Many people who are looking to implement a Roth conversion strategy also have a regular investment account. After all, retirement account contributions are limited each year, and many people are looking to set aside additional money.
Over time, these taxable accounts can accumulate quite a bit of growth in themselves, particularly if you have a sensible, long-term, diversified portfolio. In that case, you might have capital gains that are now part of your tax planning picture.
Which begs the question, “How do capital gains affect my Roth conversion strategy?” That’s tough to answer. Capital gains harvesting (purposely triggering a determined amount of capital gains as part of a long term tax planning strategy) does compete with Roth conversions, which purposely trigger a determined amount of ordinary income as part of a long term tax planning strategy.
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.
Consideration #1: Not all capital gains are equal.
It’s important to note that capital gains harvesting usually alludes to long term capital gains, which are given preferential tax treatment to ordinary income. Long term capital gains are generally defined as capital gains on investments that have been 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. In other words, 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 could make the case that you’d still be better off selling than at the beginning of the year. After all, even at the highest federal and state tax brackets (which could be over 50%, you could have tripled your money, after taxes).
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, 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.
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 your Roth conversions in a down market. After all, if your investments are temporarily down, your Roth conversion could allow the eventual recovery to be tax-free. We’ve written at length about doing Roth conversions in a down market here.
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. For example, some shrewd investors might purposely sell security, 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 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 professional needs to know the details of how netting gains and losses work, 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). 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).
While you can only offset $3,000 of ordinary income per year with capital losses, 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 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.
The reason this might be of importance is that some mutual funds do a LOT of buying and selling, 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.
If a fund is tax-efficient, then you might not have much to worry about when it comes to capital gains distributions. But if it has high turnover and is not tax-efficient, then those capital gains distributions 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 on stocks that you never sell. However, never harvesting any capital gains can make rebalancing more difficult down the road.
This is something I see quite often in clients. A client’s investment account, which used to be smaller than their retirement accounts, 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 client, Microsoft isn’t an outsized part of the portfolio, so we are able to still rebalance tax-efficiently in other accounts.
But 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 overall investments, then you might have difficulty when you look to rebalance down the road.
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. Do you want to read more about Roth conversions? Check out the Roth conversions section of our blog! You can also download our Step-By-Step Roth Conversion Guide for free.
If you’re interested in learning more about how we might be of service to you, you can go here to learn more about how we work with clients.
The foregoing content reflects the opinions of Lawrence Financial Planning, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will recover or react as they have in the past.