What method do you use to decide how much income to realize?

[SecondCor521]

Hi,

What method do you use to determine how much income to realize?

I am FIREd and can (within pretty wide limits) choose my AGI by deciding how much to convert from my traditional IRA to my Roth IRA.

The following factors affect me:

1. Cash flow. My Roth conversions eventually become my spending money five years later, so I want my Roth pipeline to be full.

2. FAFSA. Keeping my AGI under $25K (plus some other criteria which we meet) enables a zero EFC. Keeping my AGI under $50K (plus those same criteria) means FAFSA ignores assets. If things go as they likely will, I will have one in college this year, two in college next year, and three in college the year after that.

3. Other tax-related benefits, including ACA PTC and CSRs, 0% capital gains, American Opportunity Tax Credit, and maybe the retirement savings credit.

4. Obviously the overall tax liability to federal and state.

5. The tax torpedo. Converting some now keeps me out of high tax brackets in about 20 years. It looks like converting enough to keep my cash flow good (item 1) will keep me in reasonably good shape for the tax torpedo situation.

In 2017 I created a pretty low AGI for myself so I would get every benefit which I thought I wanted. In 2018, and looking at it more closely in general, I think I may want a higher AGI: although I incur some FAFSA EFC (which functions somewhat as a flat tax at 5.64%), I also can use up some non-refundable credits (such as the CTC and the AOTC). I think that in 2017 I essentially threw away some of the non-refundable credits because my AGI was so low, which meant that I missed the opportunity for 0% taxed Roth conversions (which I'm now realizing I may have undervalued).

Rather than make this thread be about my specific situation (which gets horrendously complicated), I was hoping to learn how each of you with similar flexibility in setting your AGI each year go about deciding what to do. I know Roth converting to the top of a particular federal tax bracket or to a % of FPL for ACA PTC is a common strategy.

So:

1. If you have AGI flexibility, how do you decide what AGI to create?
2. How do you trade off between Roth conversions and 0% cap gain harvesting?
3. In particular, when faced with conflicting factors (as I am), how do you make the trade offs? That is, what method do you use to weight the various factors or how do you make those trade offs?
4. Do you optimize each year independently or do you try to have an overarching multi-year plan?

Thanks!

 

[HI Bill]

What I need to meet my budget. Then I calculate the pre- tax cost.

 

[pb4uski]

I convert to the top of the 12% tax bracket. Beginning in mid to late December, I do a tax return calculation in Excel that I continually update as information on dividends and capital gains distributions come in. Around the 30th, I do a final calculation and then do my Roth conversion online.

In past years I would intentionally slightly over convert and then recharacterize any excess in February when I finalized my tax return, but the new tax law won't allow such fine tuning, so I'll probably slightly underconvert starting in 2018.

 

[RunningBum]

I convert up to the ACA subsidy 400% FPL mark if the subsidy looks worthwhile, otherwise I convert to the top of the 12% bracket, including Qdivs and CGs to keep those from being taxed. My hope is to get my tIRA fully converted before I start taking SS, to avoid a higher tax rate since I have a smallish pension too. It's probably low enough now that it's not that big of a deal if I don't get it all. With the tax rate change maybe I should look closer at 0% LTCGs instead. I forget now why I'm thinking the conversion, which is a 10% difference between brackets, is worth more than the potential 15% savings of taking 0% gains. I don't have that much room for either, so it's not that big of a deal either way, but might as well try to make the best decision, so I'll look at that before I do anything at the end of the year.

 

[Dtail]

"I know Roth converting to the top of a particular federal tax bracket or to a % of FPL for ACA PTC is a common strategy."

Ours is a mix of your last line stated above. DGF is already on Medicare, so Roth conversion to top of 12%.
I manage my ACA income to 150% of FPL.
Don't really have an overarching multi year plan, but some extra income will stop in 2021 and then will have to recalculate between DGF and me.

 

[jebmke]

Prior to 2018 I converted up to but not including the hidden 30% marginal rate. Now I'm done with conversions due to no benefit.



I used to take capital gains for re-balancing when I had losses carried over from 2008-09 but those are gone so I am done taking gains on equity.


So, the short answer is, I will only realize income when it is forced on me.

 

[karen1972]

I have a multi-year plan in a spreadsheet. Quicken lifetime planner only allows for a flat tax rate so had to adjust it and used i-ORP calculations to get to a plan. I also did a scenario where tax rates reverted.

Based on the long-term plan, I need to focus on converting money. That made sense to me since I have a snowball problem.. ie if I'm taking out only $25K/yr (to keep an ACA subsidy) but the account is growing $100K/yr then I'm not even making a dent so my RMD and Tax problem just keeps getting bigger and bigger.

My plans may change if, for instance, we hit a dip in the market, tax law changes, etc.. so the plan is really only good for a year and needs to be re-evaluated each and every year.

 

[fosterscik]

Just a word of caution. You will have a zero EFC but that doesn't necessarily mean much to colleges. They chose how much to give in grant aid and much of any award may be "affordable" loans. You may find your kids have very large loan balances by the time they are finished with college. I suppose you could pay the loans off for them once they are out of school...

 

[SecondCor521]

Just a word of caution. You will have a zero EFC but that doesn't necessarily mean much to colleges. They chose how much to give in grant aid and much of any award may be "affordable" loans. You may find your kids have very large loan balances by the time they are finished with college. I suppose you could pay the loans off for them once they are out of school...

Very good point. One has to look at the individual colleges' aid statistics to see what is likely.

Two of my three kids are going or plan to go to very inexpensive in-state public universities.

The third is aiming at expensive out of state schools. The goal with that one is to get about 1/3 scholarship, 1/3 aid, and 1/3 529/ESA savings which seems reasonable based on the cost calculator at the school and some back-of-the-napkin math. Depending on how things turn out, there may be challenges funding the last year for that one. But there are also other options in my arsenal - co-ops, tax breaks, summer jobs, IB credits, etc.

But I'd like to keep this thread focused on taxes, not college funding if possible.

 

[Gumby]

Not yet retired (<9 months to go at ages 60.5/58.5) but the plan is as follows:

Full tax year 1 of retirement (2020. Age 61/59) - Pension income puts us right on the cusp of the 22% bracket to start. We will use the room afforded by the standard deduction to realize about $24,000 in capital gains in an after tax investment account. Obviously, the precise amount is affected by the amount of taxable dividend income that we also receive during the year.

Year 2 of retirement (2021. Age 62/60) - realize remaining after tax capital gain as necessary, then Roth convert IRA to the top of the 12% bracket.

Year 3 of retirement (2022. Age 63/61) - start social security, then Roth convert to the top of the 22% bracket

Years 4-10 (2023-29/ ages 64-70 for me) - Roth convert to top of 22% bracket.

Years 11+ (>2029) -- RMDs or to the top of 22%, whichever is greater.


At any age, to the extent we need money for spending beyond our pensions and my SS, we'll just withdraw straight from our IRAs instead of Roth converting.

By my calculation, a 4% withdrawal from our IRAs (used for spending or Roth converted) will, when added to our pension and SS, put us just at the lower edge of the 24% bracket. We'll take a withdrawal smaller than 4% as necessary to stay in the 22% tax bracket.

I'll probably tinker around the edges a little, especially if tax laws change again, but that's the essence of my plan.

 

[pb4uski]

.... Based on the long-term plan, I need to focus on converting money. That made sense to me since I have a snowball problem.. ie if I'm taking out only $25K/yr (to keep an ACA subsidy) but the account is growing $100K/yr then I'm not even making a dent so my RMD and Tax problem just keeps getting bigger and bigger ......

That is the "problem" that I'm running into... even though I am converting to the top of the 12% tax bracket I'm effectively just converting growth and my IRA balance is about the same as when I retired 7 years ago. Nice problem to have.

 

[SecondCor521]

Gumby, what was the reasoning for choosing to realize capital gains before Roth converting rather than the other way around? This is a subject which doesn't get much analysis or discussion as far as I have seen and so I am keen on people's thoughts there.

 

[Gumby]

Gumby, what was the reasoning for choosing to realize capital gains before Roth converting rather than the other way around? This is a subject which doesn't get much analysis or discussion as far as I have seen and so I am keen on people's thoughts there.

Because if I keep my AGI $200 below the top of the 12% bracket (i.e. $77,201 MFJ) when the amount of the capital gain is included, the tax on the capital gain is zero.

See https://www.kitces.com/blog/underst...st-capital-gains-for-a-free-step-up-in-basis/ Old rates, but the concept still applies.

https://www.marketwatch.com/story/your-simple-guide-to-the-new-capital-gains-tax-rates-2018-04-16 Deals with the new rates, but not as clear in my mind.

 

[SecondCor521]

Because if I keep my AGI $200 below the top of the 12% bracket (i.e. $77,201 MFJ) when the amount of the capital gain is included, the tax on the capital gain is zero.

See https://www.kitces.com/blog/underst...st-capital-gains-for-a-free-step-up-in-basis/ Old rates, but the concept still applies.

https://www.marketwatch.com/story/your-simple-guide-to-the-new-capital-gains-tax-rates-2018-04-16 Deals with the new rates, but not as clear in my mind.

Sure, I understand about 0% capital gains rates. I guess what I was wondering is why not do Roth conversions from say, age 61 to 67, then harvest capital gains at a 0% rate from 68 to 70?

It looks like you're getting your capital gains realized first chronologically, then doing your Roth conversions. And I understand the benefits of both of those things. Just trying to understand why one would do "0% cap gains then Roth convert" instead of "Roth convert then 0% cap gains".

I'm not trying to challenge you or say that your plan isn't good - I'm sure it is - I'm just trying to understand the reasoning so I can try to figure out if I can apply the reasoning to my own case.

It may be as simple as your capital gains might be something that takes fewer tax years to address than Roth conversions, or it could be that you think the tax laws around cap gains might change for the worse moreso than Roth conversions. Or it could be another entirely different reason. Again, just curious.

Thanks for the insights!

 

[Gumby]

Sure, I understand about 0% capital gains rates. I guess what I was wondering is why not do Roth conversions from say, age 61 to 67, then harvest capital gains at a 0% rate from 68 to 70?

It looks like you're getting your capital gains realized first chronologically, then doing your Roth conversions. And I understand the benefits of both of those things. Just trying to understand why one would do "0% cap gains then Roth convert" instead of "Roth convert then 0% cap gains".

I'm not trying to challenge you or say that your plan isn't good - I'm sure it is - I'm just trying to understand the reasoning so I can try to figure out if I can apply the reasoning to my own case.

It may be as simple as your capital gains might be something that takes fewer tax years to address than Roth conversions, or it could be that you think the tax laws around cap gains might change for the worse moreso than Roth conversions. Or it could be another entirely different reason. Again, just curious.

Thanks for the insights!

Once I start social security, we will always be in the 22% tax bracket just based on pensions and SS. Accordingly, the only limited window to take capital gains at a 0% rate is before I start social security. I also expect that we will never be able to Roth convert all of our IRA money before RMDs kick in.

You might well ask "well, why not defer social security?" The answer is that my young wife is not eligible for social security on her own account, as she has been a teacher for thirty years and has never paid into SS. She also will never receive a spousal benefit or a survivor benefit due to the GPO. It is therefore in our joint best interest for me to take SS early and leave more in our investment account for the likely day when I predecease her and the SS income drops to zero.

 

[Offgrid Organic Farmer]

What method do you use to decide how much income to realize?

When we were young, we knew that housing was always the biggest expense. We focused our investing to give us enough cash to buy our farm with no debt left over.

My military pension is not much, but without any housing costs we do okay.

Our farm's income is never over $1,000. It provides us with most of our food, it makes a great write-off, and this is the lifestyle that we want to live.

We have been remodeling an apartment building, which has caused us to have some conversations on this thread topic.

How much more cash do we want? Do we really want to start paying income taxes?

Our properties are currently held by LLCs, and they would easily slide into L3Cs. We have already met with lawyers and accountants, to discuss making the L3C happen. We think that we could manage the LLCs as if they were L3Cs, it really all depends on how much cash do we want?

I am not about to spend down my Net Worth, neither do I want to start paying income taxes. Fortunately, there are other options

 

[RunningBum]

Taking 0% LTCGs is a 15% tax savings, vs. 10% probably Roth conversion savings.

Seems like a slam dunk for taking 0% LTCGs, but...

- You're never required to sell equities, so they could pass to heirs with a basis reset.

- Cap Gains may be a bit harder to predict exactly if you're near the ACA subsidy cliff. Conversions used to have even better protection with recharacterizations, but that's gone now.

- A market drop could eliminate your LTCGs, but unless your tIRA account value drops to 0, you're going to have taxable income sooner or later.

- You can gift holdings with gains to someone in a lower tax bracket who could sell it at 0%

- You can donate those holdings to a charity or DAF and take a full write-off for the value without recognizing the gains.

So it's probably dependent on your situation, but these look to be the factors to me. Probably missed some.

 

[RunningBum]

Also in past years you could do the Roth conversion "horse race", but that's no longer available with the "no recharacterizations" rule, so that's out too.

 

[audreyh1]

Because if I keep my AGI $200 below the top of the 12% bracket (i.e. $77,201 MFJ) when the amount of the capital gain is included, the tax on the capital gain is zero.

See https://www.kitces.com/blog/underst...st-capital-gains-for-a-free-step-up-in-basis/ Old rates, but the concept still applies.

https://www.marketwatch.com/story/your-simple-guide-to-the-new-capital-gains-tax-rates-2018-04-16 Deals with the new rates, but not as clear in my mind.

Yeah - reviewing our tax torpedo isssues, I’ve been looking at reducing our capital gains distributions by moving to more tax efficient funds (index) as the better strategy as that still preserves the 0% cap gains benefit until we start taking SS.

If we have a bear market before RMDs we can be much more aggressive about this strategy.

This is not really a harvest unrealized capital gains strategy, it’s a strategy to get rid of funds that pay outsized capital gains. If I’d had a clue in 2008 w could have done this, but it wasn’t a serious s income problem back then. Didn’t become obvious until ~2013. The problems of a growing portfolio!

 

[pb4uski]

..... Our farm's income is never over $1,000. It provides us with most of our food, it makes a great write-off, and this is the lifestyle that we want to live.

We have been remodeling an apartment building, which has caused us to have some conversations on this thread topic.

How much more cash do we want? Do we really want to start paying income taxes?

Our properties are currently held by LLCs, and they would easily slide into L3Cs. We have already met with lawyers and accountants, to discuss making the L3C happen. We think that we could manage the LLCs as if they were L3Cs, it really all depends on how much cash do we want?

I am not about to spend down my Net Worth, neither do I want to start paying income taxes. Fortunately, there are other options

Nothing wrong with paying income taxes... especially at the 10% rate and with the new 20% profit exemption. .

Good luck with your L3C strategy. As I read it any profits would be taxed the same as a Schedule E.