Conversions Beyond 15%

[Neill]

Well I have been retired 5 months or so. This morning I started my Roth conversions. I have about $500k in deferred tax accounts that can be converted. Another $200k in foreign accounts that can't be converted (under UK law currently but they seem to be talking about having a Roth equivalent).
I am 51. So I have 19 years till RMD.
My taxable portfolio is large. It generated $73k qualified and $32k non-qualified dividends.
I can convert about $26k of IRA to Roth etc tax free. I did this amount this morning.
After this I face a rate of 35% = (15% qualified dividends + 15% qd pushed out of 0% + 5% child tax credit phase out). This changes to 30% at $55k then 25% at $79k.
Realizing capital gains has a marginal rate of 20% (15% + 5% child tax credit phase out).
I am loathed to realize anything beyond tax free. 35% isn't a good rate (I sheltered much of it from this rate and recently worse) and 20% on capital gains isn't either.
I had originally planned to spread all the income out over all the years to smooth out my income (taking into account the growth of the tax deferred portfolio). That needed me to realize about $71k in addition income each year.
So currently my thinking is to use only the 0% conversion rates and no more. Thoughts?

 

[pb4uski]

I agree. 35% is too much. I do to the top of the 15% tax bracket.... $74.9k of TI in 2015 IIRC.

I assume that even $100 over the 15% generates $35 of tax.

What you might consider is converting more until the total tax divided by the total conversion is at your threshold of pain. For example, if I understand your post, if you did $46k of conversion instead of $26k your tax would be about $7k. While that $7k is 35% of the extra $20k converted you could rationalize that the tax on your $46k of conversions is only 15% (7/46) which doesn't seem to bad given that you probably would have paid 25% or more when you deferred that income so you saved 10% (or $4,600)... and if you wait then you probably also pay 25% or more.... so nothing wrong with saving $4,600!

 

[Animorph]

The big thing I don't see is what is your projected tax rate on RMD's when they start? That's what determines how high you should let your marginal tax rate get this year. If you can convert all of your pre-tax accounts before age 70 at a low tax rate (and your taxable accounts can support you and the conversions long enough), that's great. If you will still have a large IRA balance when RMD's start and you will be paying 35% on them, then you can convert up into 35% now without losing anything. Or maybe you can get it all out while staying within the 25% bracket now.

You may need to look at it in better detail. How long are the child tax credits going to apply? How much do you need to convert to stay out of a higher bracket at age 70 (pensions, Social Security, other base income?) How can you spread conversions over the 19 years to minimize taxes?

 

[LOL!]

With $95K of taxable dividends annually and only 70% qualified, I would try to see what I could do to make that more tax-efficient. (That's a honking big taxable account.)

I was able to do just that because of tax-loss harvesting over the years and even this year. I will give one example: Sell VTI before it paid a dividend and on the same day buy VV after it paid its dividend. If VTI was selling at a loss, then that was tax-loss harvesting. If VTI was selling at a gain, then the realized gain was offset by previous losses.

Note that 100% of VV's dividends were qualified.

Each dollar of dividend increases one's AGI and reduces the amount of 0% and 15% Roth conversion space.

My taxable dividends in 2015 were 20% less than in 2014 due better tax-efficient location and fund selection.

Perhap you should have more tax-exempt bond funds in taxable in order to avoid having dividends increase your AGI?

Also, often one sees the statement: Keep international funds in taxable in order to get the foreign tax credit. I don't think that is good advice anymore since international funds have a lower percentage of qualified dividends, but run the numbers for yourself. Also, you are probably over the $20,000 in foreign dividends rule for the foreign tax credit and need to do more work on Form 1116 to get the credit.

 

[RunningBum]

What happened to the 10% bracket? I understand that you can convert some at 0% up to your deductions and exemptions, though I would think your non-qualified divs eat up all or most of that. Shouldn't the next 9225 (18450 married) be in the 10% bracket? + 15% for divs/CGs pushed into taxable, and maybe your 5% lost child tax credit, so that would be 30% not 35%?

It's complex, for sure. You need to look at what RMD tax would look like, plus whether RMDs would increase the tax on SS, or whether your other income already does that. I think as you know you want to try to have a level rate through all the years. It doesn't help to pay 15% now but 35% later. Paying some at 25% now to take that money out of 35% later is better.

Then there is always the possibility of tax law changes that make your best strategy go wrong, but I feel you can only work with what you know or can reasonably predict.

All things being equal, I prefer to pay the tax now and put my money in a Roth so it can grow and not be taxed. Growth in a tIRA can push me in a higher bracket.

 

[Neill]

Some more info in response to suggestions.

With $95K of taxable dividends annually and only 70% qualified, I would try to see what I could do to make that more tax-efficient. (That's a honking big taxable account.)

I have two sources of non-quals. REITs and foreign ETF's. I have large capital gains on everything. I don't have enough space to have all my tax inefficient assets in tax deferred or tax free. I have a slow plan for the REITs. I am doing some gifting to my Children and filling my wife's donor advised fund. Both are slow. Kiddie tax would bite me otherwise.

Also, often one sees the statement: Keep international funds in taxable in order to get the foreign tax credit. I don't think that is good advice anymore since international funds have a lower percentage of qualified dividends, but run the numbers for yourself. Also, you are probably over the $20,000 in foreign dividends rule for the foreign tax credit and need to do more work on Form 1116 to get the credit.

I have a typical foreign tax credit of about $4k/year. Won't be touched unless I earn more money. I can pass it back to prior year this first year which is very good. That will be a deduction against 39.6%. So I think things are great for 2016. I have been handling 1116 for a long time.

Perhap you should have more tax-exempt bond funds in taxable in order to avoid having dividends increase your AGI?

Portfolio is already generating about $26k in tax free municipal bond interest. That makes sense with 35% on the margin.

My taxable dividends in 2015 were 20% less than in 2014 due better tax-efficient location and fund selection.

I'll think some more on this. Thanks for the suggestion. Never thought about thinking about ex-dividend days etc.

What you might consider is converting more until the total tax divided by the total conversion is at your threshold of pain.

Yes I thought about this. I thought maybe go till the tax rate is 15% or 20%. Can't get past that marginal rate argument. I think I am better waiting for either better rates or income that forces me over the 35% hump into 25%.
I have a lot of years to get the money converted and I don't mind having a lot left for RMDs if the rates aren't crazy.

The big thing I don't see is what is your projected tax rate on RMD's when they start?

This I don't know. Will I have spent a significant amount of my taxable account by 70? I guess yes. I should plan to do that. Except we haven't really spent much money all our lives. Even at modest growth RMD's could be $50-$80k/year. That's fine if that is the only income then.

It's complex, for sure. You need to look at what RMD tax would look like, plus whether RMDs would increase the tax on SS, or whether your other income already does that.

I think it unlikely somebody like me wouldn't have at least 85% of his SS taxed. The limits aren't indexed for inflation. Sure to change the law to have it all be taxable at some point.

All roads take me to 'realize stuff at zero as you will never pay less than that'. Then wait things out. If taxable declines I can move more. If it doesn't then no matter what I have to pay a lot of tax.

Thanks for some great thoughts. Got a year till I have to lock in 2016 if I figure out a different path.

 

[Neill]

What happened to the 10% bracket?

I just checked this. The bracket is there but it's very small for me. I looked at marginal rates for the next $1000 and it doesn't really show at that granularity. The child tax credit is a credit so it offsets the tax. So most of the 10% bracket is offset by the credit but the income is still taxed at 10%. Only a small amount gets taxed at 10% for real then the 15% kicks in and the credit declines.
My kids are only 11 and 7 so I get a few miles out of them yet. This is the first year I get anything for them beyond personal exemption and I haven't been getting that since the PEP was put in place.

 

[LOL!]

You are on top of things, so I suppose you already use Optimal Retirement Planner - Parameter Form to get some ideas. Always double-check the i-orp results with tax software.

Also since you are starting Roth conversions, be sure to read the Kitces article again on that. Linked in the first post of this thread: https://www.bogleheads.org/forum/viewtopic.php?p=2441970#p2441970

And tax-loss harvesting is your BIG friend.

 

[Neill]

You are on top of things, so I suppose you already use Optimal Retirement Planner - Parameter Form to get some ideas. Always double-check the i-orp results with tax software.

Also since you are starting Roth conversions, be sure to read the Kitces article again on that. Linked in the first post of this thread: https://www.bogleheads.org/forum/viewtopic.php?p=2441970#p2441970

And tax-loss harvesting is your BIG friend.

To be honest I have played with i-orp and it's hard to see how I map it to my situation. I need to model my current portfolio income and I don't see how to do that. I plan to spend a bit more time on it. It was suggesting I move something like $46k (I think) each year but that looks like too much.

Since my income has been high for the last 15 years I have been using a lot of tricks to try and manage that. I have been tax loss harvesting. My current projections have the $-3k deduction built in. I have limited scope to generate losses as most of what I have is positive. I do have some large losses on emerging markets.

I have been reading about the multiple Roth + recharacterizations recently. Maybe something I should do next year especially if I plan to exceed the 15% bracket.
Thanks.

 

[LOL!]

If you do not have carryover realized losses to offset the capital gains you would get (and prevent them from adding to your AGI), then the idea of avoiding dividends by selling something before its dividend and buying something else after its dividend (the VTI to VV thing I mentioned) is not going to benefit you much. The reason is that the before something (VTI) sale will create a capital gain and probably a short-term gain at that.

 

[LOL!]

I have a typical foreign tax credit of about $4k/year. Won't be touched unless I earn more money. I can pass it back to prior year this first year which is very good. That will be a deduction against 39.6%. So I think things are great for 2016. I have been handling 1116 for a long time.

May I lean on your expertise with Form 1116 please?

If one stays in the 15% marginal income tax bracket, then one's qualified dividends are taxed at 0%. That means that for foreign qualified dividends, one should not be able to claim the foreign tax credit for the foreign taxes paid on the foreign qualified dividends that one does not pay US tax on --- unless one qualifies for the IRS "Adjustment exception."

This thread was about staying in/below the 15% marginal income tax bracket. Have you had to adjust your foreign-sourced dividend income to exclude foreign qualified dividends on Form 1116 before?

Also, bonus question: I guess that a capital gain on a US mutual fund of foreign stocks is not considered foreign-source capital gain, right? That is, if one sells say a Vanguard mutual fund or ETF such as VTIAX or VSS and realizes a capital gain, then that is not foreign source income.

Thanks!

 

[Gotadimple]

May I lean on your expertise with Form 1116 please?

If one stays in the 15% marginal income tax bracket, then one's qualified dividends are taxed at 0%. That means that for foreign qualified dividends, one should not be able to claim the foreign tax credit for the foreign taxes paid on the foreign qualified dividends that one does not pay US tax on --- unless one qualifies for the IRS "Adjustment exception."

This thread was about staying in/below the 15% marginal income tax bracket. Have you had to adjust your foreign-sourced dividend income to exclude foreign qualified dividends on Form 1116 before?

Also, bonus question: I guess that a capital gain on a US mutual fund of foreign stocks is not considered foreign-source capital gain, right? That is, if one sells say a Vanguard mutual fund or ETF such as VTIAX or VSS and realizes a capital gain, then that is not foreign source income.

Thanks!

Why would you not take the foreign tax credit? Regardless of whether you paid taxes on the qualified dividends, the foreign tax credit is about collecting a rebate for the taxes paid to foreign governments through your investment.

A capital gain on a "US mutual fund of foreign stocks" is still a capital gain for the purposes of the US Dept of Treasury. That is, to the extent it is taxable to you, you pay Uncle Sam. The capital gain comes from investing in US mutual funds or American Depository Receipts - all Part D taxable (or not).

 

[LOL!]

Why would you not take the foreign tax credit? Regardless of whether you paid taxes on the qualified dividends, the foreign tax credit is about collecting a rebate for the taxes paid to foreign governments through your investment.

No, a foreign tax credit is not about collecting a rebate for the taxes paid to foreign governments. It is about not paying US taxes if one has already paid foreign taxes on that income. One gets a credit for the US taxes they would pay on that income. If one would not pay US taxes on that income because of their tax bracket, then they do not get a foreign tax credit for foreign taxes paid on that income.

It's all in Form 1116 and the instructions to Form 1116.

So one would not take a foreign tax credit if the IRS did not allow one to take a foreign tax credit.

 

[Gotadimple]

No, a foreign tax credit is not about collecting a rebate for the taxes paid to foreign governments. It is about not paying US taxes if one has already paid foreign taxes on that income. One gets a credit for the US taxes they would pay on that income. If one would not pay US taxes on that income because of their tax bracket, then they do not get a foreign tax credit for foreign taxes paid on that income.

It's all in Form 1116 and the instructions to Form 1116.

So one would not take a foreign tax credit if the IRS did not allow one to take a foreign tax credit.

The ability to reduce your US Income Tax owed by the amount of foreign taxes paid is as a result of a foreign tax treaty. From Publication 514:

"If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability."

 

[Neill]

May I lean on your expertise with Form 1116 please?

If I can help. Not sure I understand all your questions.

If one stays in the 15% marginal income tax bracket, then one's qualified dividends are taxed at 0%. That means that for foreign qualified dividends, one should not be able to claim the foreign tax credit for the foreign taxes paid on the foreign qualified dividends that one does not pay US tax on --- unless one qualifies for the IRS "Adjustment exception."

This thread was about staying in/below the 15% marginal income tax bracket. Have you had to adjust your foreign-sourced dividend income to exclude foreign qualified dividends on Form 1116 before?

Yes that's right the FTC is not consumed and can be carried back or forward. This has never happened to me up till now. It won't happen to me in 2015 but it will in 2016. I am not familiar with the "Adjustment exception". Looks like I would not qualify for this as foreign dividends + capital gains has to be less than $20k. I ran last years taxes with no income to get a feel for how the FTC will work for me last year.
I use a spreadsheet each year to total up both the dividends and qualified dividends for each foreign source I own. It's always a tedious process. Go to the Vanguard site and get foreign divs + qual %. Do the same for ishares. this year I will have to do the same for Schwab. Each site has a different way of presenting it. Vanguard you have to multiple some numbers based on the foreign tax amount. Ishares I have to calculate the foreign qdi % myself. When I doubled checked vanguard their split was the same as the foreign split. So the fact they give the numbers was the same as me working them out myself pretty much. I just enter these amounts into the tax s/w. I don't use TurboTax though. I used Lacerte for prior years and am using Drake for 2015. Will these guys you just enter the foreign divs + foreign divs as part of the form.

Also, bonus question: I guess that a capital gain on a US mutual fund of foreign stocks is not considered foreign-source capital gain, right? That is, if one sells say a Vanguard mutual fund or ETF such as VTIAX or VSS and realizes a capital gain, then that is not foreign source income.

Thanks!

My understanding is a bunch of stuff is always considered US source. So capital gains and interest I believe (I don 't have foreign interest so doesn't apply to me) . I will start being super vigilant on foreign source income once I fail to consume my FTC.

 

[Neill]

The ability to reduce your US Income Tax owed by the amount of foreign taxes paid is as a result of a foreign tax treaty. From Publication 514:

"If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability."

There are a load of rules (bucketing) to stop you using the FTC except in a narrow way. If your numbers are small you get do do more things.
So for example I can only use my FTC against taxes I have on the same income in my tax return. If I am paying 0% on some foreign qualified dividends I can't use the credit to offset a tax I didn't pay.

 

[LOL!]

The ability to reduce your US Income Tax owed by the amount of foreign taxes paid is as a result of a foreign tax treaty. From Publication 514:

"If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability."

I have bolded and underlined some words in your quoted text. That word "may" is quite telling. Details are found in the Instructions to Form 1116.

 

[LOL!]

[…]
I just enter these amounts into the tax s/w. I don't use TurboTax though. I used Lacerte for prior years and am using Drake for 2015. Will these guys you just enter the foreign divs + foreign divs as part of the form.

Thanks very much for the response. I was pretty good at Form 1116 when I was in the 33%, 28%, and 25% income tax brackets and when I lived overseas. Now that I am in the 15% marginal income tax bracket, things are a little different.

I do know that tax software such as TurboTax and HRBlock TaxCut do not always do the right thing with Form 1116. They have an "out" which says something like "Please be sure to understand and follow the Form 1116 Instructions and make corrections to our software's numbers if needed."

And yes, one must figure out the amount of foreign source income which is not on one's 1099-DIVs, but is usually found somewhere on the mutual funds web site, though Fidelity really tries to hide it.

Maybe your tax software is better at all this. Anyways, please come back to this thread if you have any more insights or comments. Thanks!

 

[adrift]

So for example I can only use my FTC against taxes I have on the same income in my tax return. If I am paying 0% on some foreign qualified dividends I can't use the credit to offset a tax I didn't pay.

I think this is only partially right. If your foreign source income is below $20K, you can. But, the $20K threshold is a cliff. From memory, once you pass that, you have to adjust your foreign source income to account for the preferential tax treatment of qualified dividend income. This can have a big effect on the amount of foreign tax credit you can take.

In 2013, I went over this threshold by a small amount. If I recall correctly, this reduced the amount of of tax credit I could claim by about $1000. In 2014, I shifted part of my foreign allocation into tax sheltered accounts to avoid this happening again. I may be able to eventually use 2013's credit since you can reach back up to 10 years.

Here's a relevant thread over at the boglehead forum that you may find interesting:

https://www.bogleheads.org/forum/viewtopic.php?f=10&t=157261

 

[Sunset]

Why would you not take the foreign tax credit? Regardless of whether you paid taxes on the qualified dividends, the foreign tax credit is about collecting a rebate for the taxes paid to foreign governments through your investment....

It is really pretty complex, however you are correct for the minor amount of ~ $300 or $600 (joint) US in foreign taxes paid.

You can claim this foreign tax paid, even if no US tax is payable on the thing,.

It gets a lot more complex and limited once you are paying thousands in foreign tax, as others have said.