Our federal income tax system is progressive – meaning that the tax rate imposed increases as your income increases. See the 2023 tax brackets below for those filing a joint return with their spouse.
|Married Filing Joint|
|Taxable Income Range||Total Tax Due|
|Tax on Lower Brackets||+ Tax on Income in this Bracket|
Assume you have $10,000 of additional income and your marginal tax rate is 32%. That $10,000 will add $3,200 to your tax bill. If your marginal tax rate is 12%, the same $10,000 of additional income would add only $1,200 to your tax bill.
Your income (and thus your marginal tax rate) can differ from year to year so it makes sense to take multiple years into account when planning for the recognition of income. One multi-year tax planning strategy that we employ at Bartley Financial is maximizing tax brackets. This involves recognizing income to take full advantage of a lower marginal tax bracket when the opportunity presents itself. For example – if you file a joint tax return with your spouse and your projected taxable income is $70,000 this year, your marginal tax rate is 12%. You can maximize the 12% tax bracket by recognizing $19,450 more income this year. If you anticipate that your marginal tax rate will be 22% in the future, recognizing the income now vs. later shaves 10% off your multi-year tax bill or $1,950 in this scenario.
While you usually can’t control the timing of your income (think bi-weekly wages, interest on bank accounts, dividends declared), there are some sources of income that you have more control over. Putting a little thought into when you recognize these types of income can result in some major tax benefits.
Here are some examples of income that you may be able to control the timing of:
- IRA distributions other than required minimum distributions (RMDs)
- This includes Roth conversions – transferring assets from a traditional IRA to a Roth IRA in a taxable transaction.
- Keep in mind that you must be age 59.5 or older to avoid early withdrawal penalties.
- Disposition of assets that will trigger capital gain income
- Self-employment income – you control the invoicing of your clients.
- Non-Qualified stock awards – you control when to exercise your right to purchase shares at a discount.
When should you consider maximizing tax brackets? This can be a viable strategy in any year that you anticipate a lower tax bracket than normal. This often happens during transition periods.
- Employment Transition – Whether you are unemployed for part of a year or taking a break between jobs, if you have a year with lower income, you may have an opportunity to recognize some income at a lower tax bracket.
- Early Retirement – Your working years are over, but you have not yet tapped into all sources of retirement income like Social Security benefits, required minimum distributions from IRAs, and pension benefits. You could have a year or several years where your tax rate is lower than it will be in future years
- A useful strategy can be to maximize the lower tax brackets by taking IRA distributions during these years. You will pay a lower tax rate on the distributions now and reduce future distributions that you need to take at a higher tax rate.
- Multi-year tax planning involves keeping several years of cash inflows and outflows in mind. We ask retirees about living expenses and also about upcoming purchases such as new vehicles, home improvements, travel, etc.. Once we have an estimate of how much money is needed, we can time distributions so they occur in years that will have a lower maximum tax bracket.
- Bartley Financial recently helped a client put this strategy into play with a twist. Husband and wife took IRA distributions in the first year of retirement when their tax rate was low. They banked this money and used it to support annual expenses over the next couple of years when Social Security benefits first kicked in. Social Security benefits can be anywhere from 0% to 85% taxable depending on the amount of other income you have that year.
- Because they were able to live off their Social Security benefits and the banked money, they enjoyed a couple years with minimal taxation of Social Security benefits.
- Funding annual expenses with IRA distributions ratably over the same time period would have significantly increased the taxability of Social Security benefits and thus their multi-year tax bill.
There can be advantages to recognizing income in a lower income year that extend beyond enjoying a lower marginal tax rate. Here are some:
- You can reap additional savings if the income that you recognize now is used to pay off a loan with a high interest rate or to fund a purchase like a new car that would normally require you to take on additional debt.
- You may be able to take advantage of 0% federal tax on capital gains (normally 15%).
- Those who are ordinarily subject to the additional 3.8% tax on net investment income may be able to avoid this tax on capital gains recognized in a low income tax year.
As with any tax strategy, keep in mind that the tax code is complex so there may be pitfalls to recognizing additional income that you don’t see. Don’t go it alone! Always consult with your tax or financial advisor to come up with a plan.
Bartley Financial is built around a client-first ethos. We are as committed to exhibiting high levels of professionalism as we are to building relationships with clients built on trust and mutual respect. That’s why we hold ourselves to a fiduciary standard. It’s also why we offer a transparent, fee-only compensation structure so that our clients never need to be concerned about a conflict of interest.
Bartley Financial has an experienced team of CPAs and CFPs® (Certified Financial Planners®) dedicated to helping clients manage their investment portfolios, plan for retirement, strategize taxes, or execute any other initiatives in pursuit of optimum financial health and minimal financial stress. From our offices in Andover, MA, and Bedford, NH, we work to ease clients’ financial concerns, strengthen their portfolios, and assuage their worry that they don’t know what they don’t know.
Contact us today to begin a relationship with a team of knowledgeable, trustworthy professionals who put their clients first.