In the past, a minimize-and-defer-income approach has been rather effective. But in today's tax environment, with more tax brackets, higher top rates, and a myriad of additional phaseouts and surtaxes that can drive marginal tax rates even higher for both ordinary income and long-term capital gains, the reality is that just pushing income indefinitely into the future is not necessarily the best strategy anymore. Instead, deferring too much income into the future may simply mean that when it's finally time to liquidate - whether it's selling highly appreciated investment positions for retirement income, or beginning withdrawals (or facing RMDs) from large IRAs - income at the time can rise so high that tax rates skyrocket!
As a result, it turns out that in today's environment, it may be far more effective to consider strategies like Roth conversions or capital gains harvesting that aim to accelerate income into the current year, rather than defer it into the future. This form of "tax bracket arbitrage" - creating wealth by reporting income when tax rates will be lower, even if it's now - can actually result in greater lifetime wealth, even though it triggers a tax liability sooner rather than later! In other words, it turns out that sometimes the best way to save on taxes is to pay them as soon as possible, even if it means creating income before the end of the year in order to do so!
Paying Taxes To Save Taxes - Tax Bracket Arbitrage
The fundamental benefit of tax deferral is rather straightforward - if taxes have to be paid someday, the longer that day can be deferred into the future, the more time that the taxpayer can have those dollars working on his/her behalf instead. For instance, if an investment purchased for $100,000 has appreciated to $150,000, then at a 15% long-term capital gains tax rate, the owner will someday owe a $7,500 tax bill (a 15% liability on the $50,000 gain); however, to the extent this $7,500 can remain invested, rather than being sent to Uncle Sam, the investor enjoys compounding growth on $150,000 instead of only $142,500. With an 8% growth rate, the investor can generate an extra 8% x $7,500 = $600 of growth each year; compounded over time, this can accumulate to a non-trivial amount of additional wealth, created solely by taking advantage of tax deferral and the "time value of money."
Of course, a key caveat of this benefit is that it assumes the tax rate remains the same throughout. If the reality is that the tax rate is lower in the future, the wealth creation can be even greater; for instance, if the $50,000 gain is deferred to a time period where the taxpayer has no other income and is partially or fully eligible for the 0% long-term capital gains tax rate, then the $7,500 tax bill isn't just deferred for $600/year of economic value; some or all of that $7,500 tax liability may be permanently avoided. Similarly, if the individual might have been subject to a 23.8% long-term capital gains rate this year - due to the top 20% capital gains rate, plus the 3.8% Medicare surtax - and would only be subject to a 15% tax rate in the future, the value of tax deferral is not only compounding growth on Uncle Sam's share, but the fact that the tax bill in the future may be outright smaller than it is today if the tax rate is going to drop.
However, the caveat is that in some situations, the future tax rate is not equal, nor lower, but higher; in such circumstances, the higher tax rate in the future can undermine some or all of the economic value of tax deferral in the first place. For instance, if the taxpayer's rate was 15% now, but 23.8% next year, the liability of that $50,000 gain is about to go from $7,500 to $11,900! In such a scenario, merely generating $600 of tax deferral value means the investor actually ends out with less money by deferring taxes. The optimal strategy would have actually been to recognize the gain now, and to go ahead and pay the $7,500 tax liability today, rather than push the income into the future at a higher rate!
And unfortunately, the reality is that the potential for higher tax rates in the future is a reality that many people face. In part, this is due to the simple fact that tax brackets themselves increase as income rises; accordingly, the larger an IRA grows, the greater the risk that it will have to be liquidated in the higher tax brackets in the future, as eventually huge Required Minimum Distributions (RMDs) actually force the taxpayer into the upper brackets. Similarly, in a world where there are now effectively four capital gains tax brackets, the same problem applies for capital gains as well; if investors do too good of a job harvesting losses and deferring gains, when it actually comes time to liquidate and sell the investment, the tax bracket may be driven so high that there is actually less money as a result of deferring the tax bill!
Accordingly, "optimal" tax planning is less about just deferring and deferring and deferring taxes, and more about trying to time the income to the year when the tax rates will be lowest. Sometimes that means pushing the income out to the future, but in other circumstances the best way to save on taxes may be to choose to pay them now, at current rates, rather than paying at higher rates in the future. In essence, this creates an opportunity for "tax bracket arbitrage" - a form of free wealth creation by making well-timed decisions about when to recognize income for tax purposes.
Tax Arbitrage Through Roth Conversions
Retirement accounts are one of the few vehicles that simultaneously allow individuals the potential for tax deferral, and the opportunity to control the timing of when income occurs, creating a perfect opportunity for wealth creation through tax bracket arbitrage. And the primary means of doing so: the Roth conversion.
Since 2010, Roth conversions have been available to anyone with an IRA, without any income limitations. The only requirement is that any taxable amounts from the IRA must be reported in income at the time of conversion; yet in point of fact, being able to recognize the income for tax purposes is the whole point of the strategy in the first place. And unlike just withdrawing the money to attempt to recognize it at favorable tax rates, a Roth conversion allows the individual to report the income and still enjoy tax-free growth in the future.
Notably, though, a Roth conversion is not always a winning proposition. If the individual could have simply withdrawn (or converted) the money in the future at a lower tax rate, more wealth is preserved by not doing a Roth conversion (although there are some other minor benefits to Roth conversions, like avoiding RMDs while alive, changes in tax brackets are by far the most dominating of the four factors that impact Roth conversions). As a result, optimal Roth conversion planning requires making tactical decisions about when to time the recognition of income. In addition, the reality is that a large Roth conversion itself can create enough income to drive up a taxpayer's current rates; as a result, optimal Roth conversion planning often involves an ongoing series of partial Roth conversions, rather than a single large tax event.
Given that the general goal of Roth conversions is to execute them when is income (and tax brackets/marginal tax rates) are lower, general timing strategies for Roth conversions include:
- Years between retirement (end of employment income) and when required minimum distributions must begin
- Years with a job layoff or otherwise temporarily depressed income
- Years where business income (for business owners or the self-employed) is low
- Earlier years of working career before income/earnings have ramped up (though in this circumstance, many just contribute to a Roth account in the first place, rather than converting an existing pre-tax retirement account)
The caveat, though, is that if this year is a low-income year, the Roth conversion must be executed by the end of the year. Although taxpayers have as late as their tax filing deadline, plus extensions, to recharacterize a Roth conversion, the original conversion itself must be completed by December 31st to be eligible!
Harvesting Capital Gains Not Losses
For the past several decades, there have only been two capital gains tax rates - an ultra-low rate (10%, then 5%, now 0%) for those the bottom ordinary income tax bracket(s), and a single top rate (20%, now 15%) for all other capital gains income. Thus, regardless of whether someone had $50,000, or $250,000, or $500,000 of capital gains, once past the bottom bracket(s) all capital gains were subject to the same flat top rate.
In 2013, though, this is no longer true. The introduction of a new top 20% capital gains tax bracket (on top of the existing 0% and 15% rates), along with the introduction of the new 3.8% Medicare surtax, effectively creates four long-term capital gains tax brackets: 0%, 15%, 18.8%, and 23.8%, with progressively higher rates as income rises. The significance of these new rules is not merely that capital gains may be subject to a new higher top tax rate; the presence of this new four tax bracket structure for capital gains rates dramatically changes the economic value and potential "risks" of tax deferral.
The problem is that in the context of capital gains, systematically deferring gains and harvesting losses can create a larger and larger looming capital gain, and with today's four-bracket structure a larger future gain can actually result in less wealth. While in the past the tax rate might have been the same for a $50,000 and $500,000 capital gain (at least for those beyond eligibility for 0% rates), now it can be the difference between paying 15% tax rates and 23.8% instead. Pushing gains into the future that trigger the 3.8% Medicare surtax, and possibly the new top capital gains rate as well, can overwhelm the value of tax deferral itself.
Accordingly, those who are eligible for favorable long-term capital gains tax rates should consider harvesting gains in order to "lock in" tax rates at today's rates, if they are favorable. The good news is that harvesting gains is much easier than harvesting losses. While claiming losses requires managing around the so-called "wash sale" rules that prevent the purchase of a substantially similar security within 30 days before/after the sale that produced a loss, there is no such rule for harvesting capital gains; Congress does not have a rule that states "you owe us taxes, but since you bought the investment again, you don't have to send us the money." To the contrary, selling an investment and buying it back must trigger income recognition and a potential tax event; except that with today's capital gains rates, that can actually be an effective tax arbitration strategy, even if it simply means selling investment positions that are up and buying them back immediately!
Similar to harvesting Roth conversions, though, the key again is not to harvest such large gains that the current tax bracket is bumped into the upper levels. Instead, the goal is to harvest just enough to fill the lower tax brackets, stop before reaching the upper brackets, and then wait to repeat the process again next year! In addition, it's also important to note that those who are harvesting capital gains should not harvest losses as well; just as harvesting gains creates wealth by capturing gains at lower rates, it's also advantageous to defer losses to the future when rates will be higher (assuming, of course, that the individual projects that their tax rates will be higher in the future than they are now in the first place).
Key Steps By End Of Year
In order to effectively harvest income to take advantage of potential tax arbitrage opportunities, the first key is to recognize that the income itself must be recognized by the end of the year, which means the Roth conversion or the gains-harvesting trade must be done by December 31st.
Beyond just executing the transaction, though, the reality is that because these strategies are very sensitive to getting tax rates right, and making sure to take enough income to fill a currently-favorable tax bracket but not rise into the next one, effective implementation also requires doing a tax projection for the current year just to determine where those tax thresholds are, given income and deductions for the year. Fortunately, the recharacterization opportunity for Roth conversions gives a little more flexibility, though; it's always an option to just deliberately convert more than enough, and simply recharacterize the exact amount that turned out to be "too much" early next year once all the final numbers are in for the tax return. With harvesting gains, though, estimating the appropriate amount based on a tax projection is the best that can be done (the more accurate the estimates of income and deductions, the more precise the gains harvesting can be).
In addition, it's important to bear in mind that income creation strategies can impact more than just the obvious tax brackets themselves. Going forward, creating income may make ultra-low income individuals eligible for premium assistance tax credits, though "too much" income can also render them ineligible, resulting in a potentially significant loss of tax credits and an indirect increase in the marginal tax rate as a result of phasing out the credits. Similarly, for many retired clients, additional income can trigger the taxation of Social Security benefits, or higher Medicare Part B and Part D income-related premium adjustments; while neither of these makes it unequivocally "wrong" to create income, both represent situations that boost the marginal tax rate higher than "just" what tax brackets alone imply, yet must be accounted for when considering the value of harvesting gains or doing Roth conversions. For others, state taxation may be a factor; if there is a planned move (in the coming years, or perhaps at the retirement transition), the difference in state tax rates should be considered, and may either make Roth conversions and gains harvesting much more appealing (if the future state would have a higher tax rate) or less appealing (if the future state will have a lower tax rate). And of course, if the individual doesn't expect to use the IRA or appreciated investments at all, and they're likely held until death, it's important to consider the likely tax bracket of the beneficiaries (if lower, they may prefer to inherit a traditional IRA and not a Roth!) and the available step-up in basis at death (which essentially represents a "free" gains harvesting tax event).
Nonetheless, the fact remains that for many individuals, today's increasingly progressive tax rate structure - with higher and higher tax rates at upper income levels - creates new incentives to not just harvest losses and deferred income and gains forever, where the growth of IRAs and appreciated securities can be so significant that it drives the tax bracket up and actually results in less wealth! On the other hand, for some, the greatest decision may simply be to choose which strategy will actually result in the most savings and wealth creation; the winning strategy will be whichever one results in the greatest tax rate arbitrage and the largest difference between current and future rates (in general, do Roth conversions if taxable income is negative, then harvest capital gains in the 0% capital gains tax bracket, and then weigh whether to continue harvesting gains or go back to Roth conversions based on how high income may be in the future).
The bottom line, though, is simply this: in situations where an individual's tax rate is actually favorable now, and may be higher in the future, the best way to save money on taxes in the long run is to go ahead and trigger some of those taxes to pay them now.