Every year, millions of Americans face the bleak prospects brought on by unemployment. And while losing a job is never fun or convenient, there can be a silver financial lining for those who know how to capitalize on their time spent away from the workplace. Having no earned income for a period of time can make it much easier to accomplish certain financial tasks, especially when it comes to retirement planning and income taxes. This article outlines several financial strategies that can help take some of the bite out of not having a job.
TUTORIAL: Roth IRAs: Introduction
In 2010, the income limit was lifted for those who wished to convert their traditional IRAs and qualified plans, thus allowing those with large pretax retirement balances to move them into a Roth IRA in a single year. However, this can result in a substantial tax bill for the year as well. But if the taxpayer has little or no earned income during the year, then the tax on the conversion may be a great deal less. (For related reading, see An Introduction To Roth IRAs.)
A corporate executive earning $100,000 with a $150,000 traditional IRA is laid off in December. The next year, he converts his IRA to a Roth IRA, but is unable to find a job. He will only have to pay tax on the Roth conversion balance, which means that he will pay tax at a lower rate on a lesser amount.
Unemployment presents a golden opportunity to liquidate substantially appreciated holdings that are held in taxable accounts. Those who will realize long-term capital gains may be able to pay the lowest tax rate allowed in the code on the sale of their securities or other assets, depending upon the amount of the sale proceeds. However, low-priced securities such as penny stocks that have risen dramatically in value within a short period of time are also good candidates for liquidation, as their volatility can quickly erode any gain received, even though their sale will result in a taxable short-term capital gain.
Larry rings in the New Year without a job. But he is pleasantly surprised when a stock he purchased for about two dollars a share last January shoots up over $6.50 per share on news of the issuing company's new product. He waits until he has held the stock for a year to the day and then liquidates it at a substantial profit. Because he only owned a few thousand shares and had no other income, he will pay no capital gains tax on the sale proceeds.
But the same principle holds true for real estate and other capital assets. Landlords who lose their day jobs can use a period of unemployment to dispose of rental or rehabbed properties that have appreciated in value, particularly those that have been held for less than a year and will not be exchanged for like-kind properties under IRC Section 1031.
The loss of a job will seldom prevent an unemployed worker from having to pay expenses such as college tuition for children or the costs and fees associated with adopting a child. However, having no income in a year when these expenses are incurred will prevent the taxpayer from claiming the tax credits that are available to them. Most of the tax credits in our tax code require a certain amount of taxable income in order to be claimed. Therefore it may behoove an unemployed taxpayer to generate income from investments or other assets in order to claim these credits. For example, a taxpayer over the age of 59.5 who paid $3,000 of tuition for a child could convert a portion of a pretax retirement account to a Roth and then claim the appropriate education credit against the tax bill. Of course, a straight distribution or sale of assets can accomplish the same thing. Those who do not have assets with which to employ these strategies may be wise to simply work a low-paying job for part of the year in order to claim the Earned Income Credit. (If you're not taking advantage of these deductions, you could be missing out on tax savings. For more, see 5 Tax Credits You Shouldn't Miss.)
Get Your Financial and Estate Plan in Order
Smart job-seekers will use the extra time that inevitably comes with unemployment to accomplish such things as reviewing and updating their wills, trusts and other legal and estate planning documents, as well as their overall financial and retirement plans. This is an ideal time to research and tweak investment strategies, explore ways to reduce income taxes, roll over the previous employer's retirement plan into a self-directed IRA and assess investment portfolio performance. Those who are smart enough to do this now will not have to spend time dealing with it once they find a new job and aren't easily able to schedule meeting with lawyers or other professionals during the day. (Investors are now able to invest directly in real property, mortgages and other assets. For more, see House Your Retirement With Self-Directed Real Estate IRAs.)
Unemployment can provide valuable opportunities to accomplish a number of financial tasks that otherwise may either take much longer to complete or result in a substantially higher tax bill. These are just some of the strategies that savvy unemployed job-seekers can use to take advantage of their lack of income. For more strategies that may be effective during unemployment, consult your HR representative or financial advisor. (For more on financial advisors, see Find The Right Financial Advisor.)