The Tyranny of the “or”.
Economics is the science of choice. There are always competing choices. A choice we face in many financial plans is balancing capital gains and Roth conversions for tax efficiency.
We call it the tyranny of the “or”. Too many choices are boiled down to this or that. The tyranny is that an “either-or” choice is lop-sided when an “and-both” might be better balanced.
For example, in our house we face a choice tyranny nightly. Is it bath or shower night? Harry loves the bath. Ben loves the shower. Amazingly, I tried to break tyranny of the “or” with a shower bath. A simultaneous bath and shower experience. It resulted in two upset kids. But after some negotiating, we switch nightly. One night a bath, the next a shower. This makes both kids happy.
Unlike bath time, financial planning doesn’t have to be mutually exclusive. That is good news. Approaching solutions with an “and” mindset can give flexibility to your financial plan.
Tax efficiency.
A well-executed saving and investing plan can leave you with a tricky trade-off at retirement. How do you balance capital gains and Roth conversions for tax efficiency?
Consistent contributions into a retirement plan may create a big account balance. Withdrawals made for spending needs are taxed as ordinary income. A way to reduce this burden in the future is to convert to a Roth IRA, where withdrawals are tax free.
Excess savings may then go into a brokerage account that builds untaxed gains as it grows. When you need cash in this account, you’ll have to sell stocks and bonds and pay a capital gains tax. If we can leave these gains until our passing, our heirs won’t pay taxes on the gains due to a step up in basis.
Therefore, when searching for sources of income in retirement, we are left to decide between IRA withdrawals at ordinary income rates or brokerage withdrawals at capital gains rates.
Investment location.
Diversifying asset location is a key tenet to financial planning. There are three main options.
- A pre-tax account such as a 401(k), 403(b), or IRA, where money goes in before tax and comes out at ordinary tax rates.
- A tax-exempt account such as a Roth 401(k) or Roth IRA, where money goes in after tax but comes out tax free.
- A taxable account such as a joint brokerage account, where dividends, realized gains, and interest are taxed each year.
Most clients tend to have both taxable accounts with large unrealized gains, and large pre-tax retirement accounts, such as an IRA. Trying to get cash out of either may result in taxes. As we’ve previously noted, a Roth Conversion may work to lower future taxes. But there is also the opportunity to harvest capital gains for tax efficient income at potentially lower rates. We can plan to harvest capital gains and Roth conversions.
Whichever way you get cash, you’re likely incurring and accelerating tax costs. We need to plan wisely.
In planning for taxes with your investment accounts, it can be a struggle to choose between Roth conversions and harvesting capital gains. What follows is a guide to think through the options.
Please Note: Please do not act on the information that follows and please consult a tax professional before doing anything. This is not tax advice. It is for informational and illustration purposes only.
Do you need income or do you plan to transfer to heirs?
Attaching meaning to your actions is important when coming up with a plan. Be sure to consider the purpose of your money first. Because, when heirs are involved, their future tax brackets matter too.
We’ve talked about possible tax changes here. Nevertheless, the current rules provide a step up in basis at death for taxable assets. So, if your accounts are passing to heirs or charity, then there may be no reason to harvest gains. Essentially, long-term gains in your taxable investments will be eliminated when they are donated to charity or transferred after your passing.
Therefore, consider a Roth Conversation instead, especially if you don’t need the income, can pay the tax bill with outside funds, and intend to pass IRA funds to the next generation. Under the SECURE Act, IRAs inherited by non-spouses must be withdrawn in 10 years. That might cause a big jump in taxes for your beneficiaries. While a Roth IRA still requires liquidation, it will come out tax-free.
What is you tax bracket?
Use the following tax tables to gauge your marginal rate in 2021.
Tax Brackets
When harvesting capital gains and/or converting an IRA to a Roth, tax bracket management becomes a critical component.
10% or 12% bracket.
If you are in the 10% or 12% tax bracket this year, consider harvesting capital gains. That’s because for single taxpayers your tax rate on capital gains will be 0% up to $40,400 of income, and $80,800 for those married filing jointly. Roth conversions would be taxed at 10% or 12%. Be mindful, though, if you’re taking Social Security benefits. You may be subject to the phase in of income tax on your benefit.
22% or 24% bracket.
If you’re in the 22% or 24% tax brackets, it may be better to start Roth conversions to fill up your brackets. That’s because the capital gains tax rate jumps to 15%, and by converting to a Roth IRA you may avoid higher RMDs in the future that may push you into higher brackets. As the saying goes, use up low brackets while you can.
32%, 35%, or 37%
If you’re in the 30%’s, harvesting long-term capital gains may be best. Harvested gains would be taxed at 15% or 20% (not including surcharges) versus the 32%, 35%, or 37% tax rates that would apply to Roth conversions. When your modified adjusted gross income is over $200,000 for single filers or $250,000 for joint filers, long-term capital gains are subject to an additional 3.8% Medicare surcharge known as the NIIT.
Tax considerations for retirees.
A tax plan helps you manage the costs of taxes in regard to your income. Retirees face a couple other nuances.
First, the more income you make, the more Social Security benefits will be taxable. Up to 85% of your benefit may be taxable. It is important to consider the effects of taxes on Social Security when planning on harvesting gains or converting an IRA to a Roth IRA.
Second, higher levels of income can result in higher costs of Medicare. For single filers making over $88,000 in modified adjusted gross income ($176,000 for joint filers), you will start to incur higher Part B premiums. There is a two year look back and that could affect your healthcare expenses. It’s important to plan accordingly.
Capital gains “and” Roth conversions beats “or”.
Building tax efficiency to an investment portfolio and financial plan is a critical component to the work we do with clients. Managing the long-term effects of tax costs may help add more wealth and net worth. That means staying diversified across accounts types and having a proper income strategy.
Of course, there is no one best solution or one rule of thumb that works for every situation. In fact, balancing, asset location and gain harvesting usually involves doing both. Whether you take long-term capital gains or start converting IRA accounts to Roth IRA, the choices are not mutually exclusive. Avoid the tyranny of the “or” and plan for both. A combination is likely a better solution anyway.
While we patiently wait for clarity on new tax legislation, please let us know how we can help you save more, invest better, and pay less in taxes to build a financial plan for your goals.
