Approaches to filling up tax brackets - which one makes the most sense?

Question

My key question: which one of the 3 basic scenarios outlined below to fill up tax brackets makes most sense?

A few (simplifying) assumptions first:

We are married filing jointly, and are planning to stay in the 12% marginal tax bracket for regular income and 0% for cap gains this year. For simplicity, let's assume the cutoff for these brackets is $94K (I realize they are slightly different).

Let's also assume it's 12/31/2024 and we have taxable income of $40K at that juncture: $20K in self-employment income and $20K in cap gains/dividend income.

Let's lastly assume we do have a solo 401K, so we could defer pretty much all of that SE income into a traditional tax-deferred 401K account if we so chose (I realize not all of that income can be deferred, but again, for simplicity, let's assume we can defer all the $20K).

Here are the alternatives we are contemplating (there may be others) to get to the $94K in taxable income:

1. Do a Roth conversion of $54K -> $20K SE + $54K Roth + $20K CGDiv = $94K -> 12% marginal on SE and Roth, 0% on CGDiv.
2. Realize an additional $54K of capital gains -> $20K SE + $74K CGDiv = $94K -> 12% marginal on SE, 0% on CGDiv.
3. Defer $20K in SE income and realize an additional $74K in capital gains and -> $94 CGDiv -> 0% on CGDiv.

I wonder which one of these scenarios makes most sense. The answer may simply be "it depends", as it probably boils down to what our assumptions about future taxes, cash needs and future market returns are. But we need a sanity check and wonder if we are missing anything important or alternative scenarios that would also make sense.

For instance, 3) realizing as much CG as we can now would make sense if we need cash and if we assume a market crash is coming. But there is the chance that income (not CG) tax rates will go up as early as 2026. 1) makes most sense if we think income (not CG) taxes are going to go up and that the market is going to chugg along and if we need no additional cash at this point.

So, which scenario makes the most sense? And again, it may just "depend".

Answer 1

You are absolutely right that it depends. There are just so many factors at play here. As I mentioned in my comment, you left out the standard deduction which is $29,200 for married filing jointly in 2024, so you have more room to work with.

Personally, I would do the following:

1. Defer $20k in SE income. This is a no-brainer unless you really need the cash immediately. Of course, a Roth Solo 401(k) is also an option, which further complicates things, but let's ignore that possibility for now.
2. Roth conversions to fill up the 10% bracket using the extra space provided by the standard deduction.
3. Capital gains harvesting to fill up the 0% long-term capital gains bracket.

This gives you a good amount of Roth conversion and capital gains harvested while keeping your federal taxes low. Of course, you can increase the Roth conversions and decrease the capital gains harvesting, or vice versa, based on your situation.

I agree with you that regular income tax rates are more likely to increase in the future than long-term capital gains rates for the lower brackets, so I would prioritize Roth conversions. Also remember that after 5 years, Roth conversions can be withdrawn without tax or penalty, so that money will become accessible before retirement age.

Answer 2

It depends. Are you in accumulation mode or primarily in a withdrawal phase? Is your primary goal to maximize the 12% ordinary and 0% long-term gain brackets, or is it balancing current-year savings with maximizing those brackets? Do you have heirs that your unrealized capital gains assets could pass to with a step-up in basis (i.e. avoiding income tax altogether)? Is this year an unusual income year (higher or lower than "normal")? Are you comfortable with the amount of cash you have on hand even if the market crashes? If the market crashed, would that significantly increase the percentage of your portfolio that's withdrawn (e.g. withdrawing $50k from a $10M portfolio that falls 30% to $7M is a lot less severe than withdrawing $50k from a $100k portfolio that falls 30% to $70k). And more. There's not enough information to provide high-level guidance, even without diving into the complexities of the tax situation itself.

Keep in mind that in your scenario as provided, things will be even more complicated because of the self-employed income and associated qualified business income (QBI) deduction. Net capital gains and Solo 401(k) contributions are two things that could reduce the amount of QBI deduction you're allowed to take.