The Saver’s Credit Cliff

For all of its uncertainty, we cannot flee the future.
–Barbara Jordan

After I became a CFP, I received a worried call from a client who had done a Roth IRA conversion.

“My tax bill was way higher than I thought it would be!” he related in a tone that was quite close to freaking out. I don’t blame him. I’d have freaked out too.

I quickly moved to assure him by pointing out that he’d done a Roth IRA conversion, and all he had to do was to recharacterize some of his conversion until he got to the point that he was at the next lower tax bracket. Problem solved. I wish they were all that easy!

However, back in 2017, Congress decided to do away with the loophole that allowed you to pinpoint just how much of your IRA or 401k to convert to a Roth through the passage of the Tax Cuts and Jobs Act of 2017.

What that means is that instead of being able to use your income post facto to determine just how much you could recharacterize to stay within a targeted adjusted gross income (AGI), you now have to take an educated guess at what your AGI will be in order to determine how much to recharacterize.

Fortunately, there are tools such as Taxcaster that, for most people, get them pretty close to the right answer. Getting the number exactly right isn’t the challenge. It’s making sure that you don’t miss by tens of thousands of dollars that is the challenge.

Now that you no longer have the benefit of true hindsight in recharacterizing your IRA conversion, you’re forced to do so by December 31.

This plays into a subtle nuance for early retirees who still earn some income via self-employment or through an old employer: the saver’s credit. I first started thinking about this after reading the excellent anaysis of the saver’s credit at Go Curry Cracker.

You can read that article to get the details, but, effectively, the savers credit gives a tax credit from 10-50% of IRA contributions up to $1,000 per person for married filing jointly couples who have an AGI of less than $65,000, heads of household who have an AGI of less than $48,750, and single filers who have an AGI of less than 32,500 in 2020.

But to earn a credit, you need taxable income in order to be able to contribute to your retirement account.

So, as a married couple, there’s a sweet spot between $4,000 in income (the minimum that you could earn to contribute $4,000 to IRAs, as a married couple), to get the maximum achievable saver’s credit, and $38,499, which is the amount, with the saver’s credit, that a married filing jointly couple could have in AGI and pay $0 in taxes.

For us, we earn income in two material ways:

• My board work
• Our rental property net income

I know how much my board work will earn.

The floating target is how much net income our rental properties will earn.

However, if the net income is lower than anticipated (depreciation helps a lot here), we can always fill in the potential $0 tax blank space with a conversion of our traditional IRAs to Roth IRAs to generate more income.

We max out our Roth IRAs at the beginning of the year in anticipation that our rental property net income will cause us to have too much AGI to qualify for the saver’s credit.

However, at the end of the year, we may be in some sort of odd inflection point that would cause us to want to reduce our income.

For example, at $39,000 AGI, the saver’s credit is 50% of the contribution.

At $39,001 AGI, the saver’s credit is 20% of the contribution.

If we maxed out our IRAs and, therefore, qualified for the maximum saver’s credit, then at $39,000 AGI, our credit would be $2,000, but at $39,001 AGI, our credit would be $800.

That’s $1,200 less in tax credit because of $1 more in AGI.

It’s reminiscent of the Obamacare ACA subsidy cliff.

This is where the December 31 deadline for conversions and an April 15 deadline for contribution recharacterizations come in handy.

Since we probably won’t know to the dollar how much AGI we’ll have, if we do a conversion of a traditional IRA to a Roth IRA, we can overshoot a little.

Why?

Because we can recharacterize enough of our Roth IRA contribution for the year to get us back below a saver’s credit (or ACA subsidy, if applicable) cut line.

In the edge case hypothetical example above, since our AGI would be less than $104,000, we could take a full dollar-for-dollar reduction in our AGI for each dollar that is contributed to a traditional IRA.

So, we’d recharacterize $1 of Roth IRA contributions into a traditional IRA, lower the AGI by $1, and get an extra $1,200 in savings credit.

While you can’t use a conversion recharacterization to solve for your AGI like you could before the TCJA passed, you can still use recharacterizing that year’s Roth IRA contribution to accomplish the same task in keeping right under cliff thresholds.

As an early retiree with some known earned and an unknown amount of other income, this is an extremely useful tactic to maximize tax advantages.

If you’re concerned about doing your taxes correctly, I’ve used
TurboTax Online for several years, and, despite the complicated status of our taxes, have had no problems filing my taxes, saving us almost $1,000 compared to what we were paying our accountant when he prepared our taxes.