Many people who are looking to implement a Roth conversion strategy also have a regular investment account with their financial advisor. Since there is an annual contribution limit on retirement accounts, it’s a good idea to save additional money in a taxable account as well.
Over time, these taxable accounts can accumulate quite a bit of long term growth. This is especially true if you have a sensible, long-term, diversified portfolio. In that case, you might have capital gains, and you need to account for the tax consequences.
Which begs the question, “How do capital gains affect my Roth conversion strategy?” That’s tough to answer. Let’s start by discussing capital gains harvesting.
Capital gains harvesting is the purposeful sale of investments to take advantage of the preferential capital gains tax rate, which is better than the ordinary income tax rate.
This article isn’t going to tell you the answer, because the answer is this: “It depends on your situation.”
However, here are 9 things you should consider when you’re looking to do capital gains harvesting in addition to implementing your Roth conversion strategy.
Capital Gains Consideration #1: Not all capital gains are equal.
According to the Internal Revenue Service (IRS), there are two types of capital gains rates: short term and long term.
Short term capital gains are the capital gains for any investment held for one year or less. Generally speaking, short term capital gains are taxed at the same tax rate as ordinary taxable income.
When people discuss capital gains harvesting, they’re usually referring to long-term capital gains. Long term capital gains are from the sale of investments held for more than one calendar year.
One year or less? In that case, short-term capital gains tax treatment would apply, which is no different from ordinary income rates. So if all of your capital gains are short-term, then you might be better off waiting until you’ve had these holdings at least 1 year. But if there was a recent run-up in the stock market, maybe not.
Consideration #2: What if there was a recent run-up in the stock market?
Let’s imagine that you bought Tesla stock in January 2020, when it was available for less than $90 per share. By December 31, it was trading at over $700 per share. In other words, a $10,000 investment in Tesla could have netted over $75,000 by the end of the year.
Would it be prudent to keep holding onto Tesla? Maybe, if that was an intentional part of your investment philosophy.
But let’s imagine that you had wanted to sell by the end of the year because you thought Tesla was getting too expensive. You certainly argue that you’d still be better off selling than at the beginning of the year. After all, even after state and federal taxes, you could have tripled your money.
While Tesla was an extreme example (and certainly not something to expect in any given year), sometimes you need to be careful about letting the tail wag the dog. In other words, income taxes should be an important consideration (always), but they shouldn’t be the only consideration when looking to sell.
And sometimes, locking in the cash from the capital gains (if you’re looking to get out of a particular investment) might be better than riding that investment back down during the one-year holding period.
Which leads us to the next scenario.
Consideration #3: What if there was a recent decline in the stock market?
In a down market, different factors might be at play.
First, you might be looking to harvest capital losses as part of your rebalancing strategy. And as long as you abide by wash-sale rules (not repurchasing substantially identical securities within 30 days, before or after the sale), this can be a pretty good tax move.
Second, it might be worth evaluating Roth conversions in a down market. After all, if your investments are temporarily down, converting from a traditional individual retirement account (IRA) to a Roth account would allow the eventual recovery to be tax-free. And that means tax-free withdrawals down the road.
Consideration #4: Many times, you can harvest capital gains and capital losses in the same year, which could lower your tax liability.
While capital losses are subject to a wash sale rule, capital gains are not.
Sometimes, shrewd investors might purposely sell an investment (like mutual funds), trigger the capital gain, then immediately repurchase that security. Why would you do that? Because when you repurchase the security, you also reset the cost basis.
At the end of the tax year, all the capital gains and losses will be added against each other. This is known as netting out gains and losses. While your tax advisor needs to know the details of how netting gains and losses work, you probably don’t.
The bottom line is that you should expect one number on your Form 1040 (as calculated on Schedule D of your tax return).
If that number is positive, it could be either long-term gains, short-term gains, or a combination of both.
If that number is negative, then it can be used to reduce your adjusted gross income (AGI). In turn, this lowers your federal income tax. But only up to $3,000 per tax year. Any additional losses are carried forward to future tax years.
Consideration #5: You can take advantage of capital loss carryovers.
Have losses carried forward from previous tax years? Then you can net them against capital gains incurred in the current tax year. This is known as a capital loss carryover (sometimes erroneously referred to as a carryforward, which the IRS uses to discuss net operating losses—not capital gains).
The tax code states that you can only offset $3,000 of ordinary income per year with capital losses. But you can offset an unlimited amount of capital gains with capital losses.
So in years where you have a capital loss carryover, you may choose to offset much more capital gains than you can offset in Roth conversions (ordinary income).
Consideration #6: Even if you don’t sell them, you might pay capital gains distributions in your mutual fund and exchange-traded funds (ETFs) each year.
Have mutual funds in your investment account? Even if you don’t sell, you might be paying capital gains taxes on the capital gains distributions.
What are capital gains distributions? Simply put, each mutual fund or ETF buys and sells securities. When a fund sells assets for a gain, they incur a capital gain just like you would. Except they don’t pay taxes on the capital gains. Instead, each year (usually in December), they calculate the number of gains that are incurred, and divide those gains against the number of shares outstanding. Each fundholder receives capital gains distributions in a proportional amount to the amount of that fund they hold.
You’ll see this reported on Form 1099-DIV. Short term gains and long term gains are calculated in a similar manner as you would expect, with a few changes:
Long term capital gains distributions (reported in block 2a) are always taxable to you as long-term capital gains, regardless of how long you’ve held the fund itself.
Short term capital gains distributions are reported as ordinary dividends on block 1a.
Taxation of capital gains distributions occurs regardless of whether you reinvest in more shares or leave them in cash.
This is important because some mutual funds do a LOT of buying and selling. This is known as turnover.
The turnover rate (the percentage of a fund’s holdings that have changed over the past year) is a common proxy to measure how often a fund turns over its holdings and is directly related to the tax efficiency of that fund. High-turnover funds are considered less tax-efficient than low turnover funds.
If a fund is tax-efficient, like index funds are, then you might not have much to worry about. Tax-inefficient investments can produce a lot of capital gains distributions. In turn, those distributions could raise your income level and push you into a higher tax bracket.
This could have a direct impact on your Roth conversion planning. When this is the case, it adds an additional layer of complexity:
Do I sell now and trigger capital gains, or do I hold and run the risk of incurring capital gains distributions in the future?
Consideration #7: You don’t ever have to pay capital gains if you don’t sell. However, this might make rebalancing more difficult down the road.
This is something I used to see quite often in clients. A client’s investment account, which used to be smaller than her Roth IRA account, ends up with a couple of blue-chip holdings (think buying Apple in the 80s, or Amazon in the late 90s).
After a while, those investments become outsized parts of the entire portfolio. In one extreme example, a client bought $1,500 of Microsoft in 1990 that is now valued at over $400,000 today. Fortunately for that account holder, Microsoft isn’t an outsized part of the portfolio, so we were able to still rebalance tax-efficiently in other accounts.
But you might have difficulty rebalancing if most of your money is locked up in an employer-sponsored plan (like a 401k) with limited options. Or if your appreciated holding becomes a significant part of your portfolio, then you might have to incorporate this into your plan.
Consideration # 8: You need to incorporate this into your overall tax planning.
If you’re still working, there may be annual income limits that apply to your ability to make Roth IRA contributions. If you’re still contributing to your workplace retirement plan, there may be limits to your ability to take a tax deduction for traditional IRA contributions.
If you’re meeting with your tax advisor each year, you should sit down and make sure you’re receiving accurate tax advice.
Consideration #9: Asset location matters.
Most people have heard of asset allocation. Asset allocation is understanding that an investment portfolio should consist of different types of investments. And this should contain a certain combination of bonds, stocks, or other investments.
Fewer people have heard of asset location. Asset location is deliberately choosing where an investment is, based upon the tax treatment. This dictates the type of account, or type of IRA, you might hold an asset in.
For example, if you have Treasury bonds or CDs in your portfolio, they might go into a traditional account. That way, your bond interest (treated as ordinary income) isn’t taxed until you make a qualified distribution. This is especially true if you hold high-yield investments.
High growth investments, like small cap or overseas mutual funds, might be located in a Roth account. That way, you can take advantage of the tax-free growth, and your qualified withdrawals will be tax free.
And your capital gains–they could go in a regular investment account. This way, you can take advantage of capital gains tax rates. Additionally, qualified dividend income usually is taxed at preferential rates.
Capital gains are a good thing. After all, they indicate that you made money on an investment. And under the right circumstances, capital gains are taxed at a preferential rate when compared to ordinary income. On the other hand, capital losses, while providing some tax planning opportunities, indicate the opposite.
When implementing your Roth conversion strategy, it is important to account for capital gains as part of your tax planning. That way, you can decide for yourself whether you’re better off paying tax on a Roth conversion, or tax on gains at a lower tax bracket.