Which Of These Two Tax Tricks Is Better For A Retiree?

In a low-bracket year you could have either a long-term gain or a Roth conversion. One will save you more money.

Delaware Senator William Roth (1921-2003), fan of post-tax IRAs (Photo by Wally McNamee)

Corbis via Getty Images

“My wife and I plan to retire on my 65th birthday in 2025; we will delay taking Social Security until age 70. With required distributions from IRAs beginning in 2032, we have seven years to harvest long-term gains from brokerage accounts at a 0% tax rate, and/or do Roth conversions up to the top of the second tax bracket.

“The accounts hold essentially the same investments (large index funds). Roth conversions may reduce RMDs enough to lower provisional income, reducing taxes on Social Security, but tax-free gains go away if one of us dies and the other is now a single taxpayer.

“Which should I do first—the 0% gains or the conversions?”

Jim

California

My answer:

You present an interesting conundrum, one that confronts many a retiree. That interregnum between stopping a salary and starting pensions creates opportunities for an artful tax dodger. How best to use them?

Short answer: I’d lean toward the Roth conversions.

Long answer: The optimum strategy depends on a lot of factors, including your health, the amount you’ve saved, your expected pensions, your charitable plans and whether you want to help your grandchildren with their college costs. Indeed, it depends on who controls Congress in 2040 and whether your seaside town gets washed out by a tsunami. But for most people, Rothifying beats gain harvesting.

I’ll start by tipping my hat to your understanding of tax angles. Most people either don’t think about these things or don’t have much leeway in what assets to cash in when. You like efficient funds and you like puzzles. I’m guessing that you are an engineer.

I say amen to delaying Social Security. But I have a more nuanced rule of thumb: The higher earner in a couple should claim late, the lower earner at normal retirement age (67 in your case). That’s because the higher amount will be collected as long as either one of you is alive, while the lower amount will be collected only as long as both are alive. I say rule of thumb because age differences and health can affect the answer.

I like Roth conversions, whereby you prepay tax on an IRA. A Rothified IRA is entirely tax-free and not subject to any required minimum distribution, a.k.a. RMD. It remains tax-free for as long as you are alive or your wife is alive and, if you have descendants who can use the money, for another ten years.

If your tax bracket is destined to remain constant throughout retirement, a conversion leaves you somewhat better off. If your tax bracket is headed up, as in this case, a conversion leaves you much better off. Conversions during your early retirement years, when you are not collecting a salary, Social Security or mandatory withdrawals from IRAs, can be quite powerful.

For you, the best conversion years run from 2026 (the first calendar year with zero salary) through 2029 (the last calendar year without any Social Security payment). You could continue converting in smaller doses in 2030 and 2031. Conversions after that are possible but won’t be a grand slam.

Your mandatory withdrawals from the taxable part of the IRA start in 2032, the year you turn 72. (Those RMDs have to come out each year before any further conversions.) You are correct that doing a Roth conversion now will, by shrinking the taxable IRA, lessen the damage from RMDs down the road.

RMDs are bad, at any rate for the retiree who isn’t depending on an IRA for current expenses. Of course if you were going to take out $60,000 anyway, a mandate to take out at least $50,000 doesn’t mean anything. But if you have other resources the forced distribution simply raises your taxable income. This can kick you into a higher bracket in 2032 and/or boost your Medicare premiums.

One thing I don’t think you need to fret about is that weird formula (“provisional income” and whatnot) that determines how much of a Social Security benefit is taxable. This is a lost cause. It’s likely that you will be paying tax on the maximum 85% of your benefit no matter what.

How do the numbers work out for someone in your situation? You mention filling the two lowest brackets in your early retirement years. That would be up to roughly $110,000 of gross income on a joint return. I say roughly because the California brackets and standard deduction do not align neatly with the federal ones.

Let’s suppose that in 2026 you have $80,000 of income from pensions and dividends. That leaves you with $30,000 of dead space before you land in the next bracket. You want to do something with the dead space. Your choice is between realizing $30,000 of long-term gains or converting $30,000 of your IRA.

If you take the cap gain option, you sell an appreciated stock or fund position with $30,000 of long gain and buy it right back. The California rate on income is 6%; the federal rate on long gains, for those in the two lowest income-tax brackets, is zero. So your cash outlay for this strategy is $1,800.

Much later on, let’s assume, you have to sell that asset to cover living costs. At that point, now in a higher bracket, you have a rate of 23% (15% federal plus 8% state). Having taken care of $30,000 of gain in early retirement means you save $6,900 when you sell that appreciated position.

In sum: Realizing the capital gain costs you $1,800 now but saves you $6,900 later. Pretty good deal.

Now consider the Roth option. A conversion in your low-bracket years has an 18% tax rate (12% federal plus 6% state). In contrast, taxable distributions in later years, when Social Security and RMDs push you well above the $110,000 income level, will have a 30% burden (22% federal plus 8% state).

With a $30,000 conversion in a low-bracket year, you’re out $5,400 upfront. Important difference from the realized gain play: Rothifying saves you the future taxes not just on the original $30,000 but on whatever the $30,000 grows into in the intervening years. If you can hang onto the Roth account until it doubles in value to $60,000, you’ll save $18,000 at the back end.

Yes, you can double that Roth money. Roth accounts are the very last assets that you or your wife (or, maybe, an heir) will cash in. The $30,000 is probably going to compound for a very long time.

With the Roth conversion, then, you’re out an additional $3,600 in 2026 (vis-à-vis selling appreciated stock) but you’re ahead by an additional $11,100 down the road (saving $18,000 rather than $6,900). This is an improvement on the other strategy.

Yes, that incremental $3,600 could have been invested and could have grown. But, pulled from a taxable account, it could not have grown to anything like $11,100, not if it’s invested the same way as the tax-free Roth. The Roth account, by hypothesis, has merely doubled.

What if you can hang onto the Roth for a very long time? Until it has tripled? Then you’ll do still better: An incremental $3,600 invested in 2026 delivers an incremental $20,100 at the end.

This simple analysis doesn’t cover all the possibilities, such as you and your wife getting swept out to sea in 2027, but it gives you a good idea of how Roth schemes often outperform the alternatives.

The Roth option looks still better if you allow for the possibility of a step-up. Any appreciated assets in your taxable account get stepped up to market value when either you die or your wife dies, meaning the appreciation to that point is permanently exempt from income taxation. We don’t know if you’ll be able to avoid cashing out gain property until your demise, but if that’s how things turn out, the $1,800 of tax you fork over in a sale/buyback transaction during 2026 will end up going down the drain.

Note to readers who don’t live in California or another community-property state: Your step-up isn’t that good. For you, it applies to only half the assets in a joint account. Still, a partial step-up is worth something.

There is no step-up in an IRA. All pretax retirement money eventually gets hit with an income tax, either when you withdraw it, or when you convert it, or when your surviving spouse withdraws it or when another heir withdraws it. In short, the step-up rule is one more point in favor of Roths.

Now a few cautions to Jim and other retirees:

—Pay the tax on a conversion from funds outside the account. Dipping into the account to cover the tax tab defeats the purpose of Rothifying.

—Keep an eye on those tax rates. Converting enough to cross into the next bracket is likely to be a bad idea.

—Think about where you’re going to live. If you’re headed to a lower-tax state you probably shouldn’t convert now.

—Don’t overdo it. Leaving some IRA money unconverted gives you valuable tax flexibility late in life. You might, for example, someday want to pair a conversion with a deductible nursing home bill.

Do you have a personal finance puzzle that might be worth a look? It could involve, for example, pension lump sums, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Query” in the subject field. Include a first name and a state of residence. Include enough detail to generate a useful analysis.

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