Though we cannot predict how future legislation may impact tax rates, we can use current information and a historical perspective to devise strategies to better position our overall financial situation.
As a financial planner, my focus is on helping our clients achieve their financial goals, which entails maximizing every dollar. This can be accomplished by limiting clients' tax exposure on distributable income from their retirement or brokerage accounts. This measure requires a complete understanding of the client's current tax situation, foresight on how their taxable income will look in future years, and some educated guessing on where tax rates may be. The goal is to pay as little tax as possible.
A couple of withdrawal strategies that should be considered are the Roth conversion and harvesting of capital gains. Both strategies involve the recognition of income, though the tax impact is quite different.
The Roth Conversion
A Roth conversion can be done for many reasons. However, the driving force for doing a conversion is the prospect of paying taxes at a lower rate today compared to what they may incur during retirement years. Let's look at an example. Say a client has a projected income of $75,000 and plans to file income tax as married filing jointly in 2024. Assuming they take the standard deduction ($29,200), they will have taxable income of roughly $45,800, which puts them in the 12% tax bracket. Based on current tax brackets, they have a buffer of $48,500 before they jump into the next tax bracket (the top end of the 12% bracket is $94,300).
The strategy here would be to convert IRA assets to a Roth IRA in an amount that keeps you inside the 12% tax bracket, ensuring you pay less in taxes on that income now than you would after retirement. Further reasoning is that we are currently in a period of low tax rates, historically speaking, so taking advantage of them before sunset (potentially at year-end 2025) is sound planning.
Capital Gain Harvesting
Capital gain harvesting is conceptually similar to Roth conversion, although the strategy differs slightly. The goal is to sell appreciated securities in a non-retirement investment account to realize long-term capital gains in years when taxable income is low.
The sale proceeds would then be re-invested in the same, or similar, investment to increase your cost basis. Let's revisit our above example with clients with a taxable income of $45,800. In this case, the client can exchange or sell securities and recognize up to $48,250 in realized gains without paying any taxes on the transaction(s). You read that correctly. In the quirky world of taxes, you will pay no taxes on long-term capital gains if your taxable income is below $94,050 if filing jointly or $47,025 if single (in 2024).
One way to utilize this strategy is if a client needs to raise cash for a large purchase, say, $50,000. Using the figures from our previous example and assuming income will remain static in the coming year, they could sell securities this year to free up half the desired proceeds and the remaining half the following year. As long as they are below the $94,050 taxable income threshold in both years, they won't owe any capital gain tax in either year.
Summary
Both strategies have their place in financial planning, whether used independently or in combination. Other factors should be considered when exercising either tactic, so it's best to coordinate with your financial planner and tax advisor when making decisions that can have a long-term impact on your financial outlook. Remember, taking strategic action to lower your tax liability in later years will hopefully produce disposable income for you and your family to enjoy after retirement!
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