0% LT Capital Gain vs 12% Roth Conversion

[Drewjd]

I’m 49 and about to execute FIRE this month. I’m beyond excited and ready for the next chapter. Now to my question:

MFJ. After my brief salary for 2022 and after tax dividends (and std deduction, etc.), I will have around $70K of space remaining in the 12% ordinary income bracket, aka the 0% LT capital gain bracket. I’m trying to figure out how to use that space for a Roth conversion and a stock sale.

I’m going to sell a stock that will result in around $25K of LTCG. I’m selling that stock no matter what (don’t believe in the company’s future, and the net cash would bring me to 2 years of living expenses in cash).

I also want to start doing Roth conversions now that I’ll be in a lower tax bracket. I definitely want to do a $45K conversion, which would be taxed at 12% and then my stock sale would be at the 0% LTCG rate.

My question is whether I should instead use the entire 12% space for a Roth conversion. Doing so would push my $25K LTCG into the 15% CG rate. For context, I have enough after-tax investments to make it to 59.5 and beyond. My pre-tax accounts are around $500K in Roth and $1.5M in 401k/IRA.

Any thoughts or advice on my situation? The notion of 0% LTCG is very tempting, but I want to avoid being short sighted. Thanks so much.

[teejayevans]

You have to project out your life span what taxes will look like. Pay now or pay later, paying 0% now, but 32% later may not be the best strategy. Don’t forget SS impact on taxes.
I modeled this in a spreadsheet, but in the end, it’s a guess because we can’t predict tax changes.

[Dash man]

You have 22 years under current law to convert before your RMDs begin. If you think tax rates will be higher in the future (I do), the sooner you begin to convert the less you’ll have to convert later when tax rates will be higher. Also more time to grow in the Roth. At your age you’ll have to pay the taxes from your taxable accounts or you’ll pay a penalty, so the cash you have available is a consideration.
There are many videos on YouTube that discuss the pros and cons of Roth conversions. Some even recommend doing it all now because income taxes are historically low, and likely won’t last. It’s your call of course with many considerations. I’m 65 and planning to complete our conversions by 2026 when the TCJA tax rates end.

[SecondCor521]

Three possible answers:

1. You can try to use the "0% cap gains vs. Roth conversion" tool in the case study spreadsheet at the following link:

https://forum.mrmoneymustache.com/fo...51/#msg2955651

I don't know if the logic and conclusions in it are correct, but the author of the spreadsheet seems pretty capable on other topics around taxation, so I'm inclined to think it's got a better than average chance of being correct.

2. Here's what I do, although my situation is different in two significant ways: I'm single, and I don't have a stock I want to get rid of. What I do is sell MFs for living expenses throughout the year, realizing LTCGs. At the end of the year, I pick my AGI target based on (a) what I expect my lifetime high total marginal tax rate to be (currently just about 33% at age 75) and (b) what AGI target in the current tax year brings me up to that tax rate.

I usually have some space for either additional LTCGs or Roth conversions. Thus far I have chosen to do Roth conversions to get to that target AGI. There are several reasons for this:

a. The aforementioned CSS spreadsheet indicates it is a better choice.
b. I have children, and I want to minimize the risk of me dying with a large trad IRA and my kids having to do the 10 year SECURE Act distributions on that and probably paying lots of tax.
c. Sunset of TCJA in 2026 and locking in relatively low rates now.
d. Step up in basis at death rule means that currently, any LTCGs I realize could be considered unnecessary/wasteful, because they could be avoided by me either (a) dying or (b) giving the taxable away to charity.

Unlike Dash man, I'll probably be doing Roth conversions annually for the rest of my life, but the amounts will vary. Basically I'll be filling up tax brackets and trying to even out my overall life tax rate, with less consideration paid to the tax rates in my 80's because (a) I might be dead by then, and (b) if I'm still alive and paying those high tax rates, it'll be because I have way more money than I'll ever have use for so it won't matter in a sense.

3. Do what you like, because it probably doesn't matter for you. You probably will end up with more money than you need.

[OverThinkMuch]

I'd suggest at least $26k Roth conversion no matter what, using up your standard deduction. Then the stock (that you've held 366+ days?) can be sold in the 0% bracket.

Note if you have too much income, you can push your $25k LTCG from 0% to 15% tax. That's not a good way to use the top of the 12% bracket, so avoid the last $25k there. The 0% LTCG tax bracket ends at $81k, subtract $25k for your stock sale, leaves $56k.

First, the pay no taxes option:
Convert $26k into Roth IRAs ; $25k stock sales
Owe zero taxes on $51k AGI


If you are okay paying 10% on some Roth Conversions:
Convert $26k + $20k = $46k of Roth Conversion ; $25k stock sales
Roughly owe 10% x $20k = $2k of taxes on $71k AGI


Finally, if you want to use up the 12% tax bracket:
Convert $26k + $56k = $82k of Roth Conversion ; $25k Stock sales
$2k tax + ($36k x 12% =) $4.3k = $6.3k taxes owed on $107k AGI

[Animorph]

0% capital gains is an immediate benefit.

One benefit of a Roth conversion, when taxes are paid from a taxable account, is that the amount of the taxes is effectively moved from the taxable account to the Roth. The other benefits are in juggling tax rates on tIRA withdrawals.

All other (tax rate) things being equal, that one Roth conversion benefit may be more valuable than the 0% CG tax rate if you can leave the conversion money in the Roth account long enough. My personal tax optimization tilts towards Roth conversion if it has 10+ years to grow. Now that I'm within less than 10 years to my first Roth withdrawal I'm supposed to Roth convert only to the top of the 10% bracket and take 0% CG's to the max allowed.

With CG's that exceeded the 0% bracket without Roth converting, I kind of waffled on filling up the 10% bracket with a conversion, but I did some of it.

Plenty to think about, but I see a very broad optimum in our case. So something that seems reasonable to you is probably better than nothing.

Roth conversions are most beneficial early on, so I'd favor them bit over 0% CG's at the start. Of course figure out what tax rate your RMD's are likely to see when that time comes. Anything lower than, and sometimes equal to, that tax rate is worth considering for Roth conversions. Heavy Roth conversion now followed by heavy 0% CG's later may be more optimal than doing a little of both, but everyone is going to be different.

[SecondCor521]

Another general comment:

"0% CGs" can be a bit of a misnomer in certain circumstances.

I had some of them last year, and it is true that I won't pay federal capital gains taxes on them.

But my state charges 6.5% on them because they're part of my AGI.

My ACA subsidies were going away at about an 18% clip at that point because those CG's are, again, part of my AGI.

If I had realized more CGs than I did, I would also have 8.5% x 2 = 17% reduction in my kids' financial aid results (2 college sophomores at FAFSA schools).

The above also happens to be true in my case for Roth conversions. My point is just that "0% CGs" doesn't mean that income doesn't have any other tax consequences. Basically, because LTCGs are included in AGI, any tax benefit that is impacted by AGI (and there are loads of them, I just listed the three of relevance to me) could be impacted.

[Montecfo]

I find the tax saving differential of Zero percent versus 15 percent to be compelling. I would recognize capital gains at zero percent first, then do Roth conversions being careful to stay in zero percent LTCG tax bracket.

If you get above the zero percent it gets more complicated.

I find the immediate benefit of the low LTCG rate to be compelling compared to waiting years for Roth conversions to generate a positive cash flow.

But I like both strategies. It just depends on where you are getting cash for living expenses.

[Dash man]

Quote:

Originally Posted by Montecfo I find the immediate benefit of the low LTCG rate to be compelling compared to waiting years for Roth conversions to generate a positive cash flow.

There are a number of other factors to consider too. RMD impacts on Medicare IRMAA, effect on Social Security income tax, NIIT tax, forcing into higher brackets,
one spouse passing resulting in filing single, passing IRA on to kids in their prime earning years, and the likelihood oh higher future tax rates. Saving a few bucks now can be short sighted when paying lower taxes throughout your retirement may save a bunch more.

[oceanmd]

Hello,

I am trying to understand the benefits of Roth conversions and reading through the posts above, I have a question.

Can someone please explain to me the math in this example from OverThinkMuch post?

Finally, if you want to use up the 12% tax bracket:
Convert $26k + $56k = $82k of Roth Conversion ; $25k Stock sales
$2k tax + ($36k x 12% =) $4.3k = $6.3k taxes owed on $107k AGI

AGI is 107K (including the stock sales). Don't you have to pay 15% tax on long term CG if your AGI is above 12% marginal tax bracket?

Thank you for the clarification or explanation.

[Drewjd]

Quote:

Originally Posted by oceanmd Hello, I am trying to understand the benefits of Roth conversions and reading through the posts above, I have a question. Can someone please explain to me the math in this example from OverThinkMuch post? Finally, if you want to use up the 12% tax bracket: Convert $26k + $56k = $82k of Roth Conversion ; $25k Stock sales $2k tax + ($36k x 12% =) $4.3k = $6.3k taxes owed on $107k AGI AGI is 107K (including the stock sales). Don't you have to pay 15% tax on long term CG if your AGI is above 12% marginal tax bracket? Thank you for the clarification or explanation.

The taxes apply to taxable income, not AGI. After you calculate AGI, you then apply deductions to get to taxable income. Then you calculate tax liability.

Also, ordinary income gets taxed first, then capital gains above that.

But your basic question is correct: If your taxable income (before LTCG) is above the 12% bracket, then the LTCG would be subject to the 15% LTCG tax (or 20% if your income is high enough).

[Drewjd]

Thanks, all, for the feedback. At this point, I'm leaning towards doing a $45K Roth conversion and keeping my $25K LTCG at 0%.

The additional tax cost for converting my entire 12% bracket seems high. If I instead convert $70K Roth, that makes the additional $25K conversion subject to 12% taxes ($3,000). That also pushes my LTCG into the 15% LTCG rate ($3,750). The additional $6,750 of taxes for doing an additional $25K of Roth conversions doesn't seem worth it to me (27% effective taxes).

Greatly appreciate all the advice above, all of which I read and learned a few new things in the process.

Only last thought is that if the market tanks this year, I'd be more tempted to do a larger conversion at that point. If I'm missing anything fundamental, please chime in. I'm still learning some of this stuff.

[Montecfo]

Quote:

Originally Posted by Dash man There are a number of other factors to consider too. RMD impacts on Medicare IRMAA, effect on Social Security income tax, NIIT tax, forcing into higher brackets, one spouse passing resulting in filing single, passing IRA on to kids in their prime earning years, and the likelihood oh higher future tax rates. Saving a few bucks now can be short sighted when paying lower taxes throughout your retirement may save a bunch more.

I don't disagree which is why I said I like both strategies. But the tax savings today is more valuable (by definition) than the same tax savings in the future. And the Roth payback takes you well into the future, 15-20 years to payback in many cases.

And a big problem with Roth converion math it requires a number of assumptions about facts which will be determined decades into the future. The payoff may not happen in your lifetime or at all.

And I think trying to guess what size estate you will leave, to whom and what their tax rates will be decades into the future is difficult to know, to say the least.

I do think planning for one spouse paying taxes at a higher single rate is the most compelling concern for the largest number of married couples, because the potential impact is so large. But even there, we have no idea our longevity, that of our spouses or how long he or she will be single.

You have to run your numbers in all cases, plus sensitivity analysis to support your decision. And know that actual results will vary.

[pb4uski]

Quote:

Originally Posted by Drewjd Thanks, all, for the feedback. At this point, I'm leaning towards doing a $45K Roth conversion and keeping my $25K LTCG at 0%. The additional tax cost for converting my entire 12% bracket seems high. If I instead convert $70K Roth, that makes the additional $25K conversion subject to 12% taxes ($3,000). That also pushes my LTCG into the 15% LTCG rate ($3,750). The additional $6,750 of taxes for doing an additional $25K of Roth conversions doesn't seem worth it to me (27% effective taxes). Greatly appreciate all the advice above, all of which I read and learned a few new things in the process. Only last thought is that if the market tanks this year, I'd be more tempted to do a larger conversion at that point. If I'm missing anything fundamental, please chime in. I'm still learning some of this stuff.

Not sure your numbers are right. I ran https://www.irscalculators.com/tax-calculator with 2 scenarios... both were MFJ, both under 65 and $14,250 of "wages" (ordinary income ex LTCG and Roth conversions) and $25k of LTCG... then one scenario of $45k Roth conversion (tax of $3,591) and second scenario of $70k Roth conversion (tax of $6,591)... so that last $25k of Roth conversion increases taxes by $3k (12%).

If your $14,250 of income other than Roth conversions and LTCG is in part qualified income then the tax numbers would be a little lower but the $3k of tax on the last $25k of Roth conversions won't change.

[Drewjd]

Quote:

Originally Posted by pb4uski Not sure your numbers are right. I ran https://www.irscalculators.com/tax-calculator with 2 scenarios... both were MFJ, both under 65 and $14,250 of "wages" (ordinary income ex LTCG and Roth conversions) and $25k of LTCG... then one scenario of $45k Roth conversion (tax of $3,591) and second scenario of $70k Roth conversion (tax of $6,591)... so that last $25k of Roth conversion increases taxes by $3k (12%). If your $14,250 of income other than Roth conversions and LTCG is in part qualified income then the tax numbers would be a little lower but the $3k of tax on the last $25k of Roth conversions won't change.

Appreciate you double checking me, but I think you're using a different amount of ordinary income as the starting point. I'm expecting $42K of salary & dividends for 2022 ($40K of which will be taxable), not the $14,250 you used.

[pb4uski]

Quote:

Originally Posted by Drewjd Thanks, all, for the feedback. At this point, I'm leaning towards doing a $45K Roth conversion and keeping my $25K LTCG at 0%. The additional tax cost for converting my entire 12% bracket seems high. If I instead convert $70K Roth, that makes the additional $25K conversion subject to 12% taxes ($3,000). That also pushes my LTCG into the 15% LTCG rate ($3,750). The additional $6,750 of taxes for doing an additional $25K of Roth conversions doesn't seem worth it to me (27% effective taxes). Greatly appreciate all the advice above, all of which I read and learned a few new things in the process. Only last thought is that if the market tanks this year, I'd be more tempted to do a larger conversion at that point. If I'm missing anything fundamental, please chime in. I'm still learning some of this stuff.

Quote:

Originally Posted by pb4uski Not sure your numbers are right. I ran https://www.irscalculators.com/tax-calculator with 2 scenarios... both were MFJ, both under 65 and $14,250 of "wages" (ordinary income ex LTCG and Roth conversions) and $25k of LTCG... then one scenario of $45k Roth conversion (tax of $3,591) and second scenario of $70k Roth conversion (tax of $6,591)... so that last $25k of Roth conversion increases taxes by $3k (12%). If your $14,250 of income other than Roth conversions and LTCG is in part qualified income then the tax numbers would be a little lower but the $3k of tax on the last $25k of Roth conversions won't change.

Quote:

Originally Posted by Drewjd Appreciate you double checking me, but I think you're using a different amount of ordinary income as the starting point. I'm expecting $42K of salary & dividends for 2022 ($40K of which will be taxable), not the $14,250 you used.

Your "sweet spot" is to calibrate the Roth conversion so your total taxable income is right at the top of the 0% preferenced tax bracket for qualified dividends and LTCG, which is $83,350 for MFJ for 2022. Add in $25,900 for the standard deduction and that is total income of $109,250. Subtract your $67k of income before Roth conversions ($40k salary, $2k dividends and $25k LTCG) and that leaves $42,250 for low cost Roth conversions.... $6,351 tax with $42,250 of Roth conversions and $1,410 tax with $0 Roth conversions so an effective tax rate on the Roth conversion of 11.7%.

If you do $45k of Roth conversions, that last $2,750 of Roth conversion (from $42,250 to $45,000) increases your tax by $743 from $6,351 to $7,043... 27% of the $2,750. You would be at 27% for Roth conversions from $42,251 to $69,250 and then Roth conversions above $69,250 would be at 22% for quite a while.

What happens is that for a while above taxable income of $83,350 each $1 of Roth conversion is taxed at 12% and pushes $1 of qualified income from the 0% tax bracket to the 15% tax bracket... for an effective tax rate of 27%. See https://www.kitces.com/blog/understa...p-up-in-basis/