Roth Conversion or 0% Gain Bucket?

[Gone4Good]

So which is better at lowering your lifetime tax burden: a Roth IRA Conversion or exploiting the 0% Capital Gains bracket?

Say we have a hypothetical taxpayer who is in the 15% bracket and can earn $20K more in income before they move into the next bracket. This person has $100K invested in a traditional before-tax IRA and also has $100K in unrealized capital gains.

What should they do?

1) Convert $20K of the IRA into a Roth. Pay $3K in taxes this year but avoid future taxes on all subsequent investment returns and any taxes that would have been due on withdrawals or RMDs.

2) Sell enough assets to generate a $20K capital gain to take advantage of the 0% gain bracket and immediately repurchase the asset (there’s no wash rule for realizing gains) thereby stepping up the tax basis and forever avoiding paying taxes on that $20K.

On the surface taking the gain seems like the obvious answer. Paying no taxes forever is better than paying some taxes today. And this is almost certainly mathematically correct if our investor completely liquidates their portfolio over their lifetime.

But if they don’t liquidate their entire portfolio, they may never pay taxes on some of those unrealized gains anyway. Stepping up the basis may not save that much in future taxes after all.

I recognize that there is probably no right answer to this question. But is one answer more right than the other?

 

[pb4uski]

I struggled with this as well. In fact, the first year I was retired I favored gains trading over Roth conversions because at that time it was unclear how long 0% capital gains would last.

Over the last few years I have done Roth conversions to the top of the 15% tax bracket but do realize 0% gains as I sell equities out of my taxable portfolio to fund our living expenses.

Depending on investment performance, out taxable accounts may be close to depleted by the time I turn 70 so in a sense my strategy is a combination of 0% gains and Roth conversions. The way I look at it the window for doing low cost Roth conversions is short (10 years for me) but now that 0% capital gains has been made permanent I can always do that later if necessary.

 

[mpeirce]

One plus for ROTH conversions is flexibility. It's nice to have a source of funds that can be tapped with no tax consequences.

 

[hnzw_rui]

Personally, Roth for me. CA taxes capital gains as ordinary income.

 

[Texas Proud]

Just to throw a wrench into the question...

It makes a difference if you are getting an ACA credit... either of the two choices increases your MAGI and your credit will go down... so, as long as you are getting a credit there is no such thing as a 0% tax bracket... any income, no matter where it comes from, will have a marginal tax to it...

 

[kramer]

I have done both the past few years: convert IRA through 0%, 10% and a little into the 15% bracket and use any space left for taking cap gains.

I am early retired, currently age 50, with virtually all of my taxable income consisting of dividends (maybe 75% of these are qualified dividends).

The reason I bother to convert a trad IRA to ROTH IRA:
* Reduce how much of my SS will be taxable at age 70+ after IRA RMD starts
* My ROTH is small so the early dollars in a ROTH are more valuable than the later dollars
* My foreign tax credit (it is way over the $300 automatic credit) gets wasted if my income tax bill is zero, so converting let's me use some of it -- reduces my marginal IRA conversion rate from 10% to 8% and from 15% to 12%
* Part of the IRA conversion is in the 0% tax bracket, no use in wasting that space on capital gains

So I IRA convert what is left of the 0% tax bracket (above the non-qualified dividends), all of the 10% bracket and a little of the 15% bracket. Then I sell ETFs to get cap gain up to the top of the 15% bracket (after accounting for my dividend income). A single person with no deductions can make almost $48K income now and pay only the taxes on the conversion. This year I expect the net tax on my total conversion to only be about 6%.

I may start converting more IRA at some point as I will not be able to convert most of it using this technique at a rate of about 15K per year (even though my taxable account is much larger than my IRA).

The most important unknown variable is how SS is taxed in the future. If the income amounts at which SS is fully taxed are not inflation adjusted in the future, which is the current status quo, and you still have 20 years to go until receiving SS as I do, it may not matter much what you do. Anyway, I can't give up the chance to at least convert something each year when the tax rate is only 6%.

Edit: I have no ACA credit and no State taxes

 

[bingybear]

you have 100k in a TIRA... and assuming you are somewhat older... I would not worry too much about RMDs as they will be really small.
If you are MFJ with no other dependents, that case you present would not have an ACA subsidy.
with a 100k IRA at RMD time would start with RMDs at about $4k/ year. Not enough to have a great impact of taxes. Now if you said $1MM or 2MM, then conversions would likely be the way to go.
I think the choice really depends on the details.

 

[Animorph]

You kind of need to do detailed lifetime calculations to see which is best for you.

In this case I think I'd lean toward taking 0% capital gains, since that is a 15% tax savings.

If RMD's from the $100k IRA end up coming out at the 15% tax rate (that seems likely) there's only a small benefit to Roth converting now using the 15% tax bracket. If RMD's will be taxed at the 25% rate, then there is a 25% - 15% = 10% benefit to Roth converting now. Plus the small benefit of the Roth account holding more after-tax value than the tIRA.

So if there is nothing else in play, like ACA subsidies, the 0% capital gains strategy gets you a 15% savings and the Roth strategy gets you 0% to 10% savings.

 

[Gone4Good]

You kind of need to do detailed lifetime calculations to see which is best for you.

Yeah, I've been trying to avoid doing the work. I'm also uncertain as to how much a detailed financial model will actually tell you. There are just too many variables - how you spend down your assets; how you rebalance - or don't; how long you live; how markets perform in general and how stocks perform relative to fixed income; the sequence of returns; and how tax laws change will all impact whatever conclusion you draw.

I'm thinking that the model developed by Wellington J. Whimpy some 80 years ago is still the best fit here. It says: "I'll gladly pay you Tuesday for a hamburger today."

 

[harley]

I go back and forth, and just guesstimate which is the better option each year. I've been trying to move all of my play money for individual stock picking out of my taxable account and into my Roth so I won't have to worry about taxes in the future as I trade. So when I get an opportunity to sell in the taxable account I go with the 0% CG option, then fill up the 15% bracket with a Roth conversion. When I don't have any CGs, I max out the conversion. I suspect the difference in overall savings is small enough to be incidental, but like you I'm avoiding doing the work on it. If anybody else does it and it turns out I'm wrong, let me know.

 

[pb4uski]

y....with a 100k IRA at RMD time would start with RMDs at about $4k/ year. Not enough to have a great impact of taxes. Now if you said $1MM or 2MM, then conversions would likely be the way to go.
I think the choice really depends on the details.

Good point... at $100k tax-deferred it doesn't matter a whole lot but many people have much higher balances.