Low income year? Convert your Traditional IRA to a Roth IRA; Understand Tax Bracket Efficiency

 

Some years you just have lower (OK a lot lower, OK maybe zero) income.  Carpe Annum to get a big future tax benefit with your Traditional IRA.

If you left your job to start a small business or took a year off to travel the world, you are in a unique position to make some tax moves.  This opportunistic position exists because you can fill up your low tax bracket 'buckets' with your Traditional IRA monies that have already been deducted.  With this conversion style tax move you can grab the benefits of the Roth IRA as well.  Now your money grows tax free forever.

TAX TIP: Tax brackets are like buckets, once you fill up the 10% bucket with income that year you pay 15% only on the rest of income that pours in until you fill up that bucket and start paying 25%... and so on.  The standard deductions and personal exemptions are basically your 0% tax bucket.  

Another way of looking at it is that, in the absence of income, you have a standard deduction and a personal exemption (these create a zero tax bucket of $10,300 in 2015) to use this year that might be wasted or underutilized.

Here is how it lets you keep more of Caesar's money:

If you already have a Traditional IRA, you already got a income tax reduction with the contributions you made in earlier years; so you got the benefit of a Traditional IRA as opposed to a Roth.  The trade off is that the earnings on your (well invested) traditional contributions are taxed when you retire.   The benefit of a Roth IRA is that the earnings are not taxed when you retire, however you pay tax (at whatever income bracket you are in) when you put the money in.   

It follows that if you convert a $10,000 Traditional IRA into a Roth IRA (totally legitimate) in a year that you have no income than you get the benefit of both types of IRAs. Now your $10,000 grows tax free and you never paid tax on it.   Voila!  

This still works if you went from the 10% tax bracket in 2014 to the 15% tax bracket except now you pay less tax instead of no tax. 

Got it?  Now go for it!