Strategies if You're Temporarily in a Lower Tax Bracket

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Christine Benz: Hi, I'm Christine Benz for Morningstar. Many people will find themselves in what they hope will be a temporarily low tax bracket in 2020. Joining me to share some strategies for people in this situation is tax and retirement planning expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine.

Benz: Ed, let's discuss some of the key reasons why people might find themselves in a temporarily lower tax bracket. Obviously, we've got higher than usual unemployment rates, but what else might be factoring in?

Slott: Well, I'll stop you right there. With the people getting unemployment, you know, this is an excellent point, most people, I don't know if they realize, that's taxable income. So, you have some people that were getting actually more in unemployment, not everybody, but there were some people with the $600 a week that were getting more than they earned previously. That's taxable, but what you're really talking about, and I've seen it with businesses around the country because I talk with lots of advisors, and there are many small businesses, as you know, the local restaurants that are getting destroyed and they may be small pass-through type businesses, S corporations and partnerships, where the income and loss passes right through to the owners of the business. Some of these people have negative income in the tens of thousands of dollars from the losses--the 2020 losses--that will pass from their business to their personal returns. So, that's awful, but many of them expect to come back, we hope, in 2021 or 2022, obviously, when things turn around. So, they can take advantage of some of those losses.

One thing I always tell the advisors to look for, or consumers, if you're one of these business owners and you have an IRA: Convert that IRA to a Roth. Use up those big losses. You may be able to move, and this may be a one-time event, take advantage--like the silver lining, turn lemons into lemonade or whatever the saying is--take that IRA. And let's say, you have a $20,000 or $30,000 loss, that's $30,000 you can move to a Roth IRA for free. Or even if you have lower income, maybe you don't have losses, but your income is a lot lower--another opportunity to convert to a Roth at rock-bottom prices. We have low brackets anyway, but some people are in unusually low brackets because of the pandemic and the loss of income.

Benz: Another factor potentially figuring into loss of income for some individuals is the fact that we don't have required minimum distributions in 2020. That might be another argument for people who aren't subject to RMDs to consider conversions as well?

Slott: Yes, that's a great point. Normally, in a normal year, which we hope we'll have one day, in a normal year, you have RMDs. They were required minimum distributions. The CARES Act waived those for 2020. But in a normal year, when somebody is subject to required minimum distributions, those RMDs cannot be converted to a Roth. So, if you want to convert once you're subject to RMDs, you have to first take that taxable RMD, pay tax on it, can't convert it. Then, if you want, you can convert the rest--any part of the rest--of your IRA balance, but it costs more because you first had to take the RMD and pay tax. For the rest of 2020, and those days are winding down, if you would have normally been subject to RMDs but now they were waived, you might want to voluntarily take some money out and convert it to a Roth while you have this closing window of opportunity to convert what would have been a nonconvertible amount--an RMD. But it's not an RMD anymore, so you have an opportunity to convert. It could be any amount. I'm just saying it could be the RMD amount, it could be more, it could be less, based on your tax bracket. So, it is a closing window of opportunity to convert where you won't be able to when RMDs begin because the RMD can't be converted.

Benz: So, potentially an opportunity here. One thing you often hear in the context of making these conversions, though, is where do you get the money to pay taxes? And that might be an issue for people who have depressed income. Is it important to have the funds external to the IRA, so not have to take extra from the IRA to pay any taxes due on that conversion?

Slott: I'll take the first part. I'll cut the first part in half. Is it important to have the money to pay the tax? Yes, before we say from where. Because remember, the Tax Cuts and Jobs Act, if you go back a few years, made Roth conversions permanent. There's no undoing, no "backsies," no reversing. We used to be able to recharacterize Roth conversions, remember those days? It can't be done. They're permanent. So, first thing, wherever you have the money, make sure you have the money, because whatever you convert is permanent. You will owe the tax next year.

Now, to the second part: Where should I get the money from? Ideally, you want it from outside the IRA so the full amount can be converted. But if you don't have it outside, it's not the worst thing in the world to take it from the IRA funds themselves unless you're under 59.5 years old because the amounts not converted would be subject to a 10% penalty. You never want to pay a penalty to convert. But let's say you're 59.5 or over: All right, so you convert a little less because you used some of that IRA money to pay the tax. But either way, you're taking advantage of unprecedented low tax brackets this year, and as you said, many people have lower incomes this year and are able to convert. Anytime you can move money from an IRA or a Roth at a low cost, that's a great tax move.

Benz: Those are strategies for people with traditional tax-deferred accounts. Let's talk a little bit about taxable assets. People have heard about tax-loss selling. They may have some tax-loss sale candidates in their portfolios this year. But let's talk about tax-gain harvesting--how that might make sense for people who find themselves in a lower tax bracket for capital gains or even the 0% tax rate for capital gains.

Slott: Yeah, you know, people talk a lot about the 0% capital gain rates. And if you look at the tables, I'm looking at them now, married filing joint 0%--this is on long term, stocks held more than a year. Zero to 80,000 is a 0% rate, but most people don't understand how that works.

Almost nobody gets the 0% rate, although we talk about it all the time like it's a real thing. It is a real thing, but here's how the tax law works. Your ordinary income gets taxed first. So, your ordinary income, let's say, for example, you did a Roth conversion. That uses up that zero to 80,000 bracket. So, for example, if you had wages or any other kind of income--business income, Roth conversion, interest, dividends--and it was more than, say, 80,000 married joint, you're not going to get the 0% rate. Most people will probably fall into the 15% rate, which is still a pretty good deal. And as long as you know that's what the rate is. We don't know what's going to happen next year. And remember after 2025, we go back to the pre-Tax Cuts and Jobs Act rate. So, it may pay to, as you call it, take some of those gains, gain harvesting. We always talk about loss harvesting. But what that does, it locks in these low capital gains rates, just like I was talking about locking in the low income tax rates. Same thing with the capital gain rates. But don't expect to get the 0% rate. Most people don't get that.

Benz: That's a good point. Let's talk about strategies that might yield a deduction, like charitable giving. How people who find themselves in a temporarily low tax year should think about taking those deductions? Should they save them for a year when they might give them greater bang for their buck? Or how should they approach that question?

Slott: If you're talking about deductions for people who itemize, that's not most people. You really have to have a lot. So, one example might be heavy medical expenses. But if you have heavy enough to itemize, it might pay to itemize now. But your point is well taken. Just like you like to report income when rates are low, you like to get the benefit of deduction when rates are high. Deductions are worth more when rates are high. You get more tax bang for your buck. So, if you can push these deductions, if you think you'll have them and you bunch them, you save them up and say, do them all next year when you hope things get better and you have a high enough income, and you'll get a better hit out of those tax deductions.

Benz: Ed, really helpful recap and timely. Thank you so much for being here.

Slott: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.