Last week another 2.4 million Americans filed for unemployment benefits. Although unemployment claims are slowing, they are still at record highs. During this pandemic, many businesses have been forced to shut down and/or seen considerable drops in revenue. It follows suit that many employees and business owners have also seen their incomes drop. While this may not be ideal, there are some actions you can take during years of lower income to decrease your future tax burden. In this post, we will discuss three tax strategies you can deploy during times of reduced income.
The first strategy we want to present is the Roth Conversion. As we have written about in previous posts, a Roth conversion when your current income tax rates are temporarily low can lead to substantial tax savings in the future. As a quick example, let’s assume that you have $100,000 in an IRA today. Let’s also assume that your income typically places you in the 32% federal income tax bracket and that you expect to earn 6.5% annually in your IRA over the next 15 years. In 15 years, your IRA would be worth about $257,000. Assuming you would pay taxes at a 32% rate, the after-tax value of the IRA would be approximately $175,000.
Now let’s compare this to doing a Roth Conversion in a year when your income level drops. If your income substantially dropped in one year and you found yourself with a temporary window in the 22% tax bracket, you could convert your $100,000 IRA to a Roth IRA. You then would owe $22,000 in taxes and could therefore “invest” $78,000 in the Roth IRA. Assuming the same 6.5% rate of return over 15 years, your Roth IRA would be worth about $200,000. Having this amount in the Roth IRA is $25,000 more than you would have in the traditional IRA mentioned above (after the assumed taxes). This is a simplified example, but nevertheless the tax savings can be substantial. As a percentage, the increase in your ending account balance is over 14%.
The second strategy that you can use is taking or accelerating capital gains in a low-income year. While short-term capital gains (on assets held less than a year) are taxed as ordinary income, assets held for longer than a year qualify for long-term capital gains tax rates. The specific tax rate that you pay on long-term capital gains depends on your income level. The three different tax rates are 0%, 15%, and 20%. In a case where a small business owner was making substantial income, but due to COVID-19 has little or no income this year, their tax rate on capital gains may go from 20% down to 0%. As another example, let’s assume that you are in the 20% capital gains bracket and take $100,000 of gains in your portfolio. You would, therefore, owe $20,000 in taxes. However, if you found yourself suddenly in the 0% income tax bracket you could take these gains and wind up paying little to no taxes. Why does this matter? Eventually, people must liquidate their investments to pay for retirement expenses, business expenses, unforeseen emergencies, etc. This being the case, paying capital gains taxes is an eventual reality for most people. By accelerating gains into a year where your income is low, you could essentially “skip” the taxes on the $100,000 of gains.
Like the strategy above, many people could also “accelerate” the timing of deferred income they have into a year in which their tax rate is unexpectedly lower. A good example of this would be stock options, restricted stock, or deferred compensation. For example, you could exercise some stock options in a year in which your income is suddenly lower. When you exercise stock options, the difference between the current stock price and the exercise price of the option is taxed as ordinary income. Let’s again assume that you are typically in a 32% income tax bracket. To make the numbers simple, let’s assume that you exercise your stock options, and the difference between the current stock price and the exercise price of the options is $100,000. In a normal year you would owe $32,000 in taxes (at the assumed 32% tax rate). Let’s now assume that your income drops to a level where you are only in the 22% tax bracket. Assuming the same $100,000 of income from the exercise of stock options, you would owe $22,000 in taxes. Therefore, by accelerating the exercise of the stock options, you would save $10,000 in taxes. The caveat is there are often restrictions placed on the timing of deferred income and exercising options.
The fact is no one likes a loss of income, even if it is only temporary. However, the reality of the COVID-19 pandemic is that many people have lost their jobs or have been furloughed. Many business owners have seen a significant drop-off in their revenues which translates into a drop in their personal incomes as well. The side effect of a loss or temporary decline in income, is that your income tax rates are often lower (hopefully only temporarily). Using this to your advantage can mean substantial tax savings over time. If you would like more information on these tax-planning strategies, please contact us here.