Since I was traveling last year and had almost no earned income, I decided to look for some ways to take advantage of possible tax savings before the year ended.
I have some investments in index funds and it seemed like a good idea to sell some of them as the major indexes hit record highs last year. I found out that long term capital gains are taxed at 0% if your earned income is within the 15% tax bracket.
I also have a Traditional IRA and Roth IRA accounts and since my situation last year put me in the lowest tax bracket, it seems like a good idea to move some of my funds from the Traditional to the Roth. I figured it’s less likely that the tax brackets would be lower in the future.
The tax brackets for 2013:
- 10% Up to $8,925
- 15% Up $36,250
Tax Saving #1 – Long term capital gains
I sold some of my funds in my individual account which earned me long term capital gains. These capital gains won’t be taxed as I was below the 15% tax bracket.
If your earned income is $0, you can have long term capital gains up to $36,250 (the 15% bracket) and you’ll get taxed 0%. Long term capital gains over that will be taxed at 15%.
This worked out very well for me as the markets did very well last year and I earned a pretty good amount selling my funds.
Tax Saving #2 – Move funds from Traditional IRA to Roth IRA
Normally, you want to put money in a Traditional IRA if you’re expecting to be in a lower tax bracket when you start withdrawing money from it since the money put in is pre-taxed.
For example, if you put money in there when you’re in the 25% tax bracket, that amount won’t be taxed until you withdraw them in the future. So if you start withdrawing from your Traditional IRA in the future when you’re in the tax bracket of 15%, it will only get taxed at 15%.
With a Roth IRA it’s the opposite. You get taxed now but you don’t get taxed in the future when you make your withdrawals. So if you expect to be in a higher tax bracket in the future, it’s a great option. Also, with a Roth, there’s no penalty when withdrawing contributions before you’re 59.5 years old.
Since I was pretty much in the lowest tax bracket last year, it was the best time to convert. One important thing to keep in mind when making the conversion: don’t withhold any taxes. If you withhold taxes you’ll end up paying the 10% early withdrawal penalty. Pay the taxes now. The converted amount is taxed at your marginal tax rate.
I also had to factor in dividends I made last year. I read mixed things about it, I found a website mentioning that dividends are considered earned income and another website said it isn’t. To be safe, I considered it earned income.
So if I have $1,000 in dividends and no other earned income, I’ll subtract that from $8,925 (the 10% tax bracket), allowing me to convert $7,925 and only pay 10% in taxes.