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A FEW DAYS AGO, I RAN the numbers on our likely 2023 taxes, and reached two conclusions: We have a small refund coming—and we should find a way to pay more taxes.
How can both be true? I project that our 2023 taxable income will be well below $190,750, which is the top of the 22% tax bracket for those married filing jointly. Getting taxed at 22% strikes me as a good deal, given the likelihood that we’ll be taxed at an even higher rate later in retirement. There are a few things we could do by Dec. 31 to make sure this opportunity doesn’t go to waste.
For instance, we could convert some holdings from a traditional IRA to a Roth IRA, paying tax at 22% on the sum converted. That marginal rate is probably low compared to what we’ll pay when we draw down our traditional retirement accounts later in retirement. By the time we make those withdrawals, we hope our accounts will have grown, plus income tax rates may have gone up.
Today’s historically low tax brackets are set to sunset at year-end 2025. The costs of the pandemic, foreign wars and the government’s growing debt burden create further pressure to raise taxes. Anything can happen, of course, but it seems highly likely that our future tax burden will be higher than our present one.
We might even consider Roth conversions that would push us into the next bracket, which goes up to $364,200 for married couples. Even at that high amount, the effective marginal rate would only be 24%. While the net investment income tax (NIIT) is triggered for couples at $250,000 in modified adjusted gross income, distributions from IRAs and 401(k) accounts are exempt from this additional 3.8% tax.
Still, converting such a large sum would mean a big tax bill. Moreover, there are reasons to keep a healthy sum in traditional retirement accounts, rather than moving too much into Roth accounts. We also don’t have children, so we don’t have the legacy considerations that make Roth conversions appealing to many. But while converting at a 24% rate is debatable, converting enough to get to the top of the 22% bracket seems like a no-brainer for us, improving our tax diversification across Roth and traditional retirement accounts.
Another way we might take advantage of our low bracket is to realize some capital gains by selling appreciated investments held in our regular taxable account. We have some tax losses that we harvested last year and which are available to offset gains.
What about generating additional gains beyond the size of our realized losses? Our taxable income is too high to realize gains at the zero percent rate. On the other hand, even if we realized enough gains to get our income all the way to the top of the 24% income tax bracket, the tax on those gains would be just 15%, with the 3.8% NIIT layered on top of that 15%.
We have a few holdings in mind to sell. These are perfectly fine funds and stocks, but selective selling could reduce our large number of holdings, lower the average expense ratio of our portfolio and increase its tax efficiency. Then again, if we just sit tight, when the first of us dies, these holdings will get an adjustment in cost basis that makes the embedded gains go away.
This will be especially significant if we’re still residents of a community property state. In other words, we have a choice between paying some tax today to improve our portfolio or avoiding that tax payment and letting nature do the job for us—though hopefully not until the far distant future.
Our default would probably be to reduce some of the holdings mentioned above by the amount we can cover with carried-over losses, for a net zero capital gains tax liability for 2023. An argument could be made for preserving the carried-over losses for use in future years, when the capital gains tax rate is perhaps higher than 15%. After all, if basic income tax brackets are likely to go up, why not capital gains tax brackets?
We have to be cognizant of the NIIT in realizing capital gains. Unlike Roth conversions, dividends and capital gains are subject to the NIIT and its additional 3.8% tax. If we did both, while the Roth conversion amount itself wouldn’t be subject to the NIIT, it would count toward the $250,000 threshold beyond which dividends and capital gains would get hit with the NIIT.
Next year, we’ll have another, perhaps bigger bite at this tax apple. I project our taxable income in 2024 will be even lower, which would give us more room to do a Roth conversion or take capital gains at a relatively low rate. We’ll also still be more than three years away from Medicare, which means not having to worry about triggering higher Medicare premiums.
As I write this, we haven’t decided. I expect we’ll realize capital gains up to the point where these gains are offset by the losses harvested last year. I also expect we’ll do enough Roth conversion to get us near the top of the 22% tax bracket. Beyond that, well, we still have a few weeks to decide.
Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. Check out his earlier articles.
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Nice article and rationale. I’ve been chipping away at my IRA account balances by doing Roth conversions each year. I use the IRS draft versions of the relevant tax forms to update a spreadsheet that allows me to do pro forma tax calculations regarding various conversion scenarios. Just finished this year’s calculations. This, in conjunction with a retirement planning spreadsheet that I also update annually, gives me peace of mind. Don’t like “surprises” at tax time, nor down the road 🙂
If you already have enough and are charitably inclined, why pay any additional taxes when you can utilize qualified charitable distributions (QCD)? One can start as early as 70.5, give up to $100,000 per year, have it count towards some or all of one’s RMD (when required to take an RMD) and–best of all–there are no tax consequences! It doesn’t even show up as income. This is such a great gift from the IRS, that I worry it will go away one day. And, it can be a wonderful way to give meaningful amounts to charities that align with one’s values. There are so many smaller (and often all volunteer) worthy nonprofits where a QCD could make a world of difference. I have struggled making the transition from accumulating savings to using it, but I have found giving via QCDs to be a great option and very rewarding.
Thanks Rick, I just talked to my IRA manager about this and am starting a couple QCDs next year.
He had to call the IRA company to determine what they required and we both learned how it works with qualified, tax-exempt 501(C)3 organizations. My guy thanked me, as he has others that use the same company.
I just wonder why tax preparers don’t suggest doing this to others!
I’m single, 74 and stopped working full time 23 years ago. When I retired, I had some very large unrealized capital gains and almost no unrealized capital losses. The tax rates were much higher then, so I spread out taking capital gains over several years. Later, when my income was lower, I converted enough of my traditional IRA to a Roth to reach the top of my tax bracket.
Now, I have mostly spent down my taxable account but have more in my IRAs than I will likely ever spend. Since my only close relative probably won’t need any inheritance from me, most of my estate will go to charities. I’m pondering how much is prudent for me to donate now using QCDs vs. waiting until I die.
I have realized that I converted too much from my traditional IRA to my Roth. Since the charities are the major beneficiaries of my IRAs, they won’t pay the tax anyway.
Gary, Another newly provided approach for charitable giving from IRAs is a Chairtable Gift Annuity where the donor retains the annuity payments until death at which point the money goes to the charity. Kathleen Rehl provided excellent guidance here:
https://humbledollar.com/2023/02/better-than-cake/
We’re also not concerned about leaving money to heirs, and also have a bunch of accumulated capital gains. It will still make sense to realize these and pay the tax before taking distributions from retirement accounts. This might be by realizing some each year as you have done. Or, we might decide that we want to buy a house and have little choice but to realize lots of gains to do so. This is one argument for taking more gains now within the thresholds discussed rather than doing more Roth conversions.
I’m filling my 12% bracket with Roth conversions, careful not to go into the 15% capital gains bracket; otherwise my marginal rate would be 27%.
Thanks for the comment Randy. I don’t think your marginal rate would become 27%. As I understand, CGs would suddenly cost you 15% instead of zero, but I think the marginal rate on every dollar of ordinary income would still be 12% or 22%.
Still, avoiding that 15% is significant. It makes me think of one of my first articles on HD.
https://humbledollar.com/2021/10/getting-to-zero/