Selling in Taxable to Invest in Tax Deferred

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Middle
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Selling in Taxable to Invest in Tax Deferred

Post by Middle »

I might be trying to draw a fine line here, but I really want to get the most edge I can. I'm 49 with investment goals of funding for retirement and assisting with college for my one daughter. I am maxing out my 401k contributions, contributing to 529, and the last 5 years I have been getting out of actively managed funds into index funds. During that process I have been making IRA contributions.

I don't have any more actively managed funds to get out of anymore. Whereas I like the idea of having flexibility with investments in taxable accounts as well as tax deferred, I'm wondering if it still makes sense to make IRA contributions with money invested in index funds. Now I would have to sell index funds and pay capital gains tax to fund an IRA. Originally I thought the more money I had in tax deferred accounts rather than taxable accounts could help in any college financial aid applications (my daughter is currently 10). But if my real goal is to maximize returns does it make better sense to not sell from taxable accounts provided I don't have any other reason to do it such as tax loss harvesting?

Thanks.
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

Middle wrote:I might be trying to draw a fine line here, but I really want to get the most edge I can. I'm 49 with investment goals of funding for retirement and assisting with college for my one daughter. I am maxing out my 401k contributions, contributing to 529, and the last 5 years I have been getting out of actively managed funds into index funds. During that process I have been making IRA contributions.

I don't have any more actively managed funds to get out of anymore. Whereas I like the idea of having flexibility with investments in taxable accounts as well as tax deferred, I'm wondering if it still makes sense to make IRA contributions with money invested in index funds. Now I would have to sell index funds and pay capital gains tax to fund an IRA. Originally I thought the more money I had in tax deferred accounts rather than taxable accounts could help in any college financial aid applications (my daughter is currently 10). But if my real goal is to maximize returns does it make better sense to not sell from taxable accounts provided I don't have any other reason to do it such as tax loss harvesting?

Thanks.
The question is a complicated one, and in order to answer it fully would require knowing the timing and amounts of sales of investments or distributions from retirement accounts in order to figure out whether it's worth paying capital gains taxes now.

IN GENERAL, from the information already given, I would find it unlikely that it would be beneficial for you to incur capital gains for the purpose of making an IRA deduction.

But this depends on your taxable income now, and perhaps future expected taxable income. Do you know if you can qualify for a zero percent capital gains rate? Either now, or perhaps at some point later in life, such as retirement (if the zero percent rate persists)?
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
Topic Author
Middle
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Middle »

I do not qualify for zero percent capital tax gains. I'm in the 15% bracket with an additional almost 10% state tax.

I seem to recall reading somewhere that there is a period of time (maybe before 70 1/2) where you can pay zero percent cap gains.
livesoft
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Re: Selling in Taxable to Invest in Tax Deferred

Post by livesoft »

I always max out tax-advantaged accounts even if my budget does not allow it. To make up the shortfall in my expenses, I sell assets in taxable accounts.

So although, I wrote it differently than you did, I sell in taxable to invest in tax-advantaged. It gives me lower taxes overall to do so.
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umfundi
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Re: Selling in Taxable to Invest in Tax Deferred

Post by umfundi »

I suggest you take a look at the federal financial aid form, FAFSA. If your daughter will not qualify for needs-based aid, don't worry about strategies around financial aid.

Keith
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

Middle wrote:I do not qualify for zero percent capital tax gains. I'm in the 15% bracket with an additional almost 10% state tax.

I seem to recall reading somewhere that there is a period of time (maybe before 70 1/2) where you can pay zero percent cap gains.
If your taxable income places you in the federal 15% tax bracket, then you might indeed qualify for some zero percent capital gains UP TO an amount which would "fill-up" the 15% bracket.

In addition, since IRA contributions can lower your taxable income, one can sell taxable investments for a gain, contribute to the IRA, and get $5,500 to $11,000 (single/married) in extra room to realize capital gains.

So maybe some more information is needed from you. What do you estimate your 2013 taxable income to be, assuming you fully fund a 401k? Are you married or single? Remember to take into account either the standard deduction, or estimate of an itemized deduction, as well as any exemptions you can claim.

Read this article for some more info: http://www.bankrate.com/finance/taxes/n ... ors-1.aspx (it's three pages long, be sure to click through all the pages).
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
Topic Author
Middle
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Middle »

I stand corrected. I do qualify for the zero percent capital gains tax. I'm not sure how I got that confused. In which case, I would benefit by incurring a capital gains tax at zero percent and lowering my current taxable income amount, right? The only downside being the loss of access to that money.
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

Middle wrote:I stand corrected. I do qualify for the zero percent capital gains tax. I'm not sure how I got that confused. In which case, I would benefit by incurring a capital gains tax at zero percent and lowering my current taxable income amount, right? The only downside being the loss of access to that money.
Well, not loss of access, just limited access. On the other hand, you could fund a Roth with that money, and you would not have lost any access, as you can withdraw that money at any time without penalty. However, with a Roth, you would not get the additional tax deduction (and thus an extra amount of zero capital gains). But if you think you want to preserve liquidity, funding a Roth would be the way to go, even if it "costs" you a tax deduction and a lower amount of zero % capital gains. It would be a "free" shift of taxable --> Roth. Not a bad deal.

The better deal is: sell appreciated shares to get zero % gains --> 401k or deductible IRA --> ability for more zero % gains due to having lowered your taxable income further below the top of the 15% bracket. :D

I'm currently advising a friend who has business income of about $50,000. After taking into account deduction for health care premiums, $20,000 in 401k contribution, standard deduction and personal exemption, his federal income tax is about zero (not including the self-employment tax) and he can realize about $35,000 in capital gains and pay no tax. He does not have positive cash flow, so he needs to use the realized gain sales to actually have the cash to maximize the 401k. If his income stays in this general ball park, he'll be able to do this every year, and get all of his taxable investments with gains into the 401k. He will use his previous Roth contributions for emergency money.
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
Caduceus
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Caduceus »

If you have the opportunity to tax-gain harvest at a 0% long-term capital gains rate (up to the 15% ordinary income tax bracket), you should almost always do something to take advantage of it, although what this action might be will depend on your personal situation. Assuming LTCG is 0%, you could:

--- A. increase contributions to your retirement accounts and sell taxable assets for your living expenses. You cannot lose in this situation because long-term capital gains are taxed at a preferential rate in comparison to wage income, no matter what your tax bracket is. I would contribute to Roth-type accounts with the realized gains since the tax cost of this transfer is very low.

--- B. sell assets in taxable accounts, and buy back immediately in the same account. You will reset the cost basis of your positions to a higher level while paying no capital gains (up to the 15% tax bracket), and permanently avoid the tax. The assets will stay in the taxable account compared to option A. This is not as good as contributions to Roth-type accounts since you will still eventually pay taxes on the appreciated amount, and be subjected to taxes on dividends. But if you have already maxed out tax-deferred space, this is a good alternative.

--- C. convert some of your assets in traditional accounts into Roth accounts.
Topic Author
Middle
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Middle »

neurosphere wrote:
The better deal is: sell appreciated shares to get zero % gains --> 401k or deductible IRA --> ability for more zero % gains due to having lowered your taxable income further below the top of the 15% bracket. :D
But I'm just remembering that it's not really zero % gains in that the LTCG are still figured into the taxable income, so in that light wouldn't I be just paying the taxes on those gains now as opposed to later during disbursement from 401k or IRA? And then it's a matter of just guessing whether my tax situation is better now or in retirement?
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

Middle wrote:
neurosphere wrote:
The better deal is: sell appreciated shares to get zero % gains --> 401k or deductible IRA --> ability for more zero % gains due to having lowered your taxable income further below the top of the 15% bracket. :D
But I'm just remembering that it's not really zero % gains in that the LTCG are still figured into the taxable income, so in that light wouldn't I be just paying the taxes on those gains now as opposed to later during disbursement from 401k or IRA? And then it's a matter of just guessing whether my tax situation is better now or in retirement?
No, capital gains are NOT figured into taxable income in the way you are thinking. Income is income, capital gains get taxed in a different way. In the case of the zero percent capital gains rate, the only relationship between income and gains is that the AMOUNT of gains eligible to be taxed at zero % is determined by how far below the top of the 15% you are. The lower you are, the more gains which will be be taxed at zero.

That's the whole point of this discussion. You will pay neither income taxes NOR capital gains tax for at least some amount of gains you realize, if your taxable income is below the top of the 15% bracket.

Look at your 1040 from last year. Even though capital gains go onto line 13, this does NOT get directly computed into taxable income. Instead, tax is determined by the worksheet at the end of the schedule D instructions: http://www.irs.gov/pub/irs-pdf/i1040sd.pdf

Look at the pdf, and look at at page D-13, line 20. It reads: "This amount is taxed at 0%". All of the calculations from line 1 to 19 are used to determine OF THE TAXABLE INCOME from line 43 on the 1040, what the actual TAX is. And as you can see, there is some amount which is taxed at zero.

The summary is, any capital gains which are up to an amount which IF ADDED TO INCOME AS IF IT WERE ORDINARY INCOME but would still keep you in the 15% bracket are taxed at zero percent. I.e. look at line 15, Page D-13 of the worksheet in the pdf. You can see that the amounts there are represent the top of the 15% bracket for single, married, and head of household.

NS

P.S. all caps were for emphasis, not shouting. :)
P.P.S. I'm not an expert, so all of my posts are subject to revision and/or ridicule. :wink:
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

Caduceus wrote: --- C. convert some of your assets in traditional accounts into Roth accounts.
Wouldn't this incur some income tax now, while the other strategies lead to no extra taxes or even less tax?

Assuming that one has any taxable income (i.e. after taking deductions, exemptions, other losses, etc)?
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
Topic Author
Middle
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Middle »

Hmmm, I must be missing something here because when I look at my return I see that capital gains are included on line 13 as part of income to determine AGI which becomes the basis for your taxable income after the deductions are made.

So my understanding is that if the taxable income exceeds that $70,700 for joint filers then there is additional capital gains tax, but zero additional tax for taxable income below $70,700. However, you're still paying tax on those LTCG because it is part of your income tax basis.

Is that not right?
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

Middle wrote:Hmmm, I must be missing something here because when I look at my return I see that capital gains are included on line 13 as part of income to determine AGI which becomes the basis for your taxable income after the deductions are made.

So my understanding is that if the taxable income exceeds that $70,700 for joint filers then there is additional capital gains tax, but zero additional tax for taxable income below $70,700. However, you're still paying tax on those LTCG because it is part of your income tax basis.

Is that not right?
This is what you are missing: even though line 13 gets added to taxable income which end up on line 43. Line 13 then gets SUBTRACTED OUT again when calculating the tax using the schedule D worksheet. If you have any capital gains, you do NOT use the tax tables. You use the worksheet.

I just now used my tax software to create two sets of taxes. On one set, the taxable income was 0 (line 43). On the other set, the taxable income was $30,000 (due to $30,000 of capital gains on line 13). However, in both cases the TAX OWED was ZERO. Understand? The reason was because of the $30,000 in "taxable income" $30,000 was as a result of capital gains which don't get taxed. Thus (using schedule D worksheet) the actual TAX came out to be zero, even with a "taxable income" of $30,000.
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
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grabiner
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Re: Selling in Taxable to Invest in Tax Deferred

Post by grabiner »

Middle wrote:. Whereas I like the idea of having flexibility with investments in taxable accounts as well as tax deferred, I'm wondering if it still makes sense to make IRA contributions with money invested in index funds. Now I would have to sell index funds and pay capital gains tax to fund an IRA.
The reason this is worthwhile is that you will have to pay the tax eventually; the IRS will take 15% of any gains. Once you sell, the IRS has taken its part, and you won't need to pay tax any more (Roth IRA) or will get a tax deduction which allows you to make a larger contribution and cancels out the tax cost (traditional IRA).
Originally I thought the more money I had in tax deferred accounts rather than taxable accounts could help in any college financial aid applications (my daughter is currently 10). But if my real goal is to maximize returns does it make better sense to not sell from taxable accounts provided I don't have any other reason to do it such as tax loss harvesting?
What you want to maximize is the money you have, not specifically the returns on the funds; this is also why you want to do tax-deferred investments. If you move $20,000 from your taxable account to your IRA, this will decrease your Expected Family Contribution by about $1000 each year, which is a 20% bonus for four years of college if the college meets your full financial need.
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Topic Author
Middle
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Middle »

neurosphere wrote:
This is what you are missing: even though line 13 gets added to taxable income which end up on line 43. Line 13 then gets SUBTRACTED OUT again when calculating the tax using the schedule D worksheet. If you have any capital gains, you do NOT use the tax tables. You use the worksheet.
Yes! Thank you. That's exactly what I was missing. It was just not easy to spot on my return at first because I had a loss carryover so there wasn't anything to subtract out. I have to say that seems like a confusing way to lay it out on the tax form because it sure makes you think that you are being taxed on that LTCG as income.

So Grabiner, I guess in my situation, the IRS is not going to take 15% now, but your point is well taken.
Bob's not my name
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Re: Selling in Taxable to Invest in Tax Deferred

Post by Bob's not my name »

Middle wrote:The only downside being the loss of access to that money.
You don't lose access. You can make penalty-free withdrawals from a TIRA to pay for your daughter's college. Whether that's desirable is another question -- you'd be drawing down retirement assets and you'd pay tax on the withdrawals. I'm just pointing out that your fear of losing access is unfounded.
goodenoughinvestor
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Re: Selling in Taxable to Invest in Tax Deferred

Post by goodenoughinvestor »

neurosphere: Just want to make sure I understand this. Let's say I'm filing as single, and my income is $21,250, which puts me in the 15% bracket with $15,000 to "spare" (since $36,250 in income is the top border of the 15% bracket). Let's say I decide to convert all of a traditional IRA, worth $15,000, into a Roth IRA. $5000 of this IRA is capital gains. What am I taxed on, and at what rate? Is all of the $15,000 IRA taxed at my 15% income rate tax (as it would be if I were retired and taking an rmd). Or is the $5000 considered capital gains and taxed at 0 because of my income?
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grabiner
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Re: Selling in Taxable to Invest in Tax Deferred

Post by grabiner »

goodenoughinvestor wrote:Just want to make sure I understand this. Let's say I'm filing as single, and my income is $21,250, which puts me in the 15% bracket with $15,000 to "spare" (since $36,250 in income is the top border of the 15% bracket). Let's say I decide to convert all of a traditional IRA, worth $15,000, into a Roth IRA. $5000 of this IRA is capital gains. What am I taxed on, and at what rate? Is all of the $15,000 IRA taxed at my 15% income rate tax (as it would be if I were retired and taking an rmd). Or is the $5000 considered capital gains and taxed at 0 because of my income?
The nature of gains in an IRA is irrelevant. When you withdraw from an IRA, you pay tax on the entire value of the withdrawal as ordinary income, less any amount previously taxed (non-deductible contributions, prorated if you make a partial withdrawal).

Thus, in your example, the entire $15,000 is taxed at a 15% rate unless you made non-deductible contributions in a previous year.
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neurosphere
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Re: Selling in Taxable to Invest in Tax Deferred

Post by neurosphere »

goodenoughinvestor wrote:neurosphere: Just want to make sure I understand this. Let's say I'm filing as single, and my income is $21,250, which puts me in the 15% bracket with $15,000 to "spare" (since $36,250 in income is the top border of the 15% bracket). Let's say I decide to convert all of a traditional IRA, worth $15,000, into a Roth IRA. $5000 of this IRA is capital gains. What am I taxed on, and at what rate? Is all of the $15,000 IRA taxed at my 15% income rate tax (as it would be if I were retired and taking an rmd). Or is the $5000 considered capital gains and taxed at 0 because of my income?
I think there is confusion about the nature of IRA conversions due to Caduceus's post where his item "C" was incorrect I think. Any amount converted from a deductible IRA to a Roth are treated as "ordinary" income. So IRA conversions do not really play into this conversation of a zero percent capital gains rate.

But in your example, the $15,000 "room to spare" is the amount of capital gains you can incur and still pay zero tax.
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
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