Roth conversion or gains harvesting

[Geld ist Freiheit]

(Apologies for the rambling post)

Once again I seek the wisdom of the Oracles of ER.

Odds are high that I will be hanging it up this year. FireCalc green lights my plan with a withdrawal rate that can exceed my expenses by nearly 2:1.

Since I’ve made too much this year to do any real tax shelter/mitigation gyrations, I’m will probably run out the year stacking free cash to further feather the nest.

My question is with an eye towards next year. With a year’s worth or more is cash to live off of, my income will be essentially zero (there will be some dividends and interest but nothing to compare to previously earned income).

I plan to use COBRA for 2024 to cover healthcare. If I do some gains harvesting in ‘24, I can use that money to live off of in ‘25 and keep my income low in order to qualify for the ACA subsidies for when COBRA runs out. I can then gains harvest in ‘25 to prime to tax free cash in ‘26, re-qualify for subsidies, lather-rinse-repeat.

I’ll be 56 next year. My pension & MediCare start at 65 so I only have so many years to harvest and I’ve got more unrealized gains than I can shelter.

Using a conservative 4% growth rate for the 401k, RMDs are looking to be in the 6 figure range when they start.

Would it be better to use next year to do a Roth conversion (401k to Roth 401k) or do the gains harvesting to pave the way for more tax free cash going forward?

I’m sure I’m missing something so please feel free to set me straight.

 

[Exchme]

Your tax bracket once RMDs & SS have started and you are subject to IRMAA will be higher than the 15% savings you are making harvesting capital gains, so intuitionally it sounds like Roth Conversions would be a better bet. But you would need to model to confirm.

 

[PaunchyPirate]

If your 2024 income will be minimal, are you sure COBRA is a better option than ACA for 2024? You likely would get much of your premium paid by ACA subsidies. COBRA can be expensive. If you live in an area where ACA plans are not good, then I see why COBRA may be better for you.

 

[Geld ist Freiheit]

If your 2024 income will be minimal, are you sure COBRA is a better option than ACA for 2024? You likely would get much of your premium paid by ACA subsidies. COBRA can be expensive. If you live in an area where ACA plans are not good, then I see why COBRA may be better for you.

I had planned on COBRA because I wanted to keep my current physician. On previous trips through the ACA websites, I couldn’t find a plan that included him. Revisiting it this afternoon, I was able to find some plans he does accept so maybe that’s the way to go.

I can see Exchme’s point on the tax bracket differences. The hiccup there would be having to pay the tax bill with my free cash or can you use a portion of the converted amount to pay the tax?

 

[SecondCor521]

The hiccup there would be having to pay the tax bill with my free cash or can you use a portion of the converted amount to pay the tax?

You can do what you suggest, but it's usually better to pay taxes from taxable sources because you end up with more Roth dollars. It's especially better before 59.5, because any portion of the conversion used to pay taxes is subject to the 10% early withdrawal penalty.

Personally I sell from taxable to fund my lifestyle and Roth conversions as needed. I think this works as long as my taxable makes it to 59.5, which it definitely looks like it should.

ETA: I agree with @Exchme. Also, you should note that if you keep those taxable assets until you die, then you can "shelter" the gains via basis step-up.

 

[Alex The Great]

The hiccup there would be having to pay the tax bill with my free cash or can you use a portion of the converted amount to pay the tax?

My understanding is that you have to pay an early distribution penalty to use any funds converted from tax deferred account to Roth if you are younger than 59.5.

 

[PaunchyPirate]

I had planned on COBRA because I wanted to keep my current physician. On previous trips through the ACA websites, I couldn’t find a plan that included him. Revisiting it this afternoon, I was able to find some plans he does accept so maybe that’s the way to go.

I can see Exchme’s point on the tax bracket differences. The hiccup there would be having to pay the tax bill with my free cash or can you use a portion of the converted amount to pay the tax?

A continuous challenge with ACA, is that pretty much anything can change with the next open season and you won’t know coverages, networks, prices, etc. until November 1st of the prior year. So you’ll have to wait until then to know how 2024 plans suit you.

I retired at age 56. I have been on ACA plans the entire time. I’ve been lucky to live in an area with good plans and networks. Fingers crossed that doesn’t change as I have 5 more years before Medicare.

I had about 2.5 years of expenses in cash to live on when I retired. I have added to that mostly by doing tax loss harvesting in my taxable account to raise cash with minimal to no taxes. That coupled with taxable account dividends has given me enough to live on. I have chosen to keep my income low to maximize my ACA subsidies over doing Roth conversions. In my 4 retirement years, I have only converted $7500 in to my Roth IRA.

 

[Geld ist Freiheit]

My understanding is that you have to pay an early distribution penalty to use any funds converted from tax deferred account to Roth if you are younger than 59.5.

The Rule of 55 should shelter me from the penalty shouldn’t it?

 

[Alex The Great]

The Rule of 55 should shelter me from the penalty shouldn’t it?

Yes that's right but for 401K only and if partial distributions are allowed.

 

[Al18]

It’s complicated to do RothIRA conversions from a 401K before you are 59.5. If you want to pay taxes from the 401K, you’ll need to pay the 10% penalty.

 

[Geld ist Freiheit]

It’s complicated to do RothIRA conversions from a 401K before you are 59.5. If you want to pay taxes from the 401K, you’ll need to pay the 10% penalty.

This would be from reg 401k to Roth 401k, not Roth IRA.

 

[Al18]

I did not misspeak

 

[Alex The Great]

It’s complicated to do RothIRA conversions from a 401K before you are 59.5. If you want to pay taxes from the 401K, you’ll need to pay the 10% penalty.

To be precise, there are three scenarios:
1. 401K distributions into taxable accounts according to 55 rule i.e. after separation from service at age 55 or greater. Ordinary income tax is withheld (typically 20%), no penalty. This can happen if plan admin allow partial distributions.
2. 401K conversion into traditional/rollover IRA, and then traditional/rollover IRA funds conversion into Roth IRA. Ordinary income tax is due at second step, along with the penalty for early distribution if done before 59.5. Typically it is allowed after separation and no partial distributions, but it is up to 401K admin.
3. After tax 401K is a different story. Principal can be converted directly into Roth IRA with no tax/penalty, while earnings still go into traditional/rollover IRA which can be further converted into Roth according to #2. Again 401K admin can pose some restrictions here, for example partial distributions are allowed while in service only i.e. still employed.