Smart Tax Strategies for a Low-Income Year (Great for Sabbaticals)- Middleton & Company (2024)

Taking a sabbatical is an awesome opportunity to take a break, pursue personal goals, and recharge your batteries. But extended time without income can also be stressful if you don’t have a plan in place beforehand.

That’s where financial planning comes in!

With proper planning, you can make sure to save what you need ahead of time to feel better prepared.

Learn more about how to create a realistic budget for your sabbatical here.

But planning for a low-stress sabbatical isn’t only about budgeting and saving before you leave. There are also strategies you can take advantage of during your sabbatical when you have a lower-income year.

Do you know how to make the most of a low-income year? Well, you’re about to find out! In this post, we’ll explore four powerful tax planning strategies that can help you optimize your finances during your sabbatical.

By taking advantage of these strategies, you can potentially:

✅ reduce your total tax burden

✅ secure a more tax-efficient position for the future

1. Intentionally Generate Capital Gains in Your After-Tax Investment Account

Harvesting capital losses is a well-known tax-saving strategy among savvy investors, but let’s not overlook the potential benefits of generating capital gains during a low-income year too.

💡A lower-income year means you may be paying tax on capital gains at a lower rate. If you find yourself in a lower capital gains tax bracket (say, because you’re taking a break from work and have no wages!), especially if it’s the 0% capital gains bracket, consider selling some of your appreciated investment positions in your after-tax investment account to reset your cost basis.

This approach can help you avoid allowing your investments to appreciate so much that you don’t want to sell them due to the tax consequences of the sale.

It’s also a great opportunity to rebalance your after-tax investment account back to your target portfolio to maintain an appropriate risk level, and to make the investments that you hold in your after-tax portfolio more tax-efficient going forward.

For example, if your after-tax investment account is invested in mutual funds, now might be a good time to sell them off and buy more tax-efficient exchange-traded funds (ETFs) in their place. Learn more about the difference between mutual funds and exchange-traded funds here.

2. Convert All or Some of Your Traditional IRA Money to A Roth

The Roth conversion strategy involves moving money from a pre-tax IRA to a tax-free Roth IRA and paying tax the year in which the conversion is completed.

💡Low-income years are a great time to convert pre-tax money to Roth money because you pay tax on the amount you distribute from the IRA at your marginal tax rate at the time of distribution. In a low-income year, your overall tax rate can be lower than during your normal working years.

With proper tax planning, you can choose how much you want to convert (and pay tax on). You do not have to convert the entire IRA balance – you can do partial conversions to manage your tax rate. Roth conversions also act as a safeguard against potential future increases in tax rates if and when the tax law changes.

To maximize benefits, consider paying the tax due from savings or after-tax money to fully capitalize on the tax-free Roth conversion.

Don’t have a Traditional IRA, only a 401(k)? Don’t fret – you can still take advantage of the Roth conversion strategy by rolling an old or inactive 401(k) plan to a Rollover IRA and converting to a Roth from there. As long as you keep your Rollover IRA money separate from a Contributory IRA (money that was never in an employer-sponsored retirement plan), that Rollover IRA can be rolled back into a new employer-sponsored plan when you return from your sabbatical.

3. Make Roth Contributions Rather than Pre-Tax Retirement Contributions

If you have earned income, but your income is lower than a normal tax year, you may want to consider making a Roth contribution rather than a pre-tax contribution to your retirement savings plan (either employer-sponsored or an IRA).

💡By opting for Roth contributions, you pay taxes at your current lower tax rate. The money invested in the retirement account grows tax-free going forward. Having a combination of after-tax, tax-deferred, and tax-free funds allows for greater control over your year-over-year taxable income in the future.

4. Exercise Vested Non-Qualified Stock Options Before Expiration

Vested Non-Qualified Stock Options (NQSOs) are a type of employee stock option that companies may grant to their employees as part of their compensation package. NQSOs typically have a vesting schedule, which means employees must fulfill certain conditions, usually related to time served with the company, to gain ownership of the options. For example, a common vesting schedule could be four years, with 25% of the options becoming exercisable each year (also known as “cliff vesting”).

For those with vested non-qualified stock options, timing your sabbatical over multiple tax years can be advantageous.

When you exercise non-qualified stock options, you pay ordinary income tax on the difference between the grant price (the price of the stock when the company granted you the options) and the exercise price (the fair market value of the stock at the time of exercise). Once you hold the exercised stock for more than one year, you can then sell it at the preferential long-term capital gains rate.

💡If you time your sabbatical to bridge two tax years (say, from July 2028 to July 2029 for example), you can exercise your options in the first year, and then sell the stock the following tax year.

Before proceeding, make sure to familiarize yourself with employment requirements, expiration dates, and other limitations tied to your stock options.

Having a plan in place to manage your finances while you’re away can not only help you to feel confident as you depart, it also can have long-term benefits by setting you up for financial success after you return. By employing these four smart tax strategies for your low-income year, you can potentially ✅ reduce your overall tax liability, ✅ diversify your investments, and ✅ enhance your overall financial position.

We work with our clients to create a plan specific to their circ*mstances leading up to their time away, and implement the tax-saving strategies on their behalf while they’re unplugged so they don’t have to. If you’d like to learn how you can outsource your tax efficiency optimization while you’re on sabbatical, we’re only an email away.

Happy sabbatical and tax planning!