There are a lot of great comments on this site and on the forum. Here is one of them that deserves a longer response:
“Hey GCC, thanks for sharing your tax returns each year. How do you decide in a given year whether to do a Roth IRA conversion, harvest capital gains, or both? How do you prioritize?’
It is all a function of other income, long-term tax minimization progress, and short term spending needs.
Roth Conversions vs Capital Gain Harvesting
Roth conversions and capital gain harvesting are two powerful tools for those seeking to Never Pay Taxes Again.
For example, I’ve harvested capital gains every year for the past 6 years of our early retirement, totaling ~$175,000. I’ve also done Roth conversions in 4 of 6 years, totaling ~$36,000. Full details here.
But each year, I don’t know if I will do one or the other or both, or how much of each, until I review our entire tax picture in December.
0% Tax Space
Other income is a major factor because our 0% tax space is limited. We also must prioritize, as each dollar converted to Roth is a dollar that cannot also be used to harvest gains.
Total tax-free space in 2018 for a married couple filing jointly (MFJ) is equal to $101,200. That is $24,000 from the Standard Deduction and $77,200 from the 0% capital gain / qualified dividend tax rate. (Single filers divide by 2.)
The Standard Deduction is our most powerful 0% tax space, as it protects any type of income from taxation including earned income, short term gains, taxable Social Security, non-qualified dividends, interest, Roth conversions, etc…
I prioritize Roth conversions over capital gain harvesting because tax-free Roth conversion space is more precious.
It also has a greater long term value.
Roth conversions, my precious
Value
If we harvest $10,000 of gains this year, that is $10,000 we will never need to pay taxes on. Nice!
Although… harvesting capital gains is one and done; any future growth will be an additional taxable capital gain. And in 30 years or so, inflation will erode half the value of our shrewd tax optimization.
Fortunately, we can harvest more gains next year. And the year after that. And so on…
Conversely, the value of a Roth conversion increases over time.
If we convert $1,500 from our Traditional IRA to a Roth today, yes, we save taxes on that $1,500. But we also save the taxes on all future growth. Super nice!
With a mildly aggressive portfolio like ours, in 30 years that $1,500 could become 10,000 completely tax-free dollars.
Long Term Tax Minimization Progress
The tax code will never force us to realize a capital gain. We can just let those funds grow forever until death do us part.
Not so with our IRAs, where we will be required to withdraw funds once we reach our 70s. If our IRA / 401k gets too big, these wonderful tax-advantaged accounts can become tax disadvantageous.
I’d much rather convert $1,500 into a Roth today at 0% tax rate than $10,000 in 30 years at a non-zero rate. It’s a big part of why we are building the world’s longest Roth IRA conversion ladder.
On the other hand, if we are already well on track to beating the RMD we can give some Standard Deduction space to cap gain harvesting.
Short Term Spending Goals
Alas, there are accessibility challenges to the Roth conversion.
If total ordinary income exceeds the Standard Deduction, we forfeit any opportunity to convert tax-free. And what we do convert isn’t accessible without penalty for 4 – 5 years.
As such, it isn’t an ideal option for very large purchases or for meeting short term spending needs. (Plus, we worked hard to get those dollars into a Roth, why take them out unless absolutely necessary?)
If we want a big chunk of money sometime next year (maybe to buy a boat?), or we plan to become residents of a higher tax community, then harvesting gains might take priority this year.
As an example, in December of 2018, we were sitting on a bunch of 25% unrealized long-term gains. I could have harvested $50k of gains then, and another $50k in early January. The result would be $500k in tax-free liquid cash. Ooh, baby.
Just Catamarans has a lot of eye candy for sale
Alternatively, we might have to pay $15k in taxes on this $100k realized gain if done inefficiently. In planning for a short term purchase, we might prioritize harvesting over Roth conversions (the here and now versus the future.)
If you want a real-world example of harvesting a capital gain, I’ve written a template based on the trades I executed in December 2016. Fill out this form and I’ll email it to you.
Summary
Roth conversions and capital gain harvesting are two powerful tools for lifetime tax minimization.
Other income will largely dictate if we can do only a Roth conversion, only harvest gains, or if we can do both.
I prioritize Roth conversions, because the opportunity space is smaller and, due to compounding, the long-term value is greater. The exception is if we have short term spending goals that would benefit from harvesting large gains.
In the big picture, filling our 0% tax space each year is more important than which tool we use. Once the ball drops at midnight on December 31st, the opportunity is gone.
I would prioritize the Roth conversion when we start withdrawing. The biggest motivation is the RMD. My traditional IRA is much bigger than my Roth IRA. I need to move some money over to balance it somewhat. Capital gain harvesting isn’t a big concern to me because I have mostly dividend stocks.
No index funds?
Great post. With my own journey of Never Pay Taxes Again I struggle with good being the enemy of great. I currently can get my Federal taxes to an effective rate of ~0%. But that is contributing to Roth 401k and Roth IRAs. If I tried to turbocharge my wealth and get a negative effective tax rate (by changing to Traditional) I would have more money to put in my taxable brokerage. Then when I retire I would have to start building out my Roth IRA pipeline. I have 3 kids which help get to the low tax rate currently, but as they grow up I’ll lose the CTC and ACTC space for conversion room.
First world problems I know, but any thoughts of a framework for making this decision would be greatly appreciated. Maybe I should just be content and keep filling the Roth accounts.
You have 3 kids and somehow have a 0 tax rate ? I have 3 all just phasing out youngest is 17 and no clue how you can keep taxable income. I also don’t follow the concept of negative tax rate. Isn’t that just wasted opportunity?
If I were that low I would at least take the 10% bucket to do conversions if you have any to do. Curious to hear GCC’s answer to your question.
“no clue how you can keep taxable income so low” is what I meant
MFJ w/ 3 kids could have an earned income of $77k in 2018 and pay $0 tax. $6k tax – $6k CTC
That is approximately where I’m at in income GCC. Helps to live in a LCOL area to raise a family on this income.
Negative tax rate means you get refundable credits. It may or may not be the right choice vs taking long term gains or Roth conversion. Unfortunately, I don’t think in my particular case the correct answer is obvious.
Hey jimalism,
The framework is just comparing marginal rates.
You are probably right in the middle of the 12% marginal tax bracket. If you contributed some to Traditional now, you would save 12% tax and get some ACTC. If you expected to pay <12% in retirement, then it could be worth it. This is Federal rate only, you also need to consider ACA and any State taxes.
Thanks. I’ll stick with locking in at the 0% effectiveeffec. Was thinking it would be good to have refundable credits to boost the taxable brokerage account (still in accumulating phase). Don’t think my retirement marginal rate will be <12%. Thanks again for the response.
Approaching FIRE harvesting free capital gains might be a priority if you have health insurance from work. Get the basis as high as you can for free while pumping up those tax-deferred accounts. Post-FIRE Cap Gains count towards the ACA MAGI, so this year we only did Roth conversions and no capital gains and let our gains grow. If the ACA goes away or changes we may be able to harvest free capital gains in the future, but for now the plan is to convert up to our std deduction each year.
I’m in the same boat with ACA. Really puts a damper on Cap Gain harvesting.
Roth conversions also count towards ACA MAGI. Will reduce ACA subsidies by 9-15% plus potential increases in deductibles / co-pays.
Prior to FIRE I was doing Free cap gains harvesting. So now I am waiting to see if there are changes to ACA such that I can do free cap gains harvesting again in the future. In the meantime I use the standard deductions for Roth Conversions.
The article mentions Roth conversions or cap gain harvesting at 0% tax rate. That might also make sense in the 12% bracket.
Yes, better to pay 12% now than more than 12% later. This would be on Roth conversions, the applicable rates on realized cap gains are 0%, 15%, 20% etc… but also better to pay 15% now than more than 15% later. See Harvesting Massive Capital Gains.
Were you doing this stuff during your accumulation phase when you were pre-FIRE? Can you take advantage of these strategies during this period?
If total income is less than the 0% tax space, your job provides health insurance, and you live in a no-tax State, then you can apply this stuff anytime. Odds are that you would only do cap gain harvesting.
Roth conversion to use up 0% space and then cap gain harvest. I need some cash and/or high basis investments so I can liquidate and pay for college for the kids in a few years. Roth conversion (and/or Roth 401k/IRA contributions in my case) is great for that long term tax game though. Gotta keep my eyes on 2 balls!
what kind of effective tax rates you getting on this stuff with ACA and NC State taxes?
Roughly 20% since state tax is 5.5% flat and 15% ACA phaseout.
“The Standard Deduction is our most powerful 0% tax space, as it protects any type of income from taxation including earned income, short term gains, taxable Social Security, non-qualified dividends, interest, Roth conversions, etc”
Can I do a Roth conversion against the child tax credit as well.
Example: Beginning next year, I’ll have $21,000 in taxable pension income. I’ve got 17 years to build my conversion pipeline of about $400,000. Would that give me roughly $3000 to convert against the SD and another $4000 to convert against the CTC (2 kids?)
You could. I’ve done it for the last 3 years. (See 2017 tax return.)
The credit is a dollar for dollar reduction in tax burden, so you could really fill the entire 10% bracket ($19,050 in 2018) plus a little of the 12% bracket for just one of the CTCs.
It could be worth it if you expected to pay greater than 10%-12% in the future and/or didn’t qualify for a refundable ACTC.
Pardon my interest in USA dividend taxation – in Aus a once was Labor party, now a Welfare-ist party, wants to change Aus’ full dividend imputation system to something more like the USA system but without the tax relief of the USA system.
“0% Tax Space”: Actually a USA taxpayer shareholder pays 21% tax on their share of their companies profits.
Gross dividend = (1 / ( 1 – 21%)) * $101,200 = $128,101
Tax (couple) = (21% * $128,101) + (0% * (1 – 21%) * $128,101) = $26,901
Net = $101,200
Tax% = (1 – ($101,200 / $128,101)) = 21% (current USA system).
[Comparison using USA : Aus in-country ‘wage currency’ rather than foreign currency exchange rates.]
Gross dividend / USA median gross household income = $128,101 / $61,372 = 2.09
Equivalent Aus Gross dividend ~= 2.09 * Aus median household income = 2.09 * $A84,032 = $A175,399
Tax couple (non-senior) = $A42,546
Net = $A132,853
Tax% = (1 – ($A132,853 / $A175,399)) = 24% (current Aus system).
Did I miss something?
Looks accurate. Historically US corps have paid effective rates about 10% below the statutory rate (Federal only. States also have corp taxes.)
https://en.wikipedia.org/wiki/Corporate_tax_in_the_United_States
“the statutory corporate income tax rate in the United States, including an average of state corporate income taxes, is 25.7 percent.”
https://taxfoundation.org/us-corporate-income-tax-more-competitive/
On weighted average a USA taxpayer shareholder pays 25.7% tax (including federal, state and local) on (1 / ( 1 – 25.7%)) * $101,200 = $136,205 of companies profits?
Aus couple tax on gross dividend of $186,495 would be ~ same: 24%.
Lots of exceptions though:
http://fortune.com/2019/02/14/amazon-doesnt-pay-federal-taxes-2019/
“Amazon ended up paying an 11.4% federal income tax rate between 2011 and 2016 (when the statutory rate was 35%), which is a contrast to the -1% rate this year.”
Mostly dividend stocks in our taxable account. All index funds in our tax-advantaged accounts.
gotcha. Raising basis on the div stocks could increase opportunity to tax loss harvest.
“As an example, in December of 2018, we were sitting on a bunch of 25% unrealized long-term gains. I could have harvested $50k of gains then, and another $50k in early January. The result would be $500k in tax-free liquid cash. Ooh, baby.”
Should the 500k be 100k? Did I miss something?
100k gain + 400k basis = $500k
100k / 400k = 25% gain
I think “$500k in tax-free liquid cash” refers to $500K sales proceeds ($400K cost basis + $100K gains).
I couldn’t believe the range for 0% was so high! This seems like a powerful strategy for maximizing gains.
Is there any strategy you can do while you are working? It sounds like most of this is for post retirement/FIRE.
This is great stuff. Suppose MFJ couple with $15,000 in stock/fund dividends in a taxable brokerage account. In the early retirement scenario, does this $15,000 count against the 24,000 standard deduction / 0% tax bracket for ROTH conversions? Based on the little bit of research I’ve done, it seems that qualified stock dividends in a taxable account are counted towards adjusted gross income but NOT towards earned income?
Thanks Brennan.
Income of any type can be offset with the standard deduction. Roth conversions aren’t earned income either (it is ordinary income.)
Your overarching question is probably easiest to understand by looking through a tax return. For this particular topic, I suggest our 2014 return.
Has anyone incorporated his/her company’s NQDC (non-qualified deferred compensation plan) with Roth conversions & cap gain harvesting strategies? I’m wondering if I should utilize this ability of NQDC to defer up to 70% of salary/bonuses till after leaving the company.
Thank you for this article on roths and your others on taxes. They are so well thought out. We have used the information on tax planning and converting to roths. Thank you for it and for sharing about life and fi!
Thank you. Glad it helped!
How do these Roth conversions work in practice as it relates to actually filing taxes when it’s time to pull out? In our case we had 2 years where we had no income from employment, so I filled up most of the standard deduction with IRA>Roth conversions. When I pull the funds out after 5 years what do I need to do with my tax return for that year so that I don’t pay taxes or early penalty since we’re far from retirement age? Or will my broker automatically know that the converted funds have sat for 5+ years and therefore need not be taxed/penalized?
There are specific withdrawal order rules – 1st is contributions, then seasoned conversions, then gains.
Conversions and contributions are reported to the IRS, so you / your broker / the government all have the data.
Thanks. What if this Roth IRA account has no contributions and only conversions from IRA>Roth in it?
By this order I should be able to pull out the conversions at year 5 without the 10% penalty.
This is also the only Roth account that I own so would be the first and not subject to the Roth contributions stipulation. Looked at the Investopedia article and it seems like this will work. Figuring Jan 1st 2019 for IRA>Roth conversion would mean that I can pull the funds Jan 1st 2024 tax and penalty free?
Yessir.
If no contributions, conversions are next. If no conversions, growth/earnings is next. (“Roth Distribution Ordering Rules.”)
If you did the conversion on Dec 31 2018 instead of the next day you can access the funds a whole year earlier.
I did do them the last week of 2019 which is why I said Jan 1 2019 ;) Think I learned that trick from you. Thanks.