Help understanding tax planning strategy, LTCGs vs Roth Conversions.

[BTDretire]

Looks like our income will be about $12k of qualified dividends.
I want to take LTCGs and/or do Roth conversions.
 I have enough cash to live on, so all LTCGs or Roth Conversions will be reinvested.

As I understand, We (MFJ) get a ~$24k deduction, so can I do
$78,750 + $12,000 = $90,750 in LTCGs at 0% tax?
 But, what If I do Roth Conversions? I see they are taxed as regular income, so I can convert the same $78,750 + $12,000 = $90,750, but I would owe 10% of $19,400 and 12% of $78,950 - $19,400 = $59,550 or
$1,940 + $7,146 = $9,086.
 I'm told I'm will come out ahead in just a short time doing the Roths
even though I paid the taxes. I haven't rationalized that but the spreadsheet gurus have convinced me, for now, and until I understand it.
  But is there a combination of the two that would be better?

[Mr. Green]

If you really want to pay zero tax you can fill your personal exemption space ($24,000) with your dividends and Roth conversions and then fill the 0% LTCG bracket. However, if you have a bunch of money in tIRAs that will become subject to RMDs at 70 1/2 you may be better off long term by doing as much Roth conversion as you can in the inexpensive 10% and 12% brackets. Getting that money into Roth IRAs now means future tax free growth vs. a forced RMD income that's so high it may put you into tax brackets higher than 12%. You also get to reap the reward of the recent tax cuts for those lower brackets. If they don't stick around then converting your money now is cheaper than it will be a few years down the road.

[seattlecyclone]

As I understand, We (MFJ) get a ~$24k deduction, so can I do
$78,750 + $12,000 = $90,750 in LTCGs at 0% tax?

Yes.

But, what If I do Roth Conversions? I see they are taxed as regular income, so I can convert the same $78,750 + $12,000 = $90,750, but I would owe 10% of $19,400 and 12% of $78,950 - $19,400 = $59,550 or
$1,940 + $7,146 = $9,086.

Not quite. The regular-rate income is taxed first. The full standard deduction will come out of this, meaning you're only taxed on $90,750 - $24,400 = $66,350. The first $19,400 of this will be taxed at 10%, then 12% for the rest, resulting in $7,574 of tax. Then the dividend tax (at 0%) is applied on top of this.

I'm told I'm will come out ahead in just a short time doing the Roths even though I paid the taxes. I haven't rationalized that but the spreadsheet gurus have convinced me, for now, and until I understand it. But is there a combination of the two that would be better?

In general you'll pay less tax if you keep your income as consistent as possible from year to year, both regular-rate income and capital gains-rate income. If you convert your pre-tax retirement accounts to Roth too quickly you may find at some point that you're unable to maintain an income as high as you did previously, meaning you may have paid more tax than necessary while doing Roth conversions. If you convert your pre-tax retirement accounts to Roth too slowly you may find yourself pushed into a higher bracket by RMDs after you turn 70, as Mr. Green points out.

What are you doing for health insurance? If you're on an ACA plan you will find that your tax credit subsidy goes down as your income goes up, even if the income is dividend/capital gains income that is taxed at 0%. For this reason you may find that your "sweet spot" for income is not at the top of the 0% capital gains bracket, but rather at one of the ACA cliffs that would apply to your family size.

[BTDretire]

If you really want to pay zero tax you can fill your personal exemption space ($24,000) with your dividends and Roth conversions and then fill the 0% LTCG bracket. However, if you have a bunch of money in tIRAs that will become subject to RMDs at 70 1/2 you may be better off long term by doing as much Roth conversion as you can in the inexpensive 10% and 12% brackets. Getting that money into Roth IRAs now means future tax free growth vs. a forced RMD income that's so high it may put you into tax brackets higher than 12%. You also get to reap the reward of the recent tax cuts for those lower brackets. If they don't stick around then converting your money now is cheaper than it will be a few years down the road.

  I'm looking at the long term, I figure I have 6 yrs to do Roth Conversions and my wife has 10 years. I'm right at the start of trying to figure this out, My wife and I each have about $450k in Tax deferred accounts. Then another $550k in non tax deferred accounts, split $200k cash, and $350k in VTSAX with $175k of that LTCGs.
 I mentioned previously, I'm used to paying 1% to 4% tax on my income when I was self employed, so looking at paying 10% 5tax in order to save tax money is hard :-) But I have a friend that is 78yrs old and in the 25% bracket because of RMDs and SS. I want to avoid that!

[BTDretire]

I'm told I'm will come out ahead in just a short time doing the Roths even though I paid the taxes. I haven't rationalized that but the spreadsheet gurus have convinced me, for now, and until I understand it. But is there a combination of the two that would be better?

In general you'll pay less tax if you keep your income as consistent as possible from year to year, both regular-rate income and capital gains-rate income. If you convert your pre-tax retirement accounts to Roth too quickly you may find at some point that you're unable to maintain an income as high as you did previously,

Not sure I understand the income reduction, is this because of the 10% reduction of paying the taxes or the 5yr waiting period?
 Neither of which I think will cause me a problem.

 

meaning you may have paid more tax than necessary while doing Roth conversions. If you convert your pre-tax retirement accounts to Roth too slowly you may find yourself pushed into a higher bracket by RMDs after you turn 70, as Mr. Green points out.

What are you doing for health insurance? If you're on an ACA plan you will find that your tax credit subsidy goes down as your income goes up, even if the income is dividend/capital gains income that is taxed at 0%. For this reason you may find that your "sweet spot" for income is not at the top of the 0% capital gains bracket, but rather at one of the ACA cliffs that would apply to your family size.

We have a private policy so not a concern.

[seattlecyclone]

I'm told I'm will come out ahead in just a short time doing the Roths even though I paid the taxes. I haven't rationalized that but the spreadsheet gurus have convinced me, for now, and until I understand it. But is there a combination of the two that would be better?

In general you'll pay less tax if you keep your income as consistent as possible from year to year, both regular-rate income and capital gains-rate income. If you convert your pre-tax retirement accounts to Roth too quickly you may find at some point that you're unable to maintain an income as high as you did previously,

Not sure I understand the income reduction, is this because of the 10% reduction of paying the taxes or the 5yr waiting period?

The income reduction is because Roth conversions count as income. The progressive structure of our tax brackets rewards you for keeping your income smooth. You generally pay less tax when you earn $50k this year and $50k next year than you do if you earn $100k this year and nothing next year. If you convert so much of your IRA in the next few years that there's nothing left to convert or withdraw after that, and you don't have some other source of income to replace it, you'll end up paying more tax than if you converted at a slower rate to stretch out that income source over a greater period of time.

Whatever amount you expect your traditional IRA to grow each year, converting that much or a bit more can be about right. This way the account balance won't grow out of control and stick you with huge RMDs later on, but you also won't draw the balance all the way down to zero.

[BTDretire]

The income reduction is because Roth conversions count as income. The progressive structure of our tax brackets rewards you for keeping your income smooth. You generally pay less tax when you earn $50k this year and $50k next year than you do if you earn $100k this year and nothing next year.

 My plan is to only do Roth Conversions up to an amount that doesn't put me out of the 12% tax bracket.

If you convert so much of your IRA in the next few years that there's nothing left to convert or withdraw after that, and you don't have some other source of income to replace it, you'll end up paying more tax than if you converted at a slower rate to stretch out that income source over a greater period of time.

 Hmm, ya, but I don't really expect to use my Roth Conversions for income, I'll reinvest them for later tax free growth and income. Trying to avoid the 25% tax bracket when I have SS and RMDs, I ave 6 years to get my IRAs and SEPs converted my wife has 10 years. I doubt we can get it all converted but enough to help.

Whatever amount you expect your traditional IRA to grow each year, converting that much or a bit more can be about right. This way the account balance won't grow out of control and stick you with huge RMDs later on, but you also won't draw the balance all the way down to zero.[/quote]
  But, I'm not sure it isn't already out of control. We have close to $900k in tax advantaged accounts, I would like to get as much of that into Roths as I can. If this just grows at 6% a year, I'm probably not going to be able to significantly reduce that number while trying to stay in the 12% bracket.
 Working hard at trying to figure it out.

[seattlecyclone]

Hmm, ya, but I don't really expect to use my Roth Conversions for income, I'll reinvest them for later tax free growth and income.

I think we may be using different definitions of "income." I'm talking about income in the sense of what you have to report to the IRS and pay taxes on, not income in the sense of what you withdraw from savings to pay your bills.

Trying to avoid the 25% tax bracket when I have SS and RMDs, I ave 6 years to get my IRAs and SEPs converted my wife has 10 years. I doubt we can get it all converted but enough to help.

Like I said, you probably don't want to get it all converted. My understanding from your previous posts is that your savings is in a mix of IRAs and taxable brokerage accounts, with social security coming up down the road as well. Social security and your taxable dividends/gains have favorable tax treatment, leaving only the traditional IRAs for regular-rate income. Converting a good chunk of that IRA before social security starts can be a good idea, but you probably want to stop short of converting all of it.

But, I'm not sure it isn't already out of control. We have close to $900k in tax advantaged accounts, I would like to get as much of that into Roths as I can. If this just grows at 6% a year, I'm probably not going to be able to significantly reduce that number while trying to stay in the 12% bracket.
 Working hard at trying to figure it out.

To put RMDs in perspective, the RMD for a 70-year-old with a $900k IRA balance is $32,846. For an 80-year-old with the same balance, the RMD is $48,128. For a 90-year-old, the RMD is $78,947. Even at 90, the RMD on a $900k balance is less than you're considering converting right now!

Not sure what amount you're expecting from Social Security, but plugging in $40k of Social Security and $12k of qualified dividends into the case study spreadsheet, you stay in the 12% bracket on regular income and 0% bracket on dividend income all the way up to $59k in IRA income. That's roughly the RMD on a $900k balance for an 84-year-old.

What I'm saying is you don't need to take drastic action right now. Convert at least the growth each year so that your IRA doesn't get any bigger than it already is. Gradually chipping away at the balance before you hit your 80s would be a good thing. I see little need to cut it down by a drastic amount before you even start the RMDs though.

[DaveSch]

Here are my circumstances: I'm 69yo, single, income from SS & portfolio. I have great cashflow and can easily pay taxes from my cash account. My tIRA is somewhat modest.

I decided that I would do as much Roth conversions as prudent, so as not to drive up my tax rate. I set my minimum IRA distribution amount to my next year's RMD amount. I set a maximum IRA distributions (Roth conversion) to the highest value before New York State taxes my IRA ($20k).

With those parameters and having a pretty good idea of what my taxable investment distrubutions would be, I set out to find the optimum value of a Roth conversion.

I used this tax estimator site: https://www.dinkytown.net/java/1040-tax-calculator.html#

I put in the estimated values of all my taxable income, as well as that RMD value and figured the tax. I started a table showing my AGI, amount of the IRA distribution, and the tax, and the percentage tax bill change from the last increment.

Then I incremented the IRA distribution, by $1000, looking at the amount of increasing taxes. As I went up, more of my SS would be taxed. But when 85% of my SS was taxed the increase in AGI and rate of tax increase dropped back, in my case to 12%.

I kept going until I reached the bend point in the tax rate. With my situation of capital gains having a 0% rate until it wasn't, I saw the bend point from 12% to 27%, showing that my capital gains were at last being taxed at 15%.

My plan is that in December when fund distributions have been made, I will calculate how much of my IRA I can get out of hock with the government.

While I pay more tax this way because I am filling out the brackets, in the long run, either I or my heirs will have to pay tax on my IRA, and capital gains won't be taxed to my heirs. Married couples should take note that upon the death on one spouse, the other loses that deduction in the next year, and the taxes on their IRA can zoom. Those in the ACA should consider not doing this if it ruins the subsidy.

Hope this was helpful.
Dave

[MDM]

I put in the estimated values of all my taxable income, as well as that RMD value and figured the tax. I started a table showing my AGI, amount of the IRA distribution, and the tax, and the percentage tax bill change from the last increment.

Then I incremented the IRA distribution, by $1000, looking at the amount of increasing taxes. As I went up, more of my SS would be taxed. But when 85% of my SS was taxed the increase in AGI and rate of tax increase dropped back, in my case to 12%.

I kept going until I reached the bend point in the tax rate. With my situation of capital gains having a 0% rate until it wasn't, I saw the bend point from 12% to 27%, showing that my capital gains were at last being taxed at 15%.

If you'd rather not do the plotting by hand, you could have the most recent case study spreadsheet draw it automatically if you have even a little Excel ability.

Chart below shows the (federal + state) rates for traditional withdrawals, assuming single filer in NY age 69 with $1K interest, $5K qualified dividends, and $20K SS benefit.

[BTDretire]

Hmm, ya, but I don't really expect to use my Roth Conversions for income, I'll reinvest them for later tax free growth and income.

I think we may be using different definitions of "income." I'm talking about income in the sense of what you have to report to the IRS and pay taxes on, not income in the sense of what you withdraw from savings to pay your bills.

Noted.

Trying to avoid the 25% tax bracket when I have SS and RMDs, I ave 6 years to get my IRAs and SEPs converted my wife has 10 years. I doubt we can get it all converted but enough to help.

Like I said, you probably don't want to get it all converted. My understanding from your previous posts is that your savings is in a mix of IRAs and taxable brokerage accounts, with social security coming up down the road as well. Social security and your taxable dividends/gains have favorable tax treatment, leaving only the traditional IRAs for regular-rate income. Converting a good chunk of that IRA before social security starts can be a good idea, but you probably want to stop short of converting all of it.

But, I'm not sure it isn't already out of control. We have close to $900k in tax advantaged accounts, I would like to get as much of that into Roths as I can. If this just grows at 6% a year, I'm probably not going to be able to significantly reduce that number while trying to stay in the 12% bracket.
 Working hard at trying to figure it out.

To put RMDs in perspective, the RMD for a 70-year-old with a $900k IRA balance is $32,846. For an 80-year-old with the same balance, the RMD is $48,128. For a 90-year-old, the RMD is $78,947. Even at 90, the RMD on a $900k balance is less than you're considering converting right now!]/quote]

 Let it been known that $900k at 6% over thirty years, compounds too $5,700,000. So at 90years old the RMDs might be a crazy amount. Yes, I know RMDs will knock that amount down. But still something to consider.

Not sure what amount you're expecting from Social Security, but plugging in $40k of Social Security and $12k of qualified dividends into the case study spreadsheet, you stay in the 12% bracket on regular income and 0% bracket on dividend income all the way up to $59k in IRA income. That's roughly the RMD on a $900k balance for an 84-year-old.

What I'm saying is you don't need to take drastic action right now. Convert at least the growth each year so that your IRA doesn't get any bigger than it already is. Gradually chipping away at the balance before you hit your 80s would be a good thing. I see little need to cut it down by a drastic amount before you even start the RMDs though.

 Thanks, I need to do a case study, but they don't usually go into what ifs on Roth Conversions and how much or when.
 As my buddy at 77 years old in the 25% tax bracket says, it's a nice problem to have.

[DaveSch]

If you'd rather not do the plotting by hand, you could have the most recent case study spreadsheet draw it automatically if you have even a little Excel ability.

Thank you!
I'll have to take a look. I never plotted my results, just put the numbers in a column. In my list, I also included the amount of taxable SS. For me, the magic happened when I blew through all the taxation on my SS and the tax rate thereafter dropped to 12%. Looking through all the numbers (starting with the future RMD amount), my tax rate was never that low, while the SS taxable amount was adding 1 additional dollar for each additional Roth conversion dollar.

[MDM]

If you'd rather not do the plotting by hand, you could have the most recent case study spreadsheet draw it automatically if you have even a little Excel ability.

Thank you!
I'll have to take a look. I never plotted my results, just put the numbers in a column. In my list, I also included the amount of taxable SS. For me, the magic happened when I blew through all the taxation on my SS and the tax rate thereafter dropped to 12%. Looking through all the numbers (starting with the future RMD amount), my tax rate was never that low, while the SS taxable amount was adding 1 additional dollar for each additional Roth conversion dollar.

See this post for some Excel specifics.  You should get the same results - if not, it would be interesting to understand why.

[DaveSch]

See this post for some Excel specifics.  You should get the same results - if not, it would be interesting to understand why.

Yes, that is the way I see it too. I've estimated my fixed taxation, as well as an amount of optional taxation to determine how much tax to pay now. My base amount includes interest, fund distributions, SS and RMD. (Thinking of next year when RMD is a reality.)

Above that fixed taxation amount, by adding a little Roth conversion adds a higher amount of tax, because of partial taxation of my SS income. In my case, that would be about $3000 of a Roth conversion equaling a 20% or so tax rate.

But I can convert $5000 more and pay only a 12% tax rate. This is what I am after. Maybe I should consider the overall percentage on $8000 before deciding? (I did the calculation and the tax rate on that $8000 is 14.7%.)

Gaining 100% ownership of the $8000 and having it and any gains never taxed again is very tempting.

[MDM]

In my case, that would be about $3000 of a Roth conversion equaling a 20% or so tax rate.

But I can convert $5000 more and pay only a 12% tax rate. This is what I am after. Maybe I should consider the overall percentage on $8000 before deciding? (I did the calculation and the tax rate on that $8000 is 14.7%.)

Yes.

When you have an unfavorable rate followed by a favorable rate, calculating your marginal rate as (tax change)/(total conversion amount) is appropriate.

[DaveSch]

Thank you, MDM.
It all seemed to make sense to me too. A relatively low tax rate, the Roth conversion is forever protected from taxation. New York State doesn't tax the first $20k or IRA distributions / pensions.

Many people look for the cheapest tax to pay in any one given year. I don't look at all this only in that way. (I only contributed to a tIRA only until the Roth came along in 1998. Seemed like the best deal in town for those in lower income brackets. But the truth is, I would have been best off never contributing to a traditional IRA. )