I showed how to estimate the effect of Roth conversion and capital gains when you get health insurance from the ACA marketplace in the previous post Roth Conversion and Capital Gains On ACA Health Insurance. Some readers expressed interest in seeing the same for retirees on Social Security and Medicare.
Roth Conversion for Retirees
When you do a Roth conversion, you transfer an amount of money from your pre-tax account to your Roth account. This makes you pay taxes on the transferred amount now in the hope of avoiding paying taxes at a higher rate in the future. It’s a form of prepayment.
As in other situations of prepayments, sometimes it makes sense to prepay, and sometimes it doesn’t make sense to prepay. You convert to Roth and prepay taxes now when you think your tax rates in the future will be higher than your tax rates now.
You need to know what tax rate you pay on your Roth conversion in order to judge whether it makes sense to convert. The tax rate you pay on your Roth conversion depends on how much you convert. Conversely, if you set a limit on the tax rate you’re willing to pay on a Roth conversion, you need to know how much you can convert before you hit that maximum tax rate.
Case Study Spreadsheet
My favorite tool for this type of planning calculation is the Case Study Spreadsheet created by user MDM on the Mr. Money Mustache forum. Using downloaded tax software also works, but tax software for the current year usually doesn’t come out until November or December and it’s often incomplete pending updates at that stage. The Case Study Spreadsheet is updated much sooner.
It’s an actual spreadsheet file, not an online one. You will need Microsoft Excel or compatible software to open it. As with anything downloaded from the internet, you will have to trust the source. I had some interaction with the author over email. I trust this spreadsheet.
The spreadsheet does a lot of things. It looks overwhelming if you are only looking for one feature out of many. I will show you how this spreadsheet calculates the effect of Roth conversion when you are on Social Security and Medicare. I used version 22.06a released on November 26, 2022.
Download the Spreadsheet
The link to the most recent version of the spreadsheet is in the first post in the Case Study Spreadsheet updates thread in the Mr. Money Mustache forum. Click on the link and choose File -> Download to save the file to your computer. Make a copy of the spreadsheet and only work with the copy. This way you can always start fresh from another copy of the original spreadsheet to model different inputs.
If your computer uses Windows, right-click on the copy in the file folder and click on Properties. Check the Unblock box to enable macros in the spreadsheet.
Open the copy in Microsoft Excel or a compatible program. Click on Enable Editing in the yellow ribbon you see in Excel.
Scenario – Married Filing Jointly
I’ll use this scenario of a married couple as the first example.
A retired couple, both age 66, Florida residents, married filing jointly with no dependents. They live on $60,000 of Social Security benefits, $20,000 of Traditional IRA withdrawals, $5,000 of interest income, and $10,000 of qualified dividends. They have no other income or deductions. Both of them enrolled in Medicare Part B and Part D.
They’d like to know how it affects their taxes if they convert different amounts from their Traditional IRA to Roth.
Age and Filing Status
Click on the Calculations tab at the bottom of the spreadsheet. First, you enter your filing status, your number of dependents, and ages in green-shaded cells starting at cell G2.
You go down to cell H37 to enter your state of residency.
Income and Medicare
Next, you enter your income. Because the couple in our scenario are both retired, we skip the paycheck items and go down to the non-paycheck income starting at cell D23. You only input into cells shaded in green. Use annual numbers here.
Because they’re both on Medicare, we enter their Medicare Part D premium in cell AF78. This is the monthly premium for one person. If they’re on different Part D plans, use the average premium of the two plans. Here we assume their monthly Part D premium is $40 per person.
Now we go back to the tax calculation area starting at cell F11. This shows their baseline income taxes.
This retired couple with a gross income of $95,000 pays $2,015 in taxes. That’s only a little over 2% of their gross income.
Explore Roth Conversion
This couple is interested in doing Roth conversion to take advantage of their low tax rates. Scroll down to cell F81 to see a chart like this:
It shows the marginal and cumulative tax rates at different amounts of withdrawals from their Traditional IRA. The number on the X-axis includes the $20,000 they’re already withdrawing from their Traditional IRAs for living expenses.
We make a few tweaks to see the chart better.
Adjust the Chart Scale
By default, the Y-axis in the chart goes between -50% and +50%. The bottom half of the chart is empty right now. Select the Y-axis in the chart, right-click, and click on Format Axis… Set the minimum to 0 and the maximum to 0.6. It will use the full space for the chart.
Set the Starting Point
Because this couple already withdraws $20,000 from their Traditional IRAs for living expenses, we can set the starting point at $20,000 to evaluate only withdrawals above and beyond $20,000 for a Roth conversion. Enter 20,000 in cell P84. Now the chart looks like this:
It shows that converting about $25,000 (to take the total withdrawal from Traditional IRAs to $45,000) will incur a marginal tax rate of about 22%. Then the marginal tax rate spikes up to 50% before it settles down to 22% again when the total withdrawals hit about $55,000.
The spike is the so-called tax torpedo, which happens when additional income makes more of the Social Security benefits taxable (see previous post Calculator: How Much of My Social Security Benefits Is Taxable?). Although the 50% marginal tax rate looks scary, it applies to only a sliver of their income. As they increase their Roth conversion to $90,000, the effect of the “tax torpedo” gets spread out. It only causes a slight increase in their cumulative tax rate (the blue line) — from 22% to 23%. The “tax torpedo” is more like a small ding than a torpedo for this couple.
Extend the Range
Increasing the number in cell P83 will extend the X-axis in the chart to larger numbers. For example, changing cell P83 to $700 makes the chart look like this:
The next four spikes in the marginal tax rate (the gray line) represent Medicare IRMAA. Point your mouse at points before the blue line jumps up. You’ll see the total Traditional IRA withdrawals and the cumulative tax rate associated with each jump. Subtract the baseline Traditional IRA withdrawals for living expenses from the total Traditional IRA withdrawals to get the amount for Roth conversion.
The chart shows they’ll pay about 23% in taxes on their Traditional IRA withdrawals if they convert $115k before their income hits the first threshold for IRMAA. The cumulative tax rate will be 24% if they convert $165,000 and stop before the second IRMAA tier, 26% if they convert $230,000 and stop before the third IRMAA tier, and so on.
|Break Point||Roth Conversion Amount||Cumulative Tax Rate|
|Before “tax torpedo”||$25,000||22%|
|Before the first IRMAA tier||$115,000||23%|
|Before the second IRMAA tier||$165,000||24%|
|Before the third IRMAA tier||$230,000||26%|
This couple can decide how much to convert based on the size of their pre-tax accounts and their view of tax rates in the future. Convert more if they have large pre-tax accounts and they think tax rates will be high in the future. Convert less if they don’t have large pre-tax accounts and they think tax rates will be low in the future.
The shape and the breakpoints for your specific scenario will be different. You can follow this example and use the chart to map your own breakpoints and tax rates.
Save the Spreadsheet
You may see a warning like this when you save the spreadsheet:
This is normal. Click on Continue and the spreadsheet will be saved.
Scenario – Single
I’ll do another example for someone in the Single filing status.
A retired person, age 66, Florida resident, single with no dependents, enrolled in Medicare Part B and Part D. She lives on $30,000 of Social Security benefits, $20,000 of Traditional IRA withdrawals, $2,000 of interest income, and $5,000 of qualified dividends. She has no other income or deductions.
Entering 1 in cell G2 for the Single filing status and leave adult #2 blank.
Enter the income in the same green-shaded cells starting at cell D23:
After you adjust the chart scale, set the starting point, and extend the range of the X-axis, the chart looks like this:
The first spike in the marginal tax rate (the gray line) is the so-called “tax torpedo.” The next four spikes are due to Medicare IRMAA. Point your mouse at points before each jump in the blue line. You’ll see the total Traditional IRA withdrawals and the cumulative tax rate associated with each jump. Subtract the baseline Traditional IRA withdrawals for living expenses from the total Traditional IRA withdrawals to get the amount for Roth conversion.
Here are the corresponding breakpoints and tax rates:
|Break Point||Roth Conversion Amount||Cumulative Tax Rate|
|Before “tax torpedo”||$8,500||22%|
|Before the first IRMAA tier||$48,000||25%|
|Before the second IRMAA tier||$74,000||26%|
|Before the third IRMAA tier||$105,000||27%|
|Before the fourth IRMAA tier||$135,000||27%|
She can decide how much to convert depending on the size of her pre-tax accounts and her view of tax rates in the future. Convert more if she has large pre-tax accounts and she thinks tax rates will be high in the future. Convert less if she doesn’t have large pre-tax accounts and she thinks tax rates will be low in the future.
Again, the shape and the breakpoints for your specific scenario will be different. You can follow this example and use the chart to map your own breakpoints and tax rates.
The Case Study Spreadsheet is an excellent tool to explore how converting different amounts to Roth affects your taxes, but the part of the spreadsheet used in this post shows only the current year. It doesn’t show the effect of doing so over many years.
For example, you see that you will pay X% in taxes if you convert this much now, but you don’t know whether converting more (or less) would be better in the long run when you take into account the size of your pre-tax accounts, your age, your spending needs, investment returns, your Required Minimum Distributions (RMD), etc., etc. You’ll have to decide yourself whether paying X% in taxes on Roth conversion is “worth it.”
Other software tools such as Optimal Retirement Planner (ORP), Retiree Portfolio Model (RPM), and Pralana Gold look across multiple years based on a set of inputs and assumptions to suggest an amount you should convert to Roth each year. The big question is whether those inputs and assumptions will hold true.
Mike Piper, CPA made a good argument against projecting out too many years in his blog post Long-Term Tax Planning Requires Guessing. Focus on the Near-Term. The future can’t be predicted precisely. Your spending needs will change. Investment returns may be strong or weak. Tax laws change. You won’t know what your tax rates will be in the future.
I see a good reason to only look at the current year with the Case Study Spreadsheet. The decision won’t be “optimal” but trying to “optimize” may be only chasing rainbows. I strive to banish the word “optimize” from my financial life and from life in general.
The purpose of a Roth conversion is to take advantage of low tax rates. If your retirement is dicey, the best Roth conversion strategy won’t cure it. If your retirement is secure, a reasonable attempt at Roth conversion is only trying to make an already good situation better. So don’t get stressed out when you don’t know how much you should convert. You can use the Case Study Spreadsheet to find a reasonable answer for the current year.
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Thanks so much, Harry! I love all your articles, and this is exactly what I need to help my mom decide how much is reasonable to convert each year.