Many of you are wrapping up a low income year. You’re getting a business launched with little income and lot of effort. It could be a period of under- or unemployment. Or like many, you have suffered a significant catastrophic flood loss and not been made whole by your insurance company or FEMA. For more information on how much such a loss might affect your taxes, see my last column or IRS Publication 547 at irs.gov.
As painful as it might be, you don’t want to let a low income year go to waste. When clients start with us they provide their two most recent tax returns. Those times when I’ve seen very low or even negative income in years past, I’m frustrated at the lost opportunity. Don’t let this be you. Instead when your federal tax rate is low, take a look these options and enjoy the perks of low income.
Zero percent capital gains tax. If you’re in the 15 percent federal tax bracket or lower, which goes up to $72,500 of taxable income for married couples and half that amount if filing single, capital gains tax pulls a sly trick: it disappears completely. That’s right. If you’re in the 10 or 15 percent tax bracket for ordinary income, you’re in the 0 percent federal tax bracket for capital gains. So consider selling some investments that have increased in value over time. If you have stocks or mutual funds in your taxable account, consider selling them to recognize income that will not be taxed. You’ll still pay 4.6 percent state income taxes on the gains if you’re in Colorado.
Roth Conversion. With a Roth conversion, you’re taking an IRA or other pre-tax retirement account and moving it into a Roth IRA. It makes sense for most to have a significant percentage of wealth in a Roth because it’s tax-free money. When you take out a qualified distribution, you don’t have to pay taxes on the gains in the account. Roths also give you flexibility as you’re not forced to take retirement distributions and may have access to the funds before you retire. For estate planning purposes, Roth IRAs are wonderful. Your heirs under current law can get tax-free growth for their lifetimes.
The downside of Roth conversions is that you must recognize the amount you convert as ordinary income. If you convert $40,000 of your IRA into a Roth, in most cases this adds $40,000 to your taxable income. But if you are deducting a significant loss from a catastrophe, you may be in low or negative income territory. A Roth conversion allows you to benefit tomorrow from the low income tax bracket that circumstances put you in today.
End of year deadline. When you sell appreciated investments to recognize capital gain or convert an IRA into a Roth, remember that you only have until the end of the year to do this. If you project you will have a low income year in 2013, and you want to “use” your low tax bracket you must sell stocks for gain and complete the Roth conversion by the end of the year. Once we get into January, the opportunity has passed you by.
Amend last year for catastrophic loss. There’s one final wrinkle to consider when it comes to catastrophic losses related our floods in September. If you live in a county that was declared a federal disaster area, you have the opportunity to take the loss against your 2012 taxes through amending your return. Your accountant can tell you which option makes the most sense.