Finding the Silver Linings in a Lower Income

Finding the Silver Linings in a Lower Income

My wife and I didn’t make all that much money in 2014.

The big reason for that is that I’ve spent the entire year building up my financial planning practice. And while it’s steadily grown throughout the year, the reality is that I will earn much less in this first year of business than I earned at my previous job. It was an expected change, and it was exactly why I was so happy to have my emergency fund to help me through the transition.

And while everyone hopes to make more money, there are some silver linings to having a year with lower income than normal. In fact, we’re taking advantage of our lower income in two specific ways, both of which are long-term moves that will save us money on taxes years down the line.

Here are the two tax moves we’re making to take advantage of this year with a temporarily lower income:

  1. Converting a Traditional IRA to a Roth IRA, and
  2. Selling some of our investments to avoid taxes

Converting to a Roth IRA

My wife had a retirement plan at her old job, and when she quit it to stay home with our first son we decided to roll that money over into a Traditional IRA. And that’s where it’s been sitting for the last 2.5 years.

If you have a Traditional IRA, the IRS gives you the option of converting it to a Roth IRA. The advantage of doing so is that money within a Roth IRA will be tax-free when you withdraw it in retirement. The disadvantage is that the amount you convert is counted as income in the year of conversion, and you therefore have to pay taxes on it. (Click here for a more detailed comparison between Traditional and Roth IRAs).

But because our income is low this year, the taxes we’ll have to pay on that conversion are minimal. All of our various deductions and credits will wipe out most of the tax liability. Which means we get to:

  1. Convert the money to a Roth IRA basically tax-free, AND
  2. Eventually withdraw the money tax-free.

Pretty cool, right? It’s not a huge amount of money, but every little bit helps. Especially when you’re keeping more money in your account and out of the hands of the IRS.

Avoiding taxes on investments

In addition to the money we have in our emergency fund and our dedicated retirement accounts, we have a little bit in a regular investment account with Vanguard. We like having it there because we can invest it just like we would in a retirement account, but the money is a little more accessible in case we want to use it for other goals (because, you know, you ARE allowed to enjoy life before age 65).

The disadvantage of a regular old investment account is that there are no special tax benefits. So when you invest and the money grows over time, any amounts you earn above what you have contributed will eventually be taxed.

But there’s an exception. Our tax code is weird, and for some reason investment income is treated differently than regular income. Investment income is actually called “capital gains”, and it’s categorized into two different types:

  • Short-term capital gains – When you sell an investment that you’ve held for 1 year or less, it’s taxed at the same rate as the income you earn from your job.
  • Long-term capital gains – When you sell an investment that you’ve held for MORE than 1 year, it has special tax rates. It’s taxed at 15-20% if you’re in the 25% Federal tax bracket or higher. BUT if you’re Federal tax bracket is 15% or below, your long-term capital gains are not taxed at all!

We will definitely be in 15% Federal tax bracket or below this year, so what we’re going to do is sell the investments we have in our regular investment account. We’ll have a few thousand dollars worth of long-term capital gains on the sale, but they won’t be taxed! Then we’ll just buy back the exact same investments, but they will no longer have those few thousand dollars just waiting to be taxed.

I know this is all a little complicated, but we’ll have effectively done is take a few thousand dollars that probably would have been taxed eventually, and turned it into tax-free money.

If you want to learn more about how this process works, here’s a good resource: Tax gain harvesting.

Here’s another one on the basics of capital gains.

We talked to our accountant before doing all of this

Taxes can be complicated, and a move that looks good on its own can often have negative consequences for another part of your tax return. So while all of this sounded like a great idea in my head, I asked my accountant about it before actually pulling the trigger.

What I wanted to avoid was making a big mistake. I’m lucky that I have a decent understand of taxes just because of my financial background, but there’s no substitute for talking to a professional. I might be able to come up with good ideas, but he was the one who could see ALL the angles and tell me if I was missing something big.

Luckily he gave me the go-ahead, and now we have at least a couple of silver linings to take away from a year without a ton of income.

Have you ever had a year where you earned less than usual? Did you do anything to take advantage of it?

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6 Comments... Read them below or add one of your own
  • Olivia December 16, 2014

    This is really interesting, thanks! We are a fellow young family with 2 young kids in the 15% tax bracket and are living on one income. We THINK this is our “year before the low income year” as my husband is planning to make a career change in 2015 that will drop us down to the no-tax-liability territory at first (federally, at least). This reminds me of your other post I recently came across which we are thinking probably gave us the push we’ll need to go heavier on the traditional IRA route for this year – I hadn’t realized the way you can convert to Roth later when income drops. Paying taxes NEVER sounds like a good plan to me! (We hung on to our money to contribute this year in savings to play around with tax scenarios at the end so now have the choice.) Evaluating how the Saver’s Credit impacts things was probably our main reason for leaning that way…kind of like a partial use-it-or-lose-it retirement “match” from the IRS.

    Curious about the second point here – selling non-retirement investments. I didn’t realize you could avoid the long term capital gains tax at certain tax brackets. In fact, we haven’t really delved too much into non-retirement investing. But that’s good to know! But I wonder, does that impact the Earned Income Credit? At a year with lower income where one might be in EIC territory, is that credit jeopardized if you sell too much investment money? Maybe you want to keep yourself just under a limit? Just wondering if that would end up being a case by case thing to weigh. We’ve never had enough investment income to threaten the EIC. (Although personally, this might have been a great year for us to sell if we had anything to sell because we just missed the EIC but are still in the 15% bracket. Then again, we’re also playing around with contributing a little extra to multiply our Saver’s Credit…I guess you could come up with scenarios forever! You have to draw the line somewhere.)

    • Matt Becker December 16, 2014

      Great input Olivia! Your question about the EIC is a really good one, and the answer is yes, recognizing these investment gains can affect your eligibility for that tax credit. I’m not a CPA, and therefore these complex tax interactions really aren’t my specialty, but looking here for 2017 it appears that having more than $3,450 in investment income would disqualify you for the Earned Income Tax Credit. It would also affect your AGI, which could affect your eligibility. So you’re absolutely right to be thinking ahead about all of these factors and figuring out which route actually benefits you the most.

      And yes, the ability to convert to a Roth in a low-earning year is big reason to strongly consider a Traditional IRA. I actually wish we had more money in Traditional accounts so that we could convert even more this year. Here’s an article that goes into detail on exactly how powerful this conversion strategy can be (assuming that the government keeps the rule as is for an extended period of time, which certainly isn’t a given): Early Retirement Withdrawal Strategies and Roth Conversion Ladders from a Mad Fientist.

      All of this stuff can get complicated pretty quickly, which is exactly why I talked to me accountant before doing any of it. Sounds like you guys are considering all the right things though! I’d love to hear more about what you end up doing next year, so feel free to keep me updated!

  • Money Beagle December 16, 2014

    That’s actually great that you were able to turn a negative into somewhat of a positive. That should be something that will pay dividends way down the road when you retire, and will likely offset the income lost this year. As long as the reduced income is more of an aberration, you actually have a good shot at coming out ahead in the long run.

    • Matt Becker December 16, 2014

      Exactly. Our income this year should definitely be an aberration (at least we hope so!), so it’s just a great chance to take advantage of a few things while we can.

  • Emily @ evolvingPF December 16, 2014

    We are likely going to sell the taxable investments that have been growing for the last 3.5 years by year end (as opposed to early January) because we are still in the 15% tax bracket for 2014 and we might be in a higher bracket in 2015 (here’s hoping!). It is a silver lining, as you said.

    I’m wondering why you are choosing to convert to the Roth after your (wonderful) articles on the advantages of the traditional IRA? Obviously every situation is different so I’m just asking about your own. Did you think that your family fell under that traditional recommendation that you made before, and if so did something change? Or did you always think the Roth would be better for you if you could do it in the 15% bracket?

    • Matt Becker December 16, 2014

      Good question Emily! Basically, this is a perfect example of why a Traditional IRA is so valuable. We got the tax deduction on the way in, and now in a year where we have enough credits and deductions to offset the income, we can convert to a Roth with (likely) no tax consequence.

      FYI, while I don’t know how the exact numbers will turn out, we likely won’t owe any taxes at all this year, even with the conversion. So this is one of those cases where the conversion is a no-brainer.

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