Another "help me think" post

[SecondCor521]

Hi all,

How do you optimize multivariable tax problems? The two variables are A and B:

A. Due to the CARES act, my Dad may take less than he was scheduled to take with his RMD. It may make sense for him to do a modest Roth conversion.

B. There's also a trust that exists which can make a distribution of income to him on a K-1.

I think I know how to figure out how much of a Roth conversion for him to do if I ignore the trust.

I also think I know how to figure out how much of the trust income to distribute to him on the K-1 if I ignore Roth conversions.

What I can't wrap my brain around is what sort of approach to follow to maximize his situation given both variables. How would you approach this?

 

[VanWinkle]

Complicated process which would require knowing his current tax brkt, future tax brkt, need for current income, requirements for the distribution from the trust, and his future needs for tax free income. If you can run all of those numbers, you will likely get the answer. If not, i would either get help, or just leave well enough alone. Good luck on your decision and best wishes for your Dad.

VW

 

[SecondCor521]

Complicated process which would require knowing his current tax brkt, future tax brkt, need for current income, requirements for the distribution from the trust, and his future needs for tax free income. If you can run all of those numbers, you will likely get the answer. If not, i would either get help, or just leave well enough alone. Good luck on your decision and best wishes for your Dad.

VW

I have all those numbers. What I'm missing is how to approach solving the problem.

I could optimize the K-1 distribution first, then consider Roth conversions second, and that would give me an answer.

I could optimize the Roth conversion first, then the K-1 distribution second. That would give me an answer, which might be different than the first one.

I could optimize K-1 then Roth then K-1 then Roth until it converged...if it converged...that's a lot of work, but doable. Hmmm.

 

[RunningBum]

i don't understand the K-1 distribution characteristics to know how to factor that in, so I can't help there.

What does occur to me is, how much difference will this make if you go with your gut, or a combination of the two? Especially if it's for this year only? If it's really that hard to figure out, maybe not worrying about the full optimization is good enough.

 

[2017ish]

Sounds like he/you are looking to fill up his x% tax bracket and the question is how to allocate the incoming income between the trust and an IRA?

How relatively big are the trust and the IRA? Is the income within the trust taxed at a higher rate that his X% bracket? If there is annual income within the trust at a higher rate than X%, seems like you should try to drain that rather than focusing on roth conversions?

 

[SecondCor521]

i don't understand the K-1 distribution characteristics to know how to factor that in, so I can't help there.

What does occur to me is, how much difference will this make if you go with your gut, or a combination of the two? Especially if it's for this year only? If it's really that hard to figure out, maybe not worrying about the full optimization is good enough.

Excellent advice.

I'm kind of a perfectionist and kind of a worrier. This would be a good opportunity to work on those traits rather than optimization.

I know that last year the taxes saved from the K-1 optimization was around $2500. Since this year is a one-time year and I don't know how things will shake out with both things going on, and I don't know how far off from the optimal result I will be, it's hard to say how much difference it would make. However, in the big scheme of things none of my family is going to eat cat food if I don't get it exactly right, so....

 

[pb4uski]

Would the trust income be ordinary income or preferenced income? If the trus income is ordinary income, does it matter given that Roth conversions are also ordinary income? IOW, if $100 of trust income attracts the same tax as $100 of Roth conversion income then I don't think it matters does it?

 

[SecondCor521]

The trust income is about 2/3 qualified dividends and 1/3 tax-exempt dividends. Per a CPA's guidance, the qualified and tax-exempt dividends have to be distributed on a pro-rata basis.

As to your latter question, I'm not sure, because I don't look at it as an either/or. Consider the following four options (with arbitrary amount of $100 chosen):

1. Distribute $0 on K-1 and do $0 of Roth conversions.
2. Distribution $100 on K-1 and do $0 of Roth conversions.
3. Distribution $100 on K-1 and do $100 of Roth conversions.
4. Distribution $0 on K-1 and do $100 of Roth conversions.

All four are legitimate options worth considering. It's not clear to me how to figure out which of the above is "best". Minimizing taxes in 2020 is not necessarily globally the best thing to do, given other considerations like future tax years, etc.

What I am considering doing is something semi-arbitrary: Since my Dad doesn't have to do RMDs this year, just turn those off and let him withdraw from traditional IRA as needed this year to support his spending. Then, at the end of this year, do a Roth conversion equal to what his RMD would have been this year compared to what he actually ends up withdrawing (assuming the latter is less). Then balance the K-1 distribution as needed to minimize income taxes between the trust and my Dad. That's certainly not a "bad" spot to be in, even if there's a "better" spot somehow.

(I really appreciate the replies...they help me work through my thoughts. Thank you!)

 

[pb4uski]

Another thing that you might do was something that I was going to do this year but the COVID got in the way*... do a Roth conversion to a target tax bracket level then do withdrawals from the Roth as needed for spending... at the end of the day what ends up staying in the Roth is Roth conversion in excess of withdrawals needed for spending.

* I later decided to sell equities and use the 0% capital gain tax bracket for gains from those sales to reduce my overall equities level so there is no room left for Roth conversions.

 

[SecondCor521]

Worth considering, for sure.

The majority of his assets are in his traditional IRA. Given his age, the size of his traditional IRA, the SECURE Act 10 year rule, and my sisters still working, I think we have the potential for a "SECURE tax torpedo" if you will. So currently I'm inclined to encourage him to spend from his traditional and do Roth conversions to mitigate that torpedo.