For anyone considering recognizing more gain or doing more Roth conversions this year, I ran across a couple of quirks in the way gains may be taxed.
Suppose you have short term gains (say, $3000) and long term losses (say -$1000), so that you're net positive (+$2,000 short term). Not a common situation, but here added long term gains can get taxed at short term (ordinary income rates).
In this example, if you generate an extra $500 in long term gains, that reduces the LT loss by $500, thus increasing the net
short term gains by $500: Net LT loss = $500, net gain (short term) = $3000 - $500 = $2500.
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If your income is in the region where some but not all cap gains are taxed at 0%, then adding $1 of ordinary income can increase your taxes by 27¢, i.e. it's taxed at 27%. Kitces has an excellent piece on this; see examples 3 and 4.
https://www.kitces.com/blog/long-term-capital-gains-bump-zone-higher-marginal-tax-rate-phase-in-0-rate/He discusses how in this situation it is preferable to generate long term gains (even if taxed at 15%) as opposed to doing Roth conversions (even if nominally taxed at 12%). Going further, if one doesn't have much in cap gains/qualified divs, ISTM that it can still make sense to convert all the way up to the next tax bracket. A small amount will get taxed at 27%, but with little in cap gains, most will get taxed "normally". But if one has lots of cap gains that would get pushed into the 27% bracket, it pays to defer converting.
This suggests a multiyear strategy for planning periodic sales of assets and Roth conversions. It can be advantageous to lump them into alternating years. One year you take two year's worth of gains (taxed at 0% or 15%). The next year you work to minimize your cap gains (so there are few gains to get taxed at 27%) and convert more retirement money. Even if those conversions push you into the 22% bracket, that's still better than having a lot of cap gains taxed at 27%.
One needs to look at how much in gains one expects to recognize (including fund distributions), how much one wants to convert, other ordinary income, to see if this lumping strategy helps.
Comments
Let say I want to manage Roth conversions during market sell offs (think back to March 2020).
the-case-for-roth-conversions-in-market-downturns
Let's say I have two accounts, A T-IRA and a taxable brokerage account. They are both invested in the S&P 500 On Jan 1. 2020. Each has $10K as a starting balance. By Mar 31, 2020 they are both worth $8,037.
I take the following actions:
I convert the T-IRA to a Roth and lock in the March 31, 2020 value of $8037. On April 1, 2020 the T-IRA is now in Roth Status (conversion competed) and New Roth account continues to be invested in the S&P500. By years end the Roth value is $11,825. In April of 2021, I will owe taxes on the conversion ($8037 * my tax bracket)
In the 12% bracket I will owe $964.44
In the 22% bracket I will owe $1768.14
In the 24% bracket I will owe $1928.88
In a separate taxable account, I sell the very same investment on the same day I completed the Roth conversion and book a $1963 tax loss on that sale. On Apr 1, 2020, I re-invest back into the Total Stock Market (or appropriate wash-sale security). My $8037 by years end grows to $1287. Obviously this works perfect in hindsight. Equity markets can endure long stretches of under performance.
In April of 2021, I have a tax loss of $1963 that I can apply to my 2020 tax year or carry forward to future tax years...future Roth conversions.
tax-loss-carryforward
If I had I done nothing , both accounts would have lost and subsequently regained their losses. But by timing both a Roth conversion in the T-IRA and harvesting a tax loss in a taxable account at a pull back in the market", I have used a tax loss to "pay for" a Roth conversion.
Don't quote me on this, Derf