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Well, it’s that time of year again. No, I don’t mean the holiday decorations and music in the stores, although it’s certainly that time of year as well. I’m talking about looking at this year’s tax picture and what actions one might take before the year ends.
There are several items that pop to mind for many people – optimizing giving to charity, making gifts to family, contributing to IRAs (consider doing this earlier!), and others.
As 2024 will be a particularly low-income year for us, one thing that’s taking more of my time is deciding whether to do a Roth conversion or to realize some capital gains. We’ll do one or the other so as not to waste this year’s low tax rate, but which one to do is more complicated than it was when I wrote on it in more depth.
The benefits of Roth conversion are well known to most readers. The main attraction for us is to pay some tax now in anticipation of a higher effective tax rate later. Notice I didn’t say higher tax brackets, as effective tax rate could be higher even if not in a higher bracket. (Another benefit is that unlike with a Traditional IRA, heirs also inherit the assets tax free. This isn’t a consideration for us but is a big one for some.)
On the capital gains side, as I wrote previously, benefits would include simplifying the portfolio by reducing the number of holdings while also making it more tax efficient going forward. This year there’s a new consideration, in that we’re considering possibly buying a property soon. If we do, we’re going to need cash, and that cash is going to come from selling stocks. Why not do that now in this low-income year?
The answer to that question is because that purchase may not happen. We’ve been talking about buying property for years. Yes, maybe the discussion is a bit more serious now since we have no home and have been nomadic for two years. But we’re also enjoying our lifestyle, and there’s still no one place that beckons us to settle (at least not where we could get a long-term visa!). So, it’s possible we would realize the gains then not use the proceeds for quite some time.
Any amount of capital gains realized would miss out on the step-up in cost basis that would occur when one of us passes. Hopefully this is in the very distant future, but one never knows. And frankly it’s more of a pain than the Roth conversion, with time required to decide what trades to make and get them done, whereas I can do the Roth conversion in five minutes.
A month ago, I was leaning toward capital gains. Right now, I’m leaning toward the Roth conversion. I hate to say it, but the work factor is perhaps a bigger driver than it should be. We’re planning to meet friends in Sardinia the second half of December, and the last thing I want to be doing is optimizing stock trades. As has been said many times, what the calculator says is optimal may not be the “right” answer.
we are in this situation and chose to take the 0% capital gains this year. Next year we are taking from tIRA for some living expenses instead of a conversion. There are good reasons to do either, I think. Chris
Yes certainly different ways to play it. Thanks for the comment.
This is all super interesting. I read the comments and fully understand all the points and even counter points. I can also appreciate the need for careful planning which helps with overall optimization. The one thing I didn’t see or hear much about is simply enjoying the fruits of your labors. Yes, taxes and RMDs are a pain that no one wants to deal with and we should all want to keep our hard earned dollars. To give context, I am aged 53 and we are planning for an early retirement at aged 57, I want and hope to do Roth conversions from that point to the social security claiming at aged 63 or so. We would live off our cash reserves in that time. My dilemma leading to my comments above are two fold; we are hoping to get a low / no cost ACA plan and do Roth conversions up to a certain point to minimize the bite of the tax dog. I also want to do extensive travel during those years and enjoy some experiences that i haven’t yet had the time to do. I want to travel first class, take extended cruises in the nicest suites and so on. Well, me thinks that allowing the tax tail to wag the dog could potentially leave me crimping a bit to stay under certain income limits and make not able to splurge in my gogo years. What’s a guy to do here? Taxes be dammed to a point. There is no guarantee I get to age 73-75 to worry about the RMD bite. Let the kids worry about that is what I say, and I’ll try to enjoy some of the blessings we have. This doesn’t mean I wouldn’t plan, I would and I’d be careful not to allow careless planning to push me into higher tax brackets unnecessarily, but my effective tax rate today is somewhere around 18%, if I can stay close to that and enjoy life and never run out of money, I’ll write the tax guy a check as a trade off.
Sounds like I rambled a bit here, but that was on my mind and wanted to post.
Thanks for reading and commenting. I agree with the basic gist of what you’re saying. Tax efficiency doesn’t necessarily make for the best investment decision or life decision. And, no doubt there’s a time cost to thinking about these things and trying to optimize. It’s not necessary to really worry about to be a successful investor. But it does add some value if you’re so inclined, and I enjoy it.
I applaud you as you do Retirement your way. Yes, plan but be very flexible as that is what will help you enjoy family and friends to the fullest. Well done.
Thanks William. I agree, there is much to be said for preserving future optionality even if that means foregoing what might look like the “best” option at a given time.
I believe the 10 year rule does apply to inherited Roth designated beneficiaries, but there is no income tax on the proceeds.
Only eligible designated eligible beneficiaries such as a surviving spouse, minor child, disabled or chronically ill beneficiaries, beneficiaries who is no more than 10 years younger than the original owner.
Oops! I was thinking one thing and wrote another. I’ve corrected the original text as well. Good catch.
That’s OK, I learned the information from an excellent book entitled, The Retirement Time Bomb is Ticking Louder, by Ed Slott who is considered an eminent expert on retirement accounts. I highly recommend it.
Thanks, I like Ed as well but haven’t read the book.
If you can lock in 0% capital gains taxes, I don’t see how that isn’t a win. Lock it in, make purchases in you index portfolio (no wash sale issues), then sell what you want later if you need to make a property purchase.
In terms of the Roth Conversion, have you done a projection, where one of you are deceased and suddenly see a tax bracket change. I’ve planned on conversions because we are Trad heavy and I’m concerned about RMDs that will suddenly generate huge tax bills in that circumstance. I figure if we fill the brackets now, worst case, is we pay today what we would have later. Best case, we keep out of those high brackets and save a bundle.
I agree a guaranteed 0% cap gain is a no brainer to me, which is what we do. The other issue in our case is we also pay 0% on qualified dividends. Doing a significant Roth conversion vs cap gain harvesting would cause us to pay 15% on those qualified dividends, making the effective tax rate on the Roth conversion higher than our marginal tax rate.
We can’t make the 0% bracket on capital gains. I agree that would be an easy decision. But there’s still advantage to realizing them this year at 15% if we know we’ll be needing the money.
Yes I have projected one of us going early. There’s benefit to the Roth conversion even if we both live long lives, but that benefit is even greater if only one of us does. If we expected that to be the case, doing the conversion and waiting for a step up on the gains would be an easy choice.
The biggest benefit for a Roth conversion, in my opinion, isn’t in avoiding the future potentially higher tax rate. It is in the long term tax free growth of the dollars you convert. In our situation, the $700k we converted between age 58 and age 70.5 is now $2M……what ever tax we paid over those years is very small compared to the tax we might have had to pay on the $2M if it was still in the IRA…..So in thinking about conversions, the most important factor is how long can you leave the funds in the ROTH after you convert.
Please excuse the following nerdy point: Arguably, the advantage lies not in the tax-free growth of the converted sum, but in paying the conversion tax bill today with money that would otherwise be taxed in future. In other words, if your tax rate today and your tax rate in future are the same, there’d be no advantage to converting — except when you consider the money used to pay the conversion tax bill. If that tax-bill money grew at the same rate as the sum converted, it would be a wash: Even though the sum converted would be larger in future, you’d also have more money to pay the bigger tax bill. Where does this contention fall apart? Between now and when you pay that larger tax bill, the money set aside for the tax bill would itself be taxed as it grew, so it wouldn’t grow large enough to pay the future conversion-tax bill.
Perhaps I didn’t make it clear that you have to pay the tax from your taxable account rather than pay from the funds converted. In effect, you are being allowed to make a contribution to the Roth in the amount of the tax. These funds, if left in your taxable account and invested as you would in the Roth would grow a similar amount in your taxable account, but the growth and any dividends would be taxed while the $$ in the Roth are (in current law) forever tax free. There is also the benefit of gaining more flexibility. Had I not done the conversions my RMDs would be more than twice as high today. I don’t have to take those funds out of a tax free environment and re-invest in my taxable account.
Thanks Jonathan. Some points may be nerdy but still make a lot of difference.
That’s an interesting point. And to flip it, I suppose that’s also a way to look at capital gains. How long can those gains to continue to grow without being realized, and until they’re ultimately stepped up with no tax? Or, how quickly (though unfortunately) will a survivor benefit from the step up?