Take Advantage of Gaps in Income
For a variety of reasons, our incomes aren’t always stable throughout the course of our lives. For younger folks, it may be the pursuit of higher education or a job loss. For older individuals, it may be an early retirement. Either way, having gaps in income can create planning opportunities that we should consider.
For example, I worked for a few years before going to graduate school. When I started school, tuition credits lowered my tax bracket way down, even though I was still working. This temporary situation created the opportunity to convert IRA funds to Roth funds at a very low tax bracket.
Converting an IRA to a Roth involves paying taxes on the amount you convert. However, you are moving it into a tax-free account. So, when you withdraw those funds later in life, there is no tax. There’s also hopefully a lot of growth. The idea is to pay a little now to avoid paying a lot later. In many cases full time students who aren’t working can realize a good bit of income at a 0% tax rate. They would of course, need IRA assets to convert.
A similar opportunity can arise when people retire. We have run into many situations in which a client retires in their 60s, and delays Social Security and IRA distributions until they are 70. So, for the period between retirement and 70, there is often a gap in income. We can take advantage of this income gap to lower future tax liability. We call it “Tax Smoothing.”
Gaps in income are filled by either realizing capital gains (to lower one's risk level) or doing partial Roth conversions. In some cases, it can keep a retiree from going into a higher tax bracket for the rest of their retirement. The purpose of this strategy is to increase after-tax income.
It is particularly useful in survivor-ship scenarios. If one person in a couple dies, the survivor moves from filing jointly to filing single. Often the only change in income is a dip in Social Security. The survivor can be pushed into higher marginal and effective tax brackets. Having done partial-Roth conversions will help.
Furthermore, this can be a very powerful strategy when it is coupled with placing more risk in Roth accounts and less risk in traditional IRAs. Roth accounts accumulate tax free and have no distribution requirements.
We have developed a model that figures out how much of that income gap to fill. If you think this strategy may be right for you, we would love to discuss it with you and run some calculations.
Myles B. Brandt, M.S., CFP®