Take Advantage of Low-Income Years with Roth IRA Conversions

We all love to make money, and usually, the more the better, right?  However, there can also be an unexpected up-side opportunity in not making much money (at least temporarily), that should be understood, and some strategies that should be considered if you find yourself in this situation.

In years when you or your family unit have an unusually low income, there is a tax-planning strategy that may help significantly lower your overall lifetime tax burden. This is through what is known as a “Roth IRA Conversion.”  Basically, all a Roth IRA conversion amounts to, is taking money from a Traditional IRA account (or other pre-tax retirement account) and converting those dollars into a Roth IRA.  When you make this conversion, you pay taxes immediately on the converted amount, and then, if managed properly, you will never pay taxes on those dollars, or the growth of those dollars, again.  This strategy is essentially a bet on whether you will be in a higher or lower tax bracket in the future.  When you convert to a Roth IRA, you are betting that you will be in a higher tax bracket in the future. You are willing to pay taxes now, at what you expect to be a lower rate, to avoid paying taxes later, at the likely higher rate.  So, if you find yourself in a situation where you have an abnormally low-income year, which you do not expect to last forever, it might be a perfect opportunity to take advantage of a Roth IRA Conversion.

There are many reasons why folks suddenly find themselves in a temporary, low-income, situation. Maybe they are between jobs, or unemployed for a significant amount of time, or might have taken time off from work to have a child. Perhaps their income may have dropped due to some uncontrollable event such as not being able to work full-time during the pandemic.

Or some might have recently retired and be living off of cash reserves for a while before starting to receive social security or pension payments.

Whatever the reason(s) may be, in these scenarios, most people don’t do anything different with their investments; they simply enjoy paying less taxes than usual for a change. However, while they may pay less taxes in a given year or time period, by not taking advantage of these temporarily low-income years, they are likely setting themselves up to pay more taxes than necessary over their lifetimes.  And what they’re really doing is wasting their low tax bracket years though inaction due to ignorance of what positive strategies are actually available to them. Instead, they should be proactive and take advantage of these low-income years, by filling up their (temporary) low tax bracket retirement-savings buckets while they can, so that they lower their tax-burden in future years, when it is likely that they will be back to their normal, higher income levels and associated higher tax brackets.  To understand the impact this can have, it is important to understand how taxes and tax brackets work.  So let’s start with a couple of relatively basic tax concepts.

First, let’s talk about tax deductions.  For tax-year 2021, individuals automatically receive a $12,550 Standard Deduction before they have to pay any federal income taxes, while a married couple, filing jointly, get a $25,100 Standard Deduction.  In other words, the IRS has said: the first $12,550 earned for individuals or $25,100 for a couple, is income-tax-free.  And if you itemize your deductions, the amount you can earn tax-free may be even higher.  However, to keep it relatively simple here, we will focus solely on Standard Deductions.  Only after you have income beyond your Standard Deduction do you start actually paying income taxes. 

In the United States, we have a tax-system that is “progressive”, meaning, in general, that you pay a higher percentage in taxes the higher your taxable income goes.  To get a better sense of how this works, here are the marginal tax brackets for 2021.

2021 Tax Brackets for Single and Married Couples Filing Jointly:

Tax Rate                    Taxable Income (Single)                       Taxable Income (Married Filing Jointly)

   10%                          Up to $9,950                                        Up to $19,900

   12%                          $9,951 to $40,525                               $19,901 to $81,050      

   22%                          $40,526 to $86,375                             $81,051 to $172,750

   24%                          $86,376 to $164,925                           $172,751 to $329,850

   32%                          $164,926 to $209,425                         $329,851 to $418,850

   35%                          $209,426 to $523,600                         $418,851 to $628,300

   37%                          Over $523,600                                     Over $628,300

As you can see, for 2021, the federal marginal tax rate is only 12% on taxable incomes up to $40,525 for an individual and $81,050 for a married couple filing their taxes together.  So, in reality, as long as your total income as a single person is at or below $53,075* in 2021, or $106,150** if you are married, you are paying 12% or less in federal taxes. Of course, depending on what state you live in, you may also be subject to state and/or local taxes.

*Single:  $53,075 (income) – $12,550 (standard deduction) = $40,525 (taxable income)

** Married:  $106,150 (income) – $25,100 (standard deduction) = $81,050 (taxable income)

To illustrate how a Roth IRA Conversion works, let’s assume you are married and your family usually earns about $150,000 per year.  However, due to the pandemic, one of you was not able to work, and as such, you have an abnormally low-income year where your family earns only $50,000.  In this scenario, you can take advantage of this (temporary) low-income year and convert some or all of your Traditional IRA (or other pre-tax retirement-plan dollars) to a Roth IRA, which will add the amount of the conversion to your taxable income for the year.  You would do this in order to use up a larger part of this low-income tax bracket, while it is available.

In this example, your family could add up to an additional $56,150* to your income, through Roth IRA conversions, and still stay in the 12% federal marginal tax bracket.  Now, if you were to try this in a normal year, where your family earned $150,000**, adding this conversion amount to your taxable income for the year would push you all the way up into the 24% tax bracket.  In other words, by taking advantage of your current, temporarily-low tax bracket, you are paying half the amount of income taxes you would have to pay in a normal income year.  And remember, as long as you manage it correctly, the money that was converted to the Roth IRA will never be taxable again, so you do not have to worry about being in a higher tax bracket in the future when you eventually take distributions.

*$50,000 (income) + $56,150 (conversion) – $25,100 (standard deduction) = $81,050 (taxable income)

**$150,000 (income) + $56,150 (conversion) – $25,100 (standard deduction) = $181,050 (taxable income)

The key point to remember with a Roth IRA Conversion is that you are making a choice to pay taxes now in order to avoid paying taxes later.  This strategy makes sense any time you are in a lower tax bracket now than you will be in the future, and you can afford to pay the taxes due on the conversion now-meaning you have the money on hand to do so outside of the accounts being converted.

It is often said that only two things in life are certain: Death and Taxes.  Personally, I would add a third certainty to this list, and that is: absolutely no one likes paying taxes.  As such, it is sometimes hard to imagine paying more taxes in any given year than is absolutely necessary.  And by converting to a Roth IRA, you are most certainly paying more taxes now than is absolutely necessary.  However, when looked at holistically, paying a little more in taxes now, may well save you from paying a lot more in taxes later. This is really what a good, long-term tax-planning strategy is all about. 




We are not tax-experts and are not offering tax-advice here. Please discuss al tax matters with your tax-consultant and/or attorney before making any decisions.

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