the nominal federal tax bracket, we may have identified the source of misunderstanding.  I'll hold off more comments on the scenarios until this is clarified.

So for the person considering this scenario: (That's me, with 3 kids and the opportunity to have only $10 earned income and do a Roth Conversion in the range of 60-80K)
These things are known:

At the time that we deferred this income into our Traditional IRA/401(k) our Fed marginal rate was 12% and State was around 5-6%

That is water under the bridge at this point.  The rates of interest to you are the "convert now" vs. "convert later".

[johnhenry]

Scenario 1:
Roth Conversion of $60K
Fed Marginal Rate: 12%

Where does this 12% come from?  If this is the nominal federal tax bracket, we may have identified the source of misunderstanding.  I'll hold off more comments on the scenarios until this is clarified.

When I plug in all that info into either TaxSlayer or Intuit ProConnect, both say that for that tax return, the marginal federal rate is 12% in their "summary" sections, so to speak.  Is there a definition that you are using that wouldn't match their summary?

[MDM]

Scenario 1:
Roth Conversion of $60K
Fed Marginal Rate: 12%

Where does this 12% come from?  If this is the nominal federal tax bracket, we may have identified the source of misunderstanding.  I'll hold off more comments on the scenarios until this is clarified.

When I plug in all that info into either TaxSlayer or Intuit ProConnect, both say that for that tax return, the marginal federal rate is 12% in their "summary" sections, so to speak.  Is there a definition that you are using that wouldn't match their summary?

Note the definition of marginal tax rate: (change in tax)/(change in income).  See the linked wiki article for more.

If the change in tax is $0, then the marginal tax rate is 0%.

[MDM]

This is what the CSS suggests for the situation you describe.  Leaving the state taxes out for now but those could be added as noted earlier.

[johnhenry]

Note the definition of marginal tax rate: (change in tax)/(change in income).  See the linked wiki article for more.

If the change in tax is $0, then the marginal tax rate is 0%.

OK, so why is that definition at odds with what is calculated by tax software?  What are they actually calculating here if it is not the marginal federal tax rate??

[MDM]

Note the definition of marginal tax rate: (change in tax)/(change in income).  See the linked wiki article for more.

If the change in tax is $0, then the marginal tax rate is 0%.

OK, so why is that definition at odds with what is calculated by tax software?  What are they actually calculating here if it is not the marginal federal tax rate??

I'm not familiar with that display (I'm guessing from ProConnect because it doesn't look like a TaxSlayer output).

If that is from your $60K conversion case, "program error" is my best guess.  E.g., if you use $61K for a conversion does your federal tax change from the $60K conversion?

[johnhenry]

If that is from your $60K conversion case, "program error" is my best guess.  E.g., if you use $61K for a conversion does your federal tax change from the $60K conversion?

Going from memory now, but TaxSlayer showed 12% marginal federal rate as well, not just ProConnect. I think this is less likely a program error than that the tax software industry uses a definition of marginal tax rate based on the tax as calculated on line 16, before it is potentially adjusted by credits to show "total tax" due on line 24. 

When changing from $60K in conversions to $61K the "tax" on line 16 does increase from 4060 to 4180. By the 12% expected for an extra $1000 in income.  But the child tax credit also increases from 4060 to 4180, so the "total tax" on line 24 remains $0.

[MDM]

If that is from your $60K conversion case, "program error" is my best guess.  E.g., if you use $61K for a conversion does your federal tax change from the $60K conversion?

Going from memory now, but TaxSlayer showed 12% marginal federal rate as well, not just ProConnect. I think this is less likely a program error than that the tax software industry uses a definition of marginal tax rate based on the tax as calculated on line 16, before it is potentially adjusted by credits to show "total tax" due on line 24. 

When changing from $60K in conversions to $61K the "tax" on line 16 does increase from 4060 to 4180. By the 12% expected for an extra $1000 in income.  But the child tax credit also increases from 4060 to 4180, so the "total tax" on line 24 remains $0.

You are too kind to ProConnect. :)  TaxSlayer reports an effective tax rate, but I don't recall seeing it report any marginal tax rates.

"Program error" remains appropriate, although "misleading output" could also be defended. ;)

E.g., if the line 16 answer is being used for marginal, why not for effective?  Besides, the marginal tax rate depends on the type of income in the denominator of (change in tax)/(change in income).  Increasing the amount of capital gains has a different marginal rate than increasing the amount of ordinary income.

Given that the ProConnect output is unusable, does a correctly calculated "marginal rate now vs. later" comparison make more sense?

[johnhenry]

Yes, thank you.  I did not know it was common to use the "marginal rate" to refer to the actual rate incurred at the margin AFTER credits, etc.  But it does make sense that it is that rate actually incurred at the margin that should be used for deciding.