Tax planning during a pandemic

I spend perhaps a bit too much time optimizing my financial life, particularly the tax side of things. I make plans, learn new information, revise those plans, and repeat.

One example of this is around tax planning for early retirement. One basic strategy discussed in the FIRE community is to utilize a Roth conversion ladder to access retirement funds before the standard age. Another strategy is to harvest capital gains up to the top of the 0% bracket for this type of income. For a long time my plan was basically to combine these two: do Roth conversions up to the standard deduction, and also harvest as many tax-free gains as possible.

In the past year a couple of things have caused me to refine that plan.

First, when I did some more in-depth research into the effect of income on ACA subsidies, I realized that the “tax-free” capital gains income wasn’t so free after all. Where before I had planned to accelerate quite a bit of capital gains income into the near future, after that I decided to put that off until we’re no longer subject to the ACA acting as an additional tax on our gross income. We set a lower target income for ourselves, at 200% of the poverty level (to qualify for ACA cost-sharing subsidies) rather than the 0% capital gains threshold.

As a side effect of this ACA research, I realized that for families with kids, the 0% threshold for regular income actually extends quite a bit higher than the standard deduction because of the child tax credit. While we maintain our plan to withdraw spending cash from our taxable accounts before dipping into retirement accounts, now any additional room for income below our goal would come from Roth conversions rather than capital gain harvesting.

The second thing that changed our plans was being unexpectedly enrolled in Medicaid in December when we tried to sign up for an ACA plan for our first year of FIRE. While we projected an income well above the 138% of poverty level threshold for this program on an annual basis, we learned that Medicaid actually looks at your ongoing, monthly income to determine qualification. A one-time piece of income, such as the deferred compensation payment I received this month from my former employer, does not count at all toward this purpose.

Our experience with Medicaid has so far been mostly quite satisfactory, and so we’re now in no hurry to realize income in a way that would disqualify us from that.

Coronavirus hits

Fast forward to this March. The whole world has been turned upside down due to the novel coronavirus pandemic. This has created a lot of difficulties for a lot of people, but it also creates some opportunities as well.

With the stock market’s steep decline, this has created the opportunity to do some rebalancing in taxable accounts that may have been too cost-prohibitive before the pandemic.

Exiting employer stock

One of the first changes I made was to sell the rest of the stock I had been holding onto from the employer I left nearly six years ago. I joined that company prior to its IPO and so the shares had extremely low basis compared to their current value.

I had been gradually selling that stock off in the intervening years, but still had a pretty good chunk of it. The amount of unrealized capital gains I had embedded in that stock was high enough that selling it off in the near future didn’t fit into the plan, as much as I would have liked to diversify.

The market drop created an opportunity to do just that. Some of the index funds I had purchased in the past couple of years were now underwater. I was able to sell my old employer stock for a gain and also harvest an equivalent loss from index funds, causing no net change in our income for the year.

Optimizing foreign tax credit

One other consideration I had been looking at was how to get our foreign tax from dividend income below $600 per year. I had built up our portfolio using Bogleheads’ very well-thought-out principles of tax-efficient fund placement. This analysis suggests putting your international stock allocation in a taxable account as a first priority. This is because the foreign tax credit often makes international funds one of the most tax-efficient investments to hold in taxable form.

While I was working in a medium to high tax bracket this advice worked out wonderfully. The credit I got to claim against foreign taxes withheld from my index funds largely made up for the US taxes I would have otherwise paid on these dividends, and then some.

What I found as my taxable international investments grew is that once the foreign tax paid rises above $300 (or $600 for joint filers), you need to file Form 1116 with your taxes in order to compute the credit, rather than being automatically able to claim the full amount of foreign tax paid.

In higher income brackets this form, while a hassle to complete, quite often results in a credit equal to the amount of foreign tax paid. As a lower-income retired person this is much less likely to be the case. Therefore I had a goal to shift part of my foreign stock allocation from taxable to retirement accounts in order to avoid needing to file this form in future years.

Like with the employer stock, the amount of unrealized capital gain we had in these funds prior to coronavirus made selling these a goal that I expected to chip away at over several years. The market drop created an opportunity to sell enough of this for a loss (offsetting the employer stock) that our foreign tax amount should now be comfortably below the $600 threshold for the foreseeable future.

Minimizing dividends

Okay, so that was two big chunks of stock I didn’t want anymore that I was able to get out of with minimal tax consequences. Now what to buy? US stock is what I arrived at. It’s the next big asset class in the Bogleheads’ tax-efficiency hierarchy, and the 0% dividend and capital gains tax seems to make this tax-efficiency advantage hold true even and especially at lower income levels.

A total market fund like VTSAX might be the obvious na├»ve choice here, but in the end it isn’t what I selected. The reason lies with the earned income credit. This credit can provide pretty substantial funding to lower-income families who work, especially those with kids at home. See the chart below for an illustration of this. Our family recognized about $4,000 of earned income last year aside from the corporate job I left last year, which with two kids might be worth around $1,000 in tax credits.

There’s a catch though. This credit was designed to apply to the working class, not retirees living off their investments and also working the odd job here or there. As such, there’s a hard cutoff at $3,650 of annual investment income. Go above this cutoff by even a dollar and no earned income credit for you.

VTSAX tends to pay dividends in the ballpark of 2% of fund value. This means that someone with an all-VTSAX taxable portfolio will be disqualified from the earned income credit on dividends alone as the value of this portfolio approaches $200k. Our taxable portfolio is worth quite a bit more than this. While we do intend to spend it down over time as our first priority for liquidation in early retirement, we’re very likely to still have more than $200k in there by the time our kids are too old to qualify for the earned income credit.

I spent some time looking through Vanguard’s rather extensive lineup of index funds and found a promising solution: VIGAX, Vanguard’s Growth Index Fund. This index basically looks at the half of large US corporations that are considered “growth” companies. The other half are “value” companies tracked in another Vanguard index fund, VVIAX. So-called “growth” companies tend to reinvest their earnings back into growing their businesses rather than paying dividends. The result is VIGAX paying roughly 1% of its value in dividends, half of what VTSAX pays.

Buying VIGAX in a taxable account therefore doubles the amount of stock you can own and still potentially qualify for the earned income credit, when compared to owning VTSAX. Purchase a similar quantity of VVIAX in your retirement accounts to balance it out and you’ll still tend to track the broad market pretty well.

Even by going this route we’re several years out from when we might potentially qualify for the earned income credit, and if we hit another long bull market it may never happen, but the possibility creates a nice margin of safety to help us out if the market falls farther from here.

Stimulus payment

The stimulus check being sent out to most Americans this week is all over the news. Our income was a bit too high in 2019 to qualify for one of the immediate payments, but it will be much lower 2020. The way the law was written, the payment is a refundable tax credit against your 2020 taxes, with an advance payment given to those whose 2019 income was low enough to have qualified for that credit if it had applied last year. Come next spring we should be getting a $3,400 windfall in our tax refund.

Conclusion

This post has been about some of the ways we’re trying to make the most of this pandemic in a financial sense. What are some of the things you have been doing? I’d love to hear about it in the comments.

Finally, we consider ourselves extremely fortunate to be in a position to not need to fear much for our income in a time when so many businesses have scaled back operations or closed entirely. We are trying to pay it forward. I contributed quite a bit to a donor advised fund over the past couple years at higher incomes, and now has been a good chance to distribute that cash. We’ve made a couple of pretty sizable donations to the nearest food banks, as they struggle to feed the hordes of newly unemployed folks in our community. We’ll probably do a few more like this before the pandemic subsides. Please consider what you can do to help us all get through this.

2 thoughts on “Tax planning during a pandemic”

    1. Estate recovery only applies to services received after age 55. We have some time before we need to be concerned about that.

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