Due to the COVID shutdown(s), Homer realizes that he is only going to make $24,000 this year. He heard that the new tax law raised the standard deduction for joint returns to $24,000, so his taxable income will be zero!
He also heard the new law gives a child credit of $2,000 per eligible child, but only $1,400 of that is "refundable". Ned Flanders explains, refundable means you use as much as you need, and IRS refunds the rest. The $600 nonrefundable credit? Use what you can to bring your taxes to zero, and lose the rest. Ok, so Homer expects a refund of $1,400 x 3 kids = $4,200. Woo hoo!
But what about the $600 per child nonrefundable "use it or lose it" credit? Homer's dad always told him, “Never let a perfectly good tax credit go to waste.” So Homer devises a plan...
On December 15, Homer withdraws $18,000 from his regular IRA, which raises taxable income from zero to $18,000. Homer is in the 10% tax bracket, so his preliminary tax is now $1,800, which is reduced to zero by the nonrefundable child credit ($600 x 3 = $1,800). The refundable credit is still available, so his refund is $4,200. Smart guy, he added $18k to taxable income with no change in taxes! (We are ignoring state taxes and state tax child credits.)
His next move is even smarter: he rolls that $18,000 withdrawal from his regular IRA into a Roth IRA, thus avoiding the 10% early withdrawal penalty.
And, the final stroke of genius: If that $18,000 had stayed in the regular IRA for 30 years and averaged annual gains of 9.8% (like the S&P 500 averaged over the last 90 years), it would have grown to $297,401, which would be 100% taxable at withdrawal. After 30 years in the Roth at 9.8%, the $297,401 is 100% tax free.
Key Points:
Most of this only works if you do some planning before the end of the year.
This example assumed a single $18k rollover to the Roth. If Homer deposited more money annually, the nest egg would grow much bigger over 30 years.
The last word: This article began as a look at the opportunity to capitalize on unused nonrefundable tax credits, but the real star of this story is the Roth IRA. Even if you don't have tax credits to absorb the tax on a "rollover to Roth transaction", the tax cost of a Roth conversion pales in comparison to the long term savings of the Roth vs the regular IRA. Especially with today's lower tax rates, knowing that they are scheduled to expire in 2025.
