Black Swans and Roth Conversions

[BobKamman]

The existence of a thousand white swans does not prove there are no black swans. But the existence of one black swan (many are found in Australia) proves that not all swans are white. I am not looking for a black swan, I’m looking for an example, preferably not hypothetical, of when a Roth conversion is a good idea.

I asked this in another thread, to which someone replied astutely, “To do this, wouldn't you need to calculate tax savings and tax costs and indirect financial costs (from the Roth conversion tax) and savings related to differing uses of tax savings over a very long period of time? I'm not being sarcastic or facetious.”

Exactly. And that suggests one example. Say a resident of Florida plans to retire to New York, because they miss snowy winters and flooded subway trains in summer. They know that their state tax rate will be higher, so they act now to avoid it. But how often does that happen? Likewise, someone expecting a higher federal tax bracket next year – perhaps a lottery winner, or a lucky heiress – might use up some of the lower bracket this year.

But as I recently wrote a client, “Let's say you are in a 20% tax bracket, now and in six years. You have $100K you can convert to a Roth. Do it and you're left with $80K. If that grows at 8% for 10 years, it becomes $172,720 that you can withdraw tax-free. If you keep the whole $100K it becomes $215,900. Withdraw it, and pay 20% tax on that, you still have $172,720. Notice how it comes out to the same number.”

And I added that I have seen clients “need assisted-living that qualifies as a medical expense (so IRA distributions to pay for it are not taxable). Hope for the best but plan for the worst.”

But most of the time, I wonder if brokers get credit for every new account they open, even if they involve depleting the client’s net worth through a Roth conversion.

[TaxGuyBill]

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@BobKamman wrote:

 I’m looking for an example, preferably not hypothetical, of when a Roth conversion is a good idea.

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1) Taxpayer's income is less than the Standard/Itemized deduction.

2) Taxpayer wants to contribute towards funding the US government.  🤣

[IRonMaN]

Sometimes you just need to look for a puce swan.  It doesn't matter if it makes financial sense to do the conversion, sometimes folks that are financially secure just want to get the conversion done so their kids don't have pay taxes on their IRAs after mom and dad have gone to swan heaven.  Logic isn't required to be used for every client tax decision.

[BobKamman]

“Taxpayer's income is less than the Standard/Itemized deduction.”

That’s a good point, especially these days with the $6K/$12K “senior deduction.” I often tell clients to take IRA distributions to get their taxable income up to break-even. They can do that without a Roth conversion, though. If their tax bracket this year is below zero, it’s likely to remain there in the future, unless there are fluctuations because of (for example) capital gains.

“sometimes folks that are financially secure just want to get the conversion done so their kids don't have pay taxes on their IRAs”

Another good point. And sometimes parents are in a 10% tax bracket while the kids are paying 35%. Or parents live in Texas and kids live in California.  

And then there are the millionaires who want to reduce their estates below $14 million by paying income tax now to avoid estate tax later. Assuming it’s not going to be repealed before they die.

(Neither of these cases could be spotted by the Tax Planner feature that inspired my original comment on this subject.)  

Nevertheless, I suspect that 90% of the few who should be doing Roth conversions, won’t; and 90% of the many who are doing them, shouldn’t.

[Greta]

I am annoyed at brokers who *always* invest their clients in Roths. I point out that their already being in their fifties, and once they retire from work, they will be in a very low bracket, whereas now the AGI makes a big difference in FAFSA and other credits.

One client is converting to Roth to reduce his RMD, just enough as to not get stuck in IIRMA medicare premium hike for himself and his wife. Or, as you suggested, being in a lower bracket than one's heirs is a good reason. Or if the taxpayer is retiring and has a low-income year and is not in an RMD age. Certainly if someone is going into a nursing home, and will have a big Sch A deduction (the entry fee here is an enormous deduction in the first year), plus the new 40K SALT deduction.

On another topic, has the IRS *ever* contacted a T/P who forgot to take his RMD? I have never come across that, despite many elderly folks who forgot to take their RMDs.

[qbteachmt]

This statement here is a defining factor: "You have $100K you can convert to a Roth. Do it and you're left with $80K"

I take a person's age into account, as Greta describes. But the other issue is how the conversion is "paid" for. If I convert $100,000 there will be $100,000 to grow at 8% per Bob's example. Specifically, I would never recommend a conversion when a distribution is how they will fund the taxes.

If a person is going to have the added taxable ordinary income and also pay taxes (even though playing within tax brackets), and they are old enough or cautious enough that there isn't a lot of expectation for good growth riding out bad times, then why convert? They won't have that different of a financial position in a few years, other than maybe hitting RMDs.

If someone is in the prime earning years, say mid-50s, they have 10-12 years to convert; spread it out. It doesn't have to be all at once. They would be moving the funds before the added AGI hits for IRMAA. They have plenty of time in a variable market to find earnings and growth (20-25 years to RMDs).

It really depends on why they want to convert: avoid RMD, tax free growth, beneficiary benefits.

[BobKamman]

What is the cost and benefit from taking a distribution before age 73 in order to reduce RMD later?

To lower RMD by $100, the distribution has to be $2,650 and the tax at 12% is $318, so the client has $2,332 left. This is no longer earning tax-deferred income. The client needs to survive to age 76 for the lower RMDs to exceed the tax cost. And of course, to age 100 before $100 less income each year makes up for the $2,650 taxed long ago.