In our previous blogs, we introduced what is tax arbitrage, how to use Roth conversion and Capital harvesting to conduct tax arbitrage. 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.
Roth Conversion Recharacterization
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).
Consider More Than Tax Brackets
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 people, 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).
Roth Conversion Recharacterization
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).
Consider More Than Tax Brackets
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 people, 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).
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