Our income tax system is incredibly complex and constantly changing, and this can make it very difficult to plan for the future. Most individual income tax planning has always been focused on deferring income and accelerating deductions. The theory behind this approach is to maximize the time value of money by paying as little tax as possible right now, so you can let more of your money grow over time. However that's not the right approach for everyone, and as we have pointed out in past articles, sometimes it even makes sense to flip the script and accelerate income while deferring deductions. In order to understand why this makes sense, you have to understand the bracket structure of our tax system.
To keep things simple, we won’t go into the nuances of the tax code that will inevitably impact many taxpayers. We’ll focus on ordinary income, which covers any earned income (wages, self-employment income, etc.), interest income, nonqualified dividend income, and rental income, among others. Under our progressive tax system, your ordinary income is taxed at higher rates at higher levels of income. For 2020, this is what that bracket structure looks like:
It’s important to understand that not all of your income is taxed at a single rate based on your income level. Your income is taxed first at the lowest rate, then at the next rate, and so on. In other words, if you are a single filer with $60,000 of taxable ordinary income in 2020, here’s how you would calculate your taxes:
$9,875 x 10% = $987.50
$30,249 x 12% = $3,629.88
$19,874 x 22% = $4,372.28
Total = $8,989.66
Understanding the way your taxes are calculated is critical to managing your tax brackets. As you can see from the chart, there are two big jumps in the tax rate under the current brackets. The first is a 10% increase in taxes between 12% and 22% and the second is an 8% increase between 24% and 32%. If your income generally puts you in the range of one of these bracket jumps, you can save significant taxes if you are able to manage your income and deductions to maximize the lower rate. This is the core idea behind tax bracket management, and to do it well you really need to look beyond just the current year.
I should take a minute to point out that not everyone can manage their tax brackets. If you are a W-2 employee, you generally don’t have much control over the timing or nature of your income. You might be able to shift the timing of your bonus or deductions, and depending on your income level this could enable you to do some bracket management, but you are much more limited. If you are in the highest income tax bracket, you likewise have limited ability to manage your current tax brackets, however, you should still look to the future to think about what your brackets might be after you stop working.
Retirees are often in the best position to effectively manage their tax brackets since they will have some sources of fixed income (social security, pension, RMDs), then rely on their retirement savings to cover the rest of their cash needs. If the retirement savings are in multiple types of accounts, like IRA’s, Roth IRAs, and taxable accounts, they can take money from the different accounts in a way to stay in the lower tax brackets.
Let’s assume the taxpayer in the earlier example is a retiree who usually has $25,000 of social security income, $25,000 of RMDs, and $10,000 of interest income. This year she doesn’t have to take an RMD (under the CARES Act), so her income drops from $60,000 to $35,000, and from the 22% bracket to the 12% bracket. Since she knows next year she’ll be back in the 22% tax bracket, it makes sense for her to take a distribution from her IRA of around $5,000, which will be taxed at 12% instead of 22%. Assuming no changes to future tax rates, this is an immediate savings of $500 ($5,000 x 10%).
If the taxpayer doesn’t need that $5,000 to cover cash flow, she could instead convert that $5,000 to a Roth IRA. She would still owe the tax on the conversion amount, but the $5,000 could then grow tax-free in a Roth IRA to be used in the future. Roth IRAs have no RMDs and the money comes out tax-free so they are excellent vehicles to have in place to help manage brackets in future years.
There are many other factors to consider when managing your tax brackets. Capital gains and qualified dividends are taxed at different rates from ordinary income, and these also have a progressive rate structure. Below is the bracket structure for this type of income in 2020:
You’ll notice there is even a 0% capital gains tax bracket, which in some cases might mean you can sell appreciated assets without owing any federal taxes! The interplay between these brackets and the ordinary tax brackets is complicated so it’s important to consider all your sources of income.
If you are over 65 and on Medicare, you also have to factor in the impact of the Income-Related Monthly Adjustment Amount (IRMAA) that is based on your income from two years ago. This can be considered an additional form of tax on your income and needs to be considered before implementing any tax bracket management strategies. Here are the 2020 IRMAA brackets, which are based on your 2018 income:
While there are many complexities involved in managing your tax brackets, the key is understanding the different rates and where your income places you in the bracket structure. If you are able to manage your income/deductions, you can gain significant tax savings in the long run through effective tax bracket management. This requires looking beyond the current year’s taxes and consider your taxes for the next several years. Changes to future tax rates and your own income situation in future years will impact this planning.
Current tax rates in the US are very low compared to our history and government spending is at all-time high levels. This combination very likely means we’ll face higher income tax rates at some point in the near future. We already know that in 2026, tax rates are set to revert to the higher pre-TCJA levels and Congress will likely act before then to make further changes.
If you would like to discuss your tax situation with us or look at how you might be able to more effectively manage your tax brackets, please reach out to us.
-Chris Benson, CPA, PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.