Those who experience a job transition (voluntary or involuntary) often have annual income levels that vary significantly during the transition period. Income fluctuations can be caused by severance payments, accrued vacation payouts, deferred compensation payouts, signing bonuses as well as a reduction in income if a new job is not secured immediately. Due to shifts in tax brackets, this fluctuation in income from one year to the next can create tax planning opportunities that would not exist if income was steady year to year.
Those in a job transition may find that their income will fluctuate from year to year. If that’s the case for you, there are opportunities to capitalize on tax planning. The key is to identify what your marginal tax rate for 2015 will be compared to 2016. This will determine if income and deductions should be recognized in 2015 or deferred to 2016.
If you expect to be in a higher tax bracket in 2015 than in 2016, you will want to defer income and recognize deductions wherever possible. Here are examples of strategies to consider:
- Pay estimated state taxes in December instead of January.
- Prepay real estate taxes.
- Sell investments at a loss (up to $3,000 can be recognized in a single year) and use proceeds to purchase a similar (but not identical) investment.
- Prepay your January mortgage to increase your mortgage interest deduction.
- Make additional contributions to your tax-deferred investment accounts (401K, IRA, etc.).
If you expect to be in a lower tax bracket in 2015 than in 2016 (and beyond) you will want to recognize income and defer deductions. Some strategies to consider are as follows:
- Take Roth conversions on an IRA up to an amount that will “fill up” the lower tax bracket.
- If over 59½, withdraw money from your IRA and pay taxes at the lower rate (assuming you were already planning on withdrawing that money in the next couple of years).
- If you separate from your company at age 55 or over, withdraw money from your 401K and pay taxes at the lower rate without paying the 10% penalty (this works for a 401K but not an IRA).
- Sell investments at a gain to lock in a lower capital gains rate. To the extent you are in the 15% tax bracket, your long term capital gains rate will be 0%.
- Do not pay your quarterly estimated state tax payment until January.
- Defer your Real Estate tax payment until January if possible.
In addition to shifting income and expenses between years, consider some additional tax strategies:
- Deduct job hunting expenses and other similar tax-deductible expenses, such as unreimbursed employee expenses, tax preparation fees, investment expenses, and safe deposit box fees. The caveat is that they are part of the Miscellaneous Itemized Deductions that are deductible only to the extent they exceed 2% of your Adjusted Gross Income.
- Be aware that you may qualify for tax credits as a result of a drop in income. Examples include the American Opportunity Credit, Lifetime Learning Credit and Earned Income Credit.
- Donate appreciated securities instead of cash to religious institutions and other charities. Your charitable expense deduction will be made at the current market value and you will not be taxed on the capital gain.
- Withdrawals of contributions from Roth IRAs are not taxed if the account has been in existence for five years or more. Conversions are also not taxed if the specific conversion was made at least five years ago. This strategy does not apply to earnings on either contributions or conversions.
- Make once-in-a-lifetime tax-free transfer from an IRA to an HSA for an amount up to the annual HSA contribution limit. This approach could help with covering the cost of medical expenses during a transition.
- Take withdrawals from an IRA or 401K and use for medical expenses in excess of 10% of Adjusted Gross Income without paying the 10% penalty (but you must pay the income tax).
- If you collect unemployment for 12 consecutive weeks, withdraw from your IRA to cover medical insurance premiums without paying the 10% penalty. This strategy does not apply to withdrawals from 401Ks. Again, you must pay the income tax.
- If you are currently paying for COBRA premiums, compare the cost of those premiums to the cost of a policy on the health care exchange. Going with an exchange plan could result in significant savings, especially if you qualify for a government subsidy. Open enrollment for 2016 ends January 31 but to have the policy in place for January 1 you’ll need to enroll by December 15.
- If you have both taxable and tax-deferred investment accounts, consider which types of funds (stock, bond, real estate, etc.) to place in the taxable versus tax-deferred accounts to maximize tax efficiency. My blog post from July 2014 addresses this issue in more detail.
Everyone’s tax situation is different. For example, there are also strategies that come into play if you are impacted by the Alternative Minimum Tax. Feel free to reach out to me if you have any questions related to your specific situation.