Don't Miss Out on Using Your Low Income Year to Increase Your True Hourly Wage
This post is slightly more technical and not specific advice for your situation. I highly recommend speaking with a fee-only Certified Financial Planner if you are looking into implementing this strategy to make sure you get it right.
Having a year when you earn less income than is typical for your household can be a stressful time. Maybe you have lost a job or are transitioning jobs. Maybe you are going back to school to earn a degree. Maybe you are simply taking a break to hike in Patagonia, or have switched to a lower paying job. Although a temporary reduction in income can cause some stress, it often provides one of the greatest opportunities for your long-term financial future. And sadly, most people don’t take advantage of this opportunity.
Pay taxes now while your income is low.
The opportunity I am talking about is to pay taxes on future dollars now while your income is low. There are several ways to do this but I will touch on the easiest and most powerful way here.
As an example, let’s assume you are taking the year off to pursue an advanced degree of some sort and then plan to re-enter the workforce. So, during the year that you are in school you will be either living off of your savings or off of student loans. Let’s also assume that you have some pre-tax employer retirement account money from the employer you left in order to go back to school. This sort of example is one of the best opportunities to have a huge impact on your future income, but most people miss it.
Consider converting some, or all, of your pre-tax retirement accounts into a ROTH IRA.
Contributions to your pre-tax retirement accounts give you a deduction on income when you contribute to them. They then grow tax-deferred and the withdrawals from them in retirement are then added to any other income you may have at that time and it is taxed depending on what tax bracket that pushes you into. This can be a good thing when you are earning a lot now and will have significantly less income in retirement.
However, income in retirement, including withdrawals from pre-tax retirement accounts, can be a little sticky and cause things like your social security income to also be taxed at higher rates. So, it is generally a good idea to consider “converting” some, or all, of those pre-tax funds into tax free accounts when you have little or no other income, which means the conversion will cause little to no tax now. The funds can then grow tax-free, in a ROTH IRA for example, and will be tax-free when they are withdrawn in the future. This means the withdrawals that you take from the ROTH IRA will not impact the tax liability you have on other income at that point, including social security.
Converting pre-tax retirement funds to a ROTH IRA may even be tax-free.
Depending on your current income tax bracket, the state you live in, whether you are married or not, and other factors, you may be able to convert a certain amount of your pre-tax accounts completely tax-free.
If we continue with the example above, assuming you will have no income this year, and also assuming that you are married and have two kids, you may be able to convert over $55,000 in pre-tax retirement funds into a ROTH IRA completely free from federal taxes. This is due to the standard deduction ($24,400 in 2019) and child tax credits ($2,000 per child in 2019) that you would be eligible for. If you are extra special and live in a state that has no income tax, you will also pay no state tax on this conversion.
To summarize and think about this example in simpler terms; you paid no income tax on the $55,000 when it went into your pre-tax retirement account, you convert it with no tax into a ROTH IRA, which then grows tax-free and can be withdrawn tax-free. If it grows at an average of 7% for 30 years that $55,000 becomes $446,407! All tax-free! However, if you had missed the opportunity to convert the funds in your low income year, all of that $446,407 would be taxable when you withdraw it.
Again, this post is slightly more technical and not specific advice for your situation. I highly recommend speaking with a “fee-only” Certified Financial Planner if you are looking into implementing this strategy to make sure you get it right.
I wish you all the best as you strive to provide greater value with your limited time.
Kyle Mast, CFP®