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Christine Benz: Hello, I’m Christine Benz for Morningstar. Many people will find themselves in a hopefully temporarily low tax bracket in 2020. Ed Slott, an expert in tax and retirement planning, shares with me some strategies for people in this situation.
Ed, thank you for being here.
Ed Slott: Thank you, Christine.
Benz: Ed, let’s discuss some of the main reasons people might find themselves in a temporarily lower tax bracket. Of course we have higher unemployment rates than usual, but what else could be taken into account?
Lock: Well I’ll stop you right there When people become unemployed, this is an excellent point. Most people, I don’t know if they realize that this is taxable income. So you have some people who actually had more unemployment, not all, but there were some people on $ 600 a week who were getting more than they were earning before. This is taxable but what you are really talking about and I’ve seen it with businesses across the country because I speak to a lot of consultants and there are a lot of small businesses, as you know, the local restaurants that are being destroyed and these can be small ones Be pass-through companies, sub-companies, and partnerships where the revenues and losses are passed directly to the owners of the company. Some of these people have tens of thousands of dollars in negative income from the losses – the losses of 2020 – that will pass from their business to their personal earnings. That’s awful, but a lot of them expect to come back in 2021 or 2022 when things change. So they can take advantage of some of those losses.
One thing I always have to tell the adviser or consumer if you are one of these business owners and have an IRA: convert that IRA to a Roth. Consume these huge losses. You may be able to move, and this can be a one-off event. Take advantage of that – like the silver lining, turn lemons into lemonade or whatever the saying goes – take this IRA. Let’s say you have a loss of $ 20,000 or $ 30,000, that’s $ 30,000 that you can switch to a Roth IRA for free. Or even if you have a lower income, you may not have a loss, but your income is much lower – another rock bottom way to convert to a Roth. We have low brackets anyway, but some people are in unusually low brackets because of the pandemic and loss of income.
Benz: Another factor that could potentially cause a loss of income for some people is the fact that we did not require minimum payouts in 2020. This could be another argument for people who are not subject to RMDs to consider conversions as well.
Lock: Yeah, that’s a great point. Usually in a normal year that we hope we have a day in a normal year you have RMDs. They were required to have minimum distributions. The CARES Act waived these for 2020. In a normal year when someone is subject to the required minimum payouts, these RMDs cannot be converted into a Roth. So if you want to convert once you are subject to RMDs, you must first take that taxable RMD, pay tax on it and you will not be able to convert it. You can then convert the rest – part of the rest – of your IRA balance if you want, but it costs more because you had to take the RMD and pay tax first. For the rest of 2020, and those days go by, if you normally would have been subject to RMDs but have now been waived those, you may want to volunteer to take some money out and convert it to a Roth while having that closing window of opportunity convert a non-convertible amount – an RMD. But it is no longer RMD so you have the option to convert. It can 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 conversion closing window that you cannot convert to at the beginning of the RMDs because the RMD cannot be converted.
Benz: So possibly an opportunity here. One thing you hear a lot about these conversions is where do you get the money to pay taxes from? And that could be a problem for people on low incomes. Is it important to have the funds outside of the IRA so you don’t have to withdraw additional funds from the IRA to pay the taxes due on this conversion?
Lock: I will do 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 where from. Remember, if you go back a few years, the Tax Cut and Jobs Act made Roth conversions permanent. There is no undo, no “backsies”, no turning back. We used to be able to re-characterize Roth conversions. Do you remember those days? That will not do. They are permanent. So first of all, 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 for the second part: Where should I get the money from? Ideally, you want it from outside the IRA so that the entire amount can be converted. But if you don’t have it out there, taking it out of the IRA funds themselves isn’t the worst thing in the world unless you’re under 59.5 as the unconverted amounts come with a 10% ige Would be punished. You never want to be fined for the conversion. But let’s say you’re 59.5 or older: All right, you’re converting a little less because you used some of that IRA money to pay the tax. Either way, you’ll benefit from unprecedented low tax brackets this year, and as you said, many people will have lower incomes this year and can convert. Anytime you can move money from an IRA or Roth at a low cost, this is a great tax move.
Benz: These are strategies for people with traditional deferred tax accounts. Let’s talk a little about taxable assets. People have heard of tax loss sales. They may have some tax loss sale candidates in their portfolios this year. But let’s talk about harvesting tax profits – how that might make sense for people who are in a lower tax bracket on capital gains, or even in the 0% tax rate on capital gains.
Lock: Yeah, you know, people talk a lot about the 0% capital gain rate. And if you look at the tables, I’ll look at them now, married 0% – married – this is long term, stocks hold for 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 even though we talk about it all the time like it’s a real thing. It’s a real thing, but that’s how the tax law works. Your ordinary income is taxed first. So, your normal income, let’s say, for example, you performed a Roth conversion. That consumes that zero to 80,000 brackets. For example, if you had wages or other income – business income, Roth conversion, interest, dividends – and there were more than 80,000 married joints, for example, you won’t get the 0% rating. Most people will likely fall into the 15% rate, which is still a pretty good deal. And as long as you know, that’s the rate. We don’t know what will happen next year. And remember that after 2025 we will return to the pre-tax rate and employment law. So, whatever you call it, it may be worth making and reaping some of these profits. We always talk about harvesting losses. But what that means, it locks up those low capital gains rates, just like I talked about protecting the low income tax rates. The same applies to the capital gains rates. However, don’t expect to get the 0% rate. Most people don’t understand.
Benz: That’s a good point. Let’s talk about strategies that might result in a deduction, such as: B. charitable donations. How should people who are in a temporarily low tax year think about these deductions? Should they save them for a year when they could give them more bang for their buck? Or how should you approach this question?
Lock: When you talk about deductions for people listing, most people aren’t. You really have to have a lot. So an example could be high medical costs. But if you’re hard enough to break down, it may be worth breaking down now. But your point is well received. Just as you like to report income when interest rates are low, you want to take advantage of the deduction when interest rates are high. Deductions are worth more at high rates. You get more tax bang for your buck. So if you can push these prints forward when you think you have them and bundle them up save them and say do them all next year if you hope things get better and you have a high enough income, and you These tax deductions will hit me better.
Benz: Ed, really helpful summary and on time. Thank you for being here.
Lock: Many Thanks.
Benz: Thank you for watching. I’m Christine Benz for Morningstar.