Over the course of a career, many individuals will experience a year or more with limited income prior to retirement. It could be the result of a multi-month break from employment or simply the decision to temporarily leave the workforce for graduate school. These situations present powerful opportunities that are generally only available for a limited time. Fail to exploit the opportunity and there may not be a second chance.
When presented, we advise clients or children of clients on how to take full advantage of these opportunities. The advice differs depending on the situation but some suggestions come up again and again. The tax saving tips outlined below are several of the most common opportunities to consider if you find yourself headed off to graduate school or taking time out of the labor market for other reasons.
- Exploit the Roth. A Roth IRA is generally the most powerful long-term financial opportunity for graduate school students or other individuals in an unusually low income year. Because of the tax-free growth available to Roth IRAs, the economics of a Roth IRA contribution or conversion work best when you have any of the following three situations: 1) a long time horizon for investments to grow tax free; 2) a low tax rate at the time of the contribution/conversion; and 3) higher personal income tax rates in the future.
Graduate school generally presents all three of these variables: young individuals with limited income and a successful future waiting. This is why the opportunity is so compelling. In order to make Roth contributions, a student must have earned income during the tax year which includes wages and salaries but not investment earnings. Depending on the financing costs, the math often works out to where it can be beneficial to borrow an extra $5,500 from student loans in order for a graduate student to make annual Roth contributions.
Roth conversions, rather than contributions, can be a better opportunity available to individuals with existing IRAs or 401k accounts from prior employment. Without the income created from a Roth conversion, temporarily low income tax brackets go wasted while tax deductions and credits often go underutilized. The Roth conversion creates taxable income which can be offset by deductions and credits or taxed at unusually low rates. In some cases, deductions and credits allow low income taxpayers to transfer (convert) assets to a Roth for free.
- Sell Winners. In addition to creating income from a Roth conversion, low income years also present a unique opportunity to take advantage of the relatively new 0% capital gains rate. Single taxpayers with taxable income below $37,450 and married taxpayers with income below $74,900 qualify for this 0% long-term capital gains rate. If you’ve been holding on to an individual stock which has significantly appreciated since grandma gave you the shares years ago, consider selling it to take advantage of the 0% rate. Free is good. There is no reason you cannot immediately buy back the stock – simply increasing your cost basis. We have previously written about a related strategy in which parents can give appreciated investments to a child in school and let the child sell at the 0% rate.
- Cash Old Savings Bonds. If grandparents or parents gave you US Treasury Savings Bonds (Series EE, Series E, or Series I) as a child and you’ve been wondering what to do with them, low income years can be a great time to cash them. In most cases, the income on these bonds is not taxable until they are redeemed or mature. Realizing the income during a year when you don’t have a significant amount of other income is generally wise. You should research when the savings bonds were purchased since it may be wise to hold bonds purchased before 1995 due to interest rate floors at the time.
- Use the Retirement Savings Contributions Credit. This tax credit is rarely publicized because the income limits are relatively low to qualify but it’s a powerful tax opportunity for individuals in a low income year. This “saver’s credit” rewards you for making IRA or employer-sponsored retirement plan contributions in a low income year. In some respects, it behaves like an employer provided retirement plan match where the employer matches some percentage of savings but the matching party here is the IRS. If you are married and have adjusted gross income less than $61,000, you can qualify for the credit ($30,500 for single filers). For individuals with existing savings but limited employment income during a tax year, it often makes sense to move money from the right pocket to the left by shifting dollars from a savings account to a Roth IRA. You qualify for the tax credit which can be as much as 50% of the IRA contribution amount and you get funds into a Roth IRA, which is almost going to be optimal to having the funds in a brokerage or savings account. This credit is not available to full-time students but it can be used for a married couple when one spouse is in school and the other spouse is working. It can also be used for the final year of graduate school when someone has a partial year of income and is no longer a full-time student at the end of the tax year.
- Utilize the Earned Income Credit. You must have limited employment income and less than $3,400 in investment income to claim the Earned Income Credit but for those who qualify, this credit is a valuable opportunity. The earned income limit depends on the number of qualifying children you claim, topping at $53,267 in 2015 for a married couple with three or more children. Taxpayers without qualifying children must be at least 25 years old to claim the credit whereas taxpayers with children do not face a minimum age requirement.
The part that can make the opportunity so valuable for graduate students with limited income is that the credit is refundable. This means that the credit, which can be as much as a few thousand dollars, is redeemable even if your income tax has already been reduced to zero.
- Run Expenses Through a 529 Plan. 529 Plans were established to promote long-term college savings but state tax rules provide a loophole that encourages using these plans for short-term savings. 35 of the 45 states with an income tax (including Washington DC) offer tax deductions for 529 Plan contributions. Most of these states do not have a waiting period on withdrawals which simply means that you can funnel graduate school expenses through a 529 plan (even proceeds from a student loan), immediately distribute the funds from the 529 Plan, and claim a state tax deduction up to the state limits. For residents of states such as South Carolina and Colorado where there is no limit on the deduction or in states with high income tax rates like New York, this strategy works very well. You can’t claim any education tax credits such as the Lifetime Learning Credit or American Opportunity Tax Credit with the same dollars that you use for this 529 strategy but as long as graduate school costs exceed $10,000, you have the ability to exploit both strategies.
- Claim the Child Tax Credit. Students in medical school, business school, or other graduate schools occasionally have children during the program or before the program begins. Assuming their employment income is limited (below $75k for a single filer, $110k for a married joint filer), these students can claim the child tax credit which could reduce income tax by up to $1,000 per child. One beauty of the child tax credit, like the retirement savings contribution credit, is that the less income, the bigger the child tax credit. Another benefit is that the credit can be refundable so that taxpayers benefit even without any income tax liability.
These are some of the tax saving opportunities that taxpayers in a temporal low income year can exploit but there are certainly others. As with any tax advice, it’s generally important to run the numbers or review the nuances to understand, for example, whether the 529 Plan technique works in your state or how much Roth conversion is appropriate.
Have other ideas for low income years or ways in which graduate school students can take advantage of the tax code? We welcome you to share them in the comments section below.