Has your tax professional ever talked to you about creating income?
It’s a common misconception that saving tax today is always the best way to grow wealth. Your main objective should be to pay the least amount of total taxes possible throughout your life. In other words, you should try to pay the most amount of tax at the lowest tax brackets and defer the most income at the highest tax brackets. If you find yourself in a low tax bracket at the end of the year, then you should consider increasing your taxable income to take advantage of your tax situation.
There are two traditional methods of creating income: saving in Roth-style accounts and creating taxable conversions. The more common of the two is to save more in Roth IRA’s or Roth 401(k)’s and less in tax-deferred accounts. However, if this isn’t possible, you can also create taxable income if you have a Traditional IRA by using taxable conversions. A conversion is a transfer of money from your Traditional IRA directly to your Roth IRA. The value of the transfer is the amount of taxable income you have created. The money will then grow tax-free in the Roth IRA and all distributions will be tax-free as well.
You can determine if creating income is right for you based on two factors: your current tax bracket and your expected tax bracket in retirement.
Your tax bracket is the percentage of tax you pay if you were to have an additional dollar of income. If you will have a lower tax bracket in retirement than right now, then it makes sense to save in your 401(k) account and reduce current income. However, you may have a higher tax bracket in retirement than you do right now. If that’s the case, it may make sense to create income.
When does creating income make sense?
For people that have a gap in their income during the year, it may make sense for you to create income to take advantage of your lower tax bracket for that year. If you are a postgraduate just starting work and you will only be working for the last half of the year, it is best to save in Roth-style accounts. Your tax bracket for the year will likely be lower, so saving in a tax-deferred account is less beneficial.
Another circumstance where it may make sense to create income is during retirement but before you start collecting social security. Social security is taxed differently from regular income. You are only taxed on 85% of the benefits and that begins at taxable incomes in excess of $25,000 or $32,000, depending on your filing status. Your income goes up by 185% for every additional dollar of income over this threshold. This essentially doubles your tax bracket and could lead to you having a tax bracket as high as 40% in retirement. However, this also leaves you with a planning opportunity: if you create more taxable income before you collect social security, you minimize the doubled tax bracket by taking more distributions from your Roth IRA instead of your Traditional IRA. Paying tax at a 22% rate to avoid paying tax at a 40% rate is a wealth creation strategy that will make your retirement savings last much longer.
What about capital gains?
Capital gains are taxed differently than ordinary income as well. You can actually have a 0% tax rate on capital gains if your income is below a certain threshold. If you have highly appreciated securities like stocks or index funds and the ability to take on income at the 0% capital gains rate, then it may make sense to sell the asset. You can immediately purchase the asset again if you want to remain invested but still recognize the capital gain. The IRS doesn’t like it when you sell an asset for a loss and buy it back again, but they have no rules against selling an asset for a gain and buying it back the next day. If you are in the 0% capital gains threshold, it would be wise to take advantage of it whenever you qualify.
Let’s look at two examples:
Logan and Karly are retired but not collecting social security yet. They are currently in the 12% tax bracket. They choose to create $20,000 of income and pay $2,400 of additional tax. By doing this, they will avoid paying $4,400 of taxes on that same $20,000 of income once they are collecting social security. This helps them save $2,000 on taxes by creating income before they move into a higher tax bracket. If they were to do this strategy for 5-10 years, they would save tens of thousands of dollars of taxes over the course of their lifetime.
Alex and Amanda are both quitting their jobs and using their savings to travel the world for a year. They will not have any income this year unless they create income by utilizing a taxable conversion. Since they are married, they are allowed $24,000 of income tax-free because of the standard deduction. They can move $24,000 of money from their Traditional IRA to their Roth IRA without paying any tax saving themselves $5,280 of tax in retirement.
There are many other circumstances where it may make sense to create income, but the prevailing theme is to create income and pay tax now IF you will have a higher rate later. It is also very important to have tax diversification in retirement. You do not want to have all of your assets in only tax-deferred accounts that are subject to whatever the tax brackets at that time are. Instead, build wealth efficiently in each type of tax account and move assets between the accounts if the tax implications are favorable for you.
You should discuss these strategies with a professional tax advisor before implementing them to ensure they benefit your particular tax situation. Reach out to us if you would like to explore this tax planning strategy or ask any further questions.