Listener Drew asks about a tax strategy for juggling capital gains and Roth conversions. While it can be a complicated question – especially when large accounts are involved – James provides some general guidelines that can be helpful for anyone with similar gnarly tax strategy challenges in retirement.
In this episode, we’ll cover the extent to which required distributions will be an issue, what you need to alleviate that issue, and the timeframe within which you have to do that.
James explains how to work backward to project your various tax brackets and determine how to prioritize tax gain harvesting, Roth conversions, and other tax strategies.
Questions Answered:
What is tax gain harvesting?
What is the tax planning window and how do I use it to my advantage?
Timestamps:
0:00 - Drew’s question
2:50 - Determine use for each asset
5:59 - Tax gain harvesting
11:10 - Back to Drew
15:30 - James’ priorities for Drew
18:41 - Usually not either/or
20:07 - Working backwards
24:50 - General principles
29:50 - Tax planning window
32:16 - Summary
Create Your Custom Strategy ⬇️
Listener Drew asks about a tax strategy for juggling capital gains and Roth conversions. While it can be a complicated question – especially when large accounts are involved – James provides some general guidelines that can be helpful for anyone with similar gnarly tax strategy challenges in retirement.
In this episode, we’ll cover the extent to which required distributions will be an issue, what you need to alleviate that issue, and the timeframe within which you have to do that.
James explains how to work backward to project your various tax brackets and determine how to prioritize tax gain harvesting, Roth conversions, and other tax strategies.
Questions Answered:
What is tax gain harvesting?
What is the tax planning window and how do I use it to my advantage?
Timestamps:
0:00 - Drew’s question
2:50 - Determine use for each asset
5:59 - Tax gain harvesting
11:10 - Back to Drew
15:30 - James’ priorities for Drew
18:41 - Usually not either/or
20:07 - Working backwards
24:50 - General principles
29:50 - Tax planning window
32:16 - Summary
Create Your Custom Strategy ⬇️
One of the challenges that you're likely going to have in retirement, as you start to implement a tax strategy, is you're going to ask yourself the question of what degree should I focus on prioritized Roth conversions versus to what degree should I focus on and prioritize tax gain harvesting? This can be a tricky thing to juggle, because both have tremendous benefits, and what we're going to do in today's episode of Ready for Retirement is to help walk through, using a listener's actual situation. We're going to walk through an example to see how should you prioritize each. So let's jump right in. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode.
Speaker 1:The listener question that we're going to be going over today comes from Drew. Drew says this. He says here's the puzzle I'm trying to solve Do I continue to sell stocks out of my non-retirement brokerage account, paying 15% on the capital gains, or do I spend more money out of my traditional IRA, paying 22%, and hope that I can control my income well enough in the future to take advantage of a 0% tax rate to an ordinary capital gains? For reference, here's my situation. My annual living expenses are about $110,000. I have $2 million in a tax deferred retirement account. I have $800,000 in a Roth IRA, $300,000 in a brokerage account, $11,000 per year in a pension and social security coming someday from Drew. So, drew, thank you very much for that question. I think this is a good example to use as we start to understand how do we prioritize various tax strategies in retirement. And it looks like Drew is specifically asking about tax gain harvesting, because he asks how does he keep a 0% tax rate on his long-term capital gains. So I'm going to take that question and also add on to it and talk about to what extent should we also be looking at things like Roth conversions? So, drew, we are going to look at your question, but we're going to add on top of it because this is a very common thing. Here's what I'll say before we jump in.
Speaker 1:This typically isn't a tremendous issue for someone that doesn't have a good amount of money in both IRAs and brokerage accounts. Now, what is a good amount of money? It's all relative, of course, but if someone has, say, $10,000 in an IRA and $10,000 in a brokerage account, that's almost all gains. It doesn't really matter. There's not a lot of strategy needed. There's just not going to be much income tax generated, regardless of what you do with those assets. Where it does become an issue is now you have several hundred thousand dollars, multiple millions of dollars, in these types of accounts, because then the wrong strategy can cost you tens of thousands, hundreds of thousands, maybe even millions of dollars if you don't do things in the right way. So I just want to preface this as you're going through this. If you're looking at your situation, you've got a couple hundred thousand or a few hundred thousand dollars of retirement assets. That's great, but this maybe isn't going to be the most applicable. There will absolutely be little nuggets that you can pull out of it. But this becomes a real challenge for people that have a lot of money in a brokerage account and have a lot of money in pre-tax retirement accounts.
Speaker 1:So if I were to jump right into this, here's what I would do first. So sometimes people want to jump right into the. Okay, tell me what to do. What's the order of operations? What do I sell? What do I convert? Well, start with what do you want to use each asset for? And, specifically, what do you want to use these brokerage assets for.
Speaker 1:So if I'm using Drew as an example, he has $300,000 in a brokerage account. Well, if, after going through an exercise, drew says, yeah, I do a lot of charitable giving, well, I'm going to use some of those brokerage assets, probably for charitable giving. Now it depends upon to what extent are there a lot of gains in this brokerage account. If he has $300,000 and he originally put in $290,000 to get to that $300,000, there's not a whole lot of gains, so I'm not as worried about tax consequences there. But if he put in $30,000, and now it's $300,000, now there's a significant amount of gains. And so if we determine that charitable giving is a big part of Drew's planning, well, I might prioritize using that brokerage account to say let's gift these appreciated assets and instead of giving the 5,000 per year, 10,000 per year, whatever the actual dollar amount is, instead of giving that in cash, why don't we gift that in shares or appreciated asset so that you don't pay any taxes and you still get the full deduction?
Speaker 1:Or maybe Drew comes back and says you know what that's really legacy money? This is money I inherited from my parents and I want my children to ultimately inherit that Okay, well great. That's not necessarily look to focus on or prioritize tax gain harvesting If this is money that you are going to keep growing and not really live on because you want to pass it to your children or other hairs. Now, one caveat to that is, even in that situation, you'd want to make sure the brokerage account was invested the right way. If it was a horribly inappropriate or wildly risky allocation, well then you're sacrificing those goals or you're putting those goals at jeopardy because you might not get the growth that you want over time to pass this on to the next generation.
Speaker 1:So if it's charitable, if it's legacy money, I'm probably doing something totally different than if Drew says no, that's money that I'm going to live on, that's money that I need to pull out and I'm trying to prioritize. How do I minimize the tax implications to do so in order to pull that money out the most effective way? I am assuming that that's where Drew is coming from. Based on his question, based on the limited amounts that I know, it looks like Drew is taking this $300,000 and saying this is part of my retirement portfolio. How do I take it out the most effective way and, ideally, pay taxes at the 0% long term capital gains rates as opposed to the 15% or even 20%, which probably he wouldn't be paying those that based upon the income levels needed for that. But how do I pay taxes at 0% as opposed to 15% is the gist of his question, and now what I'm going to add onto that. So if his core question is how do I be, how can I be smart about this? How can I pay taxes at 0% versus 15% on long term capital gains? What I'm adding on is how do we balance that with potential Roth conversions? How do we balance that with spending down IRA assets now to avoid significant required distributions in the future? Here's what the analysis comes down to. If you have a large brokerage account, if you have a large IRA, like I said the beginning, that's all relative, but if you have a large balance, what's going to save you more in taxes?
Speaker 1:Tax gain harvest benefits can be pretty significant. And if you're listening, you're wondering what do I mean by tax gain harvesting? What I mean by this is there are three tax brackets for long term capital gains, and this also, by the way, counts qualified dividends. So a qualified dividend and a long term capital gain are taxed at either 0%, 15% or 20% at the federal level. Now states may tax that differently. There's net investment income tax on top of that. There's other things that you could potentially pay on top of that, but the core federal long term capital gain tax brackets are either 0%, 15% or 20%. So those gains are based upon what's called your taxable income. And if your taxable income is under certain thresholds, then what tax gain harvesting is asking, is it saying, how can we on purpose, realize gains, sell investments that have long term capital gains up until this threshold, because we're going to pay zero taxes at the federal level on that before we move into the 15% tax bracket.
Speaker 1:So when we look at what are the benefits of tax gain harvesting, what could be the difference between paying taxes at a 0% tax rate or a 15% tax rate? So that's a 15% savings. That's pretty significant If we can harvest gains in the lowest tax bracket, which of course, is 0%. Now let's hold that for a second. The tax benefit there is 15%, not on the entire amount that you sell, but on the amount of gains. Let's look at an example If you sell $40,000 worth of an investment that you originally bought for $30,000, there's not a tax benefit on the full $40,000. The tax benefit is on the $10,000 of gains, but on that $10,000 of gains you are getting a 15% benefit for realizing those at the 0% tax bracket versus the 15% tax bracket. Hold that in your mind. So 15%, that's the potential tax savings.
Speaker 1:Now let's look at the Roth conversion benefit. What's the Roth conversion benefit? By the way, this doesn't have to be a Roth conversion. This could be. What's the benefit of taking income from my IRA, say, in one tax bracket today, versus having to take income from my IRA in a tax bracket in the future? So the entire amount of that distribution is ordinary income. Unlike selling a stock, selling an investment, you're only paying taxes on the gains because you've already paid taxes on what you put in. Well, with an IRA distribution, that entire amount is taxable income. Well, what's the benefit of a Roth conversion? Let's use that as an example. It depends.
Speaker 1:If you're converting, say, today at the 12% tax bracket and in the future you expect to be in the 25% tax bracket, which is what the current 22% tax bracket is expected to be, or it's going to sunset to once current tax lock spires, what's the 13% savings? So every dollar that you put in today, there's a 13% delta versus what that could be or what you would have said had you had paid taxes instead at 25%. And of course there's details to that, because once that money's converted it grows and there's all kinds of different ways to look at it. But just simply put, there's a 13% benefit for that versus what? If you convert today at the 22% bracket and in the future you're expected to be in the 28% tax bracket, well, in that case there's a 6% savings on any money that's converted today versus the future. This is kind of like tax arbitrage. Can we choose where to realize our income? So instead of realizing that a 28% tax bracket, we realize it in a 22% tax bracket. So you look at those numbers and it kind of seems like tax gain harvesting wins. Right, instead of paying taxes at 15%, you could pay it at 0%. It's a 15% savings on all those dollars versus and I just listed two examples out of dozens of possible examples maybe Roth conversion saves you 6% marginal taxes, 13% marginal taxes. That's true, and it certainly could be the case that tax gain harvesting wins.
Speaker 1:The tax gain harvesting puts more in your pocket in terms of tax savings. But here's the key difference you will never be forced to sell your brokerage account Now. You may sell it if you want to live on that money. Of course you may sell it if you need to use that money to do something different. But you're not going to be forced to sell it versus with an IRA, you are going to be forced to sell it. With any pre-tax accounts there's going to come a time where you have to take required minimum distributions. In other words, you're going to be forced to sell and distribute a minimum portion or a minimum amount each year, whether you want to or not, whether you need that money or don't.
Speaker 1:So yes, on the surface, tax gain harvesting may seem more attractive than Roth conversions and in many cases it certainly can be, especially if you have a much larger brokerage account than you do an IRA balance. But in practice it's not always the case, because you can always control the timing of when you do take money, when you do realize gains in your brokerage account versus you can't fully control the required distribution that you have to take out. I guess one way you can control it is by getting ahead of it through things like Roth conversions or just being strategic about when you take money out of your traditional IRA and other pre-tax retirement accounts. So, as Drew is looking at this, or as you are listening to this and saying, yeah, that makes a lot of sense, I've got money in a brokerage account and I have money in IRAs, what should I do? I retired day one of retirement. What should I prioritize? Tax gain harvesting? Should I prioritize Roth conversions? There's even other tax strategies I'm not even talking about today, just to keep it a little bit simple, but that's the crux of that.
Speaker 1:Now let's look at Drew's situation specifically. I want to be very careful as I say this. This is not advice. None of this should be intended to or construed as a recommendation. I'm just using this, using the numbers that Drew provided, as an example framework. I don't know nearly enough about Drew to actually give recommendations. On top of that, I can never give recommendations on this podcast, so please don't take any of this as a recommendation. So absolutely not advice, because I don't know Drew's tax bracket. I don't know his marital status. I don't know his investment mix. I don't know even the gains on his brokerage account. I don't know his risk tolerance. There's many important details that I don't know that to do a full analysis I would want to have an understanding of. But if I would just give in these numbers here's the framework of how I would think about it the first thing that I would do is I would kind of start to work backwards, or really I would start from the beginning to say how do we start understanding which of these tax strategies might be more important, might be in the position that I would say we should prioritize that.
Speaker 1:Well, I know that Drew needs $110,000 per year for living expenses. That's what he wrote in. I also know that Drew has a pension that covers $11,000 of that. So let's assume that more or less Drew needs about $100,000 after taxes from his investment. Well, his brokerage account today is $300,000. So basic math tells me that represents about three years of income. Now I have no idea, like I said, how his brokerage account is invested. So if it's too aggressive and there's a big market downturn and the market loses a third of its value, well, all of a sudden that $300,000 brokerage account is only worth $200,000. So now, all of a sudden, it's only worth two years of living expenses, not the three that it's currently worth today. So that, along with many other reasons I already mentioned, is one reason this should not be taken as advice.
Speaker 1:I'm just using really simple numbers here. But another thing I don't know on top of that is his marital status. Well, why is that important? Why does it matter if Drew is married or not? For one, there's a number of reasons, but for one is his standard deduction. So he does not mention a spouse. I'm going to assume that he's single. If you are single in 2024, your standard deduction is $14,600. It's also assuming you're under the age of 65. If you're married, you can double that. If you're over 65, you also get additional amounts. So I'm using this as an example here.
Speaker 1:Let's assume for one second the Drew has no dividends and no interest from any other spot. No savings account interest, no dividends or interest in his brokerage account a highly unrealistic example. But I'm just using that to keep this example super basic and super simple so you can start to see the logic or the framework that would be important to work through. So here's what we know. Drew has $11,000 coming in from his pension. I'm not assuming he's taking money from his brokerage account, yet. I'm not assuming he's taking money from his traditional IRA, yet. That's all we know so far 11,000 from there. I'm also assuming no dividends or interest from savings or investment accounts. So If none of those other things are generating income, if Drew has no other income outside of his pension, then his taxable income is negative $3,600. Where does that come from? Well, he has a pension of $11,000. Remove or subtract the standard deduction, which is $14,600. So when you subtract $14,600 from the $11,000 taxable income that he has coming in from his pension, what that leaves you with is negative $3,600. Again, the reality is there's going to be some interest, there's going to be some dividends, there's going to be some other stuff. But to keep it simple, I'm just ignoring that.
Speaker 1:Well, with that in mind, does Drew do Roth conversions or does he do tax gain harvesting? Tax gain harvesting again, there's three tax brackets 0%, 15%, 20%. And how do we sell just enough from the brokerage account to fill up that 0% bracket before we go into the 15% bracket? That's the mindset there. Well, in this situation, skipping ahead a little bit, based upon what I do know about Drew, here's what I had prioritized first and why I would prioritize tax gain harvesting. For the simple fact that if Drew doesn't do it, if he doesn't sell any of his brokerage account assets, what's he going to live on? If he said, yeah, I really want to prioritize Roth conversions?
Speaker 1:Well, you can't prioritize Roth conversions if he doesn't first have the $110,000 of living expenses that he can live on, giving him the ability to move money from his IRA to his Roth IRA without actually taking an IRA distribution. So if Drew went through those exercises and he said, great, I have negative $3,600 tax pool income before conversions. I'm going to do a ton of conversions to fill up the 12% or 22% bracket. Drew, that's great on paper, but where's the remaining $100,000 going to come from that you need to live on to supplement your pension? Well, it would need to come either more from the IRA or it would need to come from the brokerage account at that point, and if it all did that, he's either pushing himself into a much higher tax bracket by taking way too much out of his IRA, or he's taking money out of the IRA via Roth conversions and he's missing out on the opportunity to do tax gain harvesting because he then needs to sell his brokerage account at a gain to free up money to live on. So here's an example of what those numbers might actually look like.
Speaker 1:So what we do know is that for Drew to get $1 after tax from his traditional IRA, he needs to actually take more than $1, because to get $1 means taxes have already been paid. So what does this look like? Well, if he needs $100,000 of after tax dollars from his IRA to supplement the $11,000 he's getting from his pension, he'd maybe need around $120,000 pre-tax dollars if he's pulling all of that from his IRA. These are just round estimates. The actual numbers would be different and also, this is assuming single tax brackets, but he might need around $120,000. So $120,000 withdrawal from his IRA plus $11,000 per year from his pension puts his adjusted gross income at $131,000. Before factoring in any interest or dividends or other types of income. Assuming he's single, that puts him in the 24% marginal tax bracket.
Speaker 1:At that point Drew's probably not doing a whole lot on Roth conversions At the 24% marginal tax bracket, the only reason he's moving more from his IRA to his Roth IRA. If he was pretty convinced that he was going to be in a higher tax bracket than the 24% tax bracket in the future. Now, looking at his assets, tough to maybe justify that he might be in the 24% tax bracket. Obviously, a big part of this comes down to. What will tax brackets be in the future? And if Drew is absolutely convinced that every single tax bracket is going to double, that's one thing. But if we thought the current tax brackets were going to stay relatively similar, maybe revert back to what they are going to be or projected to be at the end of 2025, maybe tough to justify converting a whole lot more than that. So, in other words, as Drew is taking all of his income from his IRA, he's not going to do any tax gain harvesting. So if he had that level of income, he would be in the 15% tax bracket for taxing harvesting and he would squeeze out any ability to do any conversions if he wanted to be able to convert below the 24% federal tax bracket.
Speaker 1:So why do I say all this? Well, I say all this because in certain situations and this may be one of those situations now I don't know if Drew has any money in cash he's planning to live on, but he didn't list it in his assets. But in many situations, you need to first realize some gains in order to actually have liquid money to live on that you can then live on while you're doing Roth conversions. So it's usually not an either or all this or all that type scenario. When someone says do I do Roth conversions? Do I do tax gain harvesting? In many cases it can be both, and let's actually look at Drew's situation to illustrate that.
Speaker 1:I'm going to make some assumptions here to illustrate this. I'm going to make some assumptions that kind of make this example easier for me to show. Drew has $300,000 in a brokerage account. Let's assume that $275,000 of that is cost basis. So of the $300,000, only $25,000 is gains. $275,000 is what Drew originally put in. That's what he used to purchase the investments. Well, what we know from before is, if all we're looking at is Drew's pension and if we're assuming he's single, he has a negative $3,600 taxable income once we just look at the pension and back out the standard deduction. Now, by the way, if Drew is married, then he has an even higher standard deduction. He has an even higher threshold until he starts paying taxes on capital gains and hit certain ordinary income tax brackets. So I'm showing you single here, but if he's married then this actually becomes even easier for him to do. So let's work backwards, because here's what we also know.
Speaker 1:I was said there's tax gain harvesting If your income's under certain thresholds, you pay 0% taxes on long-term capital gains. It's crucial that you understand that's only long-term capital gains. Short-term capital gains are taxed at ordinary income rates. Well, the threshold for 2024 to bump into the 15% tax bracket for federal long-term capital gains is $47,025. Once your income exceeds that, you now are in the 15% tax brackets for capital gains. So what that tells us is that becomes our target $47,025, that's our target. To say we don't want our taxable income not our adjusted gross income, but our taxable income, which is really our adjusted gross income minus deductions If we can keep that to $47,025 or lower, then we're not going to pay any federal taxes on long-term capital gains. Could be some state taxes, but the federal level. We're not going to pay that. So here's what that tells us is, if $47,025 is the target and we know that Drew has $25,000 of long-term capital gains, what that means is other income sources. He can have other taxable income of $22,025 until he moves, or before he starts to move, into the 15% federal long-term capital gain tax bracket.
Speaker 1:That sounded a little confusing to me, so it probably sounded a little confusing to you. Let me make sure. I just said that clearly, if we subtract $25,000, which is how much Drew has in long-term capital gains in his brokerage account again, that's my assumption. Drew didn't tell me that I'm just making that up $25,000 in long-term capital gains, subtract that from $47,025. That leaves us with $22,025. Or in other words, drew, all of your other income, all your non-long-term capital gain income, can add up to $22,025. That's what your taxable income can be, while still allowing you to realize $25,000 of long-term capital gains and not move into the 15% tax bracket.
Speaker 1:The question is what do we use to make that income up above? Well, he could pull money out of his IRA and that he can count his income. Or, and this might be a better option maybe he converts money from his IRA to his Roth IRA instead, and that might be a better option in this case. So now we can solve for how much money could Drew convert from his IRA to his Roth IRA, and we don't want that combined amount to exceed $22,025. So, before doing any of this, we know that Drew's taxable income was negative $3,600, which again was his pension of $11,000 minus his standard deduction. What we want to know is what's the difference between negative $3,600 and $22,025, and the answer is $25,635. What does that mean? I know this is kind of confusing A lot of numbers being thrown out.
Speaker 1:Drew in this example, could convert $25,635 from his traditional IRA to his Roth IRA while simultaneously selling his brokerage account, liquidating his brokerage account in realizing gains of $25,000, assuming those are long-term capital gains and not pay any long-term gains on that sale. So what has Drew done here? Well, he's kind of gotten the best of both worlds. He's been able to sell all of his brokerage account and realize zero gains, or I should say pay taxes at a 0% rate on all those gains, and he's been able to convert a little over $25,000 from his IRA to his Roth IRA. Now what's the reality? The reality is Drew probably has more than $25,000 of long-term capital gains in his account. He probably has that because he's probably not asking this question if he's not worried about the tax implications of the gains there. So, for example, maybe of that $300,000, $100,000 is gains and $200,000 is what he originally put in. If that was the case, then he might need to spread out those gains over a couple of years in order to pay taxes at the 0% rate and probably wouldn't be able to do any Roth conversions on top of that and then again on top of that.
Speaker 1:Just to make sure it is abundantly clear, I am purposefully excluding dividends, interest, other income sources, just to make this simple enough to go over on a podcast. I think it's already confusing enough with some of these numbers. If we start adding those other things in, it's just going to become a mess to try to listen to and make any sense of this. So for situations like Drew, just as we start to wrap up his specific situation again, this is not advice, but the first place my mind goes to is we might need to start with some tax gain harvesting to free up enough cash to live on. That will then allow us to implement Roth conversions. That's one option.
Speaker 1:Now, all of you with the exception of Drew, are, of course, not Drew, which means all of you have your own unique situations, and while this might be helpful to go through, you might be wondering what are the general principles we can take away from this. Your situation is different. You're going to have different amounts in your IRA. You're going to have different amounts in your brokerage account. You're going to have different situations in terms of marital status, in terms of what you want to live on in terms of other income sources like social security or pension. So what should you know as general principles?
Speaker 1:Well, for one and this isn't really what I would call a general principle as much as just something that's probably going to come up as you're trying to do this is understand that your standard deduction, or your itemized deduction, but just your deduction it's going to offset ordinary income first before it starts to offset long term capital gains. Or, in other words, your long term capital gains are going to stack on top of whatever ordinary income. You have Not a principle here, but just keep that in mind as you're looking at your situation. You're going to start wondering wait a minute, if I have both capital gains and I have ordinary income and I have this deduction, what am I applying that deduction against? Well, it's going to offset your ordinary income first before offsetting any long term capital gains.
Speaker 1:Next and really I would call this the first principle, where I would want to start is start with an understanding of how much of an issue will your required minimum distribution be. If you remember at the beginning, while I walked through this and said well, what's the benefit of tax gain harvesting as a percentage versus what's the benefit of Roth conversions as a percentage and it seems like tax gain harvesting is significantly superior in terms of wow I could say 15% taxes if I sell gains in the right year versus Roth conversions, which have a maybe lower marginal difference. Very true, but, as I mentioned, the challenge with IRAs and looking at that as a simple comparison is with IRAs you're going to be forced to start taking distributions, whereas you're not going to have that same thing happen with your brokerage account. So because of that, where I would start? Because if you're looking at this and saying what do I prioritize first, trying to do some tax gain harvesting, sell gains at a lower rate or do in Roth conversions start first and foremost by understanding to what extent are required minimum distributions going to be an issue and I know being an issue is vague. What I mean by that is to what extent are these required distributions in the future going to push you into a higher tax bracket than you otherwise would have been in, and the goal is not to be in a 0% tax bracket in the future. If you could be in a 0% tax bracket in the future without putting yourself in a huge tax bracket today, that's fine, but in most cases, you're not going to be in a 0% tax bracket in the future without doing some really serious conversions today, without overpaying in taxes today, in which case you probably end up paying more in lifetime taxes than you needed to. So the goal is not saying how do I get rid of my IRA for the future and convert all to Roth. The goal is not even to say how can I stay in a 0% tax bracket in the future. It's to say how can I stay in a tax bracket that's not pushing me too significantly higher to the other tax brackets that I don't need to be in, but I'm forced to be in because these require distributions.
Speaker 1:Once you've done that, the next thing I would do is this let's, for example, say you've identified that required distributions will be an issue. You project out what your IRA balance will be. You project out what you might be forced to take and you say, oh my gosh, I'm going to be forced to take out $150,000 more dollars in the future than I'm going to need to. That's going to bump me a couple of tax brackets. That is definitely an issue. I need to do some Roth conversions today. Well then, the next thing you need to do is you need to determine how much do you need to convert to offset that tax liability. Now, I'm going to make this overly simplistic so, as you're listening to this right now, understand, this is almost an embarrassingly simplistic way of looking at it, but I just want to convey a general principle. Let's assume that you've said yes, required distributions are going to be an issue. The next step is to say how much do you need to convert to eliminate some of that issue or just to negate some of that issue. So many of simple numbers. Assume you have a million dollars in an IRA and you say, okay, you know what I've determined. I need to convert $400,000 to ensure that this is not an issue Overly simplistic because there's so many other variables here. But you've determined that if you can convert $400,000 from your IRAs to your Roth IRAs before required distribution start, then you're going to be okay. Okay, that's good, we're not done yet.
Speaker 1:The final step is to understand how wide is your tax planning window. Your tax planning window is typically at the time from when you retire to the time when social security and or required minimum distributions kick in. So imagine you retire at 62. Now, this is assuming you have cash or brokerage account assets to live on, you could keep your taxable income super low. Even if you're spending 100 grand, 150 grand, 200 grand a year, that's all coming from cash or all coming from a brokerage account. You're going to be in a relatively low tax bracket until social security kicks in in the future and required minimum distribution stack on top of that. So you can almost imagine if you look at your taxable income If you're watching this on YouTube you'll see but your taxable income comes up here. Then you retire and it drops. You're still spending a similar amount or a good amount, but you're not paying taxes on that until social security kicks in and then until required distributions kick in. In that period between the time that you retire and the time that required distributions kick in, that's the tax planning window. That's when your income is much lower and you have the ability to do things like Roth conversions without pushing yourself into a much higher tax bracket.
Speaker 1:Well, let's look at that. Let's assume that you have a very short tax planning window because you retire at 69. Next year social security kicks in and then the three years require distributions kick in. So if you have $400,000 that you need to convert before age 73, you've only got four years to make that happen. You really need to prioritize making that happen because you've got a short window to do so Now.
Speaker 1:Let's assume all else is equal, but you retire at age 60. And on top of retiring at age 60, you've got a bunch of cash and brokerage assets that you can fully live on that can allow you to get a long way into the future before you run out of cash or brokerage assets. Well, if you still have that same $400,000 that you need to live on, you can spread that out over a much longer period of time. You don't need to get that all converted in a period of, say, three, four short years. You are going to have longer to convert that, one because you're younger, but two because you're required. Minimum distribution age isn't until age 75.
Speaker 1:So you've got this much larger window, which means you don't need to have to be as on it every single year. You don't have to convert giant amounts from your I-Radi or Roth I-R-A each year. You can do much smaller amounts, which also means you can more easily prioritize things like tax gain harvesting, because you can do both. You're not being forced to choose one or the other you might be able to use some years to prioritize tax gain harvesting. You might use other years to prioritize Roth conversions, or you might just do a combination each year, depending upon what the makeup of your portfolio looks like.
Speaker 1:Now this isn't how it works in reality. I said okay, we'll determine how much you need to convert from your I-Radi to your Roth I-R-A. To negate some of the issue, the reality is the longer that you take to convert those assets so that second example, or maybe you have 10, 15 years to do so well, the longer those assets remain in the I-Radi, the more they're going to grow, which means the probably the more that you need to convert. So there's all these almost conflicting variables here. But this is where at least having an understanding of what you need to do is really important.
Speaker 1:So general principles number one understand how much of an issue required distributions will be. Number two understand what you need to do to alleviate that issue. Number three understand the time frame that you have to do that. And once you have an understanding of that, then you can work backwards to say, okay, I know what I need to do, I know how long I need to do it. I can then start projecting out. What will my various tax brackets be and how can I now start to prioritize tax gain harvesting versus Roth conversions, versus any other tax strategies that potentially enter the picture?
Speaker 1:So, as we now start to wrap that up, if you're still with me now, that was kind of dense with actual numbers. Sometimes I'd like to speak more high level, but sometimes having actual numbers is more helpful to illustrate that. If you're still with me, thank you very much for listening. I hope that was helpful as we explore Drew's situation, just as a hypothetical, but then try to extract some general principles for anyone to use. If this has been helpful and you're watching on YouTube, I'd really appreciate it if you hit the subscribe button and also if you left a thumbs up for the video and a comment if this has been helpful or letting me know what you'd like to see on future videos. If you're listening on Spotify or Apple podcasts, if you could leave a review, that'd be really helpful just in terms of letting more people find the show to get the information they're looking for, to create that more secure retirement and for those of you who have been listening, and been listening for a while, thank you. Thank you for supporting the show. It's really fun to get notes from you all comments, feedback. I really appreciate you taking the time to do so. That is all I have for today and I'll see you next time.
Speaker 1:Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discussed in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.