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Multivariable tax optimization
Old 03-11-2016, 11:38 AM   #1
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Multivariable tax optimization

Hi all,

(Yes, I'm back to posting...rarely.)

So I FIREd last month and am looking at 2016 tax planning, which will be a different game than it was when I was working.

Here's some basic background:

I'll probably be filing single with 2 dependent children
ACA estimated AGI of $39K (to get 87% cost sharing reduction)
Almost certainly will take the standard deduction
A few thousand in earned income from employment before FIRE
For the sake of argument, assume I have enough cash on hand not to need any withdrawals from my portfolio.

I have three mostly independent variables that I can tweak:

X. IRA to Roth IRA conversion to create taxable AGI.
Y. Contribution to traditional IRA to potentially get the saver's credit.
Z. Capital gains that I can realize (to get 0% capital gains rate).

I'm OK with paying anything up to a 20% marginal rate but would prefer to avoid paying at any rate above that.

So here's my tentative plan for optimizing my 2016 taxes:

1. Plug all of my data into something like TaxAct.
2. Create an X-Y spreadsheet of IRA to Roth IRA conversions at $1K intervals and traditional IRA contribution at $500 intervals and note the federal tax owed.
3. Examine the results of step 2 to find (hopefully) a sweet spot with the highest conversion that still results in a ~20% marginal rate.
4. Fix the conversion amount (X) and contribution amount (Y) based on the sweet spot.
5. Vary the Z variable at $1K intervals and again note the federal tax owed. Try to maximize Z without exceeding a ~20% marginal rate (i.e., find the spot where the 0% cap gains rate is "used up").

Will this work? Any improvements? Any advice?

Thanks in advance!
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Old 03-11-2016, 11:54 AM   #2
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SecondCor21:

Even though you have lots of cash, If you have (taxable) stocks and/or mutual funds, Consider taking withdrawals from there where you get capital gains.

For incomes below $37600, ie. within and below 15% bracket, (after standard deduction and personal exemption) you pay ZERO federal capital gains taxes.

So for example if you own a Mutual fund with average capital gains of 50%. you could take out a total of 2X$37600 + $6300 (std ded) + $4050 (personal exemption) ==> $85550.

In other words you could you can take out ~$85.5k and pay ZERO federal income tax in that example.

Re-invest the extra money if you want (Beware wash-sale rules). But use the zero cap-gains taxes before they (maybe) are changed.
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Old 03-11-2016, 12:11 PM   #3
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I'd start with using Optimal Retirement Planner - Parameter Form

I read that a trick is to tell the calculator that all your accounts will have the same performance (return) or it will do weird things like use up your lowest performing account first.

Confirm results with tax software.

Many folks overconvert Roth IRAs and recharacterize back to exquisitely control income and thus taxes. That's what I do. Some caveats: Use separate multiple tIRA/Roth combos to make recharacterization math easier. Recharacterize only what is needed.

Conversions done for tax year 20XX can be recharacterized in year 20XX+1 and still affect tax return for year 20XX.
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Old 03-11-2016, 12:15 PM   #4
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Quote:
Originally Posted by SecondCor521 View Post
I have three mostly independent variables that I can tweak:

X. IRA to Roth IRA conversion to create taxable AGI.
Y. Contribution to traditional IRA to potentially get the saver's credit.
Z. Capital gains that I can realize (to get 0% capital gains rate).

I'm OK with paying anything up to a 20% marginal rate but would prefer to avoid paying at any rate above that.

So here's my tentative plan for optimizing my 2016 taxes:
Don't you also need to factor in your ACA subsidy in this calculation? For example, if you max out the tax-free cap gains (up to the top of the 15% bracket) would you not lose a portion of the ACA subsidy (premium subsidy and/or cost sharing?)

It's a tough nut. Before doing anything else, I'd make sure than none of the existing commerical tax software packages can include the ACA optimization as well as the tax optimization.
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Old 03-11-2016, 12:47 PM   #5
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Thanks all.

@MasterBlaster, yup, I want to use as much of the 0% cap gains rate as I can. That's part of step 5. But see response to @samclem below.

@LOL!, yup, I'm aware of the overconvert/recharacterize trick and may use it, especially since there are things like subsidy cliffs (although I should avoid that problem) and the fact that the brackets and exemption amounts vary slightly from tax year to tax year, so optimizing in a 2015 calculator won't be perfect. (Yes, I could adjust for the new numbers; not sure if I'll go that far.)

@samclem, you've hit the nail on the head as far as my problem goes - I have three different variables and it's tricky to optimize all three because of the interactions between them, such as the one you point out. Optimize one, then optimize another, then optimize the third may not result in an optimal result because of the feedback. <Sigh.>
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Multivariable tax optimization
Old 03-11-2016, 12:54 PM   #6
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Multivariable tax optimization

Congrats on retiring! I FIRE'd three years ago and found myself in a similar situation trying to optimize taxes. It's plain shocking how much lower income tax is now, and one of the key reasons I felt comfortable quitting w*rk.

If you are newly single, you should check whether you can qualify for head of household status which gives deeper tax brackets than single.

Your results will probably show that you'll pay less tax this year by taking long-term capital gains up to the top of the 15% bracket, as mentioned, where you'll pay 0% on the gains. If you are carrying forward capital losses from previous years, you'll get to use those as well.

Roth conversions generate ordinary taxable income, so they won't help you this year... but this ignores the big picture looking at taxes in the future. If your tax-deferred accounts are relatively large, doing partial conversions over many years may save you from the "tax torpedo" of RMD's forcing you into high tax brackets later. In a higher bracket, qualified dividends and LTCG are no longer taxed at 0%.

Choosing between tax now or later is a tough call, and won't be revealed by a one-year analysis. You'll need to consider several things:
What tax bracket will you be in when IRA distributions start?
Do you expect tax rates to change because of political changes? (Who knows?)
Is there a possibility of changing filing status (getting remarried or becoming head of household)?
Do you have enough in taxable accounts now to sustain you until IRA distributions/Social Security? If not, Roth conversions can help to tap tax-deferred accounts.
Do you have enough in cash/taxable accounts to cover taxes on Roth conversions?
Do you have highly appreciated taxable investments that will need to be liquidated in the coming years?
Do you plan to sell appreciated real estate in a particular year, generating capital gains?
What effect will Increased income (cap gains or Roth conversions) have on ACA subsidies?
Planning to leave tax-free Roth accounts to heirs will also be an advantage to them, but it depends whether you feel you have enough now to pay the taxes for them.

In my case, I'm choosing Roth conversions over harvesting capital gains but I see others choosing differently based on their situation. Let us know what you decide.
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Multivariable tax optimization
Old 03-11-2016, 01:09 PM   #7
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Multivariable tax optimization

Also, since you have earned income, don't forget about a Roth contribution this year.
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Old 03-11-2016, 01:21 PM   #8
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Originally Posted by LOL! View Post
I read that a trick is to tell the (i-ORP) calculator that all your accounts will have the same performance (return) or it will do weird things like use up your lowest performing account first.

Wow, thanks for that tip. I could never get useful results from i-ORP because it insisted on wiping out my IRAs as soon as possible, even suggesting Roth conversions of gazillions in the early years. I have my bonds in IRAs so of course they have a lower return. I'll have to equalize the returns and give it another shot.


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Old 03-11-2016, 01:25 PM   #9
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If your income is low enough for ACA subsidies, you may find that keeping your income just high enough to avoid being pushed into medicaid is the best strategy. It is hard to get enough savings elsewhere (and remember - you're estimating that savings years out) to beat the ACA subsidies. The ACA subsidies may not always be there, so you may as well make the most of them now.

Estimate how much your RMDs will be before you try to do Roth conversions to 20%. If you use your tax deferred accounts for your bond allocation, they will not grow as fast as your equity allocations.
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Old 03-11-2016, 01:55 PM   #10
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Quote:
Originally Posted by Done View Post
Congrats on retiring! I FIRE'd three years ago and found myself in a similar situation trying to optimize taxes. It's plain shocking how much lower income tax is now, and one of the key reasons I felt comfortable quitting w*rk.

If you are newly single, you should check whether you can qualify for head of household status which gives deeper tax brackets than single.

Your results will probably show that you'll pay less tax this year by taking long-term capital gains up to the top of the 15% bracket, as mentioned, where you'll pay 0% on the gains. If you are carrying forward capital losses from previous years, you'll get to use those as well.

Roth conversions generate ordinary taxable income, so they won't help you this year... but this ignores the big picture looking at taxes in the future. If your tax-deferred accounts are relatively large, doing partial conversions over many years may save you from the "tax torpedo" of RMD's forcing you into high tax brackets later. In a higher bracket, qualified dividends and LTCG are no longer taxed at 0%.

Choosing between tax now or later is a tough call, and won't be revealed by a one-year analysis. You'll need to consider several things:
What tax bracket will you be in when IRA distributions start?
Do you expect tax rates to change because of political changes? (Who knows?)
Is there a possibility of changing filing status (getting remarried or becoming head of household)?
Do you have enough in taxable accounts now to sustain you until IRA distributions/Social Security? If not, Roth conversions can help to tap tax-deferred accounts.
Do you have enough in cash/taxable accounts to cover taxes on Roth conversions?
Do you have highly appreciated taxable investments that will need to be liquidated in the coming years?
Do you plan to sell appreciated real estate in a particular year, generating capital gains?
What effect will Increased income (cap gains or Roth conversions) have on ACA subsidies?
Planning to leave tax-free Roth accounts to heirs will also be an advantage to them, but it depends whether you feel you have enough now to pay the taxes for them.

In my case, I'm choosing Roth conversions over harvesting capital gains but I see others choosing differently based on their situation. Let us know what you decide.
Lots of good questions here; I'll try to answer them in order:

I've been single for 10 years now and plan to remain single. I have three kids and would prefer to file HOH rather than single, but HOH requires at least one kid to spend more than 50% of their time with me. Right now I have less than 50% custody of the younger two, and the older one is hopefully going to launch himself into an independent situation this year. So I did file HOH for 2015 but unfortunately will probably have to file single for 2016.

No carryforward capital losses at the moment, but I may have some specific lots in my taxable that are under water. Personally I prefer *not* to offset gains with losses, and try to use losses to offset ordinary income instead.

I am mainly doing the Roth conversion to keep my 5 year Roth pipeline filled, but yes, also to avoid the RMD tax torpedo.

For various reasons, I do expect my tax brackets to do nothing but increase. My simple method of multiple-year tax optimization is to willingly pay taxes up to ~20% and avoid paying taxes (when possible) above that rate. The 20% is just a SWAG. I'll probably be in the 25% bracket or maybe higher when RMDs start.

There is no possibility of remarriage. There is a small chance of HOH if kid #1 doesn't launch or kid #2 decides he wants to spend more time over here with me.

My tax-deferred is relatively large, so I plan to do a Roth pipeline as noted above.

I do have enough to cover taxes on Roth conversions as long as they are "reasonably" sized.

I don't have highly appreciated securities and don't plan on selling any appreciated real estate any time soon.

Your second-to-the-last question is the one I'm focusing on with this thread. Obviously increased income will result in decreased subsidies, but I'm not sure what balance to strike here (other than my SWAG 20% rule).

The heir question is too murky at this point. I'm 46 and in decent health, my kids are teens/young adults, and my parents are probably going to bequeath me enough to affect my plans. At this point all I'm doing is modest contribution matching into my kids' Roth IRAs. Oh, and I've got college funds for each of them.

Regarding your followup post, I plan to do an IRA contribution to try to get the saver's credit. Not sure if I will do traditional or Roth. I think I am inclined towards the traditional IRA contribution so I can, in a sense, shelter more Roth conversion money.
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Old 03-11-2016, 01:59 PM   #11
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Wow, thanks for that tip. I could never get useful results from i-ORP because it insisted on wiping out my IRAs as soon as possible, even suggesting Roth conversions of gazillions in the early years. I have my bonds in IRAs so of course they have a lower return. I'll have to equalize the returns and give it another shot.
Another trick I read is to specify a minimum amount in each account to never go below. This way, the calculator won't overconvert in the early years, but is that legit?
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Old 03-11-2016, 02:16 PM   #12
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@walkingwood, thanks. I can pretty much make my AGI whatever I want this year between perhaps $10K and $80K. And yes, it seems that a combination of ACA subsidy loss plus the 15% actual tax bracket represents an effective 30% bracket that I would want to stay under.

My bond allocation is in my tax-deferred; I am at a 90/10 AA and will likely stay between 100/0 and 80/20. Estimating my RMDs reasonably accurately requires estimating my inheritance, which is a tricky thing obviously. As things stand now my inheritance could approximately triple my net worth. <Insert link to all of the inheritance disclaimers. I know, I know.>

Another thing that weighs on my thoughts is that tax year 2016 is what my second kid will use for FAFSA purposes for his freshman year in college (using the new FAFSA rule and assuming my kid graduates on time). So there's that to think about.
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Old 03-11-2016, 03:25 PM   #13
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I'll second the motion to enter just enough income to keep out of Medicaid territory...Each dollar more you're paying 29% marginal tax and then when you hit the cliff, BOOM! Talked about that here.
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Old 03-12-2016, 06:49 PM   #14
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Another trick I read is to specify a minimum amount in each account to never go below. This way, the calculator won't overconvert in the early years, but is that legit?
One cause of early IRA withdrawals is delaying Soc. Sec benefits until age 70. This is exactly what conventional wisdom dictates and will maximize your spending.

A linear programming optimizer is its most useful when its results challenge your intuition. That's when you should give careful consideration to why ORP is doing what its doing. Usually when you try to force ORP toward what is comfortable you degrade annual spending.

If you send me a run id at the email indicated on ORP's web site I will have a look at your model.
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Old 10-26-2016, 05:02 PM   #15
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For anyone that cares, here is a brief update:

1. Kid #2 is going to start college one year later than previously expected, so tax year 2017 is the relevant one for FAFSA / financial aid.
2. I plugged all of my situation into 2015 TaxAct and played around with the three variables.
3. For X: I converted $40K to my Roth IRA and expect to recharacterize about $15K back once I put things into a 2016 tax program.
4. For Y: I contributed $5500 to my traditional IRA, although I don't think I will get the Saver's Credit.
5. For Z: I realized about $3200 in capital gains.
6. I had an unexpected large capital gain due to a small company getting bought out that is throwing a wrench in the works.

I look forward to actually filing my taxes so I can see what happened. The 2015 Turbotax program doesn't really show what's going on directly unless one pays.
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Old 10-27-2016, 01:48 AM   #16
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Missed your original thread in March... but commenting in case you find this of value.

Based on my experience and your income/tax situation, I would think your target income would be best around the lower of 399% FPL (to get ACA subsidies) and top of 15% tax bracket. I think maximizing LTCG at 0% would have greater benefit than Roth conversion. But do take State Tax laws into consideration while making that decision. For instance, if your state does not tax IRA withdrawals (and hence does not tax Roth conversion), it may be better to maximize Roth conversion than LTCG (which your state may tax as ordinary income for example).
Saver's credit will not be a worthwhile pursuit at your levels of expected future income.

Since IRA/Roth contributions can be done until April (as opposed to gain/loss or Roth conversion), you can split the $5500 contribution into Traditional and Roth to fine tune your taxable income right until tax filing time (in lieu of Roth recharacterization).

I think, even if the oldest kid is earning but you are still paying for the expenses, you can claim an exemption on your return (and skip claiming it on kid's return).
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Old 10-27-2016, 12:22 PM   #17
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Thanks, pixelville.

Unfortunately I do not have any more capital gains that I can take beyond the $3200 that I have already taken (unless the market goes gangbusters in the next two months; I don't think it will but one never knows).

My state (Idaho) starts with Federal AGI and then adjusts for a few things, but Roth conversions are not one of them unfortunately.

Good idea about tweaking the traditional/Roth contribution to adjust my taxable income. I have added it to my notes to play with that variable as well to see what I can do.

Unfortunately my oldest kid does not qualify for me to claim an exemption, basically because (a) he is not in school full time, and (b) he earns too much.
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