Saturday, June 16, 2012

Tax Loophole

I think I just figured out something pretty cool.  If it's actually accurate, I'm both shocked nobody has ever told me about it before and annoyed that I didn't come up with it sooner, especially since I basically already did it once a few years ago.  Here's the basic idea.

There are two classes of retirement accounts available to most Americans.  Both classes allow for tax free growth of assets, and the rules on when you can withdraw the money vary a little from one specific account to the next, but they'are all pretty much the same with one major distinction.  In the first type, you fund the account with post tax dollars.  A Roth IRA is an example of this type of account.  If your income is low enough (which has never been a problem for me in the past lol) you can contribute $5K/year into the thing.  Many years from now when you withdraw the money it won't be taxed, since you already paid your share before you ever put it in the account.  The second type of account is funded with "pre tax" dollars.  A 401k is an example of this type, and most people with real jobs know how these work.  You make contributions throughout the year that come directly off your paycheck, BEFORE your taxes are calculated.  So if you make $50K, but contribute $5K to the 401K, your taxable income at the end of the year is only $45K.

This is all well and good, and a lot of people discuss which one is better for you based on a couple of obvious parameters (if you think taxes are going to go up or down, and if you think your income will be higher or lower than it is now in retirement).  But what a lot of people don't know is that if you have both types of accounts you can choose (with some restrictions) exactly which year you "roll over" the balance from the second type (pre tax money) to the first (post tax money).  By doing so, you get to control what year you pay the taxes in.  I actually already did this once back in 2010, when I basically made no money whatsoever and had $30K or something sitting in my old Oracle 401K account.  I rolled it over into my roth and paid taxes at an extremely low rate (since the rollover was like 75% of my income or something ridiculous).  At the time I kind of just thought that was a one time thing and yay good for me, but recently I realized it doesn't have to be.  As a self employed person I am eligible to open and contribute to a SEP IRA;  this account is basically a replacement for the fact that I don't have access to my employer's 401k.  I can contribute up to 25% of my net income (up to I believe $50K), which will come off my taxable income (except for self employment tax, which I still have to pay on it, I think) and therefore reduce my tax liability.

At this point anybody who is still following along (and I can't fault you if you're not) has to be saying "so what, Jesse?  It doesn't really matter that much which year you pay the taxes in, does it?"   For a normal person, that would be true.  But for a professional poker player with an extremely variable income, it most certainly is not.  If you are a cash game pro for 10 years you are bound to have good years, great ones, and terrible ones.  If you take care to contribute as much as you can to the SEP in the boon years, then rollover the balance in lean years (you can do the rollover any year you make less than $100K), your tax savings could be quite large.  If you take into account the possibility of a large tournament score shooting your income into the middling 6 figures, or quitting cards to "go back to school" and having a near zero income year, they could be flat out massive.  But even without those two events (which are both extremely unlikely for yours truly), it's still worth doing.  Suppose you play the mid stakes games around LA and have a good year where you post $120K, then follow it up with a $40K clunker.  If you contributed 25% of the $120k to a SEP, you'd avoid paying taxes "from" $120K down to $90K.  Then in the next year when you rolled it over, the taxes would be incurred "from" $40k up to $70k.  Obviously the more extreme the swings in income, the more useful this trick is, but the basic idea is sound.  I even asked my tax guy, and he said it's a great idea.  So there you have it, tax advice for the professional grinder.

1 comment:

Unknown said...

Have you looked into a Solo401(k)?