The structure of marginal tax brackets presents some opportunities from a financial planning standpoint. Understanding the absolute and relative differences between the brackets for each filing status is an important first step. In the first two articles of this series, I defined what is meant by a marginal tax rate as well as how marginal rates differ at various income levels. With this foundation, I want to explore the planning opportunities presented by the structure of marginal rates.
The topic of taxation is a very complex one. Every individual’s tax situation and financial goals are different, so please consult with appropriate experts prior to implementing any strategy described herein. This article will present some situations where marginal tax rates should be considered when undertaking or considering certain financial planning courses of action.
Managing tax liability requires an ability to manage the total amount of taxable income recognized. The less taxable income, the less tax you will pay. As explained in the second article of the series, not all levels of taxable income are created equal. The progressive nature of U. S. Federal tax brackets means you will pay more tax as a percentage of your income at higher income levels. Managing both absolute and relative tax impacts comes down to managing taxable income. What are sources of taxable income? There are many, but the most common is taxable wages from employment.
How can you control your level of taxable wage income? One way is to take advantage of pre-tax deductions to your wages. These might take the form of qualified pre-tax contributions, such as contributions to an employer-sponsored 401k plan, an IRA, or a Health Savings Account (H.S.A.). Using any eligible deductions can lower your taxable income, thereby lowering your tax, which is incredibly powerful! The ability and level of pre-tax deductions you might be able to take may be limited by factors such as your age, tax filing status, and income level.
Controlling the timing of when you receive income during the year can also reduce your tax liability. The ability to do this may be limited to some specific situations, like when a person can afford to modify their hours worked. The more likely scenario where this timing lever can be pulled is when somebody is in between jobs or approaching retirement.
Deciding when you start taking social security payments is another method of managing income. This strategy is more complicated, however. There are very specific provisional income brackets that define what levels of social security income are subject to various levels of taxation. Provisional income is a combination of Adjusted Gross Income (not including Social Security payments), tax-exempt interest, and 50% of the social security benefit. These provisional income levels differ by filing status and will determine if your social security income will be subject to 0%, up to 50%, or up to 85% tax. As you can see, other sources of income work in combination with social security income to determine your tax on social security benefits.
If not managed properly, you can introduce a concept called the social security “tax torpedo.” In its simplest form, the “torpedo” refers to not appropriately managing the level of provisional income generated and subjecting social security income to a higher tax level.
As you start to combine and commingle various income sources and levels, the management of your overall income level becomes very important. Let’s explore another source of income that needs to be appreciated in this context.
Depending on your taxable income level, you will pay different levels of tax on any long-term capital gains and qualified dividends recognized throughout the year. This taxation varies from no tax at all, to 15%, or to 20% depending on taxable income. Here again, it is important to consider the tax impact of gains and dividends each year in the context of other income as well as to evaluate strategies available to help manage these sources of income to reduce your tax liability.
If you are enrolled in Medicare, you probably already know that your income level from prior years is used to determine your (and your spouse’s) monthly Medicare premiums. While not a “tax” in the traditional sense, these premiums are monies that are paid to the government in exchange for certain health benefits. These premiums are evaluated each year but have very defined income levels that determine your premium. In this instance, if your modified adjusted gross income (a very specific definition of income) is at a certain threshold, you pay a certain amount in premiums. As the determination of these premiums is done using the tax returns from two-years prior, knowing the basis of your monthly charge is important. There are also procedures that can be used to appeal these determinations to affect your premium level based on changing income situations.
In the simplest definition, a Roth conversion is the process involved with converting pre-tax investment dollars that grow in a tax-deferred way to post-tax dollars that grow tax free. It is yet another opportunity to manage taxation in the context of income. The general idea is that you pay a one-time tax on the levels of income you generate through the conversion. So, if you are contemplating such a conversion, you should be considering the tax implications. This can be especially powerful in years when income levels are lower, and you have the chance to convert dollars to a Roth vehicle at lower marginal tax rates. In certain situations, such as retirement, when someone is not yet collecting social security and recognizing very little taxable income, Roth conversions are worthy of consideration because tax consequences will be low.
The last item that I will mention with respect to the management of marginal tax brackets involves the level of deductions and/or credits you may be able to take on your tax return. These, too, directly influence the level of tax you will be required to pay by reducing income levels. Each taxpayer’s situation is different – some may take the standard deduction for their filing status, others may itemize. Some will have tax credits that will apply; others will not. These effectively lower the stated taxable income limits and need to be appreciated when navigating financial planning tax concepts.
A combination of many factors contributes to the amount of tax you will be required to pay. From income levels and definitions (taxable, provisional, modified adjusted, etc.) and the strategies to manage the taxation associated with them, there are a lot of variables to consider.
The advisors of Blue Chip Partners are skilled in exploring and evaluating these tax considerations in the context of your own, personal financial plan. We have made investments in systems that will analyze and appreciate the many considerations when making decisions about “income” and “tax” in the context of the most recent tax rules. Always be sure to consult a tax professional or CPA when dealing with the complexities and intricacies related to your personal tax situation.
The advisors of Blue Chip Partners are skilled in exploring and evaluating these tax considerations in the context of your own, personal financial plan. We leverage advanced analytical systems that help us advise you on the many financial planning considerations related to “income” and “tax” for you. Always be sure to consult a tax professional or CPA when dealing with the complexities and intricacies related to your personal tax situation.