The tax code is incredibly complex and ever changing. Factor in changes to personal situations and it’s not uncommon to find people who understand little about their tax return and how to maximize planning opportunities present within a tax return. One of the most beneficial strategies to lower lifetime income taxes is to maximize income tax brackets, both now and in future years. How do we do this?
Definition of Tax Brackets
Below are the tax brackets for someone who is married filing a joint tax return and someone who is a surviving spouse. If you’re single, you have a different tax bracket.
If your taxable income is: your tax is:
- Not over $18,650: 10% of taxable income
- Over $18,650 to $75,900 $1,865: + 15% of the excess over $18,650
- Over $75,900 to $153,100 $10,452.50: + 25% of the excess over $75,900
- Over $153,100 to $233,350 $29,752.50: + 28% of the excess over $153,100
- Over $233,350 to $416,700 $52,222.50: + 33% of the excess over $233,350
- Over $416,700 to $470,700 $112,728: + 35% of the excess over $416,700
- Over $470,700 $131,628: + 39.6% of the excess over $470,700
(Tax bracket above based on 1/2017 tax code)
The brackets listed above are based on your Taxable Income, not your Adjusted Gross Income. To find your prior year taxable income, review your 1040 Tax Form and identify line 43, located on page 2 of the return. Taxable income is generally defined as your Gross Income – exemptions and deductions.
Progressive Tax Rates
We’ve all heard about progressive tax rates, but what does this mean? Looking at the tax table above, the first $18,650 you make is taxed at 10%, income between $18,650-$75,900 is taxed at 15%, between $75,900 – $153,100 you’re taxed at 25%, and so on. If you make $153,200, only $100 is taxed at the 28% rate, not your entire income. Your Effective Tax Rate is a blend of the various tax rates listed above.
Types of Income
It’s important to understand the different types of income you will have during your lifetime.
- Earned Income – from employment
- Dividend Income – paid from investments in corporations
- Interest Income – paid from bonds and CDs.
- Capital Gain Income – resulting from the appreciation and sale of an investment.
- Passive Income – typically paid from real estate investments
- Pension Income – paid from employer sponsored pension plan
- Retirement Distributions – money taken from 401k and IRA accounts taxed as income
- Social Security Income – from government benefits
- Annuity Payments – paid from annuity contracts
Understanding Current and Future Income & Deductions
It’s important to review all of your current and future income sources when doing tax planning. Rarely are our income and deductions consistent and progressive; they tend to fluctuate over time. The fluctuations create tax planning opportunities that can lower our lifetime taxes.
It’s not uncommon for individuals to retire with a similar or even a higher income relative to their working years. Assume you’ve been a diligent saver during your 40+ years of employment. You’ll likely have retirement accounts, taxable savings in various brokerage accounts, mutual funds, and/or real estate. Maybe you’re lucky enough to have an employer pension; and you’ll have Social Security Income. Many of these income flows will begin in future years and at different time frames. So how do we maximize different income levels?
Bracket Maximization
Let’s assume you are married, age 60, recently retired and have taxable income of $100,000 from various sources, including part-time income, as well as investment income and capital gains. You are in the middle portion of the 25% tax bracket. At your Full Retirement Age (FRA), you and your spouse will begin receiving a total of $40,000 per year from Social Security. In addition, your spouse has a pension from their previous employer that begins at age 66 and will pay $30,000/year. Your retirement accounts are well funded and you project your Required Minimum Distribution (RMD) at age 70 ½ for you and your spouse will be $40,000. It is likely you’ll receive some level of inheritance from one of your parents when they pass, possibly receiving money from an inherited IRA and proceeds from the sale of their home and remaining assets.
By age 70, with no corrective action, your income may place you in the 33% income tax bracket. If you are able to accelerate income during the lower tax years, you’ll reduce your lifetime tax liability. One common technique to facilitate income would be partial Roth IRA Conversions during these low tax years. In our above situation, you could convert $53,100 from your IRAs to your Roth IRAs and stay in the 25% bracket. If you did this strategy each year until you begin your Social Security and Pension Income, you could effectively convert $318,600 into your Roth IRA, and pay a tax rate that is 3-8% lower than you would pay later.
Other Strategies to Manage Income
Other types of income sources that people can control include bonus income, deferred compensation income, and capital gain income. Planning to receive these types of income during a lower tax year could provide tax savings. In addition, maximizing pre-tax 401k contributions during working years can lower taxable income. For a married couple who are both working, over the age of 50, you may have the ability to save $48,000, significantly lowering your taxable income. Maximizing contributions to Health Savings Accounts (HSA) accounts also provides tax relief. Investing taxable assets into Exchange Traded Funds (ETFs), rather than mutual funds, provides greater tax control.
Managing Deductions
In addition to managing income, managing your deductions is equally important. One of the most common deductions that can be controlled is Charitable Contributions. During high tax years, you’re able to accelerate charitable deductions to provide more ‘bang for your charitable buck.’ One tool that facilitates this strategy is a Donor Advised Fund (DAF). In addition, bunching deductions such as property tax payments from two years into one year can also provide cost savings.
Actively managing your tax situation over multiple years can provide significant tax savings. Accomplishing this requires a strong understanding of your current and future income, current tax laws, and the ability to effectively implement the desired strategies.