[This is a guest post from Bogleheads investment forum participant Bob's not my name.]
Wouldn’t it be great to have a Time Machine that would allow your money to travel back and forth in time and from place to place, seeking out the lowest tax rates? Well, you can build one yourself with IRAs.
Deductible traditional IRAs allow a couple to spirit a $10,000 chunk of income to a better time and place. This is well known and understood for retirement — you protect that $10,000 from the high tax rate of your working years and possibly from the high tax rate of your state, and you pay tax (possibly 0%) in your low tax rate years and possibly in a low tax state to which you have retired. But it’s less commonly recognized that the time travel could be over a much shorter period — even just a few days could save you thousands of dollars.
Here are some examples:
(1) Contribute To Deductible Traditional IRA When You Are In Tax Credit Phaseout
Say you’re 50, married filing jointly, with one spouse not covered by a retirement plan, your gross income is $200,000, and you have twins graduating from college in calendar year 2012 and going on to graduate school.
You max out your 401k ($22,500) and have $4,000 of pre-tax health insurance premiums and $2,500 of Flexible Spending Account contributions, so your AGI is $171,000. That makes you fully eligible for a deductible spousal traditional IRA, but let’s say you can’t afford that because you want to help your kids pay for graduate school.
You’re in the 25% federal bracket, but the American Opportunity Credit phaseout increases your federal marginal rate to 50%. So in early April 2013 you realize you can make a deductible $6,000 contribution to a spousal traditional IRA and immediately withdraw it.
Your 2012 AGI and taxable income drop by $6,000, saving you $3,000 in federal taxes. Your 2013 income increases by $6,000, costing you only $1,500 in federal taxes, so overnight you can save net $1,500 in federal taxes.
There is no withdrawal penalty because you used the traditional IRA to pay graduate school tuition. The net savings apply whether you withdraw immediately, leave it there such that you contribute to a 2012 traditional IRA instead of a 2013 traditional IRA, or convert the traditional IRA to a Roth IRA vs. doing a direct Roth contribution.
In the withdrawal or conversion scenario you’ll also avoid $300-$400 of state tax if you live in Illinois, Kentucky, or Oklahoma (states that don’t tax IRA withdrawals regardless of age).
(2) Contribute To Deductible Traditional IRA When You Are Moving To a Low-Tax State
Now let’s travel through time and space. Helmets are not required.
Let’s say you’re a young couple renting in California and you are planning to move to Texas in 2013 and buy your first home there. Your gross income is $125,000, and you both max your 401k’s, so your AGI is below $92,000 and you’re both eligible for deductible IRAs.
You move to Texas in March 2013 and you realize that if you make two $5,000 contributions to traditional IRAs and immediately withdraw them for your first home purchase you can dodge California’s 8% tax on the $10,000, saving $800.
The withdrawal is free of federal penalties because it’s for a first home purchase, and free of state tax. The net savings apply whether you withdraw immediately or convert the traditional IRAs to Roth IRAs vs. doing direct Roth contributions.
(3) Contribute To Deductible Traditional IRA For a Free Scholarship
Let’s say you live in Illinois and you have a kid at Johns Hopkins. She does her internship in Baltimore in the summer between her sophomore and junior years, and plans to spend the following summer counting bosons at CERN and making no taxable pay.
In the spring of her junior year, she could contribute $5,000 to a traditional IRA, thereby reducing her taxable Maryland income for the prior tax year and saving $400 in state and local taxes and $500 in federal taxes. Then she withdraws the traditional IRA funds.
There’s no penalty because she’ll use the funds to pay for college. She has no other income that year so she’ll pay no federal tax, and Illinois doesn’t tax traditional IRA withdrawals, so "repatriating" and “revintaging” a $5,000 slug of income avoids $900 of taxes. Not bad for a little paperwork.
(4) Contribute To Deductible Traditional IRA When Your Income Is Temporarily High
Let’s say you’re a couple married filing jointly with one breadwinner and one child. Your base income is $110,000, so in a typical year you get down to the 15% bracket (with $5,000 of headroom) by maxing your 401k, and then you contribute to a Roth IRA, which makes sense in the 15% bracket.
In 2012, however, you win your employer’s Invention of the Year award and get a $25,000 bonus. Now you’re in the 25% bracket and you’re in the child tax credit phaseout to boot, so your federal marginal rate is 30% on your top $5,000.
So in March 2013 instead of a Roth IRA you make a $5,000 deductible contribution to a 2012 traditional IRA in the non-working spouse’s name. Your 2012 federal taxes are reduced by $1,500. You immediately convert to a Roth, but the tax rate on the 2013 conversion is only 15%, so the end result is the same but you avoided $750 of federal taxes.
The theme here is that you can use a deductible traditional IRA to shift income forward to a more advantageous place or time. Of course this only works in particular circumstances, but it’s a tactic to be considered when there is transition or discontinuity in your tax situation. [Note from editor: Many people can contribute to a deductible traditional IRA than they realize. See previous post The Forgotten Deductible IRA.]
Forward time travel is easy to grasp. What about going back in time? Can your money do that, too? You bet. See Part 2 next week.
[Photo credit: Flickr user Chaotic Good01]