Tom Martin
[Editor's Note: This is a guest post from Tom Martin, CFP®, CPWA®, AIF® and Andrew Parker. They work for Larson Financial Group, LLC, a physician-focused financial advisory firm with numerous branches across the country. We have no financial relationship, although you may recall the review I did of Tom's book, Doctors Eyes Only a few months ago. Like all posts on this site, this information is for educational and entertainment purposes only, NOT TAX ADVICE. Neither I nor the guest posters are responsible for the consequences, financial or otherwise, of your actions based on information you read here.]
With December 31st right around the corner, now is the time to consider some important year-end tax moves. These two potentially tax-saving strategies could help reduce thousands of dollars in unnecessary future taxes.
Andy Parker
Strategy #1 – Use your AMT tax exposure to lower your Roth IRA conversion tax rate
If, like many physicians, you find yourself regularly having to pay Alternative Minimum Tax, this may present you with an opportunity to convert your Traditional IRA to a Roth IRA (or a portion of it) at a lower tax rate of 26% or 28% instead of a future potential tax rate of 40%+.
Doesn't Apply If You Don't Pay AMT
To check your own situation, check line 45 [AMT Tax line- ed] on your 2011 Federal 1040. If you have an amount greater than $0, this strategy may apply. If not, and little has changed for your taxes from last year to this year, don’t waste your time with this strategy.
Presently many physicians fall into either the 33% or 35% marginal tax bracket. That means on the next dollar of income you earn, you would owe this percentage in taxes. A conversion from a traditional IRA (funded with pre-tax dollars) to a Roth IRA is normally taxed at your marginal income rate. However, if you are being hit with AMT, your marginal rate is actually the 26-28% AMT rate, instead of the higher 33-35% rate. It's important to understand the difference between effective and marginal tax rates when contemplating any Roth conversion, of course.
The Strategy
If you are being hit with AMT, when you convert your traditional IRA to a Roth IRA, as long as the dollar amount on the AMT line of your tax return remains positive, you are actually paying 28% or less on the conversion, regardless of your marginal tax rate.
How to do it:
- Have your CPA or tax program run a proactive projection of what your 2012 tax return should look like.
- If you find yourself with anything on the AMT line (line 45 for 2011 but could change for 2012), have your CPA or the program build in an IRA conversion.
- If the amount in the AMT line goes to $0, you have converted too much, and part of your conversion is being hit with your marginal tax rate instead of the lower AMT rate. Note: This isn’t always a bad thing, but the analysis on whether a non-AMT Roth conversion makes sense or not is beyond the scope of this post.
- If this happens, rerun it with a smaller conversion amount. Keep doing this until you get a value in line 45 greater than $0. This will show that you are paying the lower AMT rate (maximum of 28% on your conversion).
With marginal rates probably rising in January, [Congress is wrangling over the “fiscal cliff” as this is written-ed] this could save you as much as 12% in Federal tax on your IRA conversion. Remember that after converting, the funds in the Roth IRA should grow on a tax-free basis moving forward, and you should be able to pull these funds out tax-free for retirement, provided you follow the IRS guidelines. Learn more about the AMT in our upcoming post.
Some Criticisms/Caveats – An Editorial Note
A few criticisms of this technique are appropriately inserted at this point. First, if you're doing Backdoor Roth IRAs each year, you've already gotten rid of your traditional IRAs by either rolling them into a 401K or converting them (at whatever rate.) If you still haven't converted them, you might save a little on the conversion if you would otherwise pay AMT, but that benefit is probably far smaller than enabling yourself to do Backdoor Roth IRAs going forward.
Second, you should always question the wisdom of converting at such a high rate. While converting at 26-28% is better than converting at 35% (or more), there is a decent chance you'll have the opportunity to convert later at a lower rate, perhaps during a sabbatical, during a period of disability or lower earnings, or during the first few years of an early retirement.
Last, “locking in” a conversion at a rate likely to be much higher than your effective rate in retirement might not turn out to be wise. Remember that a retired couple taking the standard deviation doesn't even hit the marginal tax rate (much less the effective tax rate) of 28% until they have $143K+ of taxable income. Obviously, the more you make and the more income you expect in retirement, the better this technique will be for you. This could be a very good idea for a two-physician family with a gross income of $600K+ and planning on retirement income of $200K+.
Would you consider using this technique? Comment below!
I think this article has a major flaw that pretty much makes this idea just wrong. They are not taking into account that the exemption under AMT (starts at $74,450 for married filing jointly) is phased out as your income increases over a set amount (for married filing jointly this is $150,000). In this phaseout income, the exemption goes down by a total of 25% of every dollar above $150,000.
I do not lose all of my exemption, but a large portion of it. So for me, my last dollar is taxed at 28% plus an additional amount because I have lost part of my exemption. If I did the math correctly, I think this number is an additional 7%. So I am pretty sure my last dollar is taxed at 35%.
Maybe a tax expert can verify this, but I have stared at the AMT a long time trying to understand how it impacts me.
Hi Alan,
You’re not alone in struggling to figure out the calculations behind AMT. This is a fantastic question and a definite consideration people need to pay attention to. I’ll break it down for you further as calculating AMT isn’t overly difficult once you know the formula and I think this will answer your great question.
To calculate AMT:
1. Take taxable income from normal tax return
2. Add all of the following to this (personal exemptions, standard deduction or miscellaneous itemized deductions, State & Local taxes, property taxes, private activity bond interest, depreciation deduction differences, capital gain differences, and incentive stock option add back)
3. This total now equals your AMT income amount.
4. Now subtract your AMT exemption (see note below on this aspect*).
5. The remaining amount is your AMT Taxable Income which is where your 26 – 28% tax rate comes into play.
When it comes to the exemption, Alan is right on that if someone is still in the Phase Out range for AMT (part of the exemption calculation), a conversion of the wrong amount could actually push them back up to the 35% marginal rate (either too big of a conversion or too small of a conversion can trigger this).
There is a sweet spot though, where provided the conversion is large enough, but you remain in AMT, then you should be able to hit that 28% tax rate you’re after.
It’s definitely a case by case basis issue, but for those physicians in the right circumstances it is a nice way to take advantage of AMT to lower the tax rate on the conversion. The White Coat commentary is right on about the effective tax rate issue. A conversion at a 28% tax rate only makes sense if you expect to be in an effective rate of greater than approximately 15%-18% in retirement (effective, not marginal). Otherwise, you would likely come out better by leaving the funds in the Traditional IRA. Please note that the break-even point is not at the same effective tax rate. I’ll see if I can provide the White Coat blog access to a tax calculator that can easily confirm a break-even point on a case by case basis.
Additionally, in a case last week where we used the AMT Roth Conversion strategy for an Orthopedic surgeon, we had him send the unconverted portion of his Traditional IRA over to his 401(k) in order to allow him to begin making Back-door Roth contributions. That was a great solve for the White Coat commentary’s second consideration and might be helpful for others as well. (Sometimes we’ve even set up a solo-401(k) for minimal 1099 income in order to get Traditional IRA dollars out of the aggregation calculation. Even if someone has a 401(k) through their practice, they could still establish a Solo-401(k) for their 1099 income and fund it with a transfer of the Traditional IRA. They wouldn’t be able to fund additional dollars if they were already maxing out their practice’s 401(k) but it is a nice fix for getting rid of Traditional IRA dollars while still maintaining your own investment flexibility).
For your verification, I’d highly encourage you to check out the journal article titled, “Roth 2010 Conversion Strategies: Using the AMT to Lock in Tax Savings” from the Journal of Financial Planning. It’ll give you case study examples that will confirm your question but also show that there is a sweet spot to get back to the 28%.
Here’s a link to the article:
http://www.fpanet.org/journal/BetweentheIssues/LastMonth/Articles/UsingtheAMTtoLockInTaxSavings/
Thanks for providing the excellent follow up question, Alan. I hope this helps answer your question more fully. You’re thinking through the right items for sure!
*The $75,000 exemption you reference is only if Congress passes a patch. They haven’t done it yet for 2012 so right now the exemptions are $45,000 for married couples and $33,750 for single individuals. Note that the patch hasn’t been passed twice previously and Congress has put it in place retroactively prior to tax time in each previously instance. Since Roth conversions can be undone up until October of the following year, we can simply undo it if they don’t provide the patch as expected.
Ok, this makes sense now. Was not trying to be harsh in my comments, I guess I just did not understand how this was helpful. From the examples in the article you linked, It looks like you have to be above the phaseout range for this to work.
Ill be harsh… Wow such potentially flawed advice. Most physicians in amt land are very likely to be in the marginal 35% amt exemption phaseout range. The exact income ranges which pay a 35% marginal rate in amt vary every year because of differences in patch size and exemption phaseout sizes and rates, but for at least tax year 2011 it was a very large income range. According to this forbes article the income range that paid 35% marginal amt tax was from $175,000 to $447,800. Not mentioning this important fact to readers by a professional is rediculous imho.
http://www.forbes.com/sites/feeonlyplanner/2011/12/16/the-alternative-minimum-tax-sweet-spot/
Thanks Rabb,
We’re not ignoring that issue. I think we’ve clearly stated that everyone needs to run a proactive projection to see if this strategy works in their unique situation. As you well know, if someone is getting hit by the 35% AMT, all they need to do is increase their Roth conversion amount and they will eventually pop back over to the 28% rate. We are indirectly discussing this by encouraging a conversion amount that leaves as little AMT exposure as possible while still remaining in it. Most importantly, we have clearly stated that everyone should be running a pro-active projection to make sure that this works in their circumstances.
For many physicians, this is a non-issue as their income is high enough that the Phase Out no longer matters. We’ve facilitated more than a dozen of these conversions in the past couple of months and the Phase Out wasn’t an issue In any of them due to their income and the Roth amount we were able to convert. I’m not suggesting it isn’t an issue to look at, just not one I’ve seen actually matter thus far. Hence, no direct mention in effort to keep the post readable.
Tom,
The income range is over of the phase out is around of income$250,000-$300,000 in most cases (exemption amount/0.25). Not many physicians are over $450,000 taxable income, which is what is the general ballpark needed to get back down to a 28% marginal rate. I personally have been in the 35% range three straight years.
The way I check to see where you are at in marginal rate territory is to just add $100 of income to your last years tax return in your software program of choice and see how much your tax due increases. Subtract $100 just to double check… This catches all the various phaseouts on is in, not just amt exemption.
Absolutely Rabb. I’m in total agreement. All of the AMT Roth Conversions we’ve done thus far this year were for physicians with incomes in excess of $400k. The Journal of Financial Planning article I posted above shows some good income ranges and what happens. Note that to get up to the higher income, we may just need to add more to the Roth conversion amount (which would often be a good thing).
To give one more “footnote”, in light of the patch not being in place for 2012 yet, when we’ve done the Roth conversions, we’ve actually run the calculations both ways (with the patch and without). Then we’ve converted the total amount assuming the patch goes into effect, but we’ve split it into two different Roth IRA pots. One up to the non-patched AMT max (any additional kicks them out of AMT) and the other with the difference to get up to the maximum if the patch is in place.
You can probably guess where I’m headed with this, but the idea is that if the patch doesn’t come through, then we’ll just take the second Roth IRA and re-characterize it back to a Traditional IRA, thereby bringing the client back into the proper conversion amount without the patch in place.
It’s a little tricky, but well worth it for those physicians getting hit with a lot of AMT. I usually encourage people with less than $3,000 in AMT to not waste their time. Too many pitfalls for a small conversion for sure.
Part of what I love about this forum is that we’re able to go to a deep level of discussion. My experience is that what you’re talking about, Rabb, is way beyond the expertise of many CPAs. We actually spent two whole days on the AMT during my University of Chicago training for the CPWA. One example used was for Governor Romney. His income was well beyond what we normally expect to fall into AMT at over $21 million, and yet he was still getting nailed by it ($232,000 of AMT tax). One of the most interesting aspects we found was that his actual tax rate was 17.58% (not the 14% suggested by the media). Its seems his handlers didn’t think that was a point worth arguing…
Keep the discussion going. This is great stuff. I’m wondering if anyone is willing to share how much AMT they are getting hit with each year and which preference items they believe are causing it to happen?
Good discussion so far. I think this issue with the AMT phase-out pales in comparison to the fact that it isn’t wise for most docs to make a Roth conversion at 28%. I’m 37 years old and the maximum federal bracket I’ve ever been in is 28% (although I’ll get into 33% by next year). I have had many opportunities to make Roth contributions at lower marginal rates and I expect opportunities to convert at a lower rate in the future. I also expect to withdraw pretty much all my tax-deferred money at that rate or less. I just don’t make enough money, or plan to have a big enough retirement stash, to justify doing a conversion at 28% plus state tax.
I understand that lots of docs (single, with a high-income spouse, or just higher earners) currently have higher marginal rates. But let’s keep this in perspective. This year a married doc can make $217K a year PLUS all your retirement contributions, exemptions, and deductions and stay in the 28% bracket. Most docs will retire on far less income than $217K a year. Using a 4% withdrawal rate, (and say $30K form SS) that suggests a nest egg in the neighborhood of $4.8M in today’s dollars. Most docs aren’t going to retire on that much. No point in converting at 28% now when you can withdraw at no higher than 28% later.
I hate phaseouts like this AMT one. They’re really quite the stealth tax and make our tax code overly complex in an effort to hide the degree of progressivity of the tax code.
Without the benefit of a time machine, I think it is ridiculous to assume that you or anyone else can know whether converting at 28% or 35% is a bad idea.
Thirty years from now, when I am retired I will have
1.) a very large chunk of change in my and my spouses 401ks. All income derived for this will be taxable. RMDs will factor in.
2.) a rather significant pension (barring collapse, low six figures in 2040 dollars)
3.) a much smaller pot of $ that can either be in trad or Roth IRAs.
None of us know whether, a.) conversion to roths withhout income limits will even be allowed in the future and b.) what sort of taxes will be levied on the higher marginal rates in 2040.
Diversify diversify diversify. That includes across taxability of accounts. It is unlikely that any future tax increases, short of the much feared wealth tax (a living estate tax basically) will catch Roth IRA assets in its crosshairs.
So unless you have a way to make sure that you don’t face potentially higher tax rates in the future (crystal ball?), and unless you have a secret method to avoid paying taxes on your future distributions (and yes I even left out soc security) from traditional pre tax/deferred accounts, there is simply know way to know that placing all of your eggs in one tax basket is goi g to come out ahead.
I like your site but your constant refrain that it makes no sense to conver at 28% let alone 35% would be no different than if you suddenly began touting certain actively managed funds because you knew that the future outcome of these funds would be better than an index fund.
Minimize taxes and costs, and diversify tax costs. The certainty of the Roth income when the time comes to take, or not take, distributions from it is a huge factor hat should not be flippantly ignored!
Obviously my crystal ball is as cloudy as yours. I also agree it is key to diversify between accounts. My Roth accounts are currently about half of my portfolio thanks to maxing them out beginning as an intern, a small conversion, and backdoor Roth IRAs. Since I can only contribute $10K ($11K starting next year) via backdoor Roth IRAs, eventually the Roths will probably be something like 20%-35% of the total.
I have no idea what’s going to happen with marginal tax rates, but I think to do any kind of planning at all I think you have to assume the future will at least resemble the past, and then make necessary changes as things change. For example, if the estate tax exemption goes back to $1 Million this year, a whole lot of docs that didn’t need extensive estate planning now will.
But I think the general principle of taking your tax break now while in your peak earning years is sound. You may be an exception to what I think is a fairly general rule. It sounds like you are likely to have so much income in retirement that you’ll have quite a high marginal tax bracket even then, thanks to your pension, social security, and swollen 401Ks. If you’re looking at $200-300K in income in retirement, it makes a lot of sense to do more Roth conversions even at high rates to maximize diversification. However, if you anticipate retiring on $100K of taxable income, or even less, it just doesn’t make sense to convert at a relatively high marginal rate. I mean, let’s say I retired today and planned on $100K of income a year. I get 25K of my income from SS (85% of which is taxed), 25K from Roth IRA withdrawals, and 50K from traditional IRA withdrawals. What will my effective tax rate on the withdrawals be?
$25K from Roth- $0 in tax
$25K from Social security:
First $3750 is not taxed- $0
Next $11,900+ $3800*2= $19500 (standard deduction and exemptions) $0 in tax
Next $1750 is taxed at 10%- $175 in tax
$50 from traditional IRA
First $15650 taxed at 10%- $1,565
Next $34350 taxed at 15%- $5153
Grand total= $6893, an overall rate of 6.89% and even if you just consider the traditional IRA, a tax rate of 13.4%. I just don’t see the point in doing conversions at 28-35% when I anticipate withdrawing at 13%. Maybe I’ll work until I’m 70 and have a huge 401K, but I just don’t see it happening.
You on the other hand, if you’re anticipating a pension that pays you say $50K and social security that maybe pays you $40K and then 401K RMDs of another $150K, are in a different situation. You’ll use your deductions and fill the 10% and 15% brackets before you ever get to the 401K. So at best you’ll be withdrawing at 25-28%. Obviously at that rate tax diversification, even if done with 28%+ conversions, is a lot more attractive. But my impression is that your situation is a lot more rare than mine. I could be wrong though. Obviously everyone needs to look at their own situation before deciding.
Just one important point of clarification on the discussion about future effective tax rates. When converting to a Roth, the break even point is not the same effective rate in the future. It is actually much less. Why? Because we are taking cash out of a non-qualified account to cover the taxes on the conversion. The taxes that would have been owed in this non-qualified account creates a tax gap that assists the Roth conversion decision.
I think White Coat and Foss are both making great points above. My clarification is to note that the break even point for a 40 year old physician is probably closer to a 15%-20% effective tax rate in the future rather than the same 28% rate. In other words, I’m suggesting that the cost of taxes on the non-qualified account makes the break even point much lower than the current conversion tax rate.
To White Coat’s point, I believe many physicians could still fall under that break even point (see White Coat’s examples above) but I don’t know many higher income physicians that anticipate being under a possible 15% break even point.
I’m still trying to figure our how we can get everyone a good link to the calculator so that you can run the numbers for yourselves. In the meantime, if you give me assumptions, I’m happy to run other examples and post them.
Here is a link to the scenarios I ran: https://www.box.com/s/vugj64w9stgxhu5ltkto
I’m solving for what future effective tax rate is closest to the break even point assuming a conversion at 28%. For this 40 year old physician, the break even effective rate in retirement is 15% (assuming 25% capital gains tax during accumulation) and 20% (assuming 12% capital gains tax during accumulation). Anything higher than the 15%-20% future effective tax rate and the Roth gets better and better compared to a current conversion tax at 28%.
This is all due to the taxes owed on the growth of the non-qualified account. That’s a key variable that is often forgotten in the analysis but can make a huge impact on the decision.
Assumptions as follows (feel free to suggest any changes and I will rerun the analysis and post) for 2 different scenarios:
-40 year old physician
-converting $100k
-paying the $28k in taxes out of a non-qualified account
-SCENARIO 1: 25% capital gains rate during accumulation (calculator doesn’t allow it to be deferred, rather it is realized year by year – which is why I’m also running it at a much lower tax rate in the next scenario)
-SCENARIO 2: 12% capital gains rate during accumulation
-Distributions from age 70 – 95
-8% growth rate during accumulation and 6% growth rate during distribution
-Solve for break-even future effective tax rate in both scenarios
Tom-
I’m not sure I buy the argument that the conversion break-even is lower. Let me see if I can convince myself I’m wrong (which I may very well be) or convince you that you are.
I suppose it really comes down to where you get the money to pay the taxes on a 28% conversion. If you’re taking it out of the traditional IRA, I suppose it would have an even higher break-even than 28% because not only would you be paying the 10% penalty but also losing the equivalent of tax-protected space.
If you use taxable money to pay the taxes (which you should), it seems to make sense that it would be lower because, in effect, you’re adding money to the tax-protected account so it isn’t taxed as much as it would be in the taxable account.
But what we’re really talking about here isn’t about the outside money, we’re talking about the money already in the traditional IRA. So you shouldn’t be doing your calculation on the $100K in a traditional IRA plus $28K in a taxable account, but only on the $100K in the traditional IRA. So let’s look at the numbers.
$100K in a traditional IRA if you don’t convert. 8% returns, 30 years. Just to simplify, let’s assume you withdraw it all at the end of 30 years magically at only 15%. In reality, you’d have to withdraw it over many years to get it out at that rate.
You end up with $855,326. If you withdrew it all at 28%, you’d end up with $724, 511.
Vs.
$100K in a traditional IRA that is now converted to a Roth IRA (and now worth $72K.) 8% returns, 30 years, no taxes upon withdrawal gets you to $724,511.
So I argue that converting the money now in the traditional IRA does NOT have a lower break-even rate. That’s mostly an effect of adding additional money to the account. Now, putting more money into tax-protected accounts is a wise move most of the time, but it adds a confounder to the equation. You’re assuming the investor has no better use for the taxable money than to use it to pay the taxes on the conversion. But what if he isn’t maxing out his 401K or backdoor Roth IRAs? Then which is better? Totally different question. If he takes that $28K he could use to pay his taxes and uses it to put $10K into backdoor Roths (yea, yea, he’d have to roll the traditional IRA into his 401K) and $18K into the 401K, does he make out better than if he’d used it to pay for a conversion?
$100K in traditional IRA converted to $100K in Roth IRA, 8% returns, 30 years= $1,006,000
$118K in traditional IRA, 8% returns, 30 years, 15% tax rate on withdrawals= $1,009,000
$10K in Backdoor Roth IRAs, 8% returns, 30 years, 0% tax rate on withdrawals= $100,600
Total= $1,109,600
So you should really only consider the effects on the money already in the traditional IRA when you discuss the break even point. With respect to the money already in there, 28% now = 28% later. You’re just considering the effect of being able to add the equivalent of more after-tax money to retirement accounts, which although a good financial practice, is cheating on the calculation.
This is the common error that most calculators/people make when considering the Roth, White Coat. You are doing the math properly but I would almost never recommend a conversion where their wasn’t a side fund of non-qualified cash. Causing a 10% penalty on the taxes owed to convert isn’t a good idea and part of the power of conversion is getting non-qualified dollars moved over to the tax-free environment.
I’d submit that unless that was the game plan all along a conversion would hardly ever be appropriate. That’s certainly the way we approach the process with clients. In other words, we have to look at the accounts together to do a fair analysis because they both exist in the client’s situation and we can’t consider the Roth without using non-qualified money to pay the taxes.
You’re right on if we could do a straight conversion without an outside account but that’s rarely advisable so we have to factor in both accounts to get to the right analysis. This is the piece that most calculators ignore in getting to their results. That non-qualified piece is paramount to the whole conversion decision so we can’t ignore it and never would when designing a strategy.
I’d still submit that several physicians could be under that 15-20% effective rate in retirement so no complaints on that front. If they don’t have non-qualified funds to pay the tax, then they shouldn’t be converting.
Hope that makes sense. When the Roth 401(k) came out I actually wrote an article and ignored the non-qualified account saying exactly what your response post is saying. It wasn’t until I started actually assisting in conversions for clients that I circled back to look at it more appropriately based on what was really transpiring in their accounts. Helped change my thought process a bit.
Our real starting point is as follows:
$100,000 (Traditional IRA)
$28,000 (tax liability if we convert)
$28,000 (funds required in non-qualified account in order to convert)
We can’t have a conversion without the non-qualified money (at least it would be foolish to do so in almost all cases) therefore we can’t ignore it in the analysis.
Fair?
I think we both understand what the other is saying. I just feel you’re mixing two separate issues together, and you’re saying “Darn right, because they should be mixed together.” A Roth conversion as generally done does two things for you- it changes a tax-deferred account into a tax-free account, AND it increases the size of the tax-protected account by virtue of adding “after-tax money” to it. The first can be evaluated simply on the basis of the rate of conversion vs the later rate of withdrawal. The latter of course gives you additional tax benefits. If you choose to combine the two, as you have, and comparing it to another course of action, it may be better or worse depending on the other course of action. If you make the other course of action something dreadful, like buying whole life insurance, using it to light cigars, or investing in a taxable account, then using it to pay for the conversion looks pretty darn good in comparison. If the other course of action were contributing it to a Roth 401K, then the conversion doesn’t look so good. I acknowledge that in practice nearly everyone who opts for the conversion has taxable money with which to pay the taxes, but I think there is value in separating the transaction into its two component parts, just to make sure it actually makes sense for you. It never makes sense to do a conversion if you haven’t maxed out your Roth option, and probably doesn’t make sense very often for somebody in their peak earning years who hasn’t maxed out their 401K and other tax-deferred accounts.
Absolutely White Coat! We would definitely want to make sure people have maxed out other options first. Usually we have physicians who have already maxed out a 401(k)/403(b), 457, and their employer is making 401(a) contributions and they are still looking for additional tax shelters for their non-qualified dollars. That’s the common scenario where we’d give a conversion a good look.
Your over-arching Roth conversion warning shouldn’t be overlooked. Even though the break even point is lower in practice, most people/advisors only look at the marginal rate when converting and forget they that they need to compare against an effective/average rate in retirement. That’s a big error and I’m a huge fan of your advice on that point because that’s where people often make a big mistake.
Also, since it is the non-qualified account making the break even point lower, it follows that the longer the time horizon, the more this matters. For those physicians with a short time horizon to spend the money after the conversion, the tax on the non-qualified account won’t matter as much and the conversion break even point will be closer to the marginal rate at conversion.
I’m working with our IT guys today to see if we can get access to the calculator for your site. Then readers can play with whatever variables they want.
All right, this is my final post and then I need to get some work done prior to the holidays. Due to a licensing issue with our planning software, I wasn’t able to share the code to embed it on the White Coat blog.
Instead, I went out on a hunt this morning to find a solid Roth Conversion calculator to link for you. Here’s what’s nuts… almost all of the calculators out there are absolute junk – including those from some respectable sources. The good news is that I finally found a decent one.
THE GOOD CALCULATOR (not perfect because it doesn’t factor in all years of distributions which will add to the Roth outcome but it’s much better than the others below):
TIAA-Cref: https://www3.tiaa-cref.org/iracalcs/conversion_calc.jsp
Note: When it asks for “projected tax rate at retirement” this should not be your marginal rate but rather your effective/average rate. Please read White Coat’s great post on this issue. This is a common mistake that many professionals make when suggesting a conversion. https://www.whitecoatinvestor.com/doctors-dont-pay-50-of-their-income-in-taxes/
Then, make certain you select “Side Account” for number 8. I’ve only had one case where it made sense to pay for the conversion taxes from the IRA itself. You’re wasting a critical aspect of the strategy if you do this and will trigger a 10% penalty tax on money withdrawn from your IRA to pay the taxes on the conversion if you are under age 59.5.
Huge praise to TIAA-Cref for actually getting this one right so many of your competitors have provided such a flawed analysis!
Just for kicks, here are THE WORTHLESS CALCULATORS (for various reasons I believe none of these are helpful in doing a proper analysis*):
Smart Money: http://www.smartmoney.com/calculator/retirement/should-i-convert-my-ira-to-a-roth-ira-1304481621417/
Vanguard (seriously disappointed here!): http://www.archimedes.com/vanguard/roth/RothConsumer.phtml
Close by taxing side account at income tax rate: http://www.calcxml.com/calculators/roth-ira-conversion-calculator
One of the worst: http://www.rothretirement.com/calculator.html
Schwab: http://www.schwab.com/public/schwab/investing/accounts_products/accounts/ira/ira_center/roth/roth_ira_conversion/considerations/roth_ira_conversion_calculator
Fidelity: https://calcsuite.fidelity.com/rothconveval/app/launchPage.htm
Northwestern Mutual: http://www.nmrothiraconversioncalculator.com/
Wells Fargo: http://www.wellsfargoadvantagefunds.com/wfweb/wf/retirement/tools/convert.jsp
Merrill Lynch: http://www.merrilledge.com/retirement/roth-ira-conversion-calc
*Why are these worthless? Various reasons but in general they have one or more of the following problems:
1. They assume the same capital gains rate for the taxable account as the ordinary income rate
2. They automatically calculate the current tax rate based on income alone thereby ignoring the AMT strategy above or any tax deductions that can often lower the marginal rate
3. They are too complex with no added value for the complexity
4. They are too simple and ignore some of the critical variables
Key lesson here: Don’t trust every calculator you find on the internet. Even Vanguard screwed this one up. Sorry Bogleheads!
Just as a quick follow up to this post…
One of my tax profs at the University of Chicago taught me a great lesson. He said, “There are a lot of tax strategies that sound good in theory, but if no one is actually using them, then you have to ask yourself why.” He continued that his main point was that it’s one thing to have a strategy and it’s another thing entirely to have a strategy that is actually workable.
Here’s the good news. Now that we have legislation in place, we’re finally able to see the fruits of this strategy taking shape on our client’s 2012 tax returns.
I’m happy to report that of the dozen clients that used this strategy, thus far, all of them have found themselves at less than 29% on their effective tax rate. In other words, it’s actually working as it should – the key element was making sure that enough money was converted in order to avoid the phase out issue posted about above.
In one great example, we were able to convert $185,000 of Traditional IRA funds for a client, and still keep him from popping out of AMT. His effective tax rate was 28.1% prior to the conversion and 28.3% after the conversion – even though his income was well into the 35% marginal bracket.
Thought I’d share as this may still be a viable strategy for many physicians moving into 2013 taxation.
Found the below link to clarifying:
http://www.forbes.com/sites/anthonynitti/2013/03/11/contrarian-tax-planning-increasing-income-to-take-advantage-of-the-amt/
The key to this planning opportunity is taking advantage of the maximum AMT rate of 28%. Note, however, that while the 28% rate kicks in at AMT income of $179,500, the rate is actually 35% until the taxpayer is fully phased out of their AMT exemption. This is because for each dollar of AMT income the taxpayer earns in excess of $179,500, the taxpayer loses 25% of their exemption, subjecting even more AMT income to tax. Thus, on each dollar of income in excess of $179,500, the AMT rate is 35% (28% + (25% * 28%) until the exemption is completely eliminated.
Once the exemption is fully phased-out, however, the next dollars of income are taxed at a pure 28% tax rate. It is this amount – specifically, AMT income of $477,100 for married taxpayers in 2013 – that signify a taxpayer’s “floor.” Importantly, each dollar of income the taxpayer earns in excess of this floor will be taxed at a flat 28%.
The Ceiling
Of course, this opportunity has a ceiling as well; specifically, that point at which the taxpayer’s regular tax liability first exceeds the AMT liability. Once the taxpayer reaches this point, any additional dollars of income will no longer be subject to the AMT, but rather to the regular tax rates at a maximum marginal rate of $39.6%, or 40.78% when factoring in the phase-out of itemized deductions.
Awesome link. Thanks for posting, Larry!
[Comment edited in 6 of the 7 places it was placed on my website. The original was left up on the Larson Review post. Christopher- I’m sorry you had a terrible experience and obviously feel a need to warn other doctors about your bad experience. I would caution you on two points:
#1- Don’t spam my website or I’ll just block your IP address. Don’t place the comment on a half dozen different posts nor in multiple places on the same post.
#2- Keep things factual. If you stick to the facts and clearly identify your opinions and feelings, you’ll keep both of us out of trouble with regards to libel laws. Larson in particular takes these sorts of comments very seriously.]
This is a great analysis and still a valid strategy if you are in AMT as of 2016! The best way to figure this out is just to do a gedanken experiment. That is play a what-if game on TurboTax and change 1040 line 15A to show an IRA distribution (which will be converted to Roth with form 8606). Just enter an amount for the conversion on line 15A and see how much your total tax goes up. For me at least it was always 28%. …
This is counter-intuitive as I’d assumed I would pay the highest marginal rate (39%) on the conversion. But in fact the amount of AMT I owe actually goes down … even as my AGI is going up! The AMT goes down precisely enough to bring my net effective marginal rate to 28%.
No all Tom’s other caveats apply on whether or not its wise to do the conversion (I’m still going to wait until I’m retired, save up some cash, and convert in the early years when I can show very low income). But great to no the actual effective marginal rate I should use for the conversion is 28% not 39%. Makes the analysis quite differrent!