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Tax Planning for the “Pre-Social Security, Pre-RMD” Retirement Years

A reader writes in, asking:

“After retiring, I’ll have a window of a few years before Social Security and RMDs, during which my tax rate will be relatively low. What is your opinion on how best to use that period? Better to use long term capital gains or Roth IRA conversions to fill up that low tax rate space?”

It depends.

The goal is to figure out how much you save by doing a Roth conversion now (as opposed to the money coming out later), and compare that to the amount you save by realizing capital gains now (as opposed to later).

For example, if Roth conversions would currently face a 15% tax rate, but you expect that (if you didn’t do a Roth conversion), the money would come out later at a 25% tax rate, then your savings on each dollar you convert at that 15% rate would be 10%.

And if you’re in the 15% tax bracket right now, each dollar of long-term capital gains that you realize (while still staying in that bracket) would be taxed at 0%. And if you expect that you’ll be in the 25% bracket later, then LTCGs would be taxed at a 15% rate later (because LTCGs in the 25-35% tax brackets are taxed at a 15% rate). So you’d be saving 15% by realizing them now.

Point being: In this hypothetical case the 15% savings from realizing capital gains now exceeds the 10% savings from doing Roth conversions now, so realizing long-term capital gains is preferable.

To be clear though, this is a simplified analysis. In reality, you’d want to account for any factors that could cause your marginal tax rate (whether on Roth conversions or realization of LTCGs) to be different than the normal amount (e.g., because additional income is causing you to lose eligibility for a given tax break).

A good way to account for these complexities is to model via tax prep software. That is, you would create a hypothetical tax return in TurboTax or something similar, and see how your total tax changes if you do another $1,000 of Roth conversion or realize another $1,000 of long-term capital gains.

There can be an assortment of case-specific complicating factors as well. For example, if you expect to have a large portion of your portfolio left when you eventually pass away, it’s important to:

  1. Remember that long-term capital gains would go untaxed if you leave the appreciated assets to your heirs (because they would get a step-up in cost basis), and
  2. Consider your heirs’ future tax rates rather than just your own future tax rate when considering Roth conversions (i.e., if you don’t do a Roth conversion, money would be taxed at their rate when it comes out of an inherited traditional IRA).

As you might imagine, working with a tax planning professional is likely to be helpful.

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