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Roth IRAs and Roth Conversions: Who Needs Them?

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Roth IRAs are the darling of the financial media. Maybe it’s because they’re relatively newer. Or because the rules have changed, allowing more people to access them now. Or because, in some situations, they can save you more on taxes.

Whatever the reason, there is a pervasive belief that Roths are somehow a better place to park your money. I’ve even seen the decision to do a Roth conversion called a “no-brainer.” But are Roths really the great deal they’re made out to be? My own brain has been swimming in the details of Roth IRA conversions recently. And I can tell you the decision is not so obvious to me.

When you run the numbers, while holding other variables constant, it turns out that Roth IRAs have no magical tax reduction capabilities. They are a financial vehicle like any other — sometimes effective, but not always the best tool for the job.

We’ll look at those numbers shortly. But first, be forewarned that I have a strong distaste for adding complexity and paperwork to my life just to save a few bucks. Especially if that payoff involves parting with my money sooner than later, or requires predicting the future accurately. But your preferences or financial situation could well be different than mine. There are scenarios where Roths can save you money, particularly for those in higher tax brackets. So, put my data and insights about Roth IRAs and Roth conversions in context, and draw your own conclusions….

Roth IRAs

Though I’ve never had a Roth account (our income precluded it during most of my working years), like most people these days, my default instinct would be to “choose a Roth.” I helped my son set up a Roth account when he started receiving his first income from work. Roths are the conventional wisdom for young people starting out, because their tax bracket will probably rise later, and they may want penalty-free access to their savings for buying a first house. And I don’t argue with that.

But, it’s often implied that, given a certain sum, the Roth’s “tax-free” nature somehow leaves you with more money in the end. However, assuming your tax bracket remains the same, that simply isn’t true, as an example will demonstrate:

Suppose you’re in the 15% tax bracket and you have $5,000 to put to work in a retirement account. In a Traditional IRA account that gives you a starting balance of exactly $5,000, because the contribution is before taxes. But in the Roth account, which is after taxes, you’d have just $4,250, after paying your 15% taxes first from the initial sum.

Assume you’re getting about a 7% return. Ten years go by, and your investments have doubled in value. Now you have $10,000 in your Traditional account and $8,500 in the Roth.

Now it’s time to withdraw and use the money. (We’ll ignore various time limits and penalties which are irrelevant for this example.) The Traditional account is taxable, so when you pull out the $10,000, you must pay your 15% tax, leaving you with $8,500. The Roth however is tax free, so when you pull out the balance, you get to keep the full amount. You wind up with $8,500, just like the Traditional.

So, there is no difference in the ending values of the two accounts, assuming your tax rate is unchanged between the initial contribution, and your withdrawal. (Thanks to Mike Piper at Oblivious Investor for making this commutative property of multiplication crystal clear.)

If your tax rate changes, though, the story is different: If your tax rate goes down, a Traditional IRA does better. And if your tax rate goes up, then the Roth does better.

It makes little sense, in my opinion, for most near-retirees to assume their tax rates will rise. Yes I know we have enormous public debt and the government will need to raise that money somehow. General tax rates could go up in the future for political/budgetary reasons. But, it is highly likely that your personal taxable income in retirement, and thus your tax rate, will be significantly less than it was while you were working — which is the main comparison that matters for retirement saving. This has to be the case, almost by definition, for anybody who lives off what they put away during their working years. (Personally, not only are our tax rates lower in retirement, they are dramatically lower.)

So Roth IRAs are not a slam dunk for tax savings. It all depends on whether your tax rate changes, and in which direction. Still, for the record, Roths do have a few inherent advantages over Traditional IRAs:

  • No age limit on contributions
  • Take out original contributions tax and penalty-free
  • No tax on inherited accounts — because you already paid the taxes
  • No Required Minimum Distributions (RMDs) — again, because you already paid the taxes

(But note that taxable accounts, of which we have plenty, have very similar benefits!)

Required Minimum Distributions (RMDs)

Now, let’s quickly review Required Minimum Distributions (RMDs) — also sometimes referred to as Minimum Required Distributions (MRDs) — a key component of the Traditional/Roth IRA decision. As we saw above, your contributions to Traditional IRAs are tax deductible. The government wants to encourage retirement saving, but it also wants to make sure you pay taxes eventually. Hence the RMD rules: You must begin withdrawing from any Traditional IRAs starting at age 70 1/2, and you must include those withdrawals as part of your taxable income. (Note, you don’t have to spend the money! If you don’t need it, you can put it directly into a taxable savings or investment account.)

How much are you required to withdraw? The amount of your RMD is calculated as your Traditional IRA account balances divided by a “distribution period” (your life expectancy) from the IRS’s Uniform Lifetime Table. For most people, the distribution period at age 70 1/2 is 27.4, which equates to a 3.6% withdrawal rate. And the withdrawal rate goes up gradually from there, as you age. The government can require you to withdraw a larger percent each year, because you have less time to left to live. Cheery thought.

RMDs are a nuisance to those with very large IRA account balances and the dwindling few who receive pensions, because they generate unnecessary taxable income — money you don’t need for living expenses, that will be taxed anyway. Even worse, in some scenarios, RMD’s along with Social Security can force you into a higher tax bracket. That means you’re required to give an even higher percentage of your money to the government. And nobody likes the sound of that.

The lack of RMDs is often cited as the primary benefit of Roth IRAs. And indeed it could be, but that’s far from certain for many people. As I’ll shortly demonstrate with my own situation, and as others have pointed out, RMDs are a moot point for many of today’s retirees without pensions. Why? Because for many people, the problem isn’t being forced to take out more than they need — it’s not having enough retirement savings in the first place! The majority of us will need to make substantial withdrawals from our IRAs to make ends meet in retirement. So the government’s RMD rules may not force much, if any, “extra” income on us.

Roth Conversions

Because of the perceived threat of RMDs pushing you into a higher tax bracket, the conventional advice is often that you should “top-off” your tax bracket in low-income years of early retirement by doing a Roth Conversion. What is a Roth Conversion, exactly? Well, it’s similar to an IRA rollover. It usually involves setting up a separate account to receive the funds. And, as with rollovers, it’s always best to do a direct transfer at the same institution or between institutions, rather than taking custody of the money yourself and dealing with deadlines and possible penalties.

Now the catch: After the conversion, you must pay ordinary income tax on the converted amount for the tax year of the conversion. Importantly, you do NOT want to use funds from the IRA to pay these taxes. For starters, if you are under age 59 1/2, you would incur a penalty. More generally, you lose out on some potential tax-deferred growth….

The mechanism for this is not well explained elsewhere. I spent quite a bit of time with a spreadsheet, getting a handle on it myself. It’s important because it represents one of the few inherent advantages of a Roth. There are several ways you can understand it: Paying conversion tax from your non-IRA funds is almost like a form of leverage, borrowing from yourself to buy a tax-advantaged investment. But, the amount you have to “reimburse” yourself in the end is less, because it would have been growing at a slower rate in a taxable account. Essentially, with the option to pay the conversion tax from non-IRA funds, the government gives you the opportunity to tax-shelter a bit more money: an amount equal to the conversion tax you’re required to pay.

In case this topic isn’t confusing enough yet, note that if you made any non-deductible/after-tax contributions to your Traditional IRA (I have some of these), you can’t simply convert that portion to a Roth. Rather, the IRS requires you to pro-rate each conversion to determine how much is taxable. This will likely complicate your record keeping for the year of the conversion, and for years to come.

(I will not be discussing here what has been called a “backdoor” Roth IRA conversion — where high-income individuals make non-deductible contributions to a Traditional IRA, and immediately convert them to a Roth. That’s a different bag of worms, though some of the issues are the same.)

Analyzing a Roth IRA Conversion

This past 2014 tax year was the first time in my early retirement where our income was both low enough, and I had enough free time and information, to seriously evaluate doing a Roth IRA conversion. I plunged in, little suspecting this would be one of the most complex retirement calculations I’ve yet encountered….

For starters, I use some of the dedicated Roth IRA Conversion calculators available online. The two best that I found were:

These calculators feature similar inputs and similar results. Assuming that my tax bracket stays constant in retirement (more on that later), both of them report that I would be able to generate about 3% greater annual income if I convert our Traditional IRA to a Roth. That is provided I pay the conversion tax from non-IRA assets. If I pay the tax from IRA funds, there is no difference in the net value to me of doing a conversion.

These dedicated calculators are good for a quick answer. But I still didn’t feel I had a good understanding of why a Roth conversion could save me money, or of how doing one would interact with our RMDs, Social Security income, and tax brackets in later years. So, to get a better understanding of the math, while hoping for a more accurate picture of our future, I next ran three of my recommended high-fidelity retirement calculators:

  • J&L Financial Planner
  • Fidelity Retirement Income Planner
  • PRC2015/Gold

The first two don’t analyze Roth conversions specifically, but do model RMDs. In both cases they show modest levels of RMDs into our 90’s that don’t change our tax bracket. That implies there would be no major financial advantage to performing Roth conversions in our case. (Though there might be a modest advantage, a few percent, due to the financial “leverage” of paying the conversion tax out of non-IRA funds, as discussed above.)

The last calculator I used was PRC2015/Gold from Pralana Consulting. This is one of the most sophisticated high-fidelity retirement calculators. It incorporates detailed federal tax calculations. And, not only does it compute RMDs, but it can also perform Roth conversions over one or more years. It can even optimize the total percentage of tax-deferred savings to convert, based on your financial situation. Lastly it offers very detailed output reporting including year-by-year tables displaying parameters like adjusted gross income, taxable income, and effective and marginal tax rates, that are critical for understanding your tax situation in retirement. (Special thanks to Stuart Matthews at Pralana Consulting for technical support and enhancements.)

The picture of my situation emerging from PRC is more complex. It shows an increase in net worth of from 5-10% when doing Roth conversions, depending on whether I use the default tax calculations or tweak the Average Tax Rate on Regular Savings to reflect that I’m relying on low-tax cash and long-term capital gains in these early retirement years. Given the complexities involved, the mechanism for that relatively larger 5-10% improvement isn’t perfectly clear to me yet. It may be related to changes in marginal tax rates, possibly a higher marginal tax rate due to the incremental taxation of Social Security and other government benefits — a topic I won’t tackle just here.

Given the variation in results from the commercial calculators, I created my own spreadsheets to further analyze and understand the factors related to RMDs and the Roth conversion decision. My spreadsheets show us maintaining our current 15% tax bracket, with headroom to spare, and project only a 2-3% benefit to net worth from doing Roth conversions.

That few percent difference seems well within the margin of error for retirement calculations: I wouldn’t count on ever seeing it. If I was certain of a larger increase in net worth, I’d probably consider doing Roth conversions. But, I’m just not confident that my data input has captured all the nuances of my tax situation, or that I can even predict that situation with enough accuracy far into the future. Our tax returns have been substantially different in each of the first two years of our retirement and probably will be different again this year. So, further study is required, plus some additional years of retirement living….

Lessons Learned

I may not have the ultimate answer yet, but I’ve learned some things in my time studying Roth IRAs. For starters, when trying to understand tax brackets far into the future, it is best to show all your analysis results in current/today’s dollars rather than inflated/future dollars. This makes it much easier to view and assess tax brackets over time, because it removes the effects of inflation. Different calculators do this in different ways. (For those that can do it at all, search for “today’s dollars” in my calculator list.)

In the end, RMDs and Roth conversions produce some of the most complex retirement scenarios I’ve ever analyzed. I’d be very skeptical about any simple rules of thumb for using, or not using, Roth IRAs. I think you have to run your own numbers and, even then, the quality of the answers will be limited by your ability to predict precise details about your income far into the future. Nevertheless, after all the number crunching, I did get insights into some of the conditions that can favor doing a Roth conversion in early retirement:

  • Having substantial non-IRA assets (Social Security, taxable accounts) such that you don’t need RMDs
  • Experiencing higher real rates of return (RROR)
  • Having very large IRA-based assets at age 70 1/2
  • Having large living expenses that require withdrawing extra income from retirement accounts

Some hope that Roth conversions will be a “silver bullet” to save them from high taxation of their retirement assets. But, realistically, the impact is muted: The amount you can convert is limited by the number of years you spend in a lower tax bracket and your “headroom” to the next higher bracket.

Just how much money can you potentially save? Assuming you had 10 years until RMDs started, and you could realize a tax savings of 10% between brackets, and you converted $30K/year, you would save $30K in taxes over the course of your retirement. That’s nice money, but if you have the assets to convert that much in the first place, it’s probably not a game changer.

Why I Didn’t Do a Roth Conversion Last Year

A salesman knocks on your door. He’s hawking a sophisticated new tax shelter. Pay thousands of dollars in extra taxes now. Then, if you live into your 80’s and 90’s, and a dozen other variables hold true, you will possibly increase your net worth by a few percent. Interested? Some people would be. Not me. At least, not yet.

The Roth conversion decision is all about trading off present certainty against future uncertainty. Maybe you’ll come out a little bit ahead later, if you pay more taxes and add more paperwork to your life now. But, when it comes to retirement calculations, after I’ve had to make 3 or 4 assumptions about the future (investment returns, inflation, tax rates, lifespan, etc.), I begin to discount the results. And Roth conversion calculations require a lot of assumptions.

You won’t find many financial advisors saying: “Do nothing, you’ll be fine.” That dull message doesn’t sell financial services or content. But my goal is to minimize time spent managing money, while maximizing the rest of life. Unless significant sums are involved, or there is some threat that I won’t meet my financial goals, then my default behavior is to “let it ride.” Given the uncertainty in most of the Roth-related variables, if you’re in a lower tax bracket and expect to stay there for most of your retirement, I see nothing wrong with foregoing Roth conversions. That’s what I’m doing, for now.

But, as I’ve said, this is one of the most complex retirement scenarios I’ve ever analyzed. I may have overlooked some factors. And my financial situation probably doesn’t match yours exactly. So, if in doubt, use one or more of my recommended retirement calculators to run your own numbers….

Comments

  1. Nice post Darrow. I am very ambivalent on a Roth IRA for my clients and agree that many advisers oversell their services by implying that they help people get to the bottom of this complicated dilemma – this is why you need my important expertise, blah blah blah. Frankly, for most people, the most important issue is that they simply need to save the money. That is the key step. In the long run, I think it can be wise for middle class people to have, give or take, 20% of their overall retirement assets in Roth IRA. The reason I suggest this is that I have worked with many retirees that have years in retirement in which they need more money from their accounts. Money for Family, or car, or the big vacation, or healthcare, or whatever. In those years, they can use the Roth to manage their taxes. But I don’t think people need to micro analyze and hyperventilate about this. If they can get there, good, if not, they haven’t ruined their future.

    • Thanks for that balanced perspective Mark. I agree, just saving the money is priority #1. In our case, we wound up with half our assets in taxable accounts at the start of retirement, which gives us most of the tax flexibility we need.

  2. Darrow- I agree about not making life more complicated trying to get ahead of every perceived way to optimize retirement income. The Roth conversion question is similar to the SS question of when do you take the money. It is likely you will only know the right way to go on either when looking back on it at a very old age and after you have already made all the decisions. When I made a partial Roth conversion a few years back it was very complicated figuring out the IRS rules of what was taxable and what wasn’t. I also received a couple of letters from the IRS asking me all sorts of questions. Over the 22+ years I worked for the government, I’ve seen my share of broken promises and I always take their money as quickly as possible, but try not to give them any for as long as I can. To me, the Roth is a governmental leap of faith. They may not be able to keep all the RMD and inheritance rules in place as the population ages and the need for new sources of income arise. The SSA quickly changed the rules on taking the early benefit at 62 and paying it back for a larger benefit once they got wind everyone was doing it. I’m not paranoid, but getting the tax benefit up front always seems to be the right way to go to me. One other thing people sometimes overlook is the standard deduction and tax rate brackets continue to increase by 2-3% each year making it that much more likely you will be in the same or lower tax bracket in retirement. Thanks, Ed

  3. I have real estate note investments in my IRA. They are carefully selected, with a large margin of safety; I am confident they will pay off at face value. But I was able to gain some leverage by having them appraised at a discount immediately after I bought them (hence they did not yet show a payment history), then converting them at the discounted value to my Roth IRA. (Admittedly not a strategy for everyone, but it may open doors to some creative thinking.)

  4. did a ROTH Ira conversion a few years ago and here was my reasoning:
    1) I could never open a Roth due to the income and other restrictions
    2) I already had quite a bit invested in a tax deferred 401k and I felt having the Roth would be a nice option to have in the future.
    3) At the time the value of the IRA I was converting was down quite a bit due to the poor performing stock market. So I thought this was an ideal time to pay less taxes on the conversion.
    4) I believe this was around 2010 when some of the restrictions were removed so I could convert and spread the taxes out over 2 years.

    In the end I don’t regret doing this but as you mentioned it was complicated and I had to respond to several notices from the IRS that the conversion was not done properly. Apparently, the IRS was not keeping track of spreading out the taxes over 2 years.

    Thanks, for the informative post.

  5. supernova72 says:

    I was racking my brain trying to analyze the pro’s and cons myself. My situation may be different that most because I’m older (54) and can technically retire at 55 although I want to work 3 ish more years.

    So I decided to ask a friend of mine who is a FP and manages my mom’s investments. Here was his reply when I asked him if I’m missing the boat by NOT doing a Roth. Another side note— I’m eligible for a pension which will provide about 50% of my income stream until I reach SS age at 62. The 401K is the other 50% (I hope!).

    REPLY from Financial Plan to me: The Roth isn’t anything you should be interested in this close to retirement. During these last years of your employment, it is better for you to maximize your contributions to the pre-tax 401k (avoiding paying taxes now while you’re in a higher tax bracket, so you can withdraw them later when you’re retired and in a lower tax bracket, effectively saving you quite a bit in federal income tax).

    • Thanks for the comment supernova. Sounds like you have your priorities straight at this point. You could revisit this once you’re retired and your tax bracket is lower. And you may come to the same conclusion I just did.

      • supernova72 says:

        There are days when I think I have it figured out and then there are times when I think about the wild cards in my “plan” for ER. The largest being retiree medical. I work for a large aerospace company and as a heritage 30 yr employee I’m eligible for retiree medical ($20 a month–no kidding). I’m counting on that being there when I retire–and hoping it’s not targeted or reduction or elimination.

        On the lower taxes when retired side much of that is gut feel since I’m doing my mom’s taxes. She’s 82 and has a similar income stream as I hope to have. I’m amazed at how small her tax liability is as a senior. The biggest surprise being that SS is not taxed at the full amt. in her case the $20K from SS is taxed at 50%. Pretty sweet. Her effective tax rate has never been higher than 5% on a gross income of $45K.

  6. A factor not discussed is that a Roth is a nice thing to leave to heirs, as opposed to a traditional IRA, assuming you have enough assets to leave some sort of legacy. In either case, the “stretch” feature can allow a great deal of tax-advantaged growth. With the Roth, however, the heirs won’t need to pay income tax on distributions of either principal or growth (assuming no change in the law), as opposed to the tax at ordinary income rates they’d pay on all distributions from a traditional IRA. In a way, paying the tax on a conversion is like a deferred gift to your heirs.

    Another factor is that if you have enough assets to worry about either federal or state estate taxes (some states’ exemption amounts are significantly less than the federal amount), the tax you pay on a conversion also reduces your estate and helps to avoid or reduce the estate tax your heirs would otherwise owe.

    Granted, these are considerations for a limited subset of taxpayers, but they remain potential advantages of a conversion.

  7. I’ve looked at Roth contributions and conversions from two different perspectives, both very different from the one you’re concerned with.
    1) my own (“early accumulation phase”, let’s say) in which I’m favoring Roth because I hope to bust into a higher marginal bracket in the future, at which point I’ll favor traditional, and my overall goal is to have a bunch of each to provide flexibility for later tax planning.
    2) my parents’ (nearing non-early retirement) which falls under the “don’t need RMDs” case. It’s pretty much too late now, but if Roth had been around earlier they might now be in a position to protect more of their Social Security from taxes once they start claiming.

    I’ve heard the “bird in the hand” sentiment before, and it doesn’t resonate with me. I guess for one thing I don’t think of a tax-deferred account as fully “in the hand”, and for another, I just can’t see the tax benefits of Roth accounts being retroactively messed with. As stupid as tax policy is in this country (and as a tax software programmer, I can assure you it’s painfully stupid), that doesn’t strike me as a plausible scenario. (If anything, in a “times are tough and the government is scrambling to raise revenue” scenario, I would maybe be more nervous about traditional accounts, since an increase in tax rates or a lowering of bracket thresholds wouldn’t have to be retroactive to affect their actual value.)

    But really, I’m not that confident I know what taxes will look like when I’m retired, which is why my goal is to have a balance of the two, to the extent I can.

    • Thanks for the perspectives Klaas. I agree on tax diversification. As mentioned, we had approximately half our assets in taxable accounts at retirement, so get some of it that way.

    • This is our approach as well. We have most of our savings in traditional 401k, with the remainder in roth and taxable accounts. I wanted to have flexibility to withdraw money without pushing us into a higher bracket. That being said, I don’t disagree with the numbers that say the deduction from the traditional 401k makes it the smarter play.

  8. Darrow,

    Once you begin your early retirement, you will likely have less taxable income than you did when you were working so use this period to convert your Traditional IRA to a Roth IRA.

    IRA conversions count as ordinary income so to obtain completely tax-free conversions, you should convert an amount equal to your deductions and exemptions (assuming you have no other ordinary income).

    During this time, you can live off of your long-term capital gains and dividends, which will be taxed at 0% if you are in the 10% or 15% tax bracket.

  9. There are even more things to complicate the issue. I plan to retire at 59 1/2. I will have to purchase health insurance on the exchanges. Therefore, I want to reduce my taxable income so that I can qualify for the subsidies. Therefore, I will spend down my Roth assets first. That’s a big expense in early retirement. After I start social security at age 70, our RMD will be only a little more than the total of our standard deductions and exemptions.

  10. I’m with Klaas. A path worth considering, for those still working and anticipating living at least 15 more years, is to have balances in both a Roth and a Traditional. If you already have a big balance in a Traditional, and very little or none in a Roth, you might want to direct 100% of your contributions to a Roth for a few years.

    Call it a diversification against the big unknowns – future tax changes, cash needs in any given year, and lifespan. Since no one can predict which of the two (Roth or Traditional) will be the best for them until life actually happens, have some of both.

    Especially if you feel highly certain you will retire earlier than age 60, the feature of the Roth which allows withdrawals of contributions (not the cap gains and income, just your contributions) very freely at any time could prove to be quite a good thing.

    Final point, conversion (401K to Roth) does seem to NOT be a prudent path for the vast majority who are already retired, or very near retirement. You need many years of investment returns to offset the conversion costs (taxes). I’ll offer this link, as I think it does a nice job of succinctly explaining the general wisdom on the subject. http://retireplan.about.com/od/iras/a/Who-Should-Not-Convert-To-A-Roth-Ira.htm

  11. Darrow, Thanks for doing this deep dive so I don’t have to. I now doubt I’ll bother with Roth conversions. Your post suggests a new question for me, however: My wife and I have Roths totaling $100,000 and we’ll probably retire 8 years from now when she turns 59.5. We will have no heirs. We have been investing the Roth money 100% in stock indexes because we viewed it as a very long term, “maybe I’ll need it”, tax diversification money, admittedly with no clear purpose. However, perhaps a smarter strategy would be to invest more conservatively now with an eye to using a portion of it as tax free capital pay off our 4.1% mortage 8 years from now and, thereby, remove about 25% of our expected living expenses. Until now, I’d assumed I’d use precious taxable account dollars to knock out the mortgage at retirement. Other posters here make good points that there are no real guarantees that Roths will always be tax free. Do you think I am possibly on the right track with this revised, bird in hand, Roth strategy for mortgage payoff, or not? Thank you.

    • Hi Markola. I hesitate to advise on particulars, but I agree with most of your themes: Paying off mortgage debt. Locking in definite returns. Reducing taxable income. Lowering living expenses. Simplifying. I couldn’t say whether you’ll come out ahead financially, but these are principles I’ve lived by, and they’ve generally led me in a safe and secure direction.

  12. Here is the Roth vs. Traditional strategy we incorporated as a pre-retirement couple. During the great recession we found ourselves “between jobs” so we used the opportunity to start a business. As with many startups, profits for the initial year were rather scant. Prior to that time I had acquired quite an array of traditional IRAs due to repeated changes of employment as I progressed up the career ladder. So for us, that year was an opportunity to take advantage of a lower tax bracket and consolidate the smaller traditional IRAs into Roth. This consolidation substantially simplified our recordkeeping. Fast forward to the last three years. We continue to make contributions to the Roths (personal and spousal) while also contributing to an employer-sponsored 401k retirement account. Using the Roth rather than the traditional IRA lets us avoid confusing rules for contribution limits when also contributing to the employer-sponsored plan. I like to believe the Roth will provide some small tax advantage over other investments, but I admit this a bit more of a hope than a certainty.

  13. Could IRA withdrawals in parallel with social security receipt cause social security to be taxed? Looking at the Social Security tax worksheet, my concern is that the threshold for taxation of social security is very low. It appears that taxable income (as well as provisional income), at a threshold, will cause social security to be taxed. Going forward, I suspect that the threshold for taxing social security will not be raised, therefore due to inflation the tax will automatically get worse.

    http://apps.irs.gov/app/vita/content/globalmedia/social_security_benefits_worksheet_1040i.pdf

    • Yes, this is a concern which I reference in my article above. The post from Oblivious Investor has the most accurate analysis that I’ve seen: How is Social Security Taxed? In my case, the threshold seems low enough that I think I might be paying tax on the full 85% of SS benefits, regardless of whether RMDs are in the picture or not.

      • Given a married couple filing jointly, retired and drawing social security.
        Pension (defined benefit) : $30K
        Social Security (both): $36K
        IRA Withdraw: 30K
        Estimated taxes: $9,641

        Roth Withdraw: $30k
        Estimated Tax: $1,961

        Tax difference is $7,680

        Therefore IRA withdraw is taxed at about 25%. Given Deductions of $12,400 & Exemptions of $7,900 (I didn’t consider age). Normally, the 25% tax bracket does not start until $73,801 + $12,400 + $7,900. In this situation, the IRA is a bad deal. It causes social security to be taxed. Speculating, that if one is in the 15% tax bracket while saving for retirement. A Roth makes more sense. But, I think anyone contemplating Roth vs IRA contribution should run their numbers on a tax calculator. Be aware that tax free interest, Municipal Bonds, also cause Social Security to be taxed (provisional income). There may be errors (above), I’m making up & calculating this situation as I type.

        https://turbotax.intuit.com/tax-tools/calculators/taxcaster/index.jsp

  14. Darrow-

    Great post. I think this is something we all struggle with, especially the recently retired (like us), and your simple description of the trade-off is very useful. Based on your description, we are somewhere in the middle group: SSx2 + small pension income, with significant funds in all three categories-Tax Free, Tax Deferred and Taxable accounts. So, we will see RMDs but, according to Fido RIP, not extremely in excess of what’s required for necessary income. So, we’re currently in the “bird in the hand” camp (ie: no systematic conversions).

    In fact, what we are more likely to do is try to capture ZERO cap gains on our taxable accounts during the next several years because, that seems a more certain gain to us. I’ve seen a couple threads over on E-R.org regarding this trade-off but, would like to see more.

    Perhaps you will consider a future blog post on the trade-off btwn Roth Conversions -vs- Zero Cap Gains Capture during the first decade of retirement. I’d be very interested in what you have to say.

    • Thanks for sharing your situation and conclusions Mark. Sounds like you have positioned yourself for maximum flexibility, with potential income from a number of sources. As far as a tradeoff between Roth Conversions and Zero Capital Gains, my sense (for me, for now) is that Roth Conversions are a complex speculation about the future. But harvesting Zero Capital Gains for living expenses, is a simple mechanism with immediate and obvious payoff. I’ve already done it and expect to do more.