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:
- Converting a Traditional IRA to a Roth IRA, and
- 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:
- Convert the money to a Roth IRA basically tax-free, AND
- 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?