This is the second part of a four-part series.
When John Nersesian’s daughter left her Strategic Partner Manager job at DoorDash to travel in Italy, her income fell. That created an opportunity to recognize income in a year when she faced a lower marginal tax rate, Nersesian said.
The wealth educator sees a similar planning opportunity for some recent retirees in the years before Social Security and required retirement account withdrawals begin. He discussed how partial Roth conversions can fit into that window, and why the calculation should extend beyond a single year’s tax return.
Below is a transcript of the interview with Nersesian, edited for brevity and clarity.
Why can a lower-income year create tax opportunities?
John Nersesian: My daughter went to Italy last year. She spent a year traveling abroad. She left her job, she was an executive at DoorDash, and decided at this young age she wanted to take advantage of some travel.
During that year, her income was markedly lower than it was the year before and than what it will be in the future. Because she was in a low marginal bracket, it made more sense for her to accelerate her income.
She had options that we chose to exercise that year, realizing the income at a lower marginal tax rate. We recognized capital gains under the premise that they would be taxed at a lower rate in that year than they would in other years.
Another strategy for those who find themselves in a lower marginal bracket, whatever the circumstances might be, is to consider a Roth conversion.
A lot of us look at taxes focused on the immediate: What can I do today to save a few dollars in taxes? The more beneficial approach is: What can I look at on a multiyear basis, based on total taxes paid, that will lower my total tax bill, as opposed to simply the knee-jerk reaction of coming up with a lower number today?
How does filling a tax bracket work?
Bob Powell: One of the things I think about is this notion of advisers always talking about filling up your brackets. In the case of a Roth conversion, maybe not going above the next marginal bracket, right?
Nersesian: That’s exactly what we did with my daughter. Her income was much lower. We had some income capacity where that income could be recognized at a low marginal rate until she hit the next bracket.
We are subject to a progressive tax rate structure. The first dollar we earn is not taxed at the same rate as the last dollar we earn. Earlier dollars are taxed at lesser rates. Later dollars, or the last dollars earned, are taxed at that marginal rate.
Many of the strategies we’re discussing have the effect of either raising or lowering your income. It’s the marginal effect that we’re most interested in.
When might partial Roth conversions fit a retirement plan?
Nersesian: I certainly want my planner to sit down with me and run the numbers to determine whether a Roth conversion may make sense, given my circumstances. It doesn’t have to be the full amount.
[Consider] somebody who suffered a decline in income: I run a consulting business. I had a bad year. My income was very low. My marginal bracket is lower. Maybe I sit down with my planner and determine how much of my IRA I might convert to fill the lower rungs of my marginal tax bracket.
Another individual looks a lot like me in terms of age. I stopped working. I’m no longer generating a lot of income. I’ve got a couple of years before Social Security kicks in and a couple more years until RMDs kick in.
I’ve got a window where I might consider some partial Roth conversions to reduce the balance in my taxable IRA, to spread or lessen that tax hit, and to avoid the RMDs that would otherwise be required on those dollars.
Why consider Medicare costs and future taxes?
Nersesian: It’s not just the idea that if I get a big deduction, I offset the taxes that would be paid on that income. There are other secondary implications when I lower my income.
For those who are in the retirement phase of life, how about Medicare IRMAA premiums? That is a function of income earned. How about Social Security? When I eventually elect to receive Social Security, that will also be taxed based on my level of income.
Managing your income has the obvious impact of saving tax dollars today, but there are secondary implications as well.
Powell: I always think about this as a spreadsheet, a row-by-row, column-by-column, cell-by-cell exercise. People need to think about their lifetime tax exposure versus their annual tax exposure.
Nersesian: A lot of us look at taxes focused on the immediate: What can I do today to save a few dollars in taxes?
The more beneficial approach is: What can I look at on a multiyear basis, based on total taxes paid, that will lower my total tax bill, as opposed to simply the knee-jerk reaction of coming up with a lower number today?
Related: The year-end RMD trap: Why waiting until late December could cost retirees 25%
