A low tax bracket is a terrible thing to waste!
When calculating your income tax liability, there are three core components:
- Gross income, which includes income from all sources
- Adjustments to income, which include items such as IRA contribution deductions and student loan interest deductions
- Deductions, which consist of either the standard deduction or itemized deductions such as medical expenses, mortgage interest, state and local taxes, and charitable deductions.
When your deductions completely offset or exceed your taxable income, you have an excellent opportunity to pull-forward taxable income to “use-up” your excess deductions or to use-up or “fill” the lower tax brackets. This allows you to distribute IRA assets, convert retirement assets to a Roth account, or realize capital gains with minimal tax liability.
For example, Alexa is 62 years of age, retired, and will wait until 67 to start Social Security income payments. In the meantime, she is using her non-retirement savings accounts to meet her spending needs. Presuming her gross income is $0 and she uses the standard deduction of $12,550 (Federal, 2021), her standard deduction will go unused because there is no income to offset. Instead of wasting her deduction, she has the opportunity to create or pull-forward taxable income with taxable distributions from her retirement account. In this example, a taxable IRA distribution of $12,550 would be completely offset by the $12,550 standard Federal deduction and result in paying a 0% rate on assets for which she has already enjoyed the contribution deduction and long-term tax deferral.
To take it a step further, she could distribute twice the amount ($25,100) and pay a low Federal rate (10-12%) on the excess distribution. This could be ideal if she is certain she will be in a higher tax bracket in the future as a result of Social Security income at 67, a required distribution from her retirement account at age 72, or as a result of changes in tax policy. While there is a scheduled tax policy change at the end of 2025 as a result of the expiration of some provisions of Tax Cuts and Jobs Act, the tax landscape could be modified in the near-term under the Biden administration.
In summary, if your deductions exceed your taxable income or if you are in the lowest brackets, you may have an excellent tax planning opportunity. Please contact Gamble Jones or consult with your tax adviser to explore your unique tax bracket situation.