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Roth IRA vs Less Capital Gains via stepped up basis
Old 12-27-2010, 01:38 PM   #1
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Roth IRA vs Less Capital Gains via stepped up basis

I'm faced with a dilemma that must be answered by the end of 2010.

I can either "tax gain harvest" and increase my cost basis in my taxable investments by $23000 or I can make a $10,000 Roth IRA contribution (instead of a Traditional IRA contribution). Taking the $23000 in stepped up basis will cost me $300 more in taxes this year versus the $10,000 Roth IRA contribution. But that tax cost is minimal as compared to the possible tax advantages of having a stepped up basis or $10,000 more in the Roth IRA (instead of traditional IRA).

I'm trying to figure out what factors are key to the decision. I think one key factor is time until withdrawal/sale for the Roth assets and the taxable assets. The value of the Roth contribution increases every year (as the invested assets grow), but the value of the stepped up basis decreases in real terms every year due to inflation (and ultimately the value of stepped up basis goes to zero if/when taxable assets are inherited).

To describe where I am financially, I'm roughly 5 years from planned retirement or very semi-retirement at age 35 and planning on some combination of 72t SEPP withdrawals from Traditional IRAs and selling investments from taxable accounts (plus spending dividends, cap gains distributions, and interest). Due to a few factors, I anticipate my ordinary income effective marginal tax rates to be 50-55% and my cap gains tax rates to be 40-50%.

I wanted to get your thoughts on which tax benefit you would pick today and why/what factors influence your decision. I am leaning toward the $10,000 in the Roth IRA right now. I think the benefits of the stepped up basis may not be realized for many years or decades and be very minimal by then, whereas the Roth IRA contribution will continue to grow and the value of the tax-free withdrawals later will be much more than the value of reduction in cap gains due to stepped up basis.
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Old 12-27-2010, 01:41 PM   #2
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Here is where my portfolio may be in 5 years at ER:

(in 2010 dollars)
$350,000 taxable
$630,000 Trad. IRA/tax deferred
$100,000 Roth IRA
$70,000 HSA
$50,000 529 plan
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$1,200,000 Total
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Old 12-27-2010, 02:33 PM   #3
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Originally Posted by FUEGO View Post
Due to a few factors, I anticipate my ordinary income effective marginal tax rates to be 50-55% and my cap gains tax rates to be 40-50%.
.
Are you talking about now or in the future? I must be missing something obvious here..........how are you getting CG rates of 40-50% when the current rates are 0, 15%. And why are the marginal rates so high?

Why Roth instead of TIRA......the old basic concepts of tax rate now vs at withdrawal are still valid.
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Old 12-27-2010, 02:37 PM   #4
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If stepping up $23K in cap gains now only costs you $300 and in the future it'll cost you 40-50% I'd take the cap gains now, but I don't understand those numbers at all so I couldn't really give any advice on your situation.

- Why is it an either/or situation? Are you hitting the AGI limit for a Roth contribution?

- How is the step up only costing you $300?

- Why do you anticipate such high tax rates in the future on both ordinary income and cap gains? It sounds to me like you are planning to live off that $1.2M which would be $48K at 4% SWR, which shouldn't put you anywhere near those tax rates. I guess you have some other large income flow you haven't mentioned?

- What does your situation look like in the next year or two for taking the cap gains then (@15%, I assume) so you can take the Roth this year?
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Old 12-27-2010, 02:49 PM   #5
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Originally Posted by kaneohe View Post
Are you talking about now or in the future? I must be missing something obvious here..........how are you getting CG rates of 40-50% when the current rates are 0, 15%. And why are the marginal rates so high?

Why Roth instead of TIRA......the old basic concepts of tax rate now vs at withdrawal are still valid.
State income tax - 7% on ordinary income or CG's.
Effective marginal rate due to phase out of health insurance subsidies under Obamacare (starting in 2014) - ~18% on income over $34,301 (2010 dollars)
Repayment of student loans under the Income Based Repayment plan - 15% on income over $38,685 (2010 dollars)

That gets me to 40% effective marginal rates and then I assume a federal LTCG rate of 0-10% and a federal ordinary income tax rate of 10-15%.

There are also other known and unknown phase-outs that will occur with increasing income for us. For one, we will lose $865 a year in free/reduced lunch benefits if our income exceeds $47,711. Dining at the gravy train trough of federal handouts can be tricky. For the sake of simplicity, I did not include the loss of benefits of this nature in my effective marginal tax rates assumptions.
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Old 12-27-2010, 03:04 PM   #6
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Originally Posted by RunningBum View Post
If stepping up $23K in cap gains now only costs you $300 and in the future it'll cost you 40-50% I'd take the cap gains now, but I don't understand those numbers at all so I couldn't really give any advice on your situation.

- Why is it an either/or situation? Are you hitting the AGI limit for a Roth contribution?

- How is the step up only costing you $300?

- Why do you anticipate such high tax rates in the future on both ordinary income and cap gains? It sounds to me like you are planning to live off that $1.2M which would be $48K at 4% SWR, which shouldn't put you anywhere near those tax rates. I guess you have some other large income flow you haven't mentioned?

- What does your situation look like in the next year or two for taking the cap gains then (@15%, I assume) so you can take the Roth this year?
Basically, the Roth IRA contrib (instead of a Trad IRA contrib) costs $2200 in taxes (15% fed, 7% state for 2 IRAs at $5000 each for DW and I). If I were going to do the $23000 of Cap Gains, I would do a Trad IRA instead of Roth to free up $10000 in the 15% bracket, and pay $2500 on the $23000 in gains (after adding in some carryover losses and paying tax on some ST CG's that would otherwise be untaxed due to carryover losses). The net cost of the $23000 CG is $300 more than the cost of the Roth IRA.

Otherwise I could do a Roth plus $13000 in cap gains, but the $13000 CGs would cost me $1800 in taxes.

I'm trying to fill up my 15% bracket with LTCG's, but I have carryover losses and ST CGs that complicate the analysis, and make taking a small amount of LTCG's more expensive (14% average rate), but if I can spread that initial cost over a larger amount of LTCGs, then it is worthwhile (10.9% average rate).
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Old 12-27-2010, 06:18 PM   #7
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Still confused. A Roth IRA contribution doesn't cost you anything in taxes nor does it add to your income. You're just funding it with money that has already been taxed. Are you talking about a $10K Roth conversion?

Tomorrow's a travel day for me so I won't be able to follow up on this.
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Old 12-27-2010, 06:29 PM   #8
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Originally Posted by RunningBum View Post
Still confused. A Roth IRA contribution doesn't cost you anything in taxes nor does it add to your income. You're just funding it with money that has already been taxed. Are you talking about a $10K Roth conversion?

Tomorrow's a travel day for me so I won't be able to follow up on this.
I am eligible to deduct contributions for a traditional IRA. I can instead contribute to a Roth IRA. If I contribute to the Roth IRA instead of the traditional IRA, it "costs" me $2200 in taxes (15% fed+7% state for DW and I) to forgo the $10,000 IRA deduction.

I am definitely suffering from paralysis by analysis right now!
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Old 01-02-2011, 12:55 PM   #9
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To update the thread - I decided on the "do nothing" approach. No taking capital gains at the zero percent rate for me (but paying significant extra tax), and I left the $10000 Roth contribution as a Roth contribution (made it earlier in the year).

Next year might be the year I do some tax gain harvesting up to the edge of the 0% CG bracket, since I will have used up most of my long term cap losses this year. "Unfortunately" I think our taxable earned incomes will likely push us up to the edge of the 0% CG bracket for 2011.
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