What Will Have the Least Tax Impact: Harvesting Capital Gains Or Roth Conversions?
Roth conversions and capital gains harvesting are two effective financial strategies that can help you achieve these goals. However, implementing these strategies requires careful consideration of various factors, including your expected need for the assets, future goals, current tax brackets, projected future income and tax rates, and collateral impacts on Social Security, Medicare, wealth transfer goals, and other aspects of your financial plan.
To guide your decision-making process, we have created a flowchart that outlines the key considerations you should keep in mind when choosing between Roth conversions and capital gains harvesting. Let's delve into each of these considerations in more detail.
Expected Need for the Assets The first consideration when deciding between Roth conversions and capital gains harvesting is your expected need for the assets. If you anticipate needing the funds in the near future, it may not make sense to convert them to a Roth account, as you will incur income tax costs that may outweigh the benefits of tax-free withdrawals. On the other hand, if you have a longer time horizon and do not expect to need the funds for several years or more, converting them to a Roth account may be a better option.
Future Goals for the Assets Your future goals for the assets should also be taken into account when deciding between Roth conversions and capital gains harvesting. If you plan to leave the assets to your heirs, converting them to a Roth account may make sense, as your beneficiaries will be able to withdraw the funds tax-free. However, if you plan to use the assets for your retirement income, capital gains harvesting may be a more appropriate strategy.
Current Tax Brackets and the Effect of Increasing Income Another important consideration is your current tax bracket and the effect of increasing income. If you are in a relatively low tax bracket, converting some of your pre-tax retirement accounts to a Roth account may be a good idea, as you will pay lower taxes on the conversion. However, if you are in a high tax bracket, the tax costs of a Roth conversion may be prohibitive, and capital gains harvesting may be a better option.
Projected Future Income and Tax Rates Your projected future income and tax rates should also be taken into account when deciding between Roth conversions and capital gains harvesting. If you expect your income and tax rates to be higher in the future, it may be beneficial to convert some of your pre-tax retirement accounts to a Roth account now, as you will pay taxes at a lower rate. However, if you expect your income and tax rates to be lower in the future, it may make sense to delay the conversion and focus on capital gains harvesting instead.
Collateral Impact on Social Security, Medicare, Wealth Transfer Goals, etc. Finally, you should consider the collateral impact of your decision on other aspects of your financial plan, such as Social Security, Medicare, and wealth transfer goals. For example, converting a large amount of pre-tax retirement accounts to a Roth account may increase your taxable income and push you into a higher Medicare premium bracket. Similarly, harvesting capital gains may have implications for your wealth transfer goals, as you may need to sell assets that you had planned to leave to your heirs.
In conclusion, deciding between Roth conversions and capital gains harvesting requires careful consideration of various factors. By keeping in mind your expected need for the assets, future goals, current tax brackets, projected future income and tax rates, and collateral impacts on Social Security,Medicare, wealth transfer goals, and other aspects of your financial plan, you can make an informed decision that maximizes the benefits and minimizes the costs of these strategies.
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Robert J. Pyle, CFP®, CFA, AEP® founded Diversified Asset Management, Inc., in 1996 to provide personalized, comprehensive wealth management services to successful individuals, families, single women, and business owners. His specialty is addressing the complex financial needs of self-employed professionals, corporate executives, and small-business owners. Our disclosure can be found here. The views, opinion, information, and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc. Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting, or tax advice.