Author Topic: Roth Conversion tax bracket question  (Read 999 times)

Travis

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Roth Conversion tax bracket question
« on: July 19, 2018, 12:22:55 AM »
I think in 5 years when I retire I will want to turn my TSP (today's value $290k) into a traditional IRA so I can convert it and add it to my Roth IRA.  If I understand how this works, this will save me from taking RMDs from my TSP after age 70 which get progressively bigger each year (and therefore jacking up my tax bill).  Is taking conversions early in retirement at the 12% tax rate the right way to do this since it's added to my ordinary income which will be filled mostly with pension and unqualified dividends?

Also on the tax planning front, I have a couple questions about Tax Gain Harvesting.  The goal of TGH is to reset the cost basis so when you go to sell the shares for good you've accumulated almost no LTCG, correct?  Assuming early in retirement I don't need the money right away, I could sell $11k worth of shares and re-buy them inside my Roth IRAs ensuring I never pay taxes on that money again, correct?  Over time this would appear to also reduce the amount of unqualified dividends I'm receiving from my taxable account adding to my ordinary income.

Both the conversions and TGH seem like strategies to fold my TSP and taxable accounts into my Roth IRA keeping my tax bill low throughout retirement (assuming I didn't miss anything).  The pension reduces the amount of tax space I have to work with, but also ensures I have enough money to get by while moving retirement funds around to better tax treatments. Am I making sense?

terran

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Re: Roth Conversion tax bracket question
« Reply #1 on: July 19, 2018, 05:40:55 AM »
I think in 5 years when I retire I will want to turn my TSP (today's value $290k) into a traditional IRA so I can convert it and add it to my Roth IRA.  If I understand how this works, this will save me from taking RMDs from my TSP after age 70 which get progressively bigger each year (and therefore jacking up my tax bill).  Is taking conversions early in retirement at the 12% tax rate the right way to do this since it's added to my ordinary income which will be filled mostly with pension and unqualified dividends?

Ideally you want to make your tax bracket as even as possible throughout your life. By way of example, if you're in the 22% bracket now and expect  to be in the 12% bracket in retirement you want to defer as much as you can until you get to the 12% bracket (or don't have more deferral space). If you are in the 12% bracket in retirement and expect to be in the 22% bracket when RMDs start then you want to fill the 12% bracket with Roth conversion and capital gains. You should do some projections to try to figure out what tax bracket you're likely be in in at various stages.

Also on the tax planning front, I have a couple questions about Tax Gain Harvesting.  The goal of TGH is to reset the cost basis so when you go to sell the shares for good you've accumulated almost no LTCG, correct?  Assuming early in retirement I don't need the money right away, I could sell $11k worth of shares and re-buy them inside my Roth IRAs ensuring I never pay taxes on that money again, correct?  Over time this would appear to also reduce the amount of unqualified dividends I'm receiving from my taxable account adding to my ordinary income.

Yep, that's basically the idea. Ideally this will all happen within the 0% LTCG rate. What are you going to do with the proceeds of the sale when you rebuy stock in your Roth? Nothing wrong with harvesting capital gains beyond what you plan to spend then rebuying in taxable. As long as you're within the 0% bracket you've still reset your tax basis at no cost (except state tax).

Both the conversions and TGH seem like strategies to fold my TSP and taxable accounts into my Roth IRA keeping my tax bill low throughout retirement (assuming I didn't miss anything).  The pension reduces the amount of tax space I have to work with, but also ensures I have enough money to get by while moving retirement funds around to better tax treatments. Am I making sense?

Yes, basically right. Although as I said, capital gains harvesting can also be a good strategy even if it doesn't involve "moving" money to Roth via spending taxable and leaving Roth where it is. Don't be afraid to harvest capital gains and then reinvest in taxable if it makes sense tax wise.

Remember to pay attention smoothing state tax just like you smooth federal tax. If you plan to move to/from a no tax state at any point that can change the math a lot since changes in state tax could make up for whatever gain/loss a strategy might have in terms of federal tax.

Travis

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Re: Roth Conversion tax bracket question
« Reply #2 on: July 19, 2018, 10:24:43 PM »
Terran, thanks for the responses.  After deductions I'm currently in the 12% bracket.  My goal is to do all of this and stay there in retirement.  I'm planning on retiring in CA which taxes capital gains at the same rate as income. I'm trying to put some scenarios together, but I can't find reliable calculators that include the new tax law changes.  I may just have to wait until after the new year when the new forms are published to start tinkering.  There will definitely be a fine line to stay within federal and CA tax rates since the thresholds don't quite line up.

My unqualified dividends in my taxable account (from VTSAX and VFWAX) appear to be 2% of the total in those funds.  Is that coincidence or is that the dividend payout rate? If it's always going to be 2%, then I can make some predictions on future dividends.

If I get the pension (and I'll know in about 2 years), then I may run into the situation where I never need to touch my investments.  The projected pension plus dividends will be just above my spending requirement without selling anything.  I may be doing conversions and TGH into my Roth just for long-term tax management purposes.


Yep, that's basically the idea. Ideally this will all happen within the 0% LTCG rate. What are you going to do with the proceeds of the sale when you rebuy stock in your Roth? Nothing wrong with harvesting capital gains beyond what you plan to spend then rebuying in taxable. As long as you're within the 0% bracket you've still reset your tax basis at no cost (except state tax).

If I TGH from my taxable portfolio, I'm selling VTSAX and VFWAX.  I have VTSAX in our Roth IRAs now which I'll just buy more of.  I don't know yet if I should flip the VFWAX in my taxable or move it to Roth as well.  I suppose I could keep some in taxable after a harvest, but that will depend on how long it takes me to update the cost basis on the entire portfolio and how much it'll cost in state taxes to do so.

This brings to me one other LTCG question. Most of my lots are just a couple thousand dollars each with a few hundred dollars in capital gains per lot.  I have a couple lots that are worth tens of thousands from when I first dumped my savings into the market.  How do I sell these lots without incurring massive capital gains?

terran

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Re: Roth Conversion tax bracket question
« Reply #3 on: July 20, 2018, 05:29:28 AM »
If you're in the 12% bracket now it probably makes sense to tax gain harvest up to the top of the 0% capital gains bracket now. Also consider your tax rate now vs after you move to CA. It looks like AZ is quite a bit lower.

Other than for businesses (the pass through deduction), people with dependent kids (changes to the child tax credit) or people who itemize (fewer eligible deductions) the new lax law isn't all that different except the rates have changed, so if you like messing around with spreadsheets you coudl probably whip something up. Single filers get a $12k standard deduction, married get $24k. Here is a good set up tables with both earned income and capital gains brackets https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/. It's a little confusing because the top of the 12% bracket and the top of the of the 0% capital gains bracket don't quite line up anymore, so there's a $200 overlap between the 12% bracket and the 15% capital gains bracket.

I have heard that dividends tend to be about 2% for VTSAX. I wouldn't think that would be exact, but a good estimate. My experience is that all dividends show as unqualified until the brokerage issues tax forms, so I expect most of the unqualified dividends you're seeing are actually qualified. You can look at past year 1099's from your brokerage and divide qualified dividends by all dividends to find a ratio you can use to estimate.

What I don't understand from what you're saying is how you propose to transfer money into your Roth from taxable? Once you no longer have earned income you can't contribute, so what are you going to do with the money you get from selling stocks in taxable as you tax gain harvest? And where do you get the money in Roth you'll use to buy more VTSAX?

You'll need to check what your cost basis tracking method is with your brokerage (and maybe change it), but if it's Specific Identification you should be able to select precise tax lots or parts of tax lots when you sell. If you purchased any of your lots before 2012 they may be "uncovered shares" which I think have different rules about how the brokerage was required to track cost basis, so you might run into issues there as I think the investor was expected to do their own tracking. It sounds like you're seeing the cost basis information, so it should work out one way or another.

Remember to consider ACA limits as well as tax brackets if you'll be getting health insurance that way. Here's a good post on that: https://rootofgood.com/affordable-care-act-subsidy/ -- remember to look up the current income limits, but the thought process should be the same.

Cost basis is "stepped up" at death, so if you really don't expect to need the money in taxable none of this really matters as your heirs won't pay tax on the existing capital gains anyway (at least under current tax law). Converting traditional to Roth still makes sense as Roth is a better thing to inherit (inherited Traditional IRAs have RMDs as soon as they're inherited regardless of the heirs age).

MDM

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Re: Roth Conversion tax bracket question
« Reply #4 on: July 20, 2018, 10:22:44 AM »
I'm trying to put some scenarios together, but I can't find reliable calculators that include the new tax law changes.
Is there something significant to you that the case study spreadsheet doesn't cover?

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This brings to me one other LTCG question. Most of my lots are just a couple thousand dollars each with a few hundred dollars in capital gains per lot.  I have a couple lots that are worth tens of thousands from when I first dumped my savings into the market.  How do I sell these lots without incurring massive capital gains?
If you have enabled "specific ID" (as opposed to FIFO or average) for the cost basis in your brokerage account, you then specify the exact lots when you sell.  Does that make sense?

Travis

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Re: Roth Conversion tax bracket question
« Reply #5 on: July 20, 2018, 09:45:37 PM »
I'm trying to put some scenarios together, but I can't find reliable calculators that include the new tax law changes.
Is there something significant to you that the case study spreadsheet doesn't cover?
Probably not. I keep forgetting your case study program isn't just for budgeting.  I'll take a closer look at it.
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This brings to me one other LTCG question. Most of my lots are just a couple thousand dollars each with a few hundred dollars in capital gains per lot.  I have a couple lots that are worth tens of thousands from when I first dumped my savings into the market.  How do I sell these lots without incurring massive capital gains?
If you have enabled "specific ID" (as opposed to FIFO or average) for the cost basis in your brokerage account, you then specify the exact lots when you sell.  Does that make sense?

I'm set up for Specific ID.  I didn't realize you could be even more specific and choose to sell only a few shares out of a single group. I just saw a list of contributions and their cost basis. I never bothered to go to the "sell" menu and see you can select individual shares.

If you're in the 12% bracket now it probably makes sense to tax gain harvest up to the top of the 0% capital gains bracket now. Also consider your tax rate now vs after you move to CA. It looks like AZ is quite a bit lower.

It is, but we're here in AZ temporarily.  We're probably moving again next summer, and we'll have to move a couple more times before I retire.  My wife isn't excited about retiring here in AZ due to the extreme heat and we want to be closer to family in CA. 

I thought about doing Tax Gain Harvesting now, but I'd also like to see if there are any Tax Loss Harvesting opportunities to be had.  I don't think I can do both in the same year.

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My experience is that all dividends show as unqualified until the brokerage issues tax forms, so I expect most of the unqualified dividends you're seeing are actually qualified. You can look at past year 1099's from your brokerage and divide qualified dividends by all dividends to find a ratio you can use to estimate.

Last year's 1099 shows a number for qualified and a number for ordinary.  From what I know of taxes, some index funds produce both kinds of dividends with the "ordinary" or "unqualified" being taxable as regular income.  Then again I've been wrong a lot this week on this subject.

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What I don't understand from what you're saying is how you propose to transfer money into your Roth from taxable? Once you no longer have earned income you can't contribute, so what are you going to do with the money you get from selling stocks in taxable as you tax gain harvest? And where do you get the money in Roth you'll use to buy more VTSAX?

I didn't realize pensions don't count as earned income. There's a chance my wife will continue to work part time for a couple years past my retirement, so that's a possibility too.  If not, then I'll be keeping those funds taxable.

Again thanks for your help here.

terran

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Re: Roth Conversion tax bracket question
« Reply #6 on: July 21, 2018, 08:30:57 AM »
I'm set up for Specific ID.  I didn't realize you could be even more specific and choose to sell only a few shares out of a single group. I just saw a list of contributions and their cost basis. I never bothered to go to the "sell" menu and see you can select individual shares.

That has been my experience with Fidelity. I suspect the same with vanguard. First you say how much in total you want to sell, then select which lots you want to sell from.

It is, but we're here in AZ temporarily.  We're probably moving again next summer, and we'll have to move a couple more times before I retire.  My wife isn't excited about retiring here in AZ due to the extreme heat and we want to be closer to family in CA.


Sorry, I didn't mean to say you shouldn't move to CA. Taxes are a pretty silly reason not to live where you want to unless they're the one thing making it unaffordable to do so (which seems unlikely). I was just pointing out that you might consider doing some tax gain harvesting now while you're in in the 0% capital gains bracket and a lower tax state than you will be. Tax gain harvesting done now will be more advantageous than doing it when you're in a higher tax state.

I thought about doing Tax Gain Harvesting now, but I'd also like to see if there are any Tax Loss Harvesting opportunities to be had.  I don't think I can do both in the same year.

Yes and no (mostly yes). Any capital gains will offset capital losses, so the tax loss harvesting would only benefit you to the extent that it reduces the gains (not a huge advantage while you're in the 0% capital gains bracket) and if the losses exceed the gains, then that will count against regular income. Remember that only $3000/year of losses can count against regular income, and anything above that will carry forward to future years, so don't over tax loss harvest if you plan to tax gain harvest next year. Also, dividends (including qualified with their 0% tax) will count against the losses first, so you'll need to harvest losses of $3000 plus the amount of your dividends to see a benefit in the form of lower taxable income.

Last year's 1099 shows a number for qualified and a number for ordinary.  From what I know of taxes, some index funds produce both kinds of dividends with the "ordinary" or "unqualified" being taxable as regular income.  Then again I've been wrong a lot this week on this subject.

Remember that there's a square vs rectangle thing going on here. The Qualified dividends are ordinary dividends, but not all ordinary dividends are qualified. That is, the amount entered as ordinary dividends should be all the dividends you received in that account. The amount entered as qualified is the amount that will be taxed at long term capital gains rates. The difference between the two are the ordinary dividends that are not qualified, meaning they're the unqualified dividends, which are taxed at ordinary income tax rates.

I didn't realize pensions don't count as earned income. There's a chance my wife will continue to work part time for a couple years past my retirement, so that's a possibility too.  If not, then I'll be keeping those funds taxable.

No, it wouldn't count. This seems like a good write up on it: https://www.schwab.com/resource-center/insights/content/can-you-contribute-to-an-ira-if-you-don-t-have-a-job

You probably already know this, but if your wife does work and has at least $11k of earned income (or twice whatever the IRA limit is at the time) you can both contribute to IRAs even if you don't have earned income.


Travis

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Re: Roth Conversion tax bracket question
« Reply #7 on: July 21, 2018, 01:38:38 PM »


Last year's 1099 shows a number for qualified and a number for ordinary.  From what I know of taxes, some index funds produce both kinds of dividends with the "ordinary" or "unqualified" being taxable as regular income.  Then again I've been wrong a lot this week on this subject.

Remember that there's a square vs rectangle thing going on here. The Qualified dividends are ordinary dividends, but not all ordinary dividends are qualified. That is, the amount entered as ordinary dividends should be all the dividends you received in that account. The amount entered as qualified is the amount that will be taxed at long term capital gains rates. The difference between the two are the ordinary dividends that are not qualified, meaning they're the unqualified dividends, which are taxed at ordinary income tax rates.


Last year I had $9k in total ordinary dividends and $7k in qualified dividends.  You're saying that the $7k is a part of the $9k?  $2k was taxed as income, and $7k was taxed as LTCG?

terran

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Re: Roth Conversion tax bracket question
« Reply #8 on: July 21, 2018, 03:04:10 PM »


Last year's 1099 shows a number for qualified and a number for ordinary.  From what I know of taxes, some index funds produce both kinds of dividends with the "ordinary" or "unqualified" being taxable as regular income.  Then again I've been wrong a lot this week on this subject.

Remember that there's a square vs rectangle thing going on here. The Qualified dividends are ordinary dividends, but not all ordinary dividends are qualified. That is, the amount entered as ordinary dividends should be all the dividends you received in that account. The amount entered as qualified is the amount that will be taxed at long term capital gains rates. The difference between the two are the ordinary dividends that are not qualified, meaning they're the unqualified dividends, which are taxed at ordinary income tax rates.


Last year I had $9k in total ordinary dividends and $7k in qualified dividends.  You're saying that the $7k is a part of the $9k?  $2k was taxed as income, and $7k was taxed as LTCG?

Yes, that has been my experience.

From the instructions for Form 1040 line 9b:

Quote from: IRS
Enter your total qualified dividends on line 9b. Qualified dividends also are included in the ordinary dividend total required to be shown on line 9a. Qualified dividends are eligible for a lower tax rate than other ordinary income. Generally, these dividends are shown in box 1b of Form(s) 1099-DIV.

MDM

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Re: Roth Conversion tax bracket question
« Reply #9 on: July 21, 2018, 03:09:49 PM »
Last year I had $9k in total ordinary dividends and $7k in qualified dividends.  You're saying that the $7k is a part of the $9k?  $2k was taxed as income, and $7k was taxed as LTCG?
Quote from: IRS
Enter your total qualified dividends on line 9b. Qualified dividends also are included in the ordinary dividend total required to be shown on line 9a. Qualified dividends are eligible for a lower tax rate than other ordinary income. Generally, these dividends are shown in box 1b of Form(s) 1099-DIV.
Travis, did your Form 1040 indeed have $9K on 9a and $7K on 9b?

Travis

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Re: Roth Conversion tax bracket question
« Reply #10 on: July 21, 2018, 03:28:23 PM »
Last year I had $9k in total ordinary dividends and $7k in qualified dividends.  You're saying that the $7k is a part of the $9k?  $2k was taxed as income, and $7k was taxed as LTCG?
Quote from: IRS
Enter your total qualified dividends on line 9b. Qualified dividends also are included in the ordinary dividend total required to be shown on line 9a. Qualified dividends are eligible for a lower tax rate than other ordinary income. Generally, these dividends are shown in box 1b of Form(s) 1099-DIV.
Travis, did your Form 1040 indeed have $9K on 9a and $7K on 9b?

Yes. $9058 and $7423 to be precise.

MDM

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Re: Roth Conversion tax bracket question
« Reply #11 on: July 21, 2018, 03:44:13 PM »
Yes. $9058 and $7423 to be precise.
Then it was as terran suggested and you understood: $1635 ordinary income and $7423 qualified dividends (QDs), with the QDs taxed the same as LTCGs.

Travis

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Re: Roth Conversion tax bracket question
« Reply #12 on: July 21, 2018, 08:01:50 PM »
You guys have been awesome. @MDM  I spent the afternoon on the case study workbook and figured out the numbers well enough to whiteboard it out and explain it to my wife! 

@terran with your suggestion of TGH now while I don't have to worry about state taxes, I did some reading and there were concerns brought up in different forums that you can't simply flip an index fund at Vanguard and there would be a 30-60 days waiting period and that doing the TGH would reduce your future dividend payments.  Can you elaborate on this?

terran

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Re: Roth Conversion tax bracket question
« Reply #13 on: July 21, 2018, 08:27:30 PM »
Yeah, I think I've heard that too. Here's some info: https://personal.vanguard.com/us/whatweoffer/overview/exchangepolicy

I think I've heard of bogleheads getting around it by setting up an "automatic" transaction for the amount they want to repurchase (note that that's an exception) and then cancelling it. See https://www.bogleheads.org/forum/viewtopic.php?t=235374

You could also buy the equivalent ETF and then not have to worry about it in the future as the rule doesn't apply to ETFs per the vanguard link I posted. ETFs seem a little tricky at first, but just make sure you figure out how to do it with limit orders and you should be fine (although I've read that a market order should be fine with ETFs that are traded as much as Vanguard's).

You could also buy a different similar fund. Or if you want to stay in the same funds you're in and not pick something similar you could sell something else in your IRAs, buy that in the taxable and buy the thing you sold in taxable in your IRA. You need to be careful with things like this if you tax loss harvest, but there are no tax issues with rebuying what you sold when you tax gain harvest.

I could be wrong, but the only way I can think of that you would lose out on dividends is if you sold before the ex-dividend date and rebought after it. Otherwise you should still get all the same dividends. Even if that did happen it wouldn't really matter as fund prices adjust by the amount of the dividend when dividends are paid. See https://www.bogleheads.org/forum/viewtopic.php?f=10&t=129142

secondcor521

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Re: Roth Conversion tax bracket question
« Reply #14 on: July 21, 2018, 11:33:14 PM »
@terran with your suggestion of TGH now while I don't have to worry about state taxes, I did some reading and there were concerns brought up in different forums that you can't simply flip an index fund at Vanguard and there would be a 30-60 days waiting period and that doing the TGH would reduce your future dividend payments.  Can you elaborate on this?

I'm not @terran, but...

@Travis, if the mutual fund doesn't hold the stock for the requisite number of days before and after the dividend date (I think it's 60 out of the 121 days surrounding the dividend date or something like that).  Whether a dividend paid to you by a mutual fund is qualified or not depends on the holding period of the stock by the mutual fund, not by the holding period of the mutual fund by the mutual fund shareholder (e.g., you).  If you look at Vanguard index funds, they buy and hold shares for a long time, so nearly all of their dividends are qualified.  If you look at a mutual fund which trades more frequently, then less of their dividends would be qualified.

Dividend payments by Vanguard are determined as of the dividend record date, and it's a per share amount so it is determined entirely by how many shares you own that day.  If you TGH and sell and buy the exact same number of Vanguard shares, then unless you sell before and buy after the dividend record date, then your dividend would be unaffected.  Some (most?) Vanguard index funds have frequent-trader protections, meaning if you sell one of the applicable funds, you can't buy back in in that same account for the next 30 days.

Vanguard doesn't seem to publish their upcoming record dates, but you can get a pretty darn good idea by looking at the historical dividends paid.  VTSAX, for example, pays quarterly and their next dividend will probably be around 9/23.  So if you wanted to TGH in VTSAX, I wouldn't do your sell much later than about 8/18 or so, so you could wait the requisite 30 days (frequent trader restriction) and then buy back in on 9/20 or so.  (You could possibly cut it closer.  I don't like to cut things close or worry about weekends, or whether 30 days starts the day of the sell or the day after, and nitpicks like that.)