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Using Taxable Holdings to Fund IRA Contributions

A reader writes in, asking:

“My wife and I have a variable income. In previous years, our income has been high enough to max out our retirement accounts and still have money left over to invest for retirement in a taxable account.

This year, however, our income has been lower than in previous years, so we were not able to max out our Roth IRA contributions. Do you think it would make sense to sell some investments from our taxable account in order to raise cash to contribute to retirement accounts?”

If There Are No Capital Gains Taxes to Pay

If there’s little or no capital gains tax to pay from selling the holdings (because your cost basis is approximately the same as the current market value, because you have a capital loss carry-forward from a prior year, or because you have a capital gain but are in the 15% or lower tax bracket such that long-term capital gains would be taxed at a 0% rate), then there is no downside to selling the taxable holdings.

In such cases, the question is basically the same as if the money was already in cash: Would you contribute the money to your retirement accounts? In most cases, of course, the answer to this question would be yes. (And the question of whether the money should be used for Roth contributions or tax-deferred contributions would be much the same as always. That is, it would depend primarily upon how you expect your retirement tax bracket to compare to your current tax bracket.)

And if there’s an unrealized capital loss, then you would actually get some tax savings this year by selling the taxable investments and claiming the loss on your taxes. Any additional tax savings you get from having the money in a retirement account going forward would be a bonus. [Important note: If you’re selling something at a loss in a taxable account, be sure to steer clear of the wash sale rule when using the cash to purchase something in your retirement accounts.]

If There Would Be Capital Gains Tax to Pay

If you would have to pay tax on a large capital gain, the question is somewhat trickier. In a case like this, you would want to consider how your current capital gain tax rate compares to the capital gain tax rate you expect to face in the future.

For example, if you have a 15% tax rate on capital gains right now, and you don’t expect that tax rate to be any lower in the future, then you (usually) might as well go ahead and pay the tax now, contribute the money to a retirement account, and get tax-free growth going forward.

In contrast, let’s say you expect to retire within a couple years, and you expect to have a 0% tax rate on long-term capital gains in retirement (e.g., because you expect the current tax structure to continue, and you expect to have little taxable income in retirement). In such cases, it would probably be best to keep holding the taxable investments in order to take advantage of that lower rate in the future.

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Comments

  1. As ususal, good post. Don’t forget about basis. If you need $5,000 in proceeds and have a basis of $2,500, the effective rate on the sale is 7.5% not 15%. That should factor in when comparing the relative rates for this decision.

    Nice meeting you at FinCon.

    Dan

  2. My understanding is that the only contributions that can be made to a ROTH are earned income. The proceeds from redeeming stocks or mutual funds from a taxable account would not be considered earned income and therefore would not qualify for a ROTH contribution.

  3. Good point, Dave.

    In the case of the reader asking the question, he and his wife still had sufficient earned income to cover the $10k of Roth contributions. But that won’t be the case every time.

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