Tiny income, tax planning & ROTH conversion

[ItDontMeanAThing]

I woke up this morning and realized that I hadn't thought about year end tax planning. My primary concern is starting a gradual ROTH conversion.

This is my first full tax year of retirement, so no income = no thinking about income tax. I think I know what to do, but I'm posting this in case someone spots something I missed. Also, I've been fortunate enough to have been paid well during my working years so I don't know squat about managing taxes at the bottom end of the income scale.

My financial situation:

Age 55. Living off taxable accounts which earned about $4200 in dividends and interest. Only 'income' was a $1650 federal tax refund.

Last year I had a long term capital loss stock sale. Applied the maximum (3000?) credit possible, have about $1500 that can be used in this year or the next.

I want to make a ROTH conversion that will have a fed tax liability of 1 to 2 thousand that will be paid out of a taxable account. I think I have to do it before the year end.

Without the conversion I expect to have zero taxes this year, what with the standard deduction exceeding my income. I figure I can play with a federal tax estimation calculator, adding in conversion amounts until I reach the desired tax amount. I'm an expat, Nevada was my last residence, so there will be no state tax.

What am I missing?

 

[Stevewc]

Hello itdontmeanathing,
This is way more info than you need or ask for but check this thread out at bogleheads. There are several discussions going on about Roth conversions due to new rules that start in 2010.
Hope this helps,
Steve


Bogleheads :: View topic - Roth Conversion Strategies=

 

[ronin]

Seems like you are on the right track to me.

 

[Independent]

My first question is "What tax bracket to you expect to be in when you eventually take the money out of the traditional IRA?" If you think you're going to eventually get back into that 25% bracket, then it seems like you should consider moving more - enough to use up this year's 15% bracket.

 

[JohnP]

Hi ItDontMeanAThing

Looks like you will have lots of headroom in the 15% tax bracket and being only 55 means that you could make a pretty good dent in reducing your tax-deferred portfolio before RMD time.

Looks like you are already aware of the Roth Conversion possibilities.

Additionally, you could greatly benefit in this tax year and next from basically unlimited accumulation of qualified dividends and LTCapGains at 0% taxes if you are in the 15% or below tax brackets. See en.wikipedia.org/wiki/Capital_gains_tax_in_the_United_States

If you have some appreciated assets in your taxable portfolio, I'd recommend that you sell what you can ASAP - as long as you are in the 15% bracket and then you can rebuy after 30 or more days if you still want to own that asset.

JohnP

 

[ItDontMeanAThing]

My first question is "What tax bracket to you expect to be in when you eventually take the money out of the traditional IRA?" If you think you're going to eventually get back into that 25% bracket, then it seems like you should consider moving more - enough to use up this year's 15% bracket.

I considered that. My short term financial goal is to make it to 59 1/2 on just the funds in my taxable accounts. In the next few years if it looks like I can do that easily I'll convert more, but right now I'm wondering how the bond market and exchange rates are going to affect my planned spending over the next 4 1/2 years.

 

[ItDontMeanAThing]

Additionally, you could greatly benefit in this tax year and next from basically unlimited accumulation of qualified dividends and LTCapGains at 0% taxes if you are in the 15% or below tax brackets. See en.wikipedia.org/wiki/Capital_gains_tax_in_the_United_States

Thanks! I hadn't thought of that.

 

[harley]

Additionally, you could greatly benefit in this tax year and next from basically unlimited accumulation of qualified dividends and LTCapGains at 0% taxes if you are in the 15% or below tax brackets. See en.wikipedia.org/wiki/Capital_gains_tax_in_the_United_States

If you have some appreciated assets in your taxable portfolio, I'd recommend that you sell what you can ASAP - as long as you are in the 15% bracket and then you can rebuy after 30 or more days if you still want to own that asset.

JohnP

I'm not sure what you mean by "basically unlimited" LTCGs at the 0% tax rate. Doesn't the sale of the asset add to your AGI, eventually putting you out of the 15% bracket? Say you had a $0 income for 2009, for whatever reason. If you sold $50K worth of stocks, wouldn't you have to pay the 15% LTCG tax on anything above $33950 (assuming filing single)? Or am I misunderstanding the rule? I'd appreciate more info.

 

[kaneohe]

I'm not sure what you mean by "basically unlimited" LTCGs at the 0% tax rate. Doesn't the sale of the asset add to your AGI, eventually putting you out of the 15% bracket? Say you had a $0 income for 2009, for whatever reason. If you sold $50K worth of stocks, wouldn't you have to pay the 15% LTCG tax on anything above $33950 (assuming filing single)? Or am I misunderstanding the rule? I'd appreciate more info.

Harley............you are correct (just take into account deductions/exemptions too = 9+ K for single to convert AGI to taxable income). It is always a good idea to run your numbers through a tax calculator first to be sure reality corresponds to your own ideas.

 

[JohnP]

harley and kaneohe

The IRS forms for 2008-2010 have a 0% tax rate for LTCGs and Qualified Dividends for those who pay taxes at the 15% or lower tax brackets. This is handled in the Form 1040 line 44 where there is a check of AGI not including LTCI and QDivs compared to the top amt for the 15% tax bracket. If a taxpayer AGI is under the 15% tax bracket max, then the LTCG and QDivs are not added to the AGI... without limit... basically leaving a 0% tax on LTCG and QDivs.

To me this is a huge tax break! I'm just disappointed that I don't qualify for this significant break.

JohnP

 

[kaneohe]

This is handled in the Form 1040 line 44 where there is a check of AGI not including LTCI and QDivs compared to the top amt for the 15% tax bracket.
JohnP

Hi JohnP............I'm a bit confused by your reference as I couldn't see how line 44 on form 1040 is relevant. Perhaps you meant another line?
http://www.irs.gov/pub/irs-pdf/f1040.pdf

Have you checked your idea w/ tax software or a tax calculator? The concepts you are talking about are somewhat deceptive since they are easy to talk about in words so that the quaLitative aspect is grasped, but difficult to talk about in words so that the quaNtitative aspect is understood. I know because I was one of the earliest victims. The worst part about these concepts is that you don't know that you don't know.

I suspect that I won't be able to convince you in words so my suggestion would be to work Harley's example on tax software or a tax calculator.
I like Turbotax's tax calculator (taxcaster). I am old enough to have learned that I might always be wrong so I try to keep an open mind.
I'd bet some $$$ here since Harley's always right .

here's a link to taxcaster: http://turbotax.intuit.com/tax-tools/
select the middle one for taxcaster

 

[JohnP]

kaneohe

I may be misreading the instructions but here is what I understand to add to the chart from the tax wiki earlier
en.wikipedia.org/wiki/Capital_gains_tax_in_the_United_States

go to the Form 1040 instructions at http://www.irs.gov/pub/irs-pdf/i1040.pdf

Look for page 39 which is
Qualified Dividends and Capital Gain Tax Worksheet—Line 44
This worksheet first removes Qualified Dividends (FM 1040 line 9b) and LTCG (FM 1040 line 13) from FM 1040 Line 43 - then in Lines 7,8, and 9 compares your adjusted income to determine if you fall under the 15% tax bracket.

If you are under the 15% tax bracket you will not add-back the QDivs and the LTCG amounts for the determination of your tax owed.

We are on our way to a granddaughter 6th birthday party now, so will be gone overnight.

Hope this clarification is useful.
JohnP

 

[kaneohe]

JohnP..........suggest you do Harley's example on that worksheet with actual numbers instead of just thinking in general terms. This is purely a numbers issue and that worksheet , although simple in principle, is full of places to make careless errors.
This is one of those cases where, unless you know what the right answer is to begin with, it is easy to end up w/ the wrong one. You can use the tax calculator to check the answer. Still betting on Harley here.

 

[harley]

I'm glad somebody thinks I'm right, even occasionally. Talk to DW, will you?

The reason I asked my question is that I don't know the answer. I'd love for JohnP to be right on this one. As he says, it would be HUGE! But if it was that huge, I think more people would be talking about it. It's a similar issue as I had with the Roth conversion. My first interpretation was that I could convert ALL of my IRA money into a Roth, and only pay my highest marginal tax bracket rate, excluding the IRA money from my AGI calculation. I was disabused about that one right quickly.

If I could do what JohnP is talking about, I would be able to sell all of my after tax investments with hundreds of thousands of dollars in LTCG without paying any tax, just because I maneuvered my way into the 15% bracket this year. There's just no way the gov't would let me get away with that.

So, JohnP, while I don't claim any particular knowledge level, I do have a well developed level of skepticism. I'm going to do as Kaneohe suggests, and run some scenarios through a calculator. If it turns out you are right, I'm going to be shouting this from the mountaintops! After, of course, I sell all my holdings.

 

[kaneohe]

Harley......I would bet absolutely nothing that your voice will be hoarse after you do your exercise......and you're right that a bit of skepticism is a good thing. You might want to try the manual exercise too of filling out that worksheet that JohnP mentioned. I think you will find that you do, in fact , subtract out the LTCG/QDI initially. That's so you can calculate the normal tax on that part of the income. Later on, though through some mind-bending non-intuitive (to me, at least) contortions, you figure out what part of the LTCG/QDI is above the 15% bracket and apply a 15% rate to that; you also figure out what part of the the LTCG/QDI is in/below the 15% bracket and apply a 0% rate to that. I think JohnP didn't go far enough in his exercise so he just needs to work an example all the way through. Have fun!

 

[JohnP]

Got the six yo granddaughter in Kentucky properly birthday partyed and returned home. Now back to taxes... and I need to eat a little crow...

I was not sure that I wanted to put the time and effort into learning yet another software system to do some examples... then Humberto Cruz, one of my favorite retirement savings-related authors came to my rescue. This week he has a column in the paper ...
Savings Game: Careful planning can save your thousands at tax time - Salt Lake Tribune where he talks about using the headroom that a 10-to-15% tax bracket taxpayer has for 0% LTCG and QDI; in the article he says "...For the 2008, 2009 and 2010 tax years, qualified stock dividends and long-term capital gains are tax-free as long as total taxable income, counting the dividends and gains, does not exceed the limit for the 15 percent bracket... " ... which is basically how kaneohe explained it.

This can still be a nice tax break for those early retirees who can control their "income" levels - just not as grand as I was envisioning.

Thanks guys

JohnP

 

[harley]

Slightly off the topic, I'm trying to run this year's numbers through last years TurboTax to see how much I can convert to a Roth. Is there any way to guesstimate numbers like ordinary vs. qualified dividends are? All I could figure to do is put in the same percentage I had last year. Also, I haven't been in a low income bracket since I was a youngster, and back then I didn't itemize. What happens if your deductions are equal to or greater than your income? Does it phase out? Or do you just hit zero and stop? I think I'm going to come out pretty close to that, but I haven't been able to find anything about it.

I decided to do the max Roth conversion I can this year and next while my income is low and I'm in the 15% bracket or lower. I'm taking advantage of the 0% LTCG by gifting the stock to my (15% bracket) daughter and letting her sell them. She'll then put the money in her Roth over the next few years.

It's darn nice of the gov't to let us have these little opportunities. I seldom say anything nice about politicians, so "Thanks"!

 

[kaneohe]

harley........I don't know any way to guess QDIV other than what you're doing. You might also try calling the fund cos to see if they have any better idea. If you have DIV, you're lucky. I'm trying to do what you're doing but I can't even get DIV estimates, let along QDIV. All have CG estimates.......0 this yr, but very few have DIV until they're announced........a bit strange to me.

There are itemized deduction & exemption phaseouts (w/ AGI)
http://www.centerfortaxstudies.com/blog/taxnews/2008/09/17/p5870
but I doubt you will hit them if you're staying in the 15% bracket. Interestingly, I checked the instructions for 1040 booklet (google "1040 instructions") for lines 40a
(deductions) and line 41 (AGI minus deductions) and didn't see anything there about limiting deductions to AGI. Probably doesn't matter since when you go further to exemptions and subtract them out to get taxable income, you can't go below 0.

You might want to run your model thru the 2009 Turbotax Taxcaster to see how it compares w/ last yrs Turbotax.....you might get a few more $$ converted perhaps.
btw.......do you have any non-deductible IRAs .........those would also get you a few more $$$ you could convert.

 

[Bikerchick]

Harley, kaneohe, et. al, your discussion on this short thread has been very helpful. I'm retiring in early 2010 and must decide what to do with a $400K TSP (gvmmt IRA). Annuity is not the best option right now, and headroom allows for only $12K withdrawal in the 15% bracket (post-retirement).
There is surely some tax advantage to withdrawing in 2010 but who really benefits from it? Can someone explain?

 

[kaneohe]

BC.......seems to me the really big winners are those who are currently not eligible for deductible IRAs and Roths bc their income is too high. In 2010 they can start converting non-deductible IRAs to Roth which are much better (tho they might still have to pay taxes if they have deductible IRAs as well). Those who expect to be in higher tax brackets in retirement (bc they accumulated large retirement accounts) also might benefit even if they were converting at rates higher than the 15% bracket . You could convert what you can and do it over a period of years and make at least a dent, if not the whole thing.

 

[FinanceDude]

Slightly off the topic, I'm trying to run this year's numbers through last years TurboTax to see how much I can convert to a Roth. Is there any way to guesstimate numbers like ordinary vs. qualified dividends are? All I could figure to do is put in the same percentage I had last year. Also, I haven't been in a low income bracket since I was a youngster, and back then I didn't itemize. What happens if your deductions are equal to or greater than your income? Does it phase out? Or do you just hit zero and stop? I think I'm going to come out pretty close to that, but I haven't been able to find anything about it.

I decided to do the max Roth conversion I can this year and next while my income is low and I'm in the 15% bracket or lower. I'm taking advantage of the 0% LTCG by gifting the stock to my (15% bracket) daughter and letting her sell them. She'll then put the money in her Roth over the next few years.

It's darn nice of the gov't to let us have these little opportunities. I seldom say anything nice about politicians, so "Thanks"!

Harley, a little cautionary help for you. Check to make sure your STATE is following the federal guidelines. If they don't (like Wisconsin, ) you could face some hefty state taxes on top of the federal tax.

Would hate to have someone move up a bracker or two AND have to pay 5-7% tax or higher because they acted too quickly........

 

[kaneohe]

Are any states following federal guideline on the 0% CG/QDIV bracket? CA doesn't.....
we don't even get CG normally.

 

[Bikerchick]

Thank you, kaneohe. I may have to settle for being taxed as the price I pay for being comfortable in retirement - at 15%

 

[harley]

Harley, a little cautionary help for you. Check to make sure your STATE is following the federal guidelines. If they don't (like Wisconsin, ) you could face some hefty state taxes on top of the federal tax.

Would hate to have someone move up a bracker or two AND have to pay 5-7% tax or higher because they acted too quickly........

Good call. DD is in the top tax bracket in VA (even though she is pretty poor ). Everything is taxed at 5.75%, including LTCGs. She'll have to use part of the gift to pay the tax, but it's still the best deal we're going to get.

Bikerchick, I agree with Kaneohe. 2010 is really only a big deal for those who were previously unable to convert. I don't even think the opportunity to spread the taxes over 2011-2012 is going to be much of a deal, since I expect tax rates to increase by then. JMO, though.

Still, I'm fully on the Roth bandwagon, and think that converting even small amounts every year will pay off in the long run. Of course, if "they" switch to something like a VAT instead of income tax I won't be in as good shape. No way to tell.