Roth conversion/recharacterization game or 0% cap gains tax rate

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Kevin M
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Roth conversion/recharacterization game or 0% cap gains tax rate

Post by Kevin M » Mon Aug 31, 2015 10:21 am

EDIT: Changed post subject to reflect the additional alternative of taking long-term capital gains and paying 0% federal tax rate, which I'll discuss in a new reply.

I estimate that my fiancee can do a Roth conversion of about $30K within the 15% federal tax bracket this year (before getting married next year), which for sure is less than the federal tax bracket we'll be in when I start taking RMDs in seven years. Marginal state tax rate on the conversion would be 6%, but marginal state tax rate with RMDs probably will be over 9%.

I've done Roth conversions and recharacterizations (back to traditional), but I've never played the game of converting multiple asset classes and recharacterizing all but the best performer, and am wondering if it's worth the hassle. Would appreciate inputs from anyone who's done it, especially if at Vanguard or Fidelity.

I did a Roth conversion and partial recharacterization at Fidelity a couple of years ago, and was able to do everything online (with phone assistance in finding the online recharacterization form), and TurboTax handled the tax reporting smoothly, so it was pretty easy. She has a rollover tIRA at Fidelity with enough in it to do three or more conversions of $30K each, so we could it there.

I've done recharacterizations, but no conversions, at Vanguard, but it was some years ago, and I don't remember if I was able to do it online or not, but I don't recall it being much of a hassle. She also has a tIRA at Vanguard with enough to do two conversions of $30K each.

Am also wondering if it's worth doing an income tax return extension to October of next year to provide the additional time to see which converted asset class does better.

How many and what asset classes would you recommend for the conversions? I'm thinking of something like small-cap value, long-term Treasuries, and maybe a 5-year CD as the safety conversion, either brokered or direct, depending on the hassle of converting/recharacterizing a direct CD (I've done a conversion of a CD at PenFed, but no recharacterization). SCV and direct CDs are part of the current AA, but not long-term Treasuries, so using the latter may not be entirely rational, but I guess I'm stretching a bit in looking for lowest probable correlation between the conversion asset class candidates.

My understanding is that the cleanest way to do this is to open a new Roth IRA for each conversion, as that simplifies and optimizes the tax consequences of the recharacterizations. Then after all recharacterizations are done, the remaining Roth could be rolled into an existing Roth if there is one. Correct?

Thoughts?

Thanks,

Kevin
Last edited by Kevin M on Tue Sep 01, 2015 6:35 pm, edited 1 time in total.
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Carl53
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Re: Roth conversion/recharacterization game

Post by Carl53 » Mon Aug 31, 2015 10:41 am

Multiple conversions of different asset classes has its advantages. I generally have done the recharacterizations in early to mid December since it seems like the paperwork from VG comes out a little cleaner w regard to taxes. You have the recharacterizations in the same year as the conversion. Last year, there was a little snafu when I got into the period when VG funds were paying dividends and capital gains. It took several calls to get it straightened out. As of now we only have one of three full conversions in the black, but one is good enough. If we had none, I'd be tempted to do another now.

We also do one small, $1000, target income conversion for my spouse expecting it to be slightly positive. While it is not in positive territory as of now, the goal is to have income in my spouses name as our state gives a discount on income taxes if both spouses have a certain amount of income, which conversion income counts.

Btw, we do combine un re characterized roths.

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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by Kevin M » Tue Sep 01, 2015 6:53 pm

Now I'm thinking about the alternative of selling mutual funds in taxable accounts up to limit for the 0% federal capital gains tax rate. Either this or Roth conversions will result in same state taxes, as California gives no special treatment to either, so from state tax perspective, it's a wash.

Have been reading the other threads on the trade-off between Roth conversion to top of 15% bracket vs. taking long-term cap gains to top of 15% bracket (and paying 0% federal tax on LTCG). Many of the considerations mentioned in those threads don't apply, and a Kitces article (End Of Year Roth Conversions And Capital Gains Harvesting – Paying Taxes To Save Taxes | Kitces.com) linked in several of those threads suggests converting to top of 0% bracket (not applicable), then taking LTCG to top of 15% bracket, then evaluating whether to convert more or harvest more gains.

Since tax gains harvesting can't be dialed in as accurately, because the recharacterization option doesn't exist, I'm thinking of selling a "safe" amount of mutual funds with gains, say $20K of LTCG, and converting $10K-$15K, or whatever is likely to put her a bit above the 15% bracket, and then dialing it in by recharacterizing as necessary. This would require recharacterizing all of the losers in the Roth conversion horse race, and doing a partial recharacterization of the winner.

This has the additional benefit of not betting entirely on Roth conversion or tax-gain harvesting being the better choice, but hedging our bets by doing some of each. A downside is that a $10K Roth is a bit of a nuisance account, and doing multiple conversions of this relatively small amount seems a bit silly. However, there already is a Roth at Vanguard, so if a conversion at Vanguard is the winner, we could merge the converted Roth into the existing Roth after all recharacterizations are complete. If the winner is at Fidelity, we could do an IRA transfer of the Roth at Fidelity into the Roth at Vanguard (after all recharacterizations).

Since these are mutual funds at Vanguard, so can't exchange out and back in on same day or even next day, we would exchange into most similar funds possible, either in same account or another account.

Kevin
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celia
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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by celia » Tue Sep 01, 2015 7:58 pm

Why do you want to lock in capital gains? Do you plan to re-invest the money or spend it? If you have no specific plans for it, I don't know why you aren't converting as much as you can now. Have you calculated your & your finance's tax hit when you are married and both retired (income from pensions, SS, and ???) and both of you are taking RMDs? You need a guesstimate of your tax rate at that time to decide if converting now or then makes more sense.

You sound like you have a good handle on the conversions. She should definitely convert her most aggressive asset (the one that has dropped the most so far now and/or later this year--if the market goes down some more). I would convert at least twice so you/she can decide at the end of the year which one is the "keeper", then recharacterize the other one. ALWAYS CONVERT INTO A NEW/EMPTY ROTH in case a recharacterization is planned. You got that part down! Also pay taxes from another taxable source, not withheld from the conversion. The goal should be to get all those dollars into a Roth. (Besides, how can you recharacterize a conversion that went partly to a Roth and partly to the IRS?)
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.

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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by Kevin M » Tue Sep 01, 2015 8:43 pm

celia wrote:Why do you want to lock in capital gains?
The objective is not to lock in gains, but to pay tax at a 0% rate now instead of a 15% rate in the future. Knowing whether this or doing a Roth conversion to top of 15% bracket is better seems to require assumptions about growth rates, etc. Off the top of my head, without any complex math or assumptions, paying 0% cap gains tax instead of 15% in the future seems a bit better than paying 15% tax on a Roth conversion instead of 25% in the future. The numbers here are too small to do much more complex calculations than that.
Do you plan to re-invest the money or spend it?
As mentioned, the existing funds would be exchanged into other similar funds--perhaps even more tax-efficient funds. This actually gives us a chance to clean up our tax efficiency a bit while we're at it. So there will be no money to reinvest or spend (or I guess you could say the answer is "immediately reinvest").
She should definitely convert her most aggressive asset (the one that has dropped the most so far now and/or later this year--if the market goes down some more). I would convert at least twice so you/she can decide at the end of the year which one is the "keeper", then recharacterize the other one.

Yes, the plan is to convert several asset classes, with one safe one as the fallback keeper, and the rest risky. Not sure how much it has to do with which one has dropped the most this year, unless you believe in fairly reliable mean reversion over one-year time periods, but I was thinking of an emerging market fund as one of the risky candidates.
Also pay taxes from another taxable source, not withheld from the conversion.
Yes, this is a given.

Thanks,

Kevin
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goodenoughinvestor
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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by goodenoughinvestor » Tue Sep 01, 2015 9:07 pm

Each year I check the allowable contributions to my individual Roth (401)K (employee) and Roth IRA. (In 2014 it was $29500). I then "fill up" my 0% capital gains bracket by that amount by selling shares of a mutual fund that has appreciated significantly. On the same day that I sell, I use cash to buy the same number of shares in my Roth accounts, essentially capturing the gain tax free. With the surplus from the mutual funds sale (amount over $29500) I re-purchase the fund in the taxable account at a significantly higher cost basis. It's not a huge amount each year, but it makes me feel better about my low income!

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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by House Blend » Wed Sep 02, 2015 9:47 am

Kevin M wrote: Since tax gains harvesting can't be dialed in as accurately, because the recharacterization option doesn't exist, I'm thinking of selling a "safe" amount of mutual funds with gains, say $20K of LTCG, and converting $10K-$15K, or whatever is likely to put her a bit above the 15% bracket, and then dialing it in by recharacterizing as necessary. This would require recharacterizing all of the losers in the Roth conversion horse race, and doing a partial recharacterization of the winner.

This has the additional benefit of not betting entirely on Roth conversion or tax-gain harvesting being the better choice, but hedging our bets by doing some of each. A downside is that a $10K Roth is a bit of a nuisance account, and doing multiple conversions of this relatively small amount seems a bit silly. However, there already is a Roth at Vanguard, so if a conversion at Vanguard is the winner, we could merge the converted Roth into the existing Roth after all recharacterizations are complete. If the winner is at Fidelity, we could do an IRA transfer of the Roth at Fidelity into the Roth at Vanguard (after all recharacterizations).
I do like the idea of doing some of both (TGH + Roth convert). The multiple conversion horse race is too bothersome for my taste. YMMV.

As you say, only doing TGH means you have to estimate taxable income before the year is over, and if your final dividends are late in the year, you only have a few days to act. But perhaps they are a small contributor to overall income, and bad estimates won't cost much. (And you still won't know taxable income for sure until foreign tax withheld is reported and the final *corrected* 1099 is issued.)

Keep in mind that the 15% now vs. 25% later Roth tradeoff could turn out to be 15% now vs. 30% later (if qualified dividends is what puts you over the 15% Federal bracket). And taxes on SS income can make the future marginal rate much higher. Have you projected whether 100% of your SS income is likely to be 85% taxable?

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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by Kevin M » Wed Sep 02, 2015 2:29 pm

House Blend wrote: I do like the idea of doing some of both (TGH + Roth convert). The multiple conversion horse race is too bothersome for my taste. YMMV.
Thanks for the input. I'm starting to agree about the horse race, especially if the Roth conversion amount ends up being only $10K, or even less, as I'm leaning toward more LTCG at 0% at this point. So now I"m leaning toward just converting the relatively small amount with a safe asset class.
As you say, only doing TGH means you have to estimate taxable income before the year is over, and if your final dividends are late in the year, you only have a few days to act. But perhaps they are a small contributor to overall income, and bad estimates won't cost much. (And you still won't know taxable income for sure until foreign tax withheld is reported and the final *corrected* 1099 is issued.)
In this case, stock dividends are a small enough portion of expected income that I think we can come pretty close with our estimates, and all international stock is held in IRA accounts, so no foreign tax credit to worry about. But we could wait until late in the year to tune up the amount of gains to harvest. I'm now thinking more along the lines of TGH $25K, convert $5K-$10K (and recharacterize as necessary). I believe the actual estimate of what's left in the 15% bracket is about $32K.
Keep in mind that the 15% now vs. 25% later Roth tradeoff could turn out to be 15% now vs. 30% later (if qualified dividends is what puts you over the 15% Federal bracket). And taxes on SS income can make the future marginal rate much higher. Have you projected whether 100% of your SS income is likely to be 85% taxable?
Yes, all good points.

I'm sure we'll be in at least the 25% bracket when taking RMDs, almost certainly even before including qualified dividends, so all qualified dividends and cap gains will be already be taxed at 15%. So I don't think we'll be pushing anything from the cap gains 0% rate to the CG 15% rate, but I'll check on that. Also, tax law could change by then, so there's significant uncertainty in all of this anyway.

I'm currently receiving an SS survivor benefit, and it's already 100% taxed at 85%. I'm fairly certain that with RMDs, our SS retirement benefits will be 100% taxed at 85%, but will double-check this too.

Although I've run the simulated 2016 tax returns for each of us as individuals and for us MFJ, and for each of us as individuals after age 70, which makes having her do something this year a no brainer, I haven't yet done it for us as MFJ after age 70, but it's on my to do list. Posting on Bogleheads is more fun, but I know I need to do the simulated MFJ at age 70+, and probably will in the next few days.

From having done it for myself as an individual a few years ago, I suspect it's going to indicate that we should be doing Roth conversions even in the 25% bracket. However, I did a large one a few years ago, and it was just too emotionally painful to pay the large tax bill before I had to, especially seeing the various credits and deductions phased out.

My current plan, perhaps penny-wise and pound-foolish, is to at least wait until there are no more college expense credits available to me (currently $2,500 credit each year), and then revisit doing some large Roth conversions. I think that will be two years from now, leaving us about five years to do Roth conversions before I start taking RMDs, and an additional two years before my wife-to-be starts. Maybe running the tax simulation for MFJ at age 70+ will motivate me to accelerate that a bit.

Kevin
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ThisTimeItsDifferent
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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by ThisTimeItsDifferent » Fri Sep 25, 2015 8:35 am

You got that right. Use a separate new account. Do not let Vanguard or any other company put it in a new "sub account," which they do not isolate for pro rata re characterization purposes. Their phone reps get that wrong!

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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by Wagnerjb » Fri Sep 25, 2015 10:38 am

Kevin M wrote:Off the top of my head, without any complex math or assumptions, paying 0% cap gains tax instead of 15% in the future seems a bit better than paying 15% tax on a Roth conversion instead of 25% in the future. The numbers here are too small to do much more complex calculations than that.
Kevin: I came to the same conclusion in my situation. In 2016 I will have a low income year (I retired this year and my deferred compensation income won't begin until second half of 2016) so I am contemplating the same issue - convert pretax IRA money to a Roth, or take capital gains. I don't have a state income tax in Texas, so my calculations are as straightforward as you laid out above. Either pay 0% on the capital gains now vs 15% in the future, or convert at 15% vs. withdraw at 25% in future years. The greater tax savings appear to be in the capital gains area.

I will use the funds from realizing capital gains for spending money to supplement withdrawals from tax deferred accounts, so I am not really considering an alternative of holding the taxable securities for a longer period. These after-tax funds will help me keep out of higher tax brackets in retirement, as I will use a combination of a) withdrawals from tax deferred accounts and b) after-tax funds to keep me from breaking into the next higher tax bracket, and possibly to avoid any phase outs or penalties....whether it be college tax credits, AMT, Medicare premiums, itemized deductions, whatever....

Best wishes.
Andy

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Re: Roth conversion/recharacterization game or 0% cap gains tax rate

Post by Kevin M » Fri Sep 25, 2015 1:51 pm

We're almost done harvesting the gains up to top of 0% CG "tax bracket", and in the process, have improved the tax efficiency of the portfolio. With the help of TurboTax, I calculated that a a little over $32K of gains were harvestable at the 0% federal rate (unfortunately not 0% state rate). Currently at $25.8K, and will do a bit more today.

Exchanged all holdings of large value and small blend into Total Stock in taxable. Still holding small-cap value (best single fund for the desired small/value tilt, and less desire for this tilt than previously), although may need to sell some of that as well.

Exchanged from tax-exempt bond funds (with gains!) into Total International and Total Stock, with offsetting exchanges in IRA out of S&P 500 and Fidelity Total International (no EM) into a combination of VCIT (int-term corporate) and direct CDs (now in process of second large IRA transfer to a bank or CU offering good CDs). Much larger amount going into CDs than into VCIT.

Also did some exchanging of emerging markets into VG int-term inv-grade in an IRA to compensate for the addition of EM in VG Total International (unlike the Fidelity TI fund).

Today will sell some more S&P 500 and Fidelity Total International in the IRA to raise the rest of the cash for the new CD (2-year 2.28% at USAlliance Financial), and will offset (with additional TGH and rebalance back to stock target) by exchanging some more tax-exempt bond funds into VG Total Stock and Total International.

With each TGH move, have also rebalanced back to AA targets, which has involved buying more stocks in taxable than what has been sold in the IRA, and will do so again with today's planned exchanges.

At this point, I think we'll come close enough to the top of the federal 0% CG bracket with just TGH that no Roth conversion will be required, and don't want to mess around with a small Roth conversion/recharacterization just to hit it exactly. Another really nice emotional benefit of doing TGH instead of Roth conversion is no need to write the IRS a fat check (and probably pay a small penalty for late payment of estimated taxes). Just had to write a much smaller check to the state, which would have been the same for a Roth conversion.

Kevin
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