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.
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.
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.
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.