Wall Street Is Getting Roth Conversions Terribly Wrong

Optimal Roth Conversions Are Extremely Non-Linear Making Global Search, Not Rules of Thumb Essential

Photo by Nareeta Martin

Non-Linearity Is Our World — Physically and Financially

Non-linear is math speak for Go Big or Go Home. Non-linear problems and their solutions are everywhere. Some examples:

• We take antibiotics in large doses for a few days and for good reason. Prolonged, small doses promotes resistance. The former kills infection. The later can kill us.

• Space X, the largest rocket yet built, uses 33 engines, all fired at once, to escape earth’s gravity.

• When it’s 20 below zero, we don every bit of our extreme-weather gear before heading out the door. We don’t add layers as we’re walking to the subway.

• The Japanese attacked Pearl Harbor with everything they had and all at the same time, not bit by bit.

• Financial panics feature everyone running, not walking, to retrieve their money.

Wall Street’s Roth-Conversion Strategy Makes No Sense

Wall Street thinks that the optimal Roth-conversion strategy is to equalize federal marginal tax brackets across current and future years. This is called “bracket bumping” or “filling up tax brackets” or “equalizing marginal tax rates”.

Fidelity’s Roth Conversion Calculator, Vanguard’s Roth Conversion Calculator, and New Retirement’s Roth Converter are examples of the hundreds of tools implementing this “solution.”

Equalizing tax brackets is up there with running Space X’s engines one at a time and expecting it to budge. The reason is that determining the Roth conversion plan that minimizes lifetime taxes is an extremely non-linear problem. I’ll expand on this, but let me first point out that marginal federal tax brackets aren’t even well defined.

Marginal Tax brackets Aren’t Well Defined — Three Examples

Social Security Benefit Taxation

If your Social Security benefits are taxable, an extra dollar of non-Social Security income can add an extra 50 or 85 cents to your taxable income. If your marginal federal tax bracket is 22 percent, your true (effective) marginal federal tax bracket will be 40.7 percent if the extra taxable dollar adds 85 percent of 22 percent to your otherwise 22 percent marginal rate.

But doing a large Roth conversion could push you into, say, the 32 percent bracket and also make 85 percent of all of your Social Security benefits taxable. This would leave you facing zero marginal Social Security benefit taxation since all of it’s been taxed already.

In this case, your nominal marginal federal bracket rises from 22 percent to 32 percent, whereas you effective marginal federal bracket falls from 40.7 percent to 32 percent. Based on one definition of “the” marginal tax bracket, the conversion may have equalized or helped equalize tax brackets over the years. Based on another, it may have done the opposite. Hence, I have no idea what it means to equalize marginal tax brackets.

The IRMAA Tax is Discontinuous

The IRMAA is a nasty tax familar to everyone on Medicare. It’s called the Part B Premium and Part D Basic Premium. Paying the IRMAA doesn’t provide higher benefits or lower drug costs. It’s just a tax that’s called a premium.

But its not just a tax disguised in sheep’s clothing. It’s a super weird tax. First, it’s based on Modified Adjusted Gross Income (MAGI) two years in the past. And it’s a special measure of MAGI — one of four.

The even crazier thing about IRMAA is that its tax schedule is highly non-linear. Suppose, for example, that you’re 68, single, in the 24 percent marginal federal tax bracket, and taking Medicare. In this case, having a MAGI of $161,000 back in 2022 forces you to pay $2,496 in IRMAA tax this year.

But what if your 2022 MAGI had been just $1 more, i.e., $161,002? Now, this year’s IRMAA tax is $3,999. That’s a $1,503 increase in taxes for a $1 dollar increase in IRMAA’s measure of taxable income. (In this case, “Going Big” by adding an extra dollar to your 2022 MAGI hardly requires doing anything to produce a massive impact. This is why I’d describe the IRMAA as extremely non-linear.) The marginal tax rate on that extra dollar is over 15,000 percent!

Moreover, the marginal IRMAA tax on adding, back in 2022, an extra dollar to the $161,002, i.e., increasing your IRMAA MAGI from $161,002 to $161,003, is zero (the extra dollar doesn’t increase your IRMAA tax ),returning the effective federal marginal tax to 24 percent. Hence, earning one more dollar can, in this example, move you from a 24 percent bracket to over a 1,500 percent bracket, whereas earning two more dollars lands you back in the 24 percent bracket.

So, what does it mean to Roth convert to equalize marginal tax brackets? Should one just ignore the IRMAA tax? Doing so would be nuts. But, here’s the rub. You can be in one tax bracket for the federal income tax that holds for tens of thousands of dollars of additional taxable income, a dramatically higher tax bracket for IRMAA that holds for a range of $1, and in one of 12 tax brackets if you live in Hawaii. Even if you wanted to, you can’t simultaneously use Roth conversions to equalize nominal federal tax brackets, effective marginal federal tax brackets, IRMAA tax brackets, and, if you, say, live in Hawaii, Hawaiian state income tax brackets, of which there are 12, across all years.

Lifetime Versus Annual Marginal Tax Rates

Suppose you find a Roth conversion plan that equalizes your annual tax brackets across all future years based on some measure of marginal tax rates that pleases your fancy. You won’t have equalized marginal lifetime tax rates.

Here’s why. If you earn or receive $X more in income this year, you’ll save some of it unless you are severely cash-flow constrained. But this means the extra $X will come with higher future taxes whose present value needs to be included in calculating this year’s marginal tax. In short, if equalizing, over time, marginal tax brackets, based on a given Wall Street firm’s favorite definition of the marginal tax rate, is the goal, wouldn’t it make more sense to equalize each year’s present value lifetime marginal tax rate?

Optimal Roth Conversion is a Tough, Non-Linear Problem

Equalizing marginal tax brackets, however defined, is not the goal of Roth conversions. The goal is to minimize total lifetime taxes, measured in present value, so as to maximize lifetime spending, measured in present value, including what one chooses to leave one’s heirs.

Very large conversions this year and in the near term can dramatically impact all of your future federal income taxes on labor and asset income. Depending on your state, they can dramatically impact all of your future state income taxes. They will also impact all of your future required minimum distributions (RMDs) from non-converted, tax-deferred retirement accounts. They will potentially impact all of your future Social Security benefit taxation. And they will potentially impact all of your future annual IRMAA taxes.

The all in these sentences is crucial. If I pay a lot more taxes this year, even if doing so lands me in the 37 percent federal tax bracket, it may be worth it if it lowers all my future federal and state wage- and asset-income taxes, all my future state income taxes, all my future Social Security benefit taxes, all my future IRMAA taxes, and all my RMDs.

The reasons are that Roth conversions today mean Roth withdrawals or bequests tomorrow, which don’t count as federal taxable income, don’t count as state taxable income, don’t count as MAGI for purposes of subjecting more Social Security benefits to taxation, don’t count as a different MAGI for purposes of determining IRMAA taxation, and lower RMDs, each dollar of which is subject to federal and state taxation and also count for the MAGIs determining the federal and state taxation of Social Security benefits and IRMAA taxation. And, for a little icing on the cake, a lower Social Security MAGI-taxation measure means a lower IRMAA MAGI-taxation measure.

To hit the nail on the head, large, short-run Roth conversions produce large-scale/non-linear present value lifetime tax savings because the benefit of taking one’s medicine now — paying far higher taxes in the short-run — has a multiplied effect, where the multiplier is the number of years you will be paying far lower taxes.

MaxiFi Gets All this Right and Its Solution is NOT Equalizing Federal Brackets

As I’ve discussed in prior newsletters A and B and in this podcast with economist and CFP, Jay Abolofia, my company recently rolled out MaxiFi Planner’s fully integrated Roth Conversion Optimizer. MaxiFi Planner is our economics-based, lifetime financial planning software. (As discussed here, the differences between economics-based financial planning and conventional (Wall Street) financial planning are profound and deeply troubling.)

Finding the highest peak in the abstract mountains pictured above requires comparing the heights of each. Economists call this global search. MaxiFi’s Roth Conversion Optimizer does global search to find the path of annual Roth conversions that minimizes a household’s lifetime taxes. (MaxiFi also lets you robo optimize over Social Security benefit-collection decisions as well as when to start smoothly withdrawing non-Roth retirement funds.)

I’ve now run MaxiFi’s Roth Conversion Optimizer for enough households, including my own, to clearly state that equalizing tax brackets is definitely not what the problem calls for. In my own and my wife’s optimal conversion plan, our marginal tax starts at 37 percent and declines, over the years, to 10 percent.

I was quite surprised that the program was suggesting any Roth conversions for us, let alone that we convert over half of our tax-deferred assets in the near term. After incorporating its recommendations in a new profile, I made yet another profile where I modified the conversion recommendations in various ways — all to see if doing less or more conversion and changing the timing would produce a better outcome — higher lifetime spending. I found nothing that beat the Optimizer’s conversion recommendations. I wasn’t surprised. I’d tried beating the Optimizer manually for many other households — also with no success.

The other surprise is how much tax savings the Optimizer generated — close to $150K! I’m not a spring chicken. But I’m still decades away from my assumed maximum age of life — 100. (My mom passed at 98.) Also, my wife is younger by eight years. Hence, the non-linear positive impact of enjoying many years of gain at the smaller cost of relatively few years of pain holds even for people getting old enough to be President.

Everyone, no matter their age, should run MaxiFi’s Roth Conversion Optimizer. It’s ability to handle so many factors concurrently, coherently, and internally consistently is testament to the enormous power of economic-based computation algorithms on which I and thousands of economists have worked for years — algorithms that provide precise, verifiable answers, not anyone’s AI guesstimates.

PS, Getting Roth conversions right is important. MaxiFi generates very precise annual conversion schedules. It you deviate dramatically from the tool’s recommended lifetime total conversion amount and its recommended age-pattern — and you can run the program including such deviations to check what I’m saying, you’ll surely dramatically lower your lifetime tax savings from Roth conversions. Indeed, you can easily end up raising your lifetime taxes.

In this regard, I encourage households who have come up with a given Roth conversion plan — maybe one based on some method of bracket equalization — to use MaxiFi and enter their plan manually in a separate profile. Then compare it with a profile with no conversions and the one with MaxiFi’s recommended conversions. This will show you how much you are either raising your lifetime taxes or how much in lifetime tax savings you are leaving on the table. If you are letting an advisor — one of our nation’s hundreds of thousands — use their favorite conventional planning tool on you or they are being forced to use such a toll by their big Wall Street firm, insist they run you through MaxiFi and show you the difference in lifetime tax savings.

Last but not least. The future is uncertain. MaxiFi does deterministic planning for purposes of suggesting appropriate saving, spending, life insurance, Social Security, retirement, Roth conversion, downsizing, job-switching, career choice, education, and many other decisions.

MaxiFi does stochastic planning for purposes of helping you assess your investment decisions. This entails running and comparing Monte Carlo simulations for different investment strategies. The comparison is based on MaxiFi’s Comfort Index. For econ and fin-tech nerds, this references lifetime expected utility maximization, which goes miles beyond the work of Markowitz and Sharpe by implementing the lifetime investing frameworks of Merton and Samuelson.

Economists call deterministic planning risk-adjusted or certainty-equivalent planning. This simply means making conservative assumptions about the future. MaxiFi’s Roth Conversion Optimizer is part of its deterministic planning. It entails forming a conservative plan given what your know at the moment and, this is critical, stress-testing your plan by making different assumptions about the future, such as different assumptions about future tax increases. It also entails updating your plan at least annually as the future reveals itself.

Yes, it would be nice to do lifetime expected utility maximization that incorporates all, not just, investment-return risk. An example here is the risk of both higher and lower future taxes or Social Security benefits But doing so is a practical impossibility. For starters, no one knows the likelihood of particular future fiscal policy changes, let alone their timings, magnitudes, or precise natures.

Hence, when it comes to Roth conversions and many other decisions, the best we can do is plan cautiously based on stress testing and keep updating. Making decisions based on average outcomes of stochastic draws — as some very prominent tools do — is something an actuary would do, but every well-trained economist would abhor.

We don’t consider the average size of house fires, when we buy homeowners insurance. Instead, we focus primarily on the worst-case scenario — our house burning down. This is why we purchase full (catastrophic) coverage. Stress testing worst-case deterministic plans lets you consider what you most care about — totaling your car, not having a fender bender. In the context of Roth conversion, worst cases would include the highly unlikely prospect of taxes being reduced in the future or the highly likely prospect of the Tax Cut and Job Acts being renewed, not sunset after next year as current law provides. MaxiFi lets you make alternative assumptions about future tax and Social Security policy within as many profiles as you wish to build and compare.

PPS, Nothing, by the way, against actuaries. Economists are, as the saying goes, people that are good with numbers, but don’t have the personalities to be actuaries.

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Testimonial from Rick Miller, a financial advisor, PhD economist, and RIA.

MaxiFi is the next generation. MaxiFi’s dynamic programming provides the most accurate forecasts and projections of any financial planning product I’ve seen and is essential to our ability to deliver accurate financial advice. The Monte Carlo approach is uniquely theoretically sound, providing guidance about the impact of different investment outcomes on spending decisions. The web-based user interface is clean and intuitive. The program is stable and there is excellent technical support. Since our founding in 2002, using this product and its predecessor for financial planning, we’ve delivered hundreds of financial plans and our clients find our financial advice persuasive and compelling

Rick Miller, PhD, CFP^®, Founder and CEO, Sensible Financial Planning and Management, LLC, Waltham, MA

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Testimonial from Kevin Esler, author of tipsladder.com, and one of our tens of thousands of household clients. Here’s a podcast I did with Kevin on his amazing tool.

I have been using MaxiFi for a number of years now, as I approach retirement. It has given me confidence and insights about how to set myself up for a secure retirement. it is easy to use and very reasonably priced. It is also regularly updated to keep up with tax law changes and even with changes in economic outlook. It's "year at a glance" projections and other reports are invaluable for understanding likely future tax liabilities, Like most people planning retirement I use a number of different tools, but MaxiFi is the single most valuable one in my toolbox. Heartily recommended. My "desert island" retirement planning tool.

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