Clever Tax Move for the Un- and Under-Employed
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Dollar Coins on $10 Bill photo by Philip Brewer There are a lot of people who used to have a good-paying job but who have been unemployed or underemployed for more than a year. If you're one of those people, here's a clever tax move that can permanently cut your future tax burden.
If you used to have a good-paying job, you probably have some tax-deferred savings in an IRA or 401(k). You'll have to pay taxes on that money whenever you take it out.
So, here's the clever part: If you're unemployed or underemployed this year, your income is probably very low. If your income is low enough that you'll owe little or no income tax, seize this opportunity to shift a few thousand dollars from your IRA to your Roth IRA. The money will be taxed, but the tax will be near zero. And once the money is in your Roth, it'll be able to grow tax-free, potentially for decades, and then still be tax-free when you withdraw it. You'll have already paid the tax on it, only the tax will have been zero.
Of course, this tax move only works for a narrow slice of people, those who both:
- Have money in an IRA
- Have a very low taxable income for this year
But for that narrow group, the amount of tax savings could be substantial.
Note that it's too late to do this for last year. It is not, however, too early to start planning for this year. In particular, if your money is still in your former employer's 401(k), do a rollover to an IRA now, so that you'll be able to transfer the money to a Roth IRA before the end of the year.
How much should you move? That's kind of tricky. Ideally, you want to move as much as you can without having to pay any extra tax. But that's not so easy to calculate — it's about as much work as doing your taxes (and don't forget to consider state as well as federal). But, if you can steel yourself to crank through the numbers, the potential exists to permanently avoid ever having to pay the taxes that were only deferred when you put the money into an IRA or 401(k).
Especially for people forced into premature retirement, whose incomes are low now but will be higher once their pensions and social security kick in, this can be a great move.
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This strategy could work well for other investments as well. Suppose you are looking to rebalance your portfolio; now could be a great time to pay a minimum on capital gains taxes since you're in a lower tax bracket. Of course, you wouldn't reap those long-term tax benefits associated with the Roth but you could save substantially on taxes.
Although there may be tax savings, I would be very cautious about advising somebody who's been long-term unemployed about converting all or some of their 401(k) into an IRA.
If you lose your job and than something else bad happens like you get sick or can't pay the mortgage on your home, you may need to file for bankruptcy protection. A 401(k) cannot be touched by your bankruptcy creditors, but your IRA is fair game.
If you transfer that money to save a few pennies on taxes and then stay unemployed long enough to eat through your savings cushion and can no longer meet your bills, you'll get a nasty double whammy. First, you'll lose your IRA. Then, the IRS is going to come after you to pay the taxes on the money you took out of your IRA and (if Chapter 11) often will not "forgive" the taxes on that IRA you "used" to pay off your creditors.
The 401(k) may be boring and difficult to shift around your investment portfolio if you leave it sitting with your former employer, but at least it will be safe from your creditors if this recession drags on and your safety net goes down the toilet.
While you should certainly consult a bankruptcy attorney if you think these issues might affect you, my understanding is that since 2005, IRAs and 401(k)s are treated similarly in bankruptcy.
For IRAs only first $1 million is exempt, while money in a 401(k) is exempt without a cap, but that's not a threshold that's going to affect most people.
It's true that rules vary for different categories of compartments for holding assets, and for that reason I've long encouraged people to use all the compartments available to them. But those differences rarely add up to enough reason to leave your 401(k) with a former employer. The advantages of easier access, greater investment choice, more interested customer service, and (often) lower cost mean that rolling your money over into an IRA is usually a better choice.
So if i keep a low income i more less than likely to get taxed hard by the irs ? Sounds like a good plan to me even now in this economy. I want to learn more about this . keep up the good work Mr.Brewer
Thank you for this article! I read it last year and realized it applied perfectly to me, as an unemployed student who used to have a good job. I converted my 401(k) into a Roth IRA in 2010, and don't owe any money in taxes for the 2010 tax year. Thanks for the great tip! It certainly worked for me.