Tax brackets and Roth

[Scuba]

We have roughly a 75/25 AA in our taxable portfolio. It throws off enough dividend and interest income to put us into the 25% bracket. We don't currently have any Roth IRA's as our incomes were too high when working. I'd appreciate insights on the following:

1. I read a lot on this forum about keeping AGI in the 15% bracket. How do you do this if you have a sizable taxable portfolio generating dividends and interest income? Any suggestions on minimizing the tax bite? Our healthcare plan is not HSA qualified so HSA's aren't an option for us.

2. What is the best way to figure out if/when Roth conversions could make sense for us? We have a lot of income this year but 2018 might be more viable. Is there a tool you recommend to help with this analysis?

Thank you!

 

[NgineER]

If you can, without realizing too much cap gains and throwing the AA off, I would move the fixed income portion to a tax deferred account.
You’ll have to do some analysis to see if RMDs and SS will push you even higher when you get to that point.
I’m still accumulating, but I do Roth conversions every year to minimize tax burden later and to increase my flexibility when I start withdrawing. I plan to have at least five years of living expenses in Roth IRAs when I pull the plug and start with conversions at that point.

 

[NgineER]

I think that I-orp and a spreadsheet would be a good way to analyze if Roth conversions make sense to you

 

[LOL!]

To be in the 15% marginal income tax bracket means less than $75,900 taxable income for 2017.

Add back in 2 exemptions and standard deduction of $20,800 which means your AGI could be $75,900 + $20,800 = $96,700 and add to that the -$3,000 from your tax-loss harvesting or carryover losses means that your income could be $99,700 and you are still in the 15% marginal income tax bracket.

So if you are getting $99,700 in dividends and interest, you have S**TLOAD of assets in taxable, ... something like $5,000,000.

Here's what I do:

1. I get no interest because I have no savings accounts.

2. I don't have any bond funds in taxable, but I suppose you could have some tax-exempt muni-bond funds in taxable.

3. I invest in tax-efficient passively-managed broad market index funds which have dividends that are at about 2% and mostly qualified dividends. So while my total portfolio is only 60% equities, I don't have any bond funds in taxable to create unwanted taxed interest.

4. I don't have $5,000,000 in taxable. I stopped working before reaching that level. OK, I still work a little bit and so does my wife, but we defer almost all our income into 401(k) plans, FSA, etc. and healthcare premiums are deducted, too.

One can give away to charity enough money to get down into the 15% marginal income tax bracket.

 

[ERD50]

I was thinking long the lines of LOL!. With 75/25, if you get 2% divs on the 75% and 3% on the 25% (I rounded down) it would take > $4M to kick off enough to get you in the 25% bracket. With nothing in tax deferred, you don't have many options.

BRK pays zero divs, and I've put some of my taxable in that for this reason. It tracks other broad-based equities fairly well. Also, small cap funds tend to pay lower divs, IWM for example (1.28% per Yahoo, versus 1.86% for SPY).

And then you have to consider cap gains to make moves.

Charity, but of course that's only a % saved, and a personal decision.

-ERD50

 

[LOL!]

Scuba's bond fund shares can probably be sold for a capital loss at the present time. For instance, my bond fund shares in tax-deferred can be sold for a loss now even though the funds are up 3.5% for the year because of reinvested dividends.

 

[kaneohe]

To be in the 15% marginal income tax bracket means less than $75,900 taxable income for 2017.

Add back in 2 exemptions and standard deduction of $20,800 which means your AGI could be $75,900 + $20,800 = $96,700 and add to that the -$3,000 from your tax-loss harvesting or carryover losses means that your income could be $99,700 and you are still in the 15% marginal income tax bracket.

So if you are getting $99,700 in dividends and interest, you have S**TLOAD of assets in taxable, ... something like $5,000,000.

..................................................................

3. I invest in tax-efficient passively-managed broad market index funds which have dividends that are at about 2% and mostly qualified dividends.....................................

or perhaps OP has a lot of actively managed funds that distribute a lot more than 2% QDIV from ST/LT CG. If so consider one-time charges in tax increases for selling the low tax efficiency funds and reinvesting in the type of funds described by LOL in 3) above for a lifetime of lower taxes. Not always easy to do if you have large appreciation in the current funds.

 

[pb4uski]

+1 with others on the first part... to the extent that taxes allow, convert fixed income investments in your taxable portfolio to equities and make a corresponding change to exchange equities for fixed income in your tax-deferred accounts. You AA will stay the same but your taxable account income will be all tax preferenced.

Our taxable accounts are all equities other than cash but the interest on that is only about $1k a year. As a result of us including some international equities in our taxable portfolio our taxes on our taxable portfolio is actually negative as the foreign tax credit exceeds the taxes on interest and non-qualified dividends. In our case the excess tax credit offsets taxes on income from Roth conversions.

Roth conversions make sense if the tax you pay on the conversion today is less than your marginal tax rate later in life. You can get a sense of the tax you'll pay on the conversion by doing a pro forma 2017 tax return using TurboTax or TaxCaster without any Roth conversions and the adding in some Roth conversions and compare the increase in tax to the Roth conversion.

Then compare that tax rate to what you expect your marginal tax rate will be once SS, pensions, etc. start. You can get an idea of that tax rate by doing a pro forma tax return of your income once you start SS, pensions, etc and seeing what your marginal tax rate is (what tax bracket you are in).

 

[RunningBum]

Without knowing more details, I agree with the rest that the best way is to replace any tax inefficient investments with more tax efficient ones. You may or may not want to do that. I wouldn't change my AA just to tweak taxes. However, replacing a managed fund with a similar indexed fund could work.


Another thing to consider is that 15% may not be the one you look at. Your marginal rate is essentially 30% right now, because any income from conversions now, or RMDs in the future, is taxed at 15%, plus you are pushing 15% of dividends into being taxed. Does it look like you'll be in this position the rest of your life?


If so, you might look at taking a year or two or three and converting all the way through that 30% rate, at which point all divs are taxed and your income is taxed at 25%. Go to the top of that, and perhaps even the top of 28%. Converting some at 25-28% compared to 30% later is not as big of a gain as the 15% now to 25% later many are doing, but it may be your only break. 28% hardly seems worth it since tax rates could change, and if one of you dies the other may be all the way through the 30% window as a single and down to 25% anyway, but top of 25% is worth considering.


Watch out for AMT when you convert a lot. I'm still not clear when AMT gets triggered but when I've had to avoid large conversions to prevent AMT. It's not worth paying an extra few % alternative tax on top of the 25% rate. I'm not sure if TaxCaster checks for AMT, so modelling your situation in TurboTax would be best. Or convert away and recharacterize as necessary when you do your taxes, but recharacterizations may go away with the new tax proposals.

 

[kaneohe]

........................


Another thing to consider is that 15% may not be the one you look at. Your marginal rate is essentially 30% right now, because any income from conversions now, or RMDs in the future, is taxed at 15%, plus you are pushing 15% of dividends into being taxed. Does it look like you'll be in this position the rest of your life?


If so, you might look at taking a year or two or three and converting all the way through that 30% rate, at which point all divs are taxed and your income is taxed at 25%. Go to the top of that, and perhaps even the top of 28%. Converting some at 25-28% compared to 30% later is not as big of a gain as the 15% now to 25% later many are doing, but it may be your only break. 28% hardly seems worth it since tax rates could change, and if one of you dies the other may be all the way through the 30% window as a single and down to 25% anyway, but top of 25% is worth considering.


Watch out for AMT when you convert a lot. I'm still not clear when AMT gets triggered but when I've had to avoid large conversions to prevent AMT. It's not worth paying an extra few % alternative tax on top of the 25% rate. I'm not sure if TaxCaster checks for AMT, so modelling your situation in TurboTax would be best. Or convert away and recharacterize as necessary when you do your taxes, but recharacterizations may go away with the new tax proposals.

Good points about the 30% marginal tax bracket and AMT. Taxcaster does calculate AMT and having a large amount of tax-favored income (QDIV/LCG) does set the stage for AMT.

Sounds like a tricky scenario. If you back away from the 30% marginal bracket (which could be quite wide if there is a large amount of QDIV/LTCG)
you might get trapped later when RMDs start and you have 36% marginal rates instead.

 

[cathy63]

I'll second the recommendation to get TurboTax or a similar package and do some modeling there.

If you itemize deductions and have medical and/or misc deductions, then your marginal rate on the conversions is higher than 30% because you are also losing up to $12 in deductions for every $100 you convert.

Plus, if you have carryover losses on Sched E (and maybe Scheds C, D?) those are limited as you increase the amount you convert to a Roth and that limitation also affects your med and misc itemized deductions.

And Scuba is in CA, so there are also state taxes to consider.

It's like a web where pulling on one thread causes everything else to shift. I have a very nice TTax file that shows us owing $0 in fed tax. I increase the Roth conversion by $100 and suddenly I owe $41 in fed tax and $10 more to the state. I've decided the best thing for us to do this year is avoid that 41% marginal rate altogether and do the max conversion that keeps us at $0 tax.

 

[Gotadimple]

Well there could be Roth conversions if the OP has a traditional IRA, but, he doesn't reference it. So, if he has no tax-deferred that can be converted, then, he has no way to take bonds and put them in a tax-deferred or tax-free account. About all he has is the ability to move his bond investment into municipals to shield income. Or did I miss something?

- Rita

 

[RunningBum]

Well there could be Roth conversions if the OP has a traditional IRA, but, he doesn't reference it. So, if he has no tax-deferred that can be converted, then, he has no way to take bonds and put them in a tax-deferred or tax-free account. About all he has is the ability to move his bond investment into municipals to shield income. Or did I miss something?

- Rita

In the OP:

2. What is the best way to figure out if/when Roth conversions could make sense for us? We have a lot of income this year but 2018 might be more viable. Is there a tool you recommend to help with this analysis?

Since Roth conversions are mentioned, there must be a tIRA.

 

[audreyh1]

You can be much higher than $4-5M in taxable and still in the 15% ordinary income tax bracket, because most of your income is qualified divs and cap gains.

But you'll probably pay AMT on the ordinary income. That's 26%.

At least you still get 0% cap gains tax to the extent your ordinary income is below the top of the 15% bracket, even under AMT rules.

I don't really see the point of doing Roth conversions under these circumstances.

 

[GrayHare]

1) Consider switching a portion of high dividend and interest investments to growth stocks which yield less dividends.

2) Roth IRA can be useful to minimize the impact of the so-called tax torpedo that can occur when you begin SS / pension / RMDs, the sum of which can push you into an even higher tax bracket.

 

[Scuba]

Thanks for all the suggestions. I do have a sizable tIRA that is 100% invested in interest bearing instruments, no equities. I also have some deferred comp accounts that are invested in a mix of equities and fixed income. While working, I maxed out 401K & deferred comp contributions but also saved a lot in taxable accounts to provide a source of funds for ER since I cannot access the tax deferred accounts for a few more years.

We have been paying AMT for years and will for 2017 as well. Not sure about 2018 yet. Living in CA with high state income taxes and property taxes (high due to valuations) makes it hard to get away from AMT.

Our taxable portfolio is in a combination of individual stocks, ETF's and individual bonds. The bonds are there mainly to provide stability early in ER so we shouldn't have to sell equities in a down market. I could change the taxable portfolio to 90-100% equities and increase fixed income in my deferred comp accounts to maintain an overall similar AA, but haven't done that to date due to sequence of returns risk. In the long term all money will be accessible but that isn't the case for another 2-3 years.

This thread has convinced me that I need to get our tax CPA to review our situation and help us with some long-term modeling to see what can be done to optimize our situation. With pension, SS, tax deferred account payouts, and eventually RMD's on the horizon as additional income, plus the potential for Roth conversions and/or HSA contributions if we changed insurance, there are a lot of moving pieces to consider. Some of you may find these variables easy to model on your own, but I don't.

 

[pb4uski]

.....Our taxable portfolio is in a combination of individual stocks, ETF's and individual bonds. The bonds are there mainly to provide stability early in ER so we shouldn't have to sell equities in a down market. I could change the taxable portfolio to 90-100% equities and increase fixed income in my deferred comp accounts to maintain an overall similar AA, but haven't done that to date due to sequence of returns risk. In the long term all money will be accessible but that isn't the case for another 2-3 years.....

This is something that you don't have to worry about. Let's say that you need to raise $100k in cash for living expenses. You just sell $100k of equities to in your taxable accounts and sell $100k of bonds and buy $100k of the same equities in your tax deferred accounts.

The equity buy and sell net, so taken together, you have effectively sold $100k of bonds to fund living expenses... plus if you did this because equities were down, you also have a lower gain or loss that can be used against ordinary income.

Since your overall AA is no different, your sequence of returns risk is no different.

 

[LOL!]

Good luck with getting help with modeliing and please report back if your CPA does that sort of thing. Lots of folks ask how to find a good tax advisor who does more than just tax returns and who gives good advice for how to minimize taxes going forward, but few people actually have found such a person.

Since you hold individual bonds and live in CA, I would have guessed that all your bonds in your taxable account would be triple-tax-free munis. That is, free from Federal, State, and Local taxes. Is that not the case?

I agree with pb4uski, you don't need bonds in taxable to tide you over until tax-advantaged accounts have penalty-free withdrawals. That's a very common misconception, but tax-exempt bonds are the solution to that for highly-taxed taxpayers.

And now that I know you live in CA, another option to reduce taxes is to move out of California for awhile.

 

[imokurok]

Great thread. Only thing I have to add is the caveat that it remains to be seen what DC folks do or don’t do regarding taxes. That could change rules of the game a bit.

 

[pb4uski]

True, but I suspect that in most cases any tax law changes will just result in our tweaking our current strategies... time will tell.

I doubt that things will change enough that I will regret having done Roth conversions and paying taxes at about 10% of the converted amount.

 

[Scuba]

Good luck with getting help with modeliing and please report back if your CPA does that sort of thing. Lots of folks ask how to find a good tax advisor who does more than just tax returns and who gives good advice for how to minimize taxes going forward, but few people actually have found such a person.

Since you hold individual bonds and live in CA, I would have guessed that all your bonds in your taxable account would be triple-tax-free munis. That is, free from Federal, State, and Local taxes. Is that not the case?

I agree with pb4uski, you don't need bonds in taxable to tide you over until tax-advantaged accounts have penalty-free withdrawals. That's a very common misconception, but tax-exempt bonds are the solution to that for highly-taxed taxpayers.

And now that I know you live in CA, another option to reduce taxes is to move out of California for awhile.

No, the net of tax returns on the munis were still below several good corporate issues, so we chose to go with the highest net returns rather than munis. Moving away is definitely something we considered but decided to stay for many non-financial reasons.

 

[Scuba]

This is something that you don't have to worry about. Let's say that you need to raise $100k in cash for living expenses. You just sell $100k of equities to in your taxable accounts and sell $100k of bonds and buy $100k of the same equities in your tax deferred accounts.

The equity buy and sell net, so taken together, you have effectively sold $100k of bonds to fund living expenses... plus if you did this because equities were down, you also have a lower gain or loss that can be used against ordinary income.

Since your overall AA is no different, your sequence of returns risk is no different.

In theory I like this suggestion. In practice I'll have to think about how I could implement this. My tIRA is 100% invested in hard money loans, so I can't sell bonds and buy equities in my tIRA. The returns I've been earning on my hard money loans are consistently very good, so I don't want to reallocate away from these as loans mature. My deferred comp account is invested in a balanced fund. I could reallocate it to 100% equities but not sure if I want to do that as I'll be drawing on these funds over the next 3-5 years. My deferred comp account is similar in time horizon to my taxable account - something to live on before SS and tIRA distributions. But maybe reallocating between these does make sense if I source from our taxable account first instead of thinking of them as a combined "pool." Thanks for the idea. Maybe I can make this work.

 

[pb4uski]

All you need is a tax-deferred account with access to liquid equities and fixed income investments.

 

[Scuba]

All you need is a tax-deferred account with access to liquid equities and fixed income investments.

I do have that. Right now my tax deferred non-tIRA accounts are invested 100% in a balanced fund that is about 70% equities. Would just have to reallocate part of what's in my balanced fund to fixed income and put my fixed income money in my taxable account into equities. It's not "like for like" as my taxable account has individual bond issues while my tax deferred account only offers a bond fund. Several of my individual bonds are paying higher than today's going rate so I'd probably lose some return doing this but would also save some taxes. Definitely something to consider.