Anyone dig into the McQuarrie study into Roth conversions?
In another thread I started to ask about "wash" Roth converesions, I was pointed to this document by Edward McQuarrie https://www.financialplanningassociation.org/learning/publications/journal/MAY23-arithmetic-roth-conversions-OPEN
This paper famously paints Roth conversions as being of limited value. I had seen this paper referenced in the past, but didn't know enough about the workings of Roth conversions to really understand the math. Looking at it again, it made a little more sense, and I tried making a simple spreadsheet to better follow how the math worked (the math in the paper is relatively straightforward and easily translated into a spreadsheet). I certainly don't have the mathematical rigor that Mr. McQuarrie used, but I think I found a problem with the reasoning behind the arithmetic. I'm going to sketch out my thinking, hoping for someone to point out the error in my thinking, or maybe confirm a known issue. I'll try to keep this simple, but its a little long - feel free to skip ahead to the conclusions if the math is too heavy.
The paper starts out showing the difference between withdrawing the taxes from the conversion to pay the tIRA taxes, and using outside money to pay the taxes. The example is converting $100K in a 25% tax bracket, where the tax will be $25K. Taking the taxes from the conversion results in $75K in the Roth, while using $25K in outside money results in $100K in the Roth. Assuming the funds are invested in the same equities and compound at the same rate, the one with outside money will clearly always be way ahead going forward.
The example looks at the case where both the conversion and distribution taxes are the same rate. And indeed, the distribution tax rate never enters the outome of a conversion, it only comes into play in modeling the no-conversion case, where tIRA funds are taken directly and incur the distribution tax.
The paper then points out that the $25K outside money has an opportunity cost. If instead of using it to the pay taxes on the conversion, it was invested (in a taxable account), it would compound, and generate LTCG taxes on the earnings. The paper models the invested outside money as a rather tax-inefficient investment where the gains are taxed every year (interestingly enough, the example is very similar to that used in the Vanguard BETR study). Because of the tax drag, this hypothetical outside investment generates less growth than if it were compounding with tax-free-gains in the Roth; every year the Roth balance would grow bigger than the alternative of withdrawing taxes from the conversion and investing the $25K in a taxable account. This is exactly what the various conversion advocates suggest: using outside funds is a win over withdrawing the taxes from the conversion (I'll get to how big the difference is in the conclusions).
Here is where I think the problem is (and the paper does not show a detailed example of the numbers, so I may be confused). The average retiree won't have a "spendable" $25K sitting in a low-interest bank account or stuffed in their mattress to pay conversion taxes or invest; more likely we will get the funds from selling investments in a taxable account and paying LTCG taxes. To get that $25K, we might have to sell as much as $29K in stock, paying an extra $4K to the IRS. Mr. McQuarrie sees that extra $4K as an additional cost of the conversion; he subtracts the entire $29K from the Roth balance using outside money and finds a lower balance than just discounting the $25K conversion taxes from the converted amount. There is still $100K in the outside-money Roth generating more growth that will eventually cover the $4K, and the paper defines this as the "break even" point - which with typical ROIs and tax-rates could be 10+ years!
The problem is, I think it is wrong to include the taxable-taxes as part of the cost of the conversion. Yes, the person converting took $29K from their taxable account, but that was never all of their own money; the government was already owed a piece of that $29K that the tax-payer would never receive. Selling $29K of equities was simply necessary to generate $25K in un-encumbered (what I think of as "spendable") money to pay the conversion taxes (the IRS always wants paid with "spendable money"). If we turned this around, and left the $29K invested, the spendable funds it would generate over time would be exactly the same as if we had invested $25K of spendable funds.
If you use this interpretation, the Roth balance when paying conversion taxes with outside money from selling taxable investments is never less than withdrawing the tax from the conversion, and as suggested above can give a slight advantage in spendable-dollars every year following the conversion. This seems like a pretty important distinction, since it suggests that conversions can never hurt - that you never have to wait multiple years just to avoid losing money on a conversion.
I played around with the knobs in my little spreadhseet and discovered something that should have been obvoius: the examples in the paper assume that both the Roth investments and the taxable account investments have the same ROI. This is somewhat reasonable; if you had an investment in one account with a better ROI, why wouldn't you change the other account to have the same investment? In practice, that isn't always possible or wise; it might make your portfolio less diverse, or generate a taxable event to move funds. Taking advantage of a conversion to sell off poor performing investments can make the conversion much more valuable, and conversely if your taxable account is doing well - and has minimal tax drag - you might want to leave it alone, as converting it has little impact on the Roth.
Conclusion (based on my re-interpretation of the paper): there is no real downside to converting even in a "wash" scenario; there is no real break even period (converting at a lower tax rate than withdrawing is even better). Here's the bad news: while converting with the proceeds from selling taxable equities is always positive, the difference is very small over reasonable time-scales. After 10 years, a $100K conversion may be ahead $4K versus taking the money from the conversion and $16K versus not doing a conversion. Dealing with estimated tax payments to use outside money may not be worth the few percent gain; its not nothing, but you're not going to buy a second-hand Ferrari with the difference. I think the impact on RMDs may be more significant, but I need to think about those some more - but converting tIRA funds will always reduce the tIRA balance and reduce future RMDs. All of these estimates are based on lots of guesses as to ROIs and tax-rates., so YMMV.
Does this make sense - or (won't be the first time) am I missing some subtle issue?