You’re Broke, Tax Like It

If your only income this calendar year is the $20,000 you made this summer, you’re probably in a pretty low tax bracket. This is where your good old down-40% 401k comes in. You’re going to have to pay taxes on those 401k distributions eventually, why not take the tax hit now? When are you ever going to be in a lower tax bracket than you are this year?

Personally, I know that I plan to get out of Obama’s “95%” as quickly as possible after leaving Fuqua. Might as well create as much taxable income this year as I can. And I’m not talking about my Career Fellow gig.

That’s why I’m grabbing my massively unprofitable traditional IRA and my slimmed down (“Jared after Subway”) 401k, taking what’s left of it, and converting them both to a Roth IRA before December 31st. This will allow me to recognize the conversions as income for tax year 2008, and I’ll pay a lower tax rate on most (or even all) of it than I would in the future.

Another option is to think about recognizing some capital gains. Don’t have any capital gains? Me neither. But just in case you do have capital gains, maybe sell some of that stock. Maybe pay the low cap gains taxes before Obama gets the keys to the Oval Office.

But I know what you’re asking. “Where am I going to get the cash to pay these extra taxes?” Well, that’s where federal tax benefits for students come in. There’s a strong chance that you’re eligible for the full Lifetime Learning Tax Credit, which basically means you have a $2,000 IRS Gift Card and little to spend it on.

If you qualify for the Lifetime Learning Tax Credit then, all things being equal, on roughly your first $25,000 (including internship money and any tips you make at Teasers) you could be paying ZERO taxes. That’s if you: 1) file as a single taxpayer, 2) take the $5,450 standard deduction, 3) grab one $3,500 personal exemption, and 4) use the $2,000 Lifetime Learning Tax Credit (“gift card”) to pay the rest.

After $25,000, you’re only paying 15% on any income up to about $41,500. After that the benefits start to diminish because now you’re paying 25% on any additional income.

There are also some downsides. Like if you’re married (and here I am referring specifically to the financial downside). Then you probably have all this wifey/hubby income to tell the IRS about, which will bump up your tax bracket and ruin this great plan.

And if you are a FY then you will probably want to wait until 2009 to pull this move off.

There’s also a chance that you won’t qualify for the Lifetime Learning Tax Credit if all of this taxable income brings your Adjusted Gross Income above $57,000 (filing as a single taxpayer).

Another big downside is that you actually will have to PAY the taxes that the Lifetime Learning Credit doesn’t cover. If you don’t have the massive loans and accompanying cash flow that I do, then you may not be in a rush to pay the IRS cash money right now. Ultimately it’s your call.
So that’s what I’m going to do. Maybe you should too. Just be sure to do it by December 31st if you’re an SY.