tax rate quiz question

[Rapid Robert]

In Year 1, AGI is $88K, Year 2 = $96K

In Year 1, taxable income is $67K, Year 2 = $75K

No AMT either year.

In Year 1, tax is $8.1K, Year 2 = $7.9K.

Taxable income has increased by $8K from year 1 to year 2, yet tax has decreased by $0.2K.

How could that be? (assume pre TCJA tax law, Year 1 = 2016 and Year 2 = 2017, and we are not considering credits or withholding or payments of any kind).

[Jiggers]

Year 2 has capital gains taxed at the lower rate.

[Rapid Robert]

Year 2 has capital gains taxed at the lower rate.

Yes, that's the primary reason. This zero percent cap gains rate when MFJ taxable income is under $77,200 is pretty amazing. Taxable income for many could actually be much lower under the new law than before, even with the same AGI that in many cases could approach six digits.

It can be somewhat offset by state taxes if they don't have special cap gains rates for the state. But still...

It makes me wonder why Roth IRAs are often assumed to be the ne plus ultra of retirement investing. With both Roth IRA and an ordinary brokerage account, you are most likely going to be making the same types of investments. And you don't have to pay tax on current unrealized gains. But with an ordinary account, you can deduct up to $3K losses per year against ordinary income, possibly in a very high bracket, even if those losses are later recovered when the market goes up - highly unlikely to ever get a write-off on Roth losses, especially under the new law. And the potential step up upon death makes the brokerage account roughly equal to Roth if held for heirs. And once in retirement, it should be much easier to keep taxable income below the zero rate threshold, leading to zero rate on qualified dividends and cap gains, so again roughly equal to Roth.

And unlike a Roth, the brokerage is not required to report to the government the FMV each year -- less tempting to the politicians looking for new ways to pay for all the debt they have been foisting on us lately. (referring here to speculation that someday an indirect tax on Roth distributions or balances may be implemented).

My best advice is to diversify after-tax retirement money, maybe half in Roth and half in ordinary brokerage account.

[edit] Especially for those agonizing over how to make a back-door Roth contribution when they have little or no basis in Trad IRA -- why not just put the money in a brokerage account instead? No muss, no fuss, and potentially the same end result.

[kathyc2]

Other than the one point that loss on NQ can be taken, in every other situation Roth option is better.

Even if someone is in 0% LTCG rates in retirement, chances are they are not going to be during their working years. The unrealized gain will not be taxed, but the in account CG and dividends will be.

With step-up the heirs will still be paying on the gains/dividends on the full amount after inherited. With a Roth, none will be taxable and even with minimum distribution requirements, the balance will still accumulate gains tax free.

For those in 0% LTCG rate, earnings on investments can make more SS benefits taxable. Also, the gains/dividends increase AGI (which Roth does not do) for items that are AGI dependent.

There is also no guarantee that the 0% rate will prevail in the future.

[Rapid Robert]

Other than the one point that loss on NQ can be taken, in every other situation Roth option is better.

Yes, Roth does have the advantages you mention. So I guess I'm saying an ordinary brokerage account can be almost as good, for those who can keep their taxable income in a lower range during retirement and avoid any AGI-related phase-outs.

Making an investment in a passive activity that doesn't throw off current income could be even better than a brokerage account (no divs/cap gain distributions to worry about). There are lots of restrictions on what you can invest in and what kind of transactions you can make with a Roth.

And the one situation where the Roth is clearly not better, is when one is phased out on making contributions in the first place (thus my comment about back-door Roth anxiety). I would never argue that a Roth is a bad choice, simply that there are a few alternatives worth looking at in addition. I think many taxpayers have the impression that their choices are Roth or nothing, and that is why they are frustrated when contributions are phased out.

Back to a tax rate question: should one be willing to do a taxable conversion of a Trad IRA to Roth no matter what? If not, why not? In other words, if the taxpayer has enough investable cash to pay the current tax on the conversion, why not always convert up to that amount each year, until it's all converted? The sooner, the better?

[kathyc2]

Back to a tax rate question: should one be willing to do a taxable conversion of a Trad IRA to Roth no matter what? If not, why not? In other words, if the taxpayer has enough investable cash to pay the current tax on the conversion, why not always convert up to that amount each year, until it's all converted? The sooner, the better?

There are times when it makes sense, and other times it doesn't. The immediate one that comes to mind would be for moderate income people with only SS and IRA's in retirement. IOW, no traditional pension. The optional point would be that they have just enough income each year to use up the standard/itemized deductions. It they convert and pay tax now, they may miss the opportunity to get it out or convert tax free in the future.

One couple I'm working with both retired at 63. They have about 1M in IRA's mostly traditional. Other than SS and small NQ accounts, this will be their retirement income. Current RMD's would have the effect of for each $100 of withdrawal adding $185 to taxable income due to taxation of SS. IOW, the 12% bracket effectively becomes 22.2%. We determined the best course for them would be start her SS now as it's much lower and hold off of his for a couple years. In the meantime they are converting to Roth enough to take them to the top end of the 12% bracket.

Another couple, early 60's has about 100K in NQ and minimal amounts is IRA's. Best course for them is to take the 13K from NQ and put it in Traditional. They get the deduction now and because of them being lower income in retirement, they can get it back out tax free.

There is no one size fits all approach, it just depends on each clients individual situation.

[BP.]

Roth conversions were a great tool for a client who was changing careers. She became a full time student with a part time lower level job in the new field. She needed the conversions to fully utilize AOC, and I think maybe a few other assorted credits, like energy and savers. It was like triple dipping!