(Note: all screenshots in this post are from our 2015 Numbers Unlimited financial planning worksheet, which you can access here.) With April 15 nearly upon us, you’ve submitted your tax returns by now, and the chances are good you’re breathing easy knowing the next tax season is nearly a year away. But before you get too excited to forget about the IRS for another ten months, consider that now is a better time than ever to start planning your taxes early! And while you might not relish the idea of revisiting your tax forms so soon, in reality even a few minutes spent reviewing your form 1040 can help you build a plan that could significantly ease your tax burden in the future. Your review can be as simple as this:
Part 1: What is My Taxable Income?
What is My Marginal Tax Bracket?
Once you have your income, review the federal tax brackets and determine what marginal tax bracket you are in. Also examine where you fall within the range (are you at the higher end of the bracket, lower end, or somewhere in the middle?) It is important to understand that tax brackets are progressive. This means you pay a higher tax rate on each additional dollar of taxable income as you bump into higher marginal tax brackets.
How Does My Current Marginal Tax Bracket Compare to My Future Marginal Tax Bracket?
Now it’s time to start planning. We can’t predict the future, but we can make an educated guess as to our current tax bracket relative to the future. If I am just starting my career, for instance, I may assume I am in a lower tax bracket now than I will be during my peak earning years. If I am in my peak earning years, my tax bracket may drop once I decide to retire. If I own investment properties, the income may currently be offset by depreciation and other deductions, resulting in a lower tax bracket, but I can predict that future rents may be higher and the deductions will be gone, forcing me into a higher tax bracket. Analyzing our current situation relative to the future allows us to build a plan around when we should pay tax. So now, with an understanding of where we stand and where we’re likely headed in the future, we’re in a good place to start thinking about various ways to make the best of our current and future tax brackets.
Part II: Retirement Planning
One of the best ways to control your tax bracket is to take advantage of the tax incentives provided by the government for retirement savings. Qualified retirement plans all have the benefit of tax-deferral (income generated annually through dividends, interest, and gains is not taxed annually), but some offer an immediate tax deduction. Qualified Retirement Plan accounts that offer an immediate tax deduction we call “Tax-Deferred” and those that don’t we call “Tax-Free”. Contributions to Tax-Free accounts are made after you pay tax on the income, but are withdrawn tax free later as long as you make a qualified distribution. Withdrawals from Tax-Deferred accounts will show up as ordinary income in the year in which they are withdrawn. Here are some common Tax-Deferred and Tax-Free Accounts.
Where to Save?
Once you know your taxable income, marginal bracket, and have estimated future tax brackets, you can use your knowledge of qualified retirement accounts to control your future tax brackets. For example, if I am a single filer and my 2014 tax return reveals I have a taxable income of $50,000 I would be in the 25% marginal tax bracket. If I believe I will be in the 15% marginal tax bracket in retirement and I have $18,000 to save in 2015, I may want to save my first $12,550 in a tax-deferred account like a 401(k) that avoids current income tax and the remaining $5,450 in tax-free account (ROTH) that I pay tax on now, but will grow tax free. The end result would be dropping my taxable income to $37,450, thus putting me in the 15% bracket and saving $3,137.50 in current year taxes. By saving in both tax-deferred and tax-free accounts I create tax diversification which will open the door for additional withdrawal strategies in retirement.
Where to Withdraw?
What if I am a single retiree and I need $50,000 a year of inflow to maintain a comfortable retirement? In that case I might withdraw the first $36,000 from a Tax-Deferred account that shows up as ordinary income and the remaining from a source that won’t generate any income tax like a bank account or Tax-Free account. This strategy results in keeping me in the 15% marginal tax bracket and avoids spiking income into the 25% marginal tax bracket, reducing current year taxes by $3,137.50.
Part III: Making the Most Of Qualified Dividends and Long Term Capital Gains – Lines 9b and 13
The tax rate on qualified dividends (QD) and long term capital gains (LTCG) is lower than the ordinary income tax, and you can use this to your advantage. Holding an asset for one year is the difference between short term capital gains and long term, so if you buy an investment and sell it 364 days later, you’ll still be taxed at the ordinary income rate. On the other hand, if you hold the investment for just one more day, you will receive the beneficial long term capital gain treatment. Consider how long you have owned an asset before selling: if your investments are generating a large amount on non-qualified dividends, review the investments to see if there are more tax-efficient investments that can be held in the taxable accounts. The less tax-efficient investments could be held in an account with tax deferral, such as a qualified retirement plan. Again, a little bit of forethought can make a significant difference in how much this advantage helps you. Notice that the QD and LTCG rate is 0% in the bottom two tax brackets. If you are in these tax brackets, you may want to consider harvesting long term gains sooner, so as to realize the gain at 0%, rather than deferring to a later date when you may be in a higher bracket.
Unrealized losses. If you have unrealized capital losses, you may want to realize these losses and use them to offset short term capital gains, or you can use the losses to offset up to $3,000 in ordinary income each year. If you harvest losses, you need to watch out for the wash sale rule , which prevents you from buying “substantially identical” shares or securities of the investment you sold within 30 days. Selling large gain assets. If you plan on selling an asset with a large gain, you may want to consider structuring the sale in a manner that spreads the gain out over a number of years, like an installment sale, to avoid spiking taxes in the year of sale. There is a 3.8% Medicare surtax on net investment income that comes into effect for higher earners*, which may be avoided or reduced by spreading out the sale and lowering the income realized each year.
Social Security Benefits – Lines 20a and 20b
If you receive social security benefits, examine how much you are receiving (line 20a) relative to how much you are paying tax on (line 20b). Knowing the amount of tax you pay on your social security benefits is based on your provisional income will allow you to build a plan that reduces the total tax paid. If you are in the 25% tax bracket or above line 20b will be 85% of line 20a and there may not be much you can do to avoid this, but for those of you in the 10% and 15% brackets you want to include this in your tax planning. For example a single filer that receives $20,000 a year from Social Security and $15,000 of taxable income from other sources wouldn’t pay any tax on their Social Security benefit. However, if an additional $15,000 of income was added to the tax return it would result in $9,600 of the Social Security Benefit being taxed.
Itemized Deductions – Line 40
Know whether you are able to itemize deductions or if you are using the standard deduction. If you are on the cusp of qualifying for itemized deductions, you may want accelerate or postpone deductions such that you maximize deductions every other year. Strategies may include timing when you make charitable contributions or when you pay your property taxes. By understanding your current tax situation and just a few tax basics, you can make informed decisions regarding where to save or withdraw assets, when to realize / defer income or deductions, and how to structure investments in a way that enables you to keep more of your hard earned money.