In my previous post we covered how long term capital gains are calculated, and I made available an excel sheet that allows you to play with the numbers. In today’s post we are going to pick up where we left off and explore the following topics:
- How Roth conversions affect taxation of long term capital gains and
- How to take advantage of the 0% LTCG taxation bracket to harvest tax gains.
Remember the Hypothetical-BITAs?
In the last post we figured out how taxation of long term capital gains works by following the fortunes of a couple that we called Hypothetical-BITAs (the H-BITAs). To recap:
Mr. and Mrs. H-BITA retired early, at the age of 42. They have one child. Their tax designation is married, filing jointly (a.k.a. MFJ). They plan to withdraw $60,000 a year from their investment portfolio. Let’s assume that the cost basis of the $60,000 withdrawal is $35,000. Their taxable brokerage account throws off $5,000 in qualified dividends a year. The H-BITAs prefer to spend their days in the hammock sipping margaritas, so they make no earned income.
While their investments are spread across two traditional IRAs, two Roth IRAs and one taxable brokerage account, at the start of their retirement journey they plan to leave their IRAs untouched, and will withdraw the $60,000 from their taxable brokerage account.
When we ran the numbers for this scenario, it turned out that while the H-BITAs spent $65,000 a year and sipped their margaritas, they owed the federal taxman a princely sum of $0.
The H-BITAs are thrilled to discover their tax bill of $0 and wonder if they can move some money from their 401ks to their Roth IRAs and still keep their tax bill as close to $0 as possible.
Why are the H-BITAs interested in such a Roth conversion? Because unlike funds in a 401k, contributions to a Roth IRA can be withdrawn tax-free and penalty free before retirement age. A Roth conversion is potentially a taxable event, but once you move the money to the Roth IRA pot and allow it to simmer for 5 years, you can withdraw it and owe no taxes or penalties. The other positive is that draining money from your 401k now makes for lower Required Minimum Distributions in the future, and therefore potentially less tax owed.
In the scenario above, as we discovered last week, the H-BITAs have taxable income = $30,000 ($25,000 in LTCG, $5,000 in qualified dividends). They then subtracted out standard deduction and personal exemptions to give them taxable income of $9,200. Since all $9,200 was either long term capital gains or qualified dividends they landed in the 0% tax bracket for long term capital gains.
Now let us consider the case where they also did a Roth conversion. They move $20,800 from their 401k to their Roth IRA.
Let’s run through the 5 steps with the H-BITAs again:
|The H-BITAs now have a total of $50,800 ($25,000 + $5,000 + $20,800) in income.|
|The H-BITAs taxable income is:
$50,800 – $12,700 – $4,050 * 2 = $30,000.
|With taxable income of $30,000, and MFJ, the H-BITAs land in the 15% federal income tax bracket.|
|A 15% income tax bracket gives the H-BITAs a marginal LTCG tax rate of 0%.|
|The H-BITAs have taxable income of $30,000, all of which are LTCGs and qualified dividends:
So the H-BITAs could successfully do a Roth Conversion of $20,800 and still owe the tax man $0. In 5 years they can withdraw that $20,800 tax free and penalty free. In fact, if they itemize their deductions, they could do a conversion equal to the amount of their deductions and keep their $0 tax bill.
The H-BITAs would now like to figure out the answer to the following question:
What is the most that they could convert from a 401k to a Roth IRA and continue to pay 0% long term capital gains tax on their expected withdrawal of $60,000? They are willing to pay income tax on the conversion, but want to stay in the 0% bracket for their LTCGs.
The answer is a whopping $66,700. Let’s do the math:
In this figure we want the H-BITA’s to stay in the 0% LTCG bracket, which means the total of their taxable income must stay below $75,900. If we assume standard deduction and two personal exemptions totalling $20,800, their total stack of income can go up to $96,700 and still stay in the 0% LTCG bracket. We know that they plan to withdraw $60,000 from their taxable account with a cost basis of $35,000, and that they have qualified dividends of $5,000. This means that they can convert $96,700 – $25,000 – $5,000 = $66,700 and still pay 0% LTCG. They will owe income tax of $5952.50 for the conversion.
I’ve modified the excel sheet made available to you in the last post. You input your planned income and/or dividends and/or planned withdrawals from your taxable account and the excel sheet can now tell you how many $ you can move from your 401k to your Roth IRA in a given year, and still stay in the 0% tax bracket for your long term capital gains. It also computes the income tax that you will owe on your hypothetical conversion.
Sign up to GET YOUR COPY OF THE LTCG TAXATION SHEET
The sheet is available in the Bayalis Bag of Holding to all subscribers of this blog. The password to access the subscriber-only area is in the email that you receive from us.
When you get the excel sheet you won’t be able to edit my copy, so here is what you need to do to make your own:
Click on “File”, then “Make a Copy” to get a local copy of the spreadsheet in your own Google Drive. You will then be able to modify the sheet.
Taking Advantage of the 0% Bracket to Harvest Gains
In addition to, or instead of Roth conversions, the early retiree can take advantage of the 0% long term capital gains tax bracket to do some tax gain harvesting.
What is tax gain harvesting?
Tax gain harvesting in the act of selling appreciated assets (thus ‘harvesting’ the long term capital gain), and then buying back the asset, thus locking in an increased cost basis for the asset.
For example, imagine that you own a share that you bought at $20, and the share is now with $100. You’ve held this asset for over a year. Selling this asset would generate long term capital gains of $80. If you sold the share and then immediately bought it back, the new cost basis for the share would be $100. If you don’t pay any taxes on the $80 (by virtue of being in the 0% LTCG tax bracket), your net worth is unchanged, but you’ve locked in a higher cost basis for the asset. So say three years from now if that share is worth $130 and you sell it, you will only owe capital gains on $30 instead of capital gains on $110 (as would have been the case if the cost basis was still $20).
The H-BITAs now have a new question for us. Instead of doing a Roth Conversion, what if they wanted to use their remaining 0% tax space to harvest capital gains? How much tax gain harvesting could they do in a year when they plan to have $30,000 in capital gains (to generate the $65,000 that they live on as early retirees) and still stay in the 0% LTCG tax bracket? Obviously, the answer is the same as that for the Roth conversion: they can take their usual annual withdrawal and harvest $66,700 of gains and still be in the 0% LTCG tax bracket. While a Roth conversion causes the H-BITAs to owe some income tax, tax gain harvesting within the 0% LTCG tax bracket does not.
Raising the cost basis by tax gain harvesting helps in future years when we realize those gains. We will use a smaller portion of our 0% LTCG tax bracket in the future, because our cost basis is raised, leaving us more room for Roth conversions.
So, in any given year, one could choose to do a Roth conversion, or harvest some capital gains, or some combination thereof and stubbornly refuse to owe the taxman anything more than $0.
To determine income tax bracket consider all taxable income, ordinary before preferred.
To determine your tax rate consider the kind of income being taxed.
Use any unused 0% long term capital gains tax space wisely, either for Roth conversions, or for tax gain harvesting, or some combination thereof.