Roth Conversion & Capital Gains Case Study

Last week we touched on some ways to take advantage of a year in which your income would be lower, specifically by converting funds from a traditional IRA into a Roth IRA as well as selling investments at a gain for the purpose of paying less in taxes. This week we’ll take a deeper dive into the mechanics of these two ideas to better assist you in their implementation.

Roth Conversion

To start, let’s define the differences between a traditional IRA and a Roth IRA:

Traditional IRA: Money is contributed as tax-deductible from gross income for the tax year contributed, and any gains, interest and dividends from the investments in the IRA are not taxed. Contributions and gains can be taken out penalty free beginning at age 59 ½, but are taxed as ordinary income at that time. Any contributions and/or earnings withdrawn prior to 59 ½ are taxed as ordinary income and incur a 10% penalty. Additionally, beginning at age 72 there is a requirement to begin withdrawing portions of the traditional IRA (known as a Required Minimum Distribution or “RMD”) based on a factor from an actuarial table issued by the IRS.

Roth IRA: Money is contributed after taxes have been paid, and any gains, interest and dividends from the investments in the Roth IRA are not taxed. You are able to withdraw Roth contributions without penalty at any time, and can withdraw investment earnings beginning at age 59 ½ (subject to a 10% penalty if withdrawn earlier). There is no RMD requirement for Roth IRAs, so money invested can grow tax free indefinitely.

When you elect to convert funds from a Traditional IRA to a Roth IRA, you are electing to pay taxes on the amount converted now, then allowing the converted funds to grow tax free for the duration of the time the funds are in the Roth IRA.

Roth Conversion Case Study:

Tom is 42, single and makes $60,000 per year. Unfortunately, he was laid off from his job on March 15, 2020 due to a worldwide pandemic, but he smartly had an emergency fund he could tap into while he looked for a new job. He began a new job on September 15, 2020 at the same salary level after the pandemic was over.

January 1 – March 15: $12,500 income

September 15 – December 31: $17,500 income

Total Income for the year: $30,000

Tom also has $10,000 in an IRA. Knowing that he will likely pay less tax if he converts the funds in the IRA to a Roth IRA this year, he decides to convert the entire amount and pays only $1,200 in taxes:

Total Gross Income: $40,000 ($30,000 Salary + $10,000 Roth Conversion)

2020 Ordinary Income Tax Brackets for Single Filers

AmountsTax Rate
$0 – $9,87510%
$9,876 – $40,12512%

Taxes Paid on on the first $12,400 of salary: $0 (Standard Deduction)

Taxes paid on the next $9,875 of salary: $987.50 (10% Bracket)

Taxes paid on the remaining $7,725 of salary: $927 (12% Bracket)

Taxes paid on the Roth Conversion at 12%: $1,200 

This leaves Tom with $8,800 that was transferred to his Roth IRA that will grow tax free, and he is not obligated to take out this money at any time.

Stipulation: Although regular contributions to a Roth IRA are able to be withdrawn at any time, there is a stipulation that any contributions made from a Roth conversion must be held for FIVE tax years before they can be withdrawn penalty free. Therefore, if Tom needed to tap into the $8,800 contribution in the future, he can do so penalty free beginning January 1, 2025.

Alternate Reality: Tom decides to leave the $10,000 in his traditional IRA and lets it grow throughout the remainder of his working career. Due to an accumulation of high levels of national debt, tax rates are much higher in 2043 (the year that Tom has decided to retire) than they were in 2020. 

The original $10,000 has grown to approximately $30,000 with compound interest, and Tom now needs this money to fund his retirement. Assuming a 30% average tax rate on this withdrawal, Tom will have to pay $9,000 in taxes, leaving only $21,000 left over to fund his retirement.

Using the same compound interest rates and period, Tom’s $8,800 Roth conversion would have grown into approximately $27,000, which could all be used to fund his retirement as the money had already been taxed in 2020.

Capital Gains Case Study:

As we circle back to 2020, let’s assume that Tom bought some stocks in a taxable brokerage account 10 years ago for $4,000. Tom did not tinker with these stocks in the following ten years, and with capital gains and reinvested dividends the stocks are now worth $16,000. Although Tom has had a rough year financially, one redeeming factor is that he will be locking in a $12,000 gain on his stocks and will not pay any federal taxes on the gain.

There are currently three long-term (held over one year) capital gains tax brackets: 0%, 15% and 20%. In 2020, any long term capital gains that are part of total taxable income of $40,000 or less (what normally would be taxed at 12% if classified as ordinary income) are taxed at 0%.

2020 Long Term Capital Gains Tax Brackets for Single Filers

AmountsTax Rate
$0 – $40,0000%
$40,001 – $441,45015%
$441,451 and up20%

Let’s see what happens if Tom sells his stocks at $16,000 at the end of 2020:

Total Proceeds from Sale ($16,000) – Cost Basis ($4,000) = Total Gain ($12,000).

Total Gross Income for 2020: $52,000 ($30,000 Salary + $10,000 Roth Conversion + $12,000 Gain)

Taxes Paid on on the first $12,400 of salary: $0 (Standard Deduction)

Taxes paid on the next $9,875: $987.50 (10% Bracket)

Taxes paid on the remaining $7,725 of salary: $927 (12% Bracket)

Taxes paid on the $10,000 Roth Conversion at 12%: $1,200

Taxes paid on the $12,000 gain if treated as ordinary income at 12%: $1,440*

*However, the $12,000 gain will be taxed at the long-term capital gains rate. Including this $12,000, Tom’s total taxable income for the year is $39,600, meaning the entire amount fits into the 0% bracket based on the table above. Therefore, Tom’s long term capital gains rate on his $12,000 gain is 0%, so the total tax on this gain is $0.

What Tom could do immediately after selling his stocks for $16,000 if he does not need the proceeds is buy them right back for $16,000. His new basis for the stocks is now $16,000. If the stocks go up in the future to $20,000 and he decided to sell them at that point, he will only have to pay taxes on a $4,000 gain rather than a $16,000 gain.

Summary:

We hope that these examples are able to give you a better visual on how a rough year income-wise can be seen as a blessing in disguise. Please reach out to us at mindfulcents@gmail.com for clarification on any of these items or if you are in this situation and could potentially take advantage of having a temporary lower income; we’d be happy to review your situation with you individually. 

We also hope you all are staying safe, hopeful and positive. Continue to look for the silver linings in bad situations, keep looking to improve yourself and always be grateful. This too shall pass.

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