Oblivious Investor

We’ve talked quite a bit about Roth conversions over the years. (For instance, see: Roth Conversion Rules FAQ, Roth Conversion Planning: A Step-By-Step Approach, and Roth Conversion Analysis: Not Breakeven Analysis.) Yet they are still one of the topics that comes up most frequently in questions from readers.

So what follows are the four primary things I think about when evaluating a potential Roth conversion — the four primary ways in which a Roth conversion can change a household’s trajectory.

Effect #1: Pay Tax Now Instead of Latter

The first effect of a Roth conversion is that you pay tax now (on the conversion) instead of later (i.e., whenever the money would come out of the account later, if you don’t convert it right now). This is the effect that gets the most discussion because it’s the most obvious one and because it is, in many cases, the largest effect. (That is, the difference between the two tax rates in question is often more impactful than effects #2-4 below.)

This first effect can be helpful or harmful. It’s helpful if the tax rate you pay on the conversion is lower than the tax rate that would have been paid later. And it’s harmful if the tax rate paid on the conversion is higher than the tax rate that would have been paid later.

With regard to this first effect, there are two important subtleties to keep in mind:

• The “pay tax later” tax rate might be the tax rate you would pay later on distributions for spending or RMDs. But it might also, to an extent, be the tax rate that your heir(s) would pay later on distributions from inherited tax-deferred accounts. Or, it can even be a 0% tax rate, to the extent the money goes to charity — either via qualified charitable distributions (QCDs) or as a bequest.
• When doing this analysis, you must look at actual marginal tax rates (ideally including Medicare IRMAA effects) rather than just tax brackets. As we’ve discussed in various previous articles, there are many things that can cause your marginal tax rate to be different than just your tax bracket.

Effect #2: Using Taxable Dollars to “Buy More” Roth Dollars

The second effect of a Roth conversion occurs when you get to use taxable dollars (i.e., non-retirement-account dollars) to pay the tax on the conversion. If applicable, this effect generally is beneficial, though how beneficial it is varies from one household to another. Some relevant factors would include:

•  The length of time that the money will stay in the Roth. (That is, how long do you get to benefit from the tax-free growth that the dollars will now experience, because they’re no longer in a taxable account?) This could be “time until you spend the dollars.” Or it could be “time until the dollars have to come out of the account as distributions to heirs” (in which case your age and health would be major factors).
• What rate of return you anticipate earning on the assets and how that return is broken down in terms of interest/dividends/price appreciation.
• The tax rate(s) you would have to pay on that return (and when you would have to pay it), if the assets stayed in a taxable account.
• What (if any) tax cost must be incurred as a result of selling the taxable assets in question now in order to use that money to pay the tax on the conversion.

Of course, if you don’t have significant assets in taxable accounts (and you would therefore be using dollars from the traditional IRA to pay the tax on the conversion), this effect is not applicable.

Effect #3: Smaller RMDs (Less Future Tax Drag)

The third effect of a Roth conversion is that it reduces your later RMDs (because Roth IRAs don’t have RMDs during the original owner’s lifetime), thereby reducing future tax drag if you aren’t spending (or donating) your RMD dollars.

To be clear, we’re not talking here about the tax paid on the RMDs themselves. That would fall under effect #1. What we’re talking about here is that, after an RMD is taken, if the money is just reinvested in a taxable brokerage account, it will incur taxes on any further growth. (And, critically, that tax would not occur if a conversion were done, because the dollars would be in a Roth IRA.)

This effect of a conversion can never be harmful. Though, as with effect #2, it might not apply. RMDs are (in a several way tie for) the most tax-efficient dollars to spend every year. If you’re going to spend (or QCD) your entire RMD every year, this effect is a zero because the dollars aren’t getting reinvested in a taxable account.

Other relevant factors that influence the size of effect #3 include:

• The length of time that the money would be in a taxable brokerage account (rather than a Roth IRA) after taking the RMD. Of note, unlike with effect #2 above, your current age is not a factor here unless you’re already age 72, because this effect by definition does not begin until age 72. Your health is a major factor though.
• What rate of return you anticipate earning on the assets and how that return is broken down in terms of interest/dividends/price appreciation.
• The tax rate(s) you would have to pay on that return (and when you would have to pay it), if the assets stayed in a taxable account.

Effect #4: Fewer Dollars Appearing on the Balance Sheet

The fourth effect of a Roth conversion is that you now have fewer total dollars. For example, there might now be $75,000 in a Roth IRA whereas before there was $100,000 in a traditional IRA.

For most people, this doesn’t matter at all. But it is helpful for anybody whose estate will be subject to an estate tax. (Given the current federal estate tax exclusion amount, few people have to worry about federal estate tax. But 12 states, as well as Washington DC, have estate taxes, many of which kick in at significantly lower thresholds.)

So like effects #2 and #3, this effect will be irrelevant for many households, whereas it will be helpful for others. (I’m not aware of any ways in which it would be harmful.)

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

Many taxpayers in the U.S. have come to expect a sizable refund check every tax season. To some people who don’t prepare their own tax returns, it’s a mystery how the refund is calculated.

The idea is really quite simple. After calculating your taxable income, you use the information in the tax tables to determine your total income tax for the year. This amount is then compared to the amount that you actually paid throughout the year (in the form of withholdings from your paychecks). If the amount you paid is more than your tax, you are entitled to a refund for the difference. If the amount you paid is less than your tax, it’s time to get out the checkbook.

Withholding: Why It’s Done

If you work as an employee, you’re certainly aware that a large portion of your wages/salary doesn’t actually show up in your paycheck every two weeks. Instead, it gets “withheld.”

The reason for this withholding is that the federal government wants to be absolutely sure that its gets its money. The government knows that many people have a tendency to spend literally all of the income they receive (if not more). As a result, the government set up the system so that it would get its share before taxpayers would have a chance to spend it.

The amount of your pay that gets withheld is based upon an estimate of how much tax you’ll be responsible for paying over the course of the year. (This is why you are required to fill out Form W-4, providing your employer with some tax-related information, when you start a new job.)

Withholding: How It’s Calculated

At this point you may be thinking, “OK. Well I’m in the __% tax bracket, and it’s obvious that my employer is withholding way more than that!”

You’re probably right. That’s because your employer isn’t just withholding for federal income tax. They’re also withholding for Social Security tax, Medicare tax, and (likely) state income tax.

The Social Security tax is calculated as 6.2% of your earnings, and the Medicare tax is calculated as 1.45% of your earnings. Before you’ve even begun to pay your income taxes, 7.65% of your income has been withheld.

Your refund is determined by comparing your total income tax to the amount that was withheld for federal income tax. Assuming that the amount withheld for federal income tax was greater than your income tax for the year, you will receive a refund for the difference.

EXAMPLE: Nick’s total taxable income (after subtracting deductions) is $32,000. He is single. Using the 2023 tax table for single taxpayers, we can determine that his federal income tax is $3,620.

Over the course of the year, Nick’s employer withheld a total of $8,500 from his pay, of which $4,000 went toward federal income tax. His refund will be $380 (i.e., $4,000 minus $3,620).

Simple Summary

• Every year, your refund is calculated as the amount withheld for federal income tax, minus your total federal income tax for the year.
• A large portion of the money being withheld from each of your paychecks does not actually go toward federal income tax. Instead, it goes to pay the Social Security tax, the Medicare tax, and possibly state income tax.

To date, there are more than 1,000 articles published on this blog on a variety of topics — many of them answers to reader questions. A large portion of the email questions I receive deal with either tax brackets or withholding. As far as I can tell, these questions stem from the fact that many (most?) taxpayers do not understand:

1. How tax brackets work, and
2. How the amount withheld for taxes from one’s paychecks can be different from the amount of tax one actually has to pay.

Let’s take a crack at each of those, shall we?

How Do Tax Brackets Work?

Based on the 2023 tax brackets, we can see that for an unmarried taxpayer, the 10% tax bracket goes from $0-$11,000 of taxable income. For example, if John’s taxable income is $11,000, his income tax will be $1,100. Nothing tricky there.

But what if John’s taxable income increases by $1 to $11,001 (thereby putting him in the 12% tax bracket)? How much extra income tax will John pay?

Answer: He’ll pay an additional $0.12 of income tax. That is, only his final dollar of income (the dollar that’s in the 12% tax bracket) will be taxed at 12%. His first $11,000 of income will still be taxed at 10%.

Important conclusion #1: Getting a raise at work that puts you into a higher tax bracket will not reduce your after-tax take-home pay. (Possible exception: The raise could make you ineligible for certain deductions or credits, the loss of which could outweigh the increase in income.)

Important conclusion #2: If you’re trying to get an estimate of how much income tax you’ll owe for a given year, do not simply multiply your income by your marginal tax bracket–doing so would overestimate your tax (by a very wide margin in many cases).

How Does Withholding Work?

From every paycheck, your employer withholds some of your salary/wages to go toward taxes. The Federal government requires this because they understand that many people spend every dime that makes it into their bank account (plus some). By making withholding mandatory, the government gets its money before taxpayers have a chance to spend it.

It’s important to note that the amount of tax that’s withheld over the course of a year goes to more than just Federal income taxes. It also covers:

• Social Security tax (6.2% of your earnings, up to $160,200 for 2023),
• Medicare tax (1.45% of earnings), and
• State/local income tax (if applicable).

In addition, the amount that’s withheld over the course of the year for Federal income tax will not actually equal the amount that you’re responsible for paying that year. This is the result of the fact that your employer doesn’t have all of the information necessary to precisely calculate the tax that you’re responsible for paying. (For example, they don’t know what deductions you’ll claim or how much your spouse earns.)

The fact that the amount that’s withheld does not equal the amount you’re responsible for paying is why tax season is basically a massive “settling up,” during which taxpayers either receive a refund (for the amount by which their withholding exceeded their tax) or write a check to the U.S. Treasury (for the amount by which their tax exceeded their withholding).

One useful thing you can do with your portfolio during market declines is check your taxable accounts for opportunities to tax-loss harvest. (Note: tax-loss harvesting does not apply to IRAs or other tax-sheltered accounts.)

To explain what tax-loss harvesting is, let’s look at an example.

Mary is in the 24% tax bracket. At the beginning of the year, Mary bought $100,000 of Vanguard Total International Stock Index Fund in her taxable account. And let’s imagine that as of today, it’s worth approximately $93,000. To tax-loss harvest, Mary would sell that fund, thereby recognizing a $7,000 capital loss. And Mary would use the proceeds from the sale to purchase another fund to serve as a replacement in her portfolio.

Mary can use the $7,000 capital loss to offset any capital gains she realized this year. And if Mary’s capital losses exceed her capital gains for the year, she can use up to $3,000 of her net capital loss to offset ordinary income, thereby reducing her income tax by $720 (i.e., $3,000 x 24%). If she still has remaining capital losses after that, they can be carried forward to be used in future years (subject to the same limitation).

What’s the Point?

You may have noticed, however, that when you eventually sell the replacement fund, your capital gain will be larger than it would have been had you not tax-loss harvested (because the replacement fund will have been purchased at a lower price than the original fund).

To return to our example above, if Mary uses her $93,000 to purchase Vanguard FTSE All-World Ex-US Index, which she sells a few years later for $130,000, her long-term capital gain will be $37,000 rather than $30,000.

So did Mary still come out ahead? Yes, for a few reasons.

First, if nothing else, she deferred her taxes for a few years — in essence getting an interest-free loan from Uncle Sam.

Second, if she was able to use any of her $7,000 capital loss to offset ordinary income (or short-term capital gains), then the capital loss saved her money at a rate of 24% (because she’s in the 24% tax bracket). When she sells the replacement fund, the long-term capital gain will be taxed at a lower rate (likely 15%).

Finally, if Mary had ended up dying before she sold the fund, the savings from tax-loss harvesting would be pure profit (because her heirs will receive the fund’s current market value as their cost basis when they inherit it).

When to Tax-Loss Harvest

Many investors check for tax-loss harvesting opportunities right before the end of the year — when they start thinking about taxes. While that’s perfectly fine, it can be advantageous to check several times throughout the year. Investments can be volatile, and it’s entirely possible that a tax-loss harvesting opportunity will arise early in the year, only to disappear before year-end.

Potential Pitfall: The Wash Sale Rule

The place where people often trip up is by accidentally triggering the “wash sale” rule. A wash sale occurs when you:

1. Sell an investment for a loss, and
2. Buy “substantially identical” securities within 30 days before or after the sale.

When a wash sale occurs, the loss is disallowed. Fortunately, the cost basis of your new shares is adjusted upward by an amount equal to the disallowed loss so that when you sell the shares in the future — assuming you don’t trigger the wash sale rule yet again — you’ll be able to claim the loss (or, depending on circumstances, a smaller capital gain).

Example: Catherine buys 100 shares of a stock at $38 per share. A few months later, Catherine sells the shares for $25 per share. Five days later, she buys another 100 shares of the same stock at $29 per share. Because she bought new shares within 30 days of the sale, the wash sale rule will be triggered, and Catherine’s loss of $13 per share will be disallowed. Her cost basis in the new shares, however, will be $42 per share ($29 purchase price + $13 from the disallowed loss), thereby allowing for a larger capital loss or smaller capital gain when she sells the shares in the future.

Wash Sales Due to a Spouse’s Transactions

Some investors hope to avoid the wash sale rule by having their spouse buy a particular investment at the same time that they sell it for a loss. But, as explained in IRS Publication 550, this does not work. For the purpose of triggering a wash sale, your spouse buying or selling an investment has the same effect as you buying or selling the investment.

Wash Sales Due to Buying in an IRA

Other investors try to avoid a wash sale by selling an investment for a loss in their taxable account, then buying the same investment in their IRA — with the idea being that the IRA is titled differently than the taxable account, so it would not trigger a wash sale.

This doesn’t work either. Buying a “substantially identical” investment in your IRA (whether Roth or traditional) within 30 days of the sale will result in a wash sale.

Wash Sales Due to Buying Within 30 Days Prior to Sale

Finally, many investors think of wash sales as only occurring if you re-buy the investment shortly after selling it. That is, they forget that a wash sale can occur if you buy shares within 30 days prior to the sale.

Example: On January 1, Josh buys 100 shares of Vanguard Total Stock Market ETF in his brokerage account for $60 per share. On January 15, Josh buys another 100 shares for $58 per share. On January 20, Josh sells 100 shares, at a price of $56 per share. Josh has a wash sale. His loss will be disallowed and added to the cost basis of his remaining 100 shares.

Note, however, that you do not need to worry about wash sales if you liquidate all of your shares of a given investment and you do not repurchase substantially identical securities within 30 days.

Example: On January 1, Lucy buys 100 shares of Vanguard Total Stock Market ETF in her brokerage account, at a price of $60 per share. On January 10, Lucy sells her 100 shares for $55 per share, and she does not purchase substantially identical securities in any of her accounts within the next 30 days. Lucy will be able to claim her loss of $5 per share, despite the fact that a purchase occurred within 30 days prior to the sale.

Wash Sales from Buying in a 401(k)

Update: A few readers asked whether a wash sale can be triggered when, after selling an investment for a loss in a taxable account, substantially identical securities are purchased in a 401(k) or 403(b).

This answer is a bit trickier. Section 1091 of the Internal Revenue Code is the law that creates the wash sale rule. It doesn’t mention retirement accounts at all. The rule about wash sales being triggered from purchases in an IRA comes from IRS Revenue Ruling 2008-5. If you read through the ruling, you’ll see that it speaks specifically to IRAs and does not mention 401(k) or other employer-sponsored retirement plans.

To the best of my knowledge, there is no official IRS ruling that speaks specifically to wash sales being created by a transaction in a 401(k). In other words, I’m not aware of any source of legal authority that clearly says that a purchase in a 401(k) would trigger a wash sale.

However, in my opinion, it seems pretty clear that the line of reasoning in the above-linked revenue ruling would apply to employer-sponsored retirement plans as well as IRAs.

So, personally, I would not be comfortable taking a position on a tax return that’s based on the assumption that purchases in a 401(k) cannot trigger a wash sale. But that’s just my personal opinion. Others may disagree.

What Makes Two Mutual Funds “Substantially Identical”?

Update #2: Several readers also wrote in with questions about how to know whether two mutual funds are “substantially identical” for the purposes of triggering a wash sale.

Unfortunately, I’m not aware of any official IRS position providing a cut-and-dried test to determine whether two mutual funds are substantially identical. From what I gather, challenging people on the wash sale rule is just not a top priority from a tax enforcement standpoint.

Personally, my standard is this: If the IRS did challenge my position, and I ended up in court having to make the case that these two funds were not substantially identical, would I feel confident about my chance of success? Unless the answer is “yes, absolutely,” I’d choose a different (less similar) mutual fund.

For example, I would not be comfortable making the case that the following are not substantially identical:

• The ETF version and the mutual fund version of a given Vanguard index fund,
• Two index funds or ETFs that track the same index (even if their holdings are not identical), or
• Two “total market” index funds, even if they track slightly different indexes.

In short, I would probably not want to use a given fund as a tax loss harvesting partner for another fund unless I could not only show that the underlying portfolios are different, but also provide a chart showing that the two funds really do perform noticeably differently. But, as with the previous question, this is one in which other people could rationally reach a different conclusion.

Finally, as author Taylor Larimore often reminds investors at the Bogleheads forum: If you want to tax loss harvest with a particular fund, and you don’t want to worry about finding a replacement fund that’s similar but not substantially identical, you can always just wait 31 days after the sale, then re-buy the original fund.