The Shaw Atlas – September 2018 Article

Tax Planning Strategies In Low-Income Years

Though it typically isn’t ideal to have a low-income year, it can actually provide beneficial opportunities that could potentially save you significant amounts of money on your taxes and help you plan for future success. This month, we will be discussing a few strategies to take advantage of IRAs and capital gain rates to help you achieve this growth and security for your future, even in low-income years. 

How to Use IRAs to Your Advantage in a Low-Income Year

Low-income years are a great time to evaluate your IRAs. First, let’s look at a summary of the differences between traditional and Roth IRAs.

The tax advantage of a traditional IRA is all current contributions are tax deductible. If you’re making $50,000 a year and you contribute $5,000 to a traditional IRA, your taxable income will be $45,000 (excluding any other deductions you may have). The catch is when withdrawing from your traditional IRA upon retirement, the amount you withdraw becomes taxable income in that year. An additional catch is any earnings you’ve generated in the IRA are also taxable upon withdrawal. Thus, what your projected future marginal tax bracket is when withdrawing funds will have a bearing on your strategy.

Roth IRAs are taxed exactly the opposite from traditional IRAs. Contributions to your Roth are not tax deductible when you make the contribution. Therefore, if you’re making $50,000 in income and contributing $5,000 to a Roth IRA, you will still be taxed on your full $50,000 of income (again, excluding any other deductions). The biggest advantage is when the time comes to withdraw your funds. Your contributions, plus earnings the fund has generated, will be tax-free.     

Consider Contributing or Converting to Roth IRAs

If you are in a low-income year at lower marginal tax brackets, your benefits from making a traditional IRA contribution (and getting a tax deduction) are reduced. Roth IRAs, on the other hand, can be perfect for this situation, especially if you plan to withdraw your funds while residing in a higher marginal income tax bracket. When you withdraw Roth funds in a higher-income year the earnings won’t be subject to tax the same way they would with a traditional IRA.

You should also consider converting funds, up to the point of reaching the next marginal tax bracket, from your existing traditional IRA to a Roth IRA. As long as you convert the funds in a 60 day window, there is no 10% early withdrawal fee. The amount you convert will become taxable income for that year — the same way as if you had made a contribution directly to a Roth — which is why this can be such an effective strategy during low-income years.  

If You Plan to Be in a Lower Tax Bracket In or Around Retirement

If in retirement, or whenever you begin withdrawing from your IRA’s, you plan on being in a lower income tax bracket, a traditional IRA may potentially be the more financially beneficial strategy. This will depend on the spread between the marginal tax brackets during your contribution years vs. your marginal tax bracket in retirement. It also is predicated on what you do with your tax savings generated by the tax benefit you receive from your annual traditional IRA contributions. If you reinvest the savings it is possible that the traditional IRA could be more beneficial, but if you spend the savings a Roth IRA would most likely be the better alternative.

Finding a Balance Investing in IRAs

When it comes time to decide what type of IRA to invest in, it can generally be beneficial to strike a good balance between Roth and traditional IRAs. For instance, if you plan on being in a lower income bracket in retirement but you have invested solely in traditional IRAs, you can unintentionally force yourself into a higher tax bracket when you withdraw. Large withdrawals from your traditional IRA in addition to other forms of income in retirement, like Social Security Benefits, can leave you in a higher tax bracket than you may have planned. Thus, it is important to mix in some Roth IRAs to your portfolio as the money has already been taxed and will not increase your taxable income whenever you choose to withdraw.

How to Use Low-Income Years to Avoid Large Capital Gains Tax

Capital gains for individuals are primarily profit gained from the sale of capital assets such as stocks, bonds, and real estate. Profits made from the sale of these items will be subject to a lower capital gains tax rate as long as you hold the asset for at least one year. It’s important to understand how to avoid getting taxed too heavily, or not taxed at all, on profits from these capital assets.

A Potentially Great Time to Unload Long-Term Capital Gains

Long-term capital gains are stock, bonds, or real taxable property you’ve held for more than one year. If you’re filing jointly and are reporting taxable income of less than $77,400 — or $38,700 for singles — your capital gains are actually tax-free (for federal purposes) up to the point the capital gains move you to the next tax bracket. So, if you’re reporting income in those brackets, it’s a great opportunity to sell some investments tax-free. This strategy can be potentially great for those nearing retirement or having a low-income year and are in need of cash. For example, let’s say you’re filing jointly and reporting $40,000 of taxable income and you want to sell stock with $50,000 of capital gains that you have held for more than one year. Since the income limit (for those filing jointly) to not have to pay any capital gains tax is $77,400, $37,400 of the sale of your stock would be federally tax-free. But since the rest of the sale will put you into the next highest income tax bracket, you’ll pay a 15% capital gains tax on the remaining $12,600 of the sale. This means you have to be mindful of how the capital assets you sell may affect how much you are taxed on capital gains.

How to Make the Most on the Sale of Your Home

The IRS allows you to exclude a significant amount of capital gains on the sale of your home if you meet the requirements stated below. You are tax exempt up to $250,000 of your capital gain if you’re single or $500,000 if you file jointly. If you’re a married couple, however, and you’re lucky enough that the house you bought for $200,000 is now worth over $700,000, surpassing the exemption amount, it could be beneficial to wait until a lower-income year to sell your house. This way you can avoid being taxed too heavily on your excess capital gains from the sale. If you’re nearing or in retirement, are reporting lower income, and don’t necessarily need all the space, this could be a great time to sell your home for maximum profit.

You CAN’T qualify for the real estate exclusions if any of these factors apply to you:

  • The house wasn’t your principal residence.
  • You owned the property for less than two years in the five-year period before you sold it.
  • You didn’t live in the house for at least two years in the five-year period before you sold it. (People who are disabled, and people in the military, Foreign Service or intelligence community can get a break on this.)
  • You already claimed the $250,000 or $500,000 exclusion on another home in the two-year period before the sale of this home.
  • You bought the house through a like-kind exchange (esentially swapping one investment property for another) in the past five years.
  • You are subject to expatriate tax.

Navigating low-income years can be difficult but also extremely financially beneficial. Hopefully some of these simple yet effective strategies offer you better insight into finding financial peace of mind in these times. We know that much of this material can often be confusing, so we would be more than happy to discuss any further questions with you. We will all we can to make sure you leave feeling confident and comfortable in your financial future. Call us today to set up an appointment.