I’m one of the many baby boomers who are inheriting some accounts from our parents after they pass. I inherited a taxable account, so the step-up in cost basis wiped out the tax liability back to the date of my father’s passing a year ago.
My wife and I are 58, and recently retired, so I’m also doing Roth conversions of about $100,000 a year, staying inside the 12% bracket, to keep our future required minimum distributions from becoming a tax bomb on us. How do I best balance Roth conversions and tax gain harvesting over the long term?
I’m sorry to hear of your dad’s passing. My condolences to you and your family.
Exercising Roth conversions in your situation can be a sound tax strategy because tax rates applicable to your household are probably going to be higher in the future, but we’re talking about taxes so it’s rarely that straightforward.
The conversions create an additional attractive source of future tax-free funds and reduce future taxation on the IRA—the tax bomb you are trying to avoid. I’ll assume you are converting traditional IRA funds to a Roth IRA, but the basic strategic issues would also apply to other types of retirement accounts convertible to Roth accounts.
Say you need $10,000. You sell $10,000 of assets in the taxable account to raise the cash but only the gain portion is taxable. Since you inherited the holding, that tax will be at the long-term capital gain rate. (Absent inheritance one must hold for at least 12 months to qualify a gain as long-term.)
For many decades, the long-term capital gain rate has been less than the tax on ordinary income at every portion of the tax bracket structure. IRA distributions are taxed as ordinary income. Thus, by taking funds from the taxable account you get a lower rate applied on the gain versus taking $10,000 from an IRA and having all $10,000 taxed at the higher ordinary income rate. Tax codes change but given how long rates on long-term capital gains have been lower than that on income, it is likely that this dynamic will persist.
Because you are converting at 12%, you are paying a historically low rate on ordinary income to establish a pool of tax-free funds and are reducing the amount of taxable income to come from the IRA.
So, say you need $10,000 in some future year, you could take a distribution from the Roth account tax-free or sell something in the taxable account and probably pay some tax on any gain at the lower capital-gains tax rates, or take it from the IRA and pay taxes on the entire $10,000 distribution at higher ordinary income rates.
Compare that to harvesting some gains now. To the extent your taxable income (including capital gains) is below $89,250 (the applicable threshold for married couples filing a joint return in 2023), the tax rate on long-term capital gains is zero. “Gain harvesting” refers to the practice of selling a holding for a gain and immediately buying it back. Unlike loss harvesting, there are no wash sale rules to navigate.
Say, you sell for $25,000 a holding that was valued at $20,000 on your father’s date of death. Due to the step-up in basis you mention, your gain is $5,000. If that $5,000 gain does not put you over the $89,250 threshold, the gain is not taxed. If you then buy the holding back for $25,000, future gains will be calculated based on that $25,000 purchase. The result of gain harvesting below the threshold is no taxes on gains now and lower future taxation on gains in the taxable account due to the increased basis.
That could be beneficial. However, harvesting gains in lieu of Roth conversion means the IRA and its future tax bill keep growing. Also, ultimately at your demise, the Roth goes to heirs tax-free and the taxable account could get a cost-basis step up, making it tax-free to your heirs but the funds in the IRA will be taxable as income to the recipient whenever it is distributed. For most the entire IRA must be paid out to heirs in less than 10 years.
Clearly many factors come into play in assessing these trade-offs. From analyzing many of these for clients, often when that 12% rate is available, Roth conversions usually get priority over gain harvesting when one or one’s spouse or future heirs are expected to be in dramatically higher brackets in the future.
If you have a question for Dan, please email him with ’MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.