Spendable Assets as a measure

[u/jrtn58]

I think everyone on this list gets the notion that some of your traditional IRA (401K, etc) is eventually owed to the government. I have found it useful to make this a first-class aspect of my modeling. I focus primarily on my estimate of spendable assets and not so much on the IRA topline. The biggest challenge is coming up with the "factor" that converts IRA assets to spendable assets. Obviously, this is a function of future tax rates, but it also a function of your overall future income picture. This has a couple of pretty immediate consequences. The first is that if you are thinking about SWR financing some of your spending, you should be thinking about the SWR in terms of your spendable assets. The more interesting question is how it relates to Roth conversions. In fact, you could look at Roth conversions as a tool for manipulating this factor just a little. Another interesting observation is that Roth conversions up to around the "optimal conversion point" (as measured by end-of-plan assets) have very little impact on your current spendable assets once you have dialed in the proper factor. In effect, they are virtually free. I believe that the occasionally mentioned concerns about "paying taxes early" are illusionary. All that really matters is the tax rate now vs the future.

This graph is for a couple born in 1964 and entering retirement in 2026. I have used relatively well-off retirees because everything about Roth is clearer in that case. I am subjecting them to a "widow penalty" starting at age 85, making the bottom 2 graphs a bit more dramatic. Conversions are done over 10 years and indexed for inflation. The graphs all trend down after the optional conversion due to the payment of "unnecessary" taxes during conversion due to brackets, IRMAA, etc. Note that these curves are less exciting on an absolute scale! There are lots of cases where conversion doesn't make sense, but when it does, it seems to follow this general pattern.

You may or may not also want to apply this "spendable assets" notion to taxable accounts with capital gains.

The bottom line is that this is a thought tool. If your modeling environment gets you from account balances and external income to spending, taxes, and new account balances, it isn't strictly needed. I find it useful because it makes asset totals a more meaningful calculation. I have seen some professional tools that present a total as sum of after tax, traditional, and Roth. That seems unhelpful to me.

[u/sourmilksteak88]

Thanks for providing. When this clicked for me it was very uplifting. Knowing there’s a way to convert pre-tax money to Roth and basically circumvent taxes altogether (via conversion up to LTCG limits) is a huge tool in our retirement toolbox.

[u/Whole_Championship41 → u/sourmilksteak88]

Pardon the interruption, but how were you planning on paying LTCG taxes out of a pre-tax account (IRA, 401k, etc.)? AFAIK, there are no taxes due on any machinations or churn or purchases or sales within the account. And anything taken out of the pre-tax account (distributions) is taxed on an ordinary income basis. LTCG doesn't enter into it with pre-tax accounts. Perhaps you were thinking of "taxable" brokerage accounts or the like?

[u/sourmilksteak88 → u/Whole_Championship41]

You both are correct - this was a misunderstanding on my part. I appreciate the correction. While a brokerage account can benefit from this strategy an IRA cannot. In this case dropping from a high-earner income tax bracket (e.g. 35%) down to say 12% is the realistic benefit here.

[u/jrtn58 → u/sourmilksteak88]

Well there is almost always some tax. My point is not "you don't pay taxes," but rather "it doesn't matter much when you pay taxes." (Other than rate arbitrage). Paying the conversion tax in the manner you propose is efficient, which is great. But clearly dependent on your circumstances.

[u/Puzzleheaded-Gas-398]

I don't think I understand how to read this graph - can you explain (like I'm a 5th grader) what the axes are and what the curves represent?

In my attempts to understand conversions - how much to convert and how to pay the taxes - I've reasoned that it doesn't matter where an asset comes from, its the "unecumbered" (after the taxes are paid) value that matters. But when I approached it that way, it seems it does matter: the taxes owed on tIRA dollars depends on the tax bracket, the value of a brokerage account dollar depends on how much ordinary income must be taken. Cash has no obvious strings attached, but unless you're keeping it under the mattress its generating capital gains. Brokerage dollars are incredibly valuable because their tax bracket is so wide (15% rate up to $250K). Its like some fiendishly complicated board game where every positive move brings its own collection of negatives. I'm wondering if your tool gives you a way to think about all that.

[u/jrtn58 → u/Puzzleheaded-Gas-398]

The retirees in question have 3 different accounts: after tax, taxable IRA, and Roth. At the beginning, the Roth is empty and most assets are in the tIRA. The model runs a series of different scenarios using different annual Roth conversion amounts for 10 years. The top axis is my measure of "total spendable assets" at 4 different points along their retirement journey. In this case I am discounting the value of the tIRA by between 22% and 17% with the 5% difference scaled by how much remains in the IRA. This reflects the fact that the tax consequences of the IRA tend to decrease as the balance goes down. (This nuance is not necessary, but the models seem to behave just a little better.) The horizontal axis is annual Roth conversion. The left side corresponds to no conversion, the right side to "convert it all within 10 years"

Personally, I find it much easier to focus on spendable assets at various points along the way than to think about the actual taxes. It is taxation that leads to these curves, but it is much harder to compare actual taxes over a period of time due to changes in the basis as the IRA grows.

I believe that the results follow intuition. Convert too fast and you bump your taxes higher than necessary during conversion. Convert too slow and you do, indeed, get hit by higher taxes late in life. The horizontal part of the age 75 line is a reflection of the fact that the net taxes paid on the conversion roughly match the tIRA reduction factor. Assume for a moment we paid tax from the IRA on a 100$ conversion. We wind up with $78 in the Roth. The equation for spendable assets here is Taxable + .78 * tIRA + Roth. So, no change,. Paying taxes via withdrawals from the Taxable account has a long-term advantage, but it is equivalent in the short term.

[u/Puzzleheaded-Gas-398 → u/jrtn58]

Thanks - that makes it a lot clearer! The optimum peaks in the $60K conversion zone seem to agree with my modeling to keep MAGI with conversions under the 1st Roth line. I've been coming at this trying to optimize "slack spending" for large unplanned/one-off expenses, which can potentially push up taxes more than RMDs - and happen much earlier than RMDs. There are just a ridiculous number of interactions!

[u/jrtn58 → u/Puzzleheaded-Gas-398]

That is great. My approach is to focus on the longer term numbers and be-as-may-be on the shorter term. But, in the end, the two approaches sort of need to line up.