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In a Lower Tax Bracket? Check These Areas

Jeff Levine shares some ways to think about improving your tax position.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz from Morningstar. Amid the unfolding coronavirus and its related economic impact, some investors may find themselves in a temporarily low tax bracket. Joining me to share some ways to think about improving your tax position in such a time is Jeff Levine. He's the lead financial planning nerd for kitces.com, the director of advance planning at Buckingham Wealth Partners, and the lead creator and content expert for Savvy IRA Planning.

Jeff, thank you so much for being here.

Jeff Levine: Thank you for having me.

Benz: Jeff, you've been very busy at writing about the implications of the CARES Act for investors and advisors. Let's start with this general idea that it seems like a pretty safe bet where we are in 2020 that many people's tax bills will be lower this year than they were last year. Many people are experiencing job losses or related income reductions, and we have not gotten off to a great start in terms of investment gains either. I want to talk about strategies to take advantage of people landing in lower tax brackets this year. Let's start by looking at conversions of traditional IRA accounts to Roth. Why might that be advantageous right now?

Levine: Sure. I think that now may be perhaps one of the best times we've seen in the last decade for a lot of people to make these conversions--if it's right in the first place. If you happen to be one of the lucky few who continue to have an income that was commiserate to previous years, maybe now is not the right time. In other words, just because asset values are low doesn't mean you should overpay your taxes. But if a conversion was right in the first place, doing it while we're at depressed market levels can be a really great thing because as the market rebounds, which historically it has always done, then you ride that rebound inside of your Roth IRA where all those gains can be tax-free. So it's an ideal time to look at doing that. 

And for those investors who may be on the fence, who are looking at this and saying, "I know we're low now, but I think we're going lower." If they have that pessimistic outlook, maybe you hedge your bets a little bit. Maybe if you were planning on doing a $100,000 conversion, you decide to do one now for $50,000 and do another one for $50,000 later in the year. This way, if the market does continue to go lower, you are doing another conversion at those lower values, but if the market does rebound, you're getting some of it at today's depressed values. Almost like Roth conversion cost-averaging, if you will.

Benz: Right. If you have a very large balance, would doing a series of conversions over a series of years make sense as well potentially?

Levine: Generally speaking, that's the case. When you're looking at deciding how much to convert or when to convert, etc., the heart of good tax planning is: Pay tax when your rate is the lowest. Unfortunately, that is a lot simpler said than done for a variety of reasons. One is, income can fluctuate, deductions can fluctuate, and more for some individuals than others. For instance, a retiree living on a pension and Social Security and taking the standard deduction, I can pretty much ballpark your taxable income at the beginning of the year to within a few dollars. But if you're a business owner and you're going through this situation, your income may be dramatically different than other years. Similarly, we talk about tax rates and some people say, "Well, what if Congress changes the rates?" That's another possibility, too. 

And then of course, there's just other aspects. For instance, you may be a joint filer today. Let's just say that there's a married couple, the husband and wife and the husband is three years older than the wife. Actuarially speaking, she's probably going to outlive him by about seven years, eight years, maybe. That's seven or eight years that she would go from using the joint brackets down to the single brackets, which up until about $400,000 of income are literally half the size for single filers as they are for joint filers. And many times the surviving spouse has all the same income, just not the lower Social Security check. And that's it. So when you say pay tax at your lowest rate, there's a lot that goes in there. 

Now having said that, if you believe this is a low-rate environment and if asset values are depressed, there is no better time to convert them today, and it doesn't have to be an all-or-nothing decision. As you mentioned, it's probably better to do some over a number of years. If I had a $2 million IRA balance and I converted it all today, a overwhelming majority of that distribution is going to be taxed at the highest rate. If I were to instead take a 10-year time frame and do $225,000 or $250,000 a year, I might be able to get more of that money out at lower brackets as well.

Benz: So get some tax help here, it sounds like. Also, I think it's important to mention that you don't want to be rating the IRA for the tax bill, right? You'd want to have those funds external to the account to pay any taxes due on the conversion.

Levine: Ideally, absolutely. That is, I would say, if you've got other--because it increases the cost of that conversion, right? ...

Benz: Right.

Levine: ... You're now taking more money out of your IRA, pushing you into a higher bracket, etc. Now, there are some individuals who I've run across over the years who've just been incredibly successful savers, but they've done all of that savings inside their 401(k) or IRA, and in those limited exceptions, it sometimes can pay like ... You may still be better off doing some conversions and paying the tax out of the IRA simply because when you get to retirement, you're going to have to do the same thing anyway. Once you get to RMD age and you're taking it out, you're still going to have to because there's just no other place for you to pay the tax. You have no other money. So in those limited situations, sometimes I would say the answer is yes. But generally speaking, we do want to use outside assets simply because it allows us convert more because less of your income is being used up by income to pay the tax in the first place.

Benz: Got it. Turning over to people with taxable assets. Let's think about them in this situation, strategies that they might use to take advantage of the fact that their tax bills might be at a low ebb in 2020.

Levine: I would say certainly anybody who has losses, tax-loss harvesting is like your bread and butter. But while assets are depressed now from where they were, let's say a year ago or certainly at the start of the year, we've had a 10-year bull run and a lot of people still have gains. They're just lower gains than they were before. For those individuals who may be in a lower bracket, in particular, people in the 10% and 12% ordinary income tax bracket, which can be a lot of people, it's about $100,000 of income for a married couple. Once you back out that standard deduction, gets you back to the 12% bracket. So a lot of people still fall into that, especially in those years between, let's say, retirement and Social Security, required minimum distributions, etc. So the ability to potentially sell gains that you have with positions with long-term gain at a 0% capital gains rate is huge.

For those who aren't aware, if you're in the 10% or 12% bracket, you can sell gain up to the maximum part of that bracket, the 12% ordinary income tax bracket, and they will be taxed at a 0% capital gains rate. You might say, "Well, Jeff, why would I sell when the asset is so depressed? I don't want to do that." OK, fine, sell it, and then buy it right back. You can sell it in the morning and buy it back in the afternoon, and that'll be fine. There's no wash-sale rule. That's the number-one question I always get like, "Well, Jeff, what about the wash-sale rule? 30 days." And it doesn't apply because it only applies to losses. We're trying here to get a game that's taxable at the 0% rate. Paying a 0% tax is actually better than not paying a tax at all because it increases your basis.

Benz: Want to look at one last scenario with the CARES Act: People will not have to take required minimum distributions in 2020. Let's talk about people who find themselves in that situation, where maybe their tax bracket will be lower because no RMDs. Any strategies for them?

Levine: Again, looking at a low income year, let's accelerate income. If you don't have to take it a required minimum distribution, maybe you substitute that distribution with a Roth conversion. Now, notably for individuals subject to required minimum distributions, they typically have to satisfy that required minimum distribution first and then and only then can they convert on top of it. In other words, the RMD itself can't be converted. This year may be a little bit of a golden opportunity in order to convert at lower income levels and replace what would be your normal distribution with a Roth conversion. Obviously, those who have already taken distributions earlier this year that perhaps they don't want anymore because they only took them thinking that they had a requirement minimum distribution, they can look to potentially put those dollars back into an IRA or other type of retirement account if they're, let's say, within the 60-day window. That would be an easy way just to roll it back and keep your income low that way.

Benz: Well, Jeff, as always, you are a wealth of information. Thank you so much for taking time out of your schedule to be with us today.

Levine: No, it's always a pleasure. Thanks again for having me.

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