Understanding Cap Gain "0%" tax bracket for

[nwsteve]

I have been playing with some numbers to better understand how my marginal tax rate is impacted by various levels of IRA withdrawal/Roth Conversion.
If all taxable income including IRA withdrawals stay below72500, no issues. Qualified dividends and cap gains get taxed at 0%, rest at 15%.
Using a benchmark income just below the threshold of 72500, I added $1000 to taxable income, marginal rate on the 1000 is .25. What I expected.
What I did not expect is when I add say 10000 to taxable income, marginal rate went to .287, and at 20000, marginal rate increased a tad more to .294.
From playing with IRS 'Qualified Div/Cap Gains worksheet, it looks like to me not only are you paying the higher 25% rate of the next bracket over 72500, but you are also "pushing some portion of your 0 bracket cap gains into a 15% tax burden since you are now above the break point for the 15% general tax rate.

Is this correct? Is it dollar for dollar for the income above 72500--but why does the marginal rate keep growing as you add more $$ in the over 72500 bracket?

If I correctly understand the math, it would seem that Roth conversion dollars when you move above the 15% bracket, actually "cost" more than just the bracket bump. (a 15% "surcharge on what had been 0 tax on your cap gains).

BTW, I am using the 1040 tax estimator at bankrate.com for running the options.

All help appreciated. Many thanks
Nwsteve

 

[LOL!]

I think you understand correctly. How about using TaxCaster too?

 

[RunningBum]

Yep, you've got it right. What I've found is that LTCGs and divs are part of the 15% bucket, and when I overflow that bucket with Roth conversions (or any other income), not only am I paying 15% tax on that dollar, but also 15% tax on $1 of cap gains that I've pushed out of the bucket. It's a phantom 30% bracket until you've pushed all of LTCGs and divs out of that bucket, at which point it returns to 25% because all of the cap gains and divs are now taxed at 15%.

 

[nwsteve]

It's a phantom 30% bracket until you've pushed all of LTCGs and divs out of that bucket, at which point it returns to 25% because all of the cap gains and divs are now taxed at 15%.

Ouch! Thanks to you & LOL for the confirmation.
Certainly raises the breakeven for Roth conversion. Uhmmm, pay 30% now to convert, or 25/28 latter as a RMD. How long to breakeven on that penalty?
Nwsteve

 

[FIRE'd@51]

If all taxable income including IRA withdrawals stay below72500, no issues. Qualified dividends and cap gains get taxed at 0%, rest at 15%.

I believe this is the source of the confusion. The "rest" is not all taxed at 15%.

Up to $17.9K (using 2013 tables) of ordinary income is taxed at 10%, afterwhich the 15% bracket kicks in up to $72.5K. You are seeing the blended rate on your ordinary income of the 10% and 15% brackets, plus the 15% on the LTCG pushed above $72.5K. As you add more ordinary income, you are raising the blended rate on the ordinary income as well as increasing the rate on LTCG/QD to 15% on the amount that gets pushed above $72.5K

 

[meierlde]

I believe this is the source of the confusion. The "rest" is not all taxed at 15%.

Up to $17.9K (using 2013 tables) of ordinary income is taxed at 10%, afterwhich the 15% bracket kicks in up to $72.5K. You are seeing the blended rate on your ordinary income of the 10% and 15% brackets, plus the 15% on the LTCG pushed above $72.5K. As you add more ordinary income, you are raising the blended rate on the ordinary income as well as increasing the rate on LTCG/QD to 15% on the amount that gets pushed above $72.5K

Note these are the married filing jointly brackets Single is 10% to 9705, 15% to 36.9 on up.

 

[kramer]

Another subtlety is the foreign tax credit. If you own mutual funds or ETFs of foreign stocks in your taxable account you implicitly pay a foreign tax and are issued a foreign tax credit (FTC) each year. However, you can't use it if you are not paying US income taxes. And if the amount is larger than $300/$600 for single/married, the credit has more restrictions.

Overall, this FTC issue has the effect of lowering your marginal tax rate once you move past the 0% rate.

Something else for the OP to consider is to do TraditionalIRA to ROTH conversions instead of just taking all of the money out of the IRA as taxable income.

 

[RunningBum]

Ouch! Thanks to you & LOL for the confirmation.
Certainly raises the breakeven for Roth conversion. Uhmmm, pay 30% now to convert, or 25/28 latter as a RMD. How long to breakeven on that penalty?
Nwsteve

I'd have to think this through, but I don't think that's the way to look at it. When you have cap gains, 30% is an intermediate bracket you move through to get to 25 and then 28. Here is how I view each incremental dollar earned, converted or withdrawn for tax deferred account for married filers

1. 10% income : income up to 17850, under 72500 when including divs & LTCGs
2. 15% income: income 17850-72500, under 72500 when including divs & LTCGs
3. 15% income + 15% cap gains: income 17850-72500, over 72500 when including divs & LTCGs such that each $1 earned and taxed also pushes $1 of divs/LTCGs into a 15% tax.
4. 25% income: income 72500-146,400, all divs and LTCGs have been pushed above 72500 so there is no additional 15% on that incremental dollar.
5. 28% income: 146,400- and so on through the higher brackets.

So there's no avoiding that phantom 30% bracket if you have qualified dividends or long term capital gains. My plan is, if I'm going to hit it, I might as well go all the way through it and convert up to the top of the 25% bracket (and possibly even the 28% bracket) so that in the future I can keep everything right to the top of the 15% bucket when including divs & LTCGs. If you can control or defer divs and LTCGs, it seems like it'd be better to convert to the top of the 25% bracket in years where those are low, so that the 30% window is small.

It's tricky though, because there's no sense in not reaching the top of that 15% bucket (including divs&LTGC) every year to take full advantage of the 15% income tax rate with 0% LTCGs. So in that respect, maybe it's better to just convert up to the top of the 15% bucket including divs/CGs unless you'll have so much left that RMDs will push you above 28%.

Social security tax is another consideration, since it might be to your advantage to take more income now so that you have less income when drawing SS so that less SS is taxed.

On the other hand, you may want to keep income low now for ACA subsidies.

There's also the uncertainty of what future tax rates will be.

Hope that makes sense. With so many factors pushing different ways I don't think there's a definitive correct answer. I am pretty sure though that you want to avoid topping out every year in that 30% window. Either stop at the top of the 15% bucket including divs & LTCGs, or blow all the way through it and get to the 25% bracket.

 

[jebmke]

Another subtlety is the foreign tax credit. If you own mutual funds or ETFs of foreign stocks in your taxable account you implicitly pay a foreign tax and are issued a foreign tax credit (FTC) each year. However, you can't use it if you are not paying US income taxes. And if the amount is larger than $300/$600 for single/married, the credit has more restrictions.

Overall, this FTC issue has the effect of lowering your marginal tax rate once you move past the 0% rate.

Something else for the OP to consider is to do TraditionalIRA to ROTH conversions instead of just taking all of the money out of the IRA as taxable income.

A lot of retirees with dividend income considering ROTH conversions are aware of the infamous 30% marginal rate which doesn't even exist as a statutory rate in the brackets.

I never make a financial decision that has potential significant tax consequences without creating a pro-forma tax return with real tax software. The interactions of various schedules is just to complicated to deal with in an ad-hoc way. I'd throw Form 1116 into that mix (however, in reality, for the typical passive investor, Form 1116 isn't as scary as it looks).

As far as I know, most software tools available to evaluate ROTH conversions (home grown or not so home grown like IORP) do not take into account these subtleties which can be quite significant. That is why I use them only for an approximation for more long term planning and not as a tool to evaluate real decisions.

 

[nwsteve]

A lot of retirees with dividend income considering ROTH conversions are aware of the infamous 30% marginal rate which doesn't even exist as a statutory rate in the brackets.

I guess I am "new" to this party of knowing about the "hidden 30%" bracket, having only played around at the edges previously. Now I am retired, I've got the time to look in detail at more scenarios and explore the impact of different levels of Roth conversions versus higher RMDs later.

Clearly the easiest lesson is to go right to the top of the 15% bracket each year! Now the more complex (for me) is to determine the tradeoff of harvesting cap gains at 0% now versus reducing future taxes when RMDs start. I certainly agree with the comment running a full tax software simulation to make sure you do not get an unpleasant surprise when you actually file your return. For us, we are definitely going to be pushed forever into the 25% bracket, the only question is how much higher and how often.

Any suggestions on any rule of thumbs to capture how many years of tax free compounding in the Roth, it will take to make up moving form 0% to 30%? One "guru" I chat with says, Roth conversions can be overrated if you are really only prepaying your heirs' taxes. For us that is most likely the scenario, and may make the decision.
Nwsteve

 

[tuixiu]

I think you understand correctly. How about using TaxCaster too?

This.

I've figured out a lot of what-if scenarios by fiddling with Taxcaster. I wish it had an way to differentiate qualified/nonqual dividends, I know can do musical buckets with the "misc" category but would be easier if was right there.

 

[kaneohe]

Another subtlety is the foreign tax credit. .....................
Overall, this FTC issue has the effect of lowering your marginal tax rate once you move past the 0% rate.

kramer..........The FTC can lower your tax paid , and thus your effective tax rate, but I don't think it changes the marginal rate since the FTC is basically a constant and gets subtracted from both taxes in the marginal rate calculation.

 

[jebmke]

kramer..........The FTC can lower your tax paid , and thus your effective tax rate, but I don't think it changes the marginal rate since the FTC is basically a constant and gets subtracted from both taxes in the marginal rate calculation.

Actually, if you follow the calculation on 1116, the FTC isn't always constant. You really have to work through the calculation.

 

[kramer]

Actually, if you follow the calculation on 1116, the FTC isn't always constant. You really have to work through the calculation.

If you are under the individual limit ($300/$600 for single/married) it's pretty easy -- you can simply take a credit for the full amount of foreign taxes you paid.

But for me, I am well over the individual limit and so the law does not necessarily give you that free lunch credit. So I need to go figure the percentage income tax I paid on my foreign holdings (I think this is something like 7%, on average). You can only deduct foreign taxes up to the same percentage you paid on the US portion of your taxes. So if you paid 0% US tax, you cannot use any of the foreign tax credit this year. If you paid 2% US tax on your total US-sourced income in this example, you can use 2/7 of the foreign tax credit and can carry 5/7 forward, etc. If you paid 10% US tax on your total US-sourced income, you can use the full tax credit and also use some that you carried over from previous years (carry forward up to 10 years, carry back 1 year).

Also, don't forget that in your first full year of ER, you can carry back that years foreign tax credit to the previous year when you were working and paying a high tax rate. I got a four figure refund when I did this on my 2008 taxes (I retired in 2007), even though I had no tax liability in 2008. I just carried back the full amount to my 2007 taxes by filing a form 1040X for 2007 when I did my 2008 income taxes in early 2009.

I intend to do a traditional IRA to ROTH conversion this year. My taxable income is a combination of qualified dividends, long term capital gains, interest income, and non-qualified dividends. For the conversion, I will use up the space remaining in the 0% bracket (maybe $3000) and all of the 10% bracket ($10,000). I use of the rest of the 15% bracket for Capital Gains tax harvesting. I think my conversion has an effective tax rate of around 5% because part of the conversion is in the 0% bracket and because the foreign tax credit reduces the taxes on the 10% conversion part. In this scenario, even my long term cap gains is a non-zero marginal rate because it is decreasing my foreign tax credit.

 

[Animorph]

I guess I am "new" to this party of knowing about the "hidden 30%" bracket, having only played around at the edges previously. Now I am retired, I've got the time to look in detail at more scenarios and explore the impact of different levels of Roth conversions versus higher RMDs later.

Clearly the easiest lesson is to go right to the top of the 15% bracket each year! Now the more complex (for me) is to determine the tradeoff of harvesting cap gains at 0% now versus reducing future taxes when RMDs start. I certainly agree with the comment running a full tax software simulation to make sure you do not get an unpleasant surprise when you actually file your return. For us, we are definitely going to be pushed forever into the 25% bracket, the only question is how much higher and how often.

Any suggestions on any rule of thumbs to capture how many years of tax free compounding in the Roth, it will take to make up moving form 0% to 30%? One "guru" I chat with says, Roth conversions can be overrated if you are really only prepaying your heirs' taxes. For us that is most likely the scenario, and may make the decision.
Nwsteve

I've had my optimizations Roth convert up to a state tax bracket limit. You need a really detailed tax estimate if you are going to milk it to the last drop.

Even 30% (and that's only on a portion of your income, so the absolute dollars may not be terrible) might be OK if your RMD's after age 70 end up being taxed at 35%. That's the first marginal tax rate you need to estimate: how much tIRA/401k RMD's will be taxed. Then you can convert now as long as your marginal taxes stay equal to or less than that RMD rate. For the 30% tax bump, look at your total marginal rate for the portion of your conversion within the 30% range and above that (I'm excluding the possible portion that stays within the 15% rate). If that total stays less than your RMD tax rate then it is probably worth it. So you should see some conversion at 30%, but then the rest at 25%, and maybe the total averages out to 27% and that keeps you under an RMD tax bracket of 28%.

On the other hand, I think my best optimizations gain me 1% or less additional spending per year when compared to the simplest conversion strategies. I wouldn't spend a whole lot of time worrying about perfectly optimizing your Roth conversions as long as you are covering the basics.

 

[GTFan]

I guess I am "new" to this party of knowing about the "hidden 30%" bracket, having only played around at the edges previously. Now I am retired, I've got the time to look in detail at more scenarios and explore the impact of different levels of Roth conversions versus higher RMDs later.

Clearly the easiest lesson is to go right to the top of the 15% bracket each year!

The ACA changed all of that if you are intent on maximizing subsidies, so it's not as clear a decision as it used to be. An early retiree can hold down WRs and possibly afford to retire sooner if you take the subsidy approach instead of maxing out Roths.

It all depends on what you want to do with the money if you anticipate ending up with a large 401k/IRA balance at RMD time without conversions. My plan at this point is to donate a good chunk to charity and gift some of it to the kids, but that is so far down the road I'm not sure I want to plan that far out.