Tax strategy for capital gains/ROTH conversions

[Mr Gadget]

Trying to figure out two confusing tax issues. Acknowledge that we're lucky to have them. Our current financial advisor is still vauge on solutions, so I thought I'd query the group here and see if anyone else had navigated these issues before.

Been FIRE'd and living fine on a modest military pension for the last decade, still got another decade until I'm even Medicare and SS eligible. Haven't been able to add to IRA's in the meantime because I don't have eligible 'income.'

Just got married again. Spouse works for the FED and can retire at 57 in about 6 years. So now I can add to a spousal ROTH IRA for the next few years and plan on maxing it. Due to an eventual inheritance income, ROTH is smarter than traditional. I also am considering selling a small amount of inherited stock this year as well, but our combined income will probably push us into at least the 15% capital gains tax on it. Not sure if we can claim married filing seperately to avoid this, as my pension income is 1/3 hers and seperately I would avoid the capital gains threshold. We'll do the tax prep software work both ways for our specific situation, but wanted to know if anyone had done something similar before.

Also need to do some planning for converting both of our individual TSP's into ROTH's, after she retires (and our income drops to just my pension or both of our pensions when she turns 60/62) and before we have to start taking RMD's. My eventual inheritance will push us up several tax brackets, so converting to ROTH seems like the smartest decision to keep 'our saved money' from paying the eventual inheritances tax rates.

And as always, no inheritance is guaranteed, but I want to start planning, as I'm a trustee on parents estate (Alzheimer's sucks, wish my parents were traveling on their money, not in memory care), and while it may be nice to eventually get a large inheritance, it's going to require more planning than I expected to deal with, and potentially will screw up my modest income retirement plans.

 

[braumeister]

We'll do the tax prep software work both ways.

One little wrinkle to be aware of is what state you're in. Some states require you to file the same way as federal. I remember one year when it would have been advantageous in federal tax for us to file MFS, but that would have caused such a big hit at the state tax level that it was out of the question. So you need to first see what your state requires, then do the computation for each permutation.

 

[pb4uski]

Can you elaborate on this inheritance income? Usually inheritances are not income. Perhaps you're talking about inheriting a tIRA and haivng to withdraw the balance within 10 years.

Here's a tax calculator that includes MFS so you can test: https://www.irscalculators.com/tax-calculator

 

[Mr Gadget]

Thanks braumeister, will pay attention to state/fed differences. That is exactly what I was asking to watch out for.

The inheritance will be below the inheritance tax for my parents estate (unless taxes are changed drastically) because its divided amongst siblings, but it has its own income stream, mainly dividends and bond maturities. And will include Traditional IRA's that fall under that ten year rule. (Don't have to count the ROTH's fortunately) That income will potentially be 3x to 4x my current income.

 

[SecondCor521]

Three general comments:

1. If you file MFS, you probably can't contribute anything to your IRAs. The tax code generally makes filing MFS unappealing and it's rare that it makes sense.

2. Generally speaking, paying some taxes now to avoid larger taxes later can make some sense. As long as you're sure you're going to pay those larger taxes, which requires (a) you to be alive, (b) tax code to stay the same or get worse, and (c) the later income/assets to materialize and not, for example, all get spent on ALZ care, get stolen by the maid, or get reallocated to the new spouse, or....

3. I'm in similar shoes. I am very hesitant to make plans based on a future inheritance. Not because the money won't come, because it probably could even though it might not. But more because it can harm your soul and your relationship with the person with the money, and your relationship with money in general if you start thinking of it as probably your money.

 

[Mr Gadget]

SecondCor521 Thanks on #1. Most definitely not 'banking' on anything. I would be fine without any inheritance and really wasn't planning on it. Would prefer my parents were still here, mentally. But as I said, Alzheimer's really sucks and isn't something anyone really can plan for. I'm just wondering if there is a better way to plan if this new 'income stream' that could potentially upend all my planning and invalidate the way I've set myself up. I know, first world problem to have.

Besides my dad would be furious if most of his money ended up gone via 'taxes.' His frugalness 'training' was one of the reasons why I was able to FIRE so early, I got shown the door at 18 and made my own way, and he was proud of me for it, I just wish he could have stayed around longer to enjoy more life himself. This isn't sudden, but we're getting closer to an end stage and my siblings and I need to figure if there are better ways to plan for it.

 

[SecondCor521]

A lot depends on your remaining parent(s) taxable estate, their wishes (my Mom was likewise quite opposed to taxes in general), any charitable giving they would want to do, how many descendants they have, their descendants' financial and tax situation, and probably more I'm not thinking of.

Best suggestion I can make is to read a lot, think a lot, and try to find a good tax-planning CPA and an estate attorney who is likewise sharp.

 

[pb4uski]

.... The inheritance will be below the inheritance tax for my parents estate (unless taxes are changed drastically) because its divided amongst siblings, but it has its own income stream, mainly dividends and bond maturities. And will include Traditional IRA's that fall under that ten year rule. (Don't have to count the ROTH's fortunately) That income will potentially be 3x to 4x my current income.

Still confusing. Inheritance taxes are pretty rare and are assessed on the inheritance. Inheritance taxes are fairly rare... only 6 states levy them... and Arizona is not one of the states that levy inheritance taxes.

Estate taxes would apply to the total estate whether the estate has 1 heir or 100 heirs, and would be paid by the estate before inheritances are distributed.

So the inheritance income will be dividends and interest on inherited assets?

Bond maturities are not income.

 

[Sunset]

OP - Since you control your parents money, perhaps with the expense of memory care, they are in a low tax bracket, and could do some Roth conversions.

Then when the Roths are inherited, there is zero taxes for the beneficiaries as roths are not taxed.

 

[Mr Gadget]

So the inheritance income will be dividends and interest on inherited assets?

Yep, plus traditional IRA's which could increase income for up to ten years. Not worried about the portion that is already ROTH. My current pension is not large, but this will push me much higher, and I was hoping to convert my TSP to ROTH during my spouses window of retirement before drawing her pension, but this will mess that up.


Sunset - Parent is not in a low income bracket, even with paying for expensive memory care and all the life enhancement, as we're trying to make her life as comfortable as possible. No realistic chance of running out during her life expectancy+. Again, Alzheimer's sucks. Current CPA is exploring ROTH conversion options to reduce the tax hit for all beneficiaries. And we've just started gifting the annual exclusion amounts on their advice as well.

 

[target2019]

It's not clear what type of accounts: taxable, tax exempt, and tax deferred.

I think you understand the tax-deferred, and are looking at Roth conversions now.

I suspect the dividend stocks and funds (which you are calling income stream) are in a taxable account. If so, when you inherit them, sell the dividend (income) assets, and there is little or no gain to you.

When we dealt with a similar situation to yours, we sold the inherited funds (the expense ratios were absurd) and kept most stocks. Over time we sell stocks for various reasons, mostly to simplify the portfolio for the spouse.

Keep in mind that each beneficiary has a different situation, so one strategy will not fit each.

 

[pb4uski]

Would it make sense for your parent's to do Roth conversions now so you and your siblings inherit more Roth money than tax-deferred money? It will depend on that tax bracket they are in before any Roth conversions compared to the heirs likely tax brackets when they inherit the tax-deferred money.

The unfortunate reality is that there isn't much that you can do on the Roth conversion front if you are perpetually in a high tax bracket and will never be in a lower tax bracket.

 

[Mr Gadget]

Would it make sense for your parent's to do Roth conversions now so you and your siblings inherit more Roth money than tax-deferred money? It will depend on that tax bracket they are in before any Roth conversions compared to the heirs likely tax brackets when they inherit the tax-deferred money.

The unfortunate reality is that there isn't much that you can do on the Roth conversion front if you are perpetually in a high tax bracket and will never be in a lower tax bracket.

That is the main quandry, all of the beneficiarys are in very different tax brackets and my remaining parent is in a high bracket. The CPA is attempting to see if it makes financial sense to convert more into ROTH now or wait until it has to be split. At least we have a trust we are following. But my parents didn't use their wealth as much as they should have to do things with family, while they were capable of benefiting from the gratitude of their family.

target2019 - I could immediately sell the taxable portion of the inheritance and bank it, since interest returns are currently so low I wouldn't increase my income so much, but I think it would still push me up a bracket and interfears with my Roth conversion plans. Additionally, if I re-invest in stock I have to look out for the wash rule and the new investment dividends will push me up as well.

It's still a 'problem' most people wouldn't mind having. But definately a reason to not hoard wealth because you can't take it with you. Again, Alzheimer's sucks. While my parents did a lot, I wish my parents had done more with their acquired wealth, but you get what life throws at you, not what you want.

I paid attention to that study that said if you make more than $75K, your happiness doesn't significantly increase and why my signature is what it is. I never had a problem paying reasonable taxes, as my pension basically is paid from them. But I hate paying more than those that are making insane amounts, ala what Warren Buffet mentioned that his tax rate is lower than his Secretary, as the infrastructure in this country crumbles, ugg. I guess I'll be able to directly help charitable orgs more.

 

[SecondCor521]

target2019 - I could immediately sell the taxable portion of the inheritance and bank it, since interest returns are currently so low I wouldn't increase my income so much, but I think it would still push me up a bracket and interfears with my Roth conversion plans. Additionally, if I re-invest in stock I have to look out for the wash rule and the new investment dividends will push me up as well.

A few comments:

Selling all of the taxable as soon as practicable will probably not create a large tax bill at all. First, you and the other heirs should get a step-up in basis. Second, all inherited capital assets get long-term treatment even if your holding period is less than a year. So you'll be paying LTCG (or maybe LTCL) on the small change in price between the date of death and date of sale.

Also, the wash sale rule only applies in the case of capital losses, and only if you re-buy within 30 days, and only if you buy a substantially identical security. If you're selling the taxable assets to buy what fits your financial plan better, then either (a) what you buy will be different enough to where the wash sale rule applies, or (b) what you would have sold is already what you want to own, in which case just don't sell it in the first place.

HTH.

 

[Mr Gadget]

A few comments:

Selling all of the taxable as soon as practicable will probably not create a large tax bill at all. First, you and the other heirs should get a step-up in basis. Second, all inherited capital assets get long-term treatment even if your holding period is less than a year. So you'll be paying LTCG (or maybe LTCL) on the small change in price between the date of death and date of sale.

Also, the wash sale rule only applies in the case of capital losses, and only if you re-buy within 30 days, and only if you buy a substantially identical security. If you're selling the taxable assets to buy what fits your financial plan better, then either (a) what you buy will be different enough to where the wash sale rule applies, or (b) what you would have sold is already what you want to own, in which case just don't sell it in the first place.

HTH.

Thanks on the wash sale clarification, I think we already have a step up from when the first parent passed several years ago, not sure if we get it again when the second parent passes, but do know my sister (who is the executor of the eventual estate) had some form completed (on the CPA's advice) that preserved some of the inheritance tax exclusion from the first parent. That was when we discovered how much my parents had stashed away. But we never banked on getting anything, have used it to make their lives as comfortable as possible, but that time is coming to a close.


Interesting to note the LTCG on inherited stock; The stock I am thinking of selling, may not be as impacting as I thought. I inherited it in the 90's from grandparents, just let it dividend reinvest, but it's split and more than doubled in value since then.

 

[SecondCor521]

Thanks on the wash sale clarification, I think we already have a step up from when the first parent passed several years ago, not sure if we get it again when the second parent passes, but do know my sister (who is the executor of the eventual estate) had some form completed (on the CPA's advice) that preserved some of the inheritance tax exclusion from the first parent. That was when we discovered how much my parents had stashed away. But we never banked on getting anything, have used it to make their lives as comfortable as possible, but that time is coming to a close.


Interesting to note the LTCG on inherited stock; The stock I am thinking of selling, may not be as impacting as I thought. I inherited it in the 90's from grandparents, just let it dividend reinvest, but it's split and more than doubled in value since then.

You probably will get a second step up for any assets that are owned by the second parent. This would include most things but exclude A/B bypass trusts. Check with your CPA.

The form and exclusion thing you're talking about sounds like and almost certainly is DSUEA - deceased spouse unused exclusion amount. It's a really good thing that I wish we had done when my Mom passed away in 2016 - unfortunately we got bad advice. Basically each person gets an exemption amount (currently $11.7M, but has been lower in the past). As long as the paperwork is filed (Form 709, which it sounds like you did) in a timely fashion, then whatever that first person didn't use can be added to the second-to-die's exclusion amount. This should reduce your second parent's estate tax liability.

Those dividends increase your basis, by the way, and reduce your ultimate capital gains taxes owed.