Each tax year brings a new learning experience. This year I learned all about recharacterizations, probably too much in fact! We found ourselves brainstorming a strategy to use recharacterizations to requalify for tax credits.
Background
We found ourselves in an interesting situation last year. Because we knew our income would be lower in 2007 due to my unpaid maternity leave we capitalized on the idea and worked as hard as we could to lower our adjusted gross income even further.
To try to lower our AGI, we used the following tax strategies to
lower our taxable income:
- Contributed significantly to our 401k, 403b and 457 plans.
- Maximized our dependent care flexible spending.
- Had additional money withheld from our flexible spending plan.
- Used the home office deduction to take a loss on our business.
- Took as many capital losses [1] as possible.
Had I planned better I could have also:
- Moved many of our dividend paying stocks to our kids.
- Planned the timing of our business income slightly better.
Roth IRA Conversion
Because of our newfound lower income, we took advantage of the ability to move a chunk of my 401k [2] to an IRA and then convert it to a Roth IRA. I calculated the amount of room left in the 15% tax brackets and proceeded with my conversions.
To my delight, all of our hard work paid off and we came in under the conversion limit. However, what I failed to realize was that the amount we subsequently converted would be added to our MAGI [3] for certain tax deductions and credits.
Phase-outs
Two in particular hit us hard:
- The student loan interest deduction (used to creatively finance part of our mortgage [4])
- The child tax credit
We hit the minimum phase-outs for both and lost part of the tax benefits. While I have no problem with the phase-outs, what this was doing was actually raising the effective tax on our conversions much higher than the anticipated 15%.
I began researching recharacterizations [5] and found that we could unconvert part of the Roth IRA back to the traditional IRA. By recharacterizing about 1/4 of the original amount, we should be able to claim our entire student loan interest deduction and our complete child credit. The portion that remains converted will do so at the significantly lower tax rate!
Action Plan
This was probably the only year we could pull something like this off, but maybe in 2010, when the income limits disappear I’ll give it a try again (although this time I’ll calculate the effects on other portions of our taxes first!)
What did you learn about taxes this year?