63 and Retired: Roth Conversions vs. Tax Gain Harvesting – A Case Study

Retirement is a time for relaxation and enjoying the fruits of your labor. But it also brings about a new set of financial considerations, including managing taxes on your retirement savings. As a 63-year-old retiree, you’re likely facing decisions about drawing down assets and potentially minimizing your lifetime tax burden. Two popular strategies you might be considering are Roth conversions and tax gain harvesting. Let’s delve into a case study to help you understand which might be more beneficial for your specific situation.

Understanding the Strategies:

• Roth Conversions: This involves moving pre-tax money from traditional IRAs or 401(k)s into a Roth IRA. The conversion is considered a taxable event, meaning you pay income tax on the amount converted in the year of the conversion. The benefit? Future qualified withdrawals from your Roth IRA are tax-free, and your heirs won’t pay income tax on inherited Roth assets.

• Tax Gain Harvesting: This strategy involves selling appreciated assets (like stocks or mutual funds) in a taxable brokerage account when your capital gains tax rate is low. You then repurchase the same or similar assets. This “steps up” your cost basis, meaning future capital gains will be calculated from this higher basis, potentially reducing future taxes when you eventually sell those assets.

The Case Study: Meet John

John is 63 and recently retired from a long career as an engineer. He has:

• $800,000 in a Traditional IRA: This is his primary retirement savings account.
• $200,000 in a Taxable Brokerage Account: Invested in a diversified portfolio of stocks and mutual funds with significant unrealized gains.
• Social Security Income: He expects to receive approximately $30,000 per year.
• Minimal Pension Income: A small pension provides an additional $10,000 per year.
• Current Tax Bracket: Due to his low income in early retirement, John is in the 12% federal tax bracket.
• Expected Future Tax Bracket: John anticipates that required minimum distributions (RMDs) from his traditional IRA, starting at age 73, will push him into a higher tax bracket (possibly 22% or higher). He also expects his overall income to rise in retirement as he takes on a part-time consulting role.

Analyzing the Options for John:

1. Roth Conversions:

• Pros:

  • Tax-Free Growth: Converting now allows future growth in the Roth IRA to be tax-free.
  • Tax-Free Withdrawals in Retirement: When John needs the money, withdrawals will be tax-free, potentially saving him significant taxes, especially if he’s in a higher tax bracket then.
  • Estate Planning Benefits: Roth IRAs can be a powerful estate planning tool as they are tax-free to heirs.
  • Reduced RMD Burden: Converting now reduces the size of his traditional IRA, ultimately lowering his future RMDs and potentially keeping him in a lower tax bracket later in life.

• Cons:

  • Upfront Tax Liability: Each conversion increases his taxable income in the conversion year.
  • Potential Bracket Creep: Converting too much in a single year could push him into a higher tax bracket, negating some of the benefits.

2. Tax Gain Harvesting:

• Pros:

  • Low Capital Gains Tax Rate: Since John is in the 12% income tax bracket, he might qualify for a 0% federal capital gains tax rate on long-term capital gains (subject to specific income thresholds). Even if he surpasses the income threshold, his capital gains tax rate would likely be lower than his ordinary income tax rate in future years.
  • Step-Up in Basis: Harvesting now allows him to reset the cost basis of his investments, potentially reducing capital gains taxes in the future when he eventually sells these assets.
  • Increased Flexibility: This provides greater flexibility in the future as he can sell the assets without incurring a large tax bill.

• Cons:

  • Complexity: Requires careful tracking of cost basis and capital gains.
  • Limited Long-Term Impact: While helpful, it only addresses taxes on the appreciated assets in his brokerage account and doesn’t affect his larger traditional IRA balance.
  • Wash Sale Rule: Requires avoiding repurchasing identical assets within 30 days to prevent invalidating the tax loss.

Recommendations for John:

Based on John’s situation, a combination of both strategies is likely the most effective approach.

• Strategic Roth Conversions: John should consider converting a portion of his traditional IRA to a Roth IRA each year, aiming to stay within the 12% tax bracket or just slightly above it. This allows him to take advantage of his current low tax rate and minimize the upfront tax burden. He should consult with a tax advisor to determine the optimal annual conversion amount. He can “fill up” the 12% bracket and perhaps inch a little way into the 22% bracket knowing that he will get tax-free growth and withdrawals in the future.
• Targeted Tax Gain Harvesting: John should evaluate his taxable brokerage account and identify assets with significant unrealized gains. He can then strategically sell a portion of these assets each year, taking advantage of the potentially 0% or low capital gains tax rate. He should be mindful of the wash sale rule and consider rebalancing his portfolio after harvesting.

Key Considerations:

• Tax Planning is Essential: John should work with a qualified tax advisor to develop a comprehensive tax plan that considers his individual circumstances, income projections, and future tax bracket expectations.
• Market Volatility: Both strategies are influenced by market fluctuations. Roth conversions can be more advantageous when markets are down, while tax gain harvesting might be more appealing when markets are up.
• Long-Term Financial Goals: John’s retirement income needs, spending habits, and estate planning goals should all be factored into his decision-making process.

Conclusion:

For a 63-year-old retiree like John, the decision between Roth conversions and tax gain harvesting is not an either/or proposition. A carefully considered strategy that combines both approaches can potentially minimize his overall tax burden, provide greater financial flexibility, and contribute to a more secure and enjoyable retirement. Remember to consult with a qualified financial advisor and tax professional to tailor a plan that best suits your individual needs and goals. This case study is for illustrative purposes only and should not be considered financial or tax advice.

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