If you Have Been Furloughed, Here Is One Way to Take Advantage of it
Until now you had a rather large yearly income from a very good job. Until now you did the right thing by contributing the maximum you could into the 401K of your employer. Or perhaps you were a self employed consultant. Until now business was good and you contributed the maximum you could into your SEP IRA. Now business activity has dropped tremendously, the amount in your 401k or SEP IRA has dropped with financial markets and your 2020 yearly income looks grim. What can you do to finesse the very poor cards you were just dealt?
401K, SEP IRA, regular IRA, all three have features in common. You contribute pretax money into these accounts, contributions to these accounts lowers the income tax you will pay for the year of your contributions. In these accounts the capital grows tax free and is only taxed at distribution. So it is particularly important for you to contribute to these accounts for the years your income is high, protecting you from higher income tax brackets.
Below is a table from the IRS showing the federal tax brackets for 2020. These data (and the table for single filing) are also available on Investopedia.
Married Filing Jointly Taxable Income Tax Brackets and Rates, 2020
RATE……………….TAXABLE INCOME BRACKET
10%…………………$0 to $19,750
12%…………………$19,751-$80,250
22%…………………$80,251-$171,050
24%…………………$171,051-$326,600
32%…………………$326,601-$414,700
35%…………………$414,701-$622,050
37%………………….Over $622,050
As you can see, it is quite possible that your marginal tax bracket may drop substantially in 2020. Furthermore, states and even local communities may add up to this federal income tax. Some states have no income tax, some use a flat rate, but most apply progressive tax brackets to your income. So if your federal tax bracket will drop in 2020 it is likely that your state income tax bracket will do the same. You need to check your specific income and state situation with your accountant.
There is another category of tax shelters: Roth IRA, Roth 401K. The contribution into this type of account is “post tax”. In these accounts the capital grows tax free and is distributed later free of tax. If you are in a low tax bracket these accounts should be preferred to the IRA type. It is better to pay low taxes now rather than a higher rate later at distribution. In fact, corporations who have a 401K should consider adding a Roth 401K option which would be preferred by its lower paid employees.
Low tax bracket — — — — — — — -> prefer (Roth/Roth 401K) to (IRA/SEP IRA/401K) contributions
Individuals should consider having both types of accounts. They should prefer to contribute in the Roth for the years of low income and prioritize the IRA for years of high income. Furthermore, having both can also help optimize taxes during retirement. Distributions from the Roth could be preferred for years of high income, distributions from the IRA could be prioritized for low income years. By having both types of accounts you can effectively optimize both contributions and distributions.
In retirement
High tax bracket — — — — — — — ->prefer (Roth/Roth 401K) to (IRA/SEP IRA/401K) distributions
Unfortunately contributions to a Roth account are forbidden by the IRS if your income is too high. Check here for these precise limits. This is where Roth conversions come to your rescue. You are allowed to distribute from an IRA into a Roth IRA, regardless of your income. That distribution is taxed as income the year it occurs (you cannot withdraw without penalty your capital in the Roth for five years following the conversion). Still, this is a great way to move your capital into a Roth and enjoy its future benefits, at a low tax cost. Let me illustrate with our two examples.
Peter is married filing jointly, and the sole breadwinner for his household, he earned $30K over January and February this year but was furloughed early March. Even after the market drop Peter’s 401K still contains $250,000. What can Peter do for his own benefit?
- Being furloughed most likely allows Peter to roll his 401K over into a regular IRA. This has no tax consequences, therefore it can be done regardless of the fact that Peter may find another job this year. An IRA usually comes with less costs and more choices than a 401K, therefore in general this is a beneficial move for Peter.
- Not right now, but maybe in November 2020 Peter will have a better idea of his total income for the year. If he hasn’t found a job then he should consult with his accountant and choose an amount to distribute from his IRA toward a Roth. He may distribute $50K from his IRA toward his Roth. Why $50K? Because his total income for the year would then be $50K + $30K (January-February salary) =$80K which keeps Peter in a range with a marginal federal tax bracket of 12%. Peter also has to make sure that he has enough cash in tax exposed accounts to pay that income tax.
Doing this, Peter effectively moved 50K of his capital toward a Roth at an average tax cost below 12% (his marginal tax bracket is 12% but his average tax cost is somewhere between 10% and 12%) and that cost is less than he will ever experience in the course of his later year distributions. Also, Peter will now have both an IRA and a Roth to invest his portfolio. The Roth being tax exempt at distribution, Peter will choose to place his stock in the Roth rather than in the IRA so that the larger long term capital gains of stocks will be tax free at distribution. Peter will also be able in retirement to slalom between distributions from his IRA or his Roth depending on his income tax bracket the year of distribution. With his lemons, Peter made lemonade.
Mary is single, a self employed consultant she has been contributing into a SEP IRA. She earned $30K over the first two months of the year but business has now totally dried up. What should Mary do?
- Wait until November 2020 to be able to effectively predict her total 2020 income and consult with an accountant then. Note that Mary has no need to roll over her SEP IRA into an IRA. A SEP IRA allows direct conversions into a Roth, unlike a 401K.
- With a good approximation of her yearly income and consulting the tax bracket table for singles, Mary will open a Roth and convert from her SEP IRA an amount such that her total annual income keeps her in a low bracket. A calculation analogous to that of Peter.
Mary will enjoy similar benefits to Peter.
After talking to all of you clients of Anselme Capital, we have a sharp idea of the chaos this pandemic brings to you all. We aim to provide you with support of all kinds during these times. We are following the details of new legislation being voted on. We will report to you about everything we deem relevant to help you. Please let us know if you encounter short term cash flow problems or any kind of substantial financial change, we may have recommendations to help you.
Finally, I have two little nuggets for you.
I remember reading somewhere that Charles Darwin was depressed by what he saw as the devastating cost of evolution. These shifts that nature throws at us, forcing us to adapt, that made him feel really bad. But others say that Darwin’s recurring depression itself is what pushed him to study and led to his breakthrough discovery.
Pierre de Fermat was ethically forced as a judge of the Parlement de Toulouse not to socialize with the people he administered. His sustained isolation is what pushed him into his studies in mathematics leading him to major contributions.
Change is painful, there is no doubt about it. But shifting our lives to adapt can make us richer, broader. The benefits of our shifts may not show right away, not in the fire of the storm, but when done effectively, adaptation enhances our human capital. The most adaptive thrive.
Be safe, be cool,
Marc Anselme
