Tax Planning: Start with Tax Bracket Management

Tax planning is all about keeping more of what you’ve earned. Effective tax planning must start with tax bracket management.

Tax bracket management is about WHEN you pay your tax. It can also be about WHERE you pay your tax.

Our focus in this article is about WHEN you pay your tax. You could also refer to it as tax timing strategies.

Tax bracket management is the 80/20 of tax planning strategies. You will see 80% of your results by focusing on tax bracket management with 20% of the effort.

You probably don’t believe me yet. If you follow along I hope you start to believe.

If you choose to ask your tax preparer, its likely won’t know what you’re talking about.

Unfortunately, many tax preparers don’t understand tax bracket management. This means you have to invest the time to learning it. Unless you can convince your tax preparer to learn it! 🙂

What is tax bracket management?

To pay less tax you need to change your facts.

Tax bracket management is about changing when you pay your tax. It focuses on accelerating income/deductions or deferring income/deductions.

Whether you should accelerate or defer is about finding that tax bracket imbalance in the short-term and long-term.

Accelerating income is like buying a household product on sale.

Would you rather pay full price or the discounted price? Accelerate income when that income can be taxed at a lower rate.

Accelerating deductions is like selling an item when the price is high.

Would you rather sell rather sell your Beanie Babies when it’s worth the most or mostly worthless?

You don’t always have control on timing your income or deductions. However, when the opportunity arises you want to take advantage of any mismatches that arise.

Planning empowers you to understand your facts, so you can change your facts.

Understand how tax brackets work

Before pursuing tax bracket management strategies you need to know how to tax brackets work.

A key to understanding this starts with understanding that tax brackets are progressive.

As each dollar fills up a BRACKET, the next dollar drops into the next BRACKET.

If a “cheap tax bracket” isn’t full then maybe you fill it with income. If you’re temporarily in an expensive tax bracket then maybe you accelerate deductions.

Tax bracket management hunts for tax bracket imbalances.

It seeks out opportunities to recognize income when taxes are low or maximize deductions when taxes are high.

Tax bracket management is that simple!

Ordinary Taxable Income vs Capital Gain Taxable Income

To find those imbalances you need to understand the difference between Ordinary Taxable Income and Capital Gain Taxable Income.

The Tax Bracket Manager calculator is the best tool to learn this through experience.

It’s also worth learning the theory to develop a base level of knowledge.

Two Buckets of Taxable Income

Read it twice. Maybe 2 or 3 times.

After running a dozen scenarios through the Tax Bracket Manager, this will become 2^nd nature to you.

I find this area to be the most confusing for clients, advisors, and yes… even tax preparers.

I’ve worked with numerous CPAs and EAs and frequently find out that they don’t this concept. This goes for small firms CPAs and Big Firm CPAs. In fact, I was working with a client’s CPA at the largest firm in my area who didn’t understand this concept. And he wasn’t a staff member… he was a tax partner with over 20 years of experience!!!

Don’t take this section for granted. It’s a really big deal!

• Step 1: Ordinary income is EVERYTHING except capital gain income.
• Step 2: Capital gain income is qualified dividends and long-term capital gains. That’s it!
• Step 3: Net Ordinary Income is ordinary income minus deductions. This is what determines your ordinary tax bracket!
• Step 4: Now that you know your ordinary tax bracket, you can figure out your capital gain tax bracket.

DON’T LOOK AT THE TAXABLE INCOME NUMBER ON THE TAX RETURN AND BE DONE WITH IT!

If the tax return has capital gain income you’ll either be wrong or lucky on your choice of their actual tax brackets.

Be a tax bracket manager. Not a careless practitioner.

Tax planning mental model

Every dollar you earn will pass through a tax filter.

Every dollar you withdraw from a pre-tax retirement account or stock you sell in a taxable account will pass through the same tax filter.

To lose less of your wealth to tax, you need to change your facts.

Who needs tax bracket management the most?

Retirees.

Why? Because typical retirees filled up their different buckets. Now they are set to empty those buckets.

The sequence of emptying those buckets has a big impact on the longevity of those assets.

The other fact is… retirees have the most control over their income. Control creates the option to change your facts and pay less tax. They need tax bracket management.

A common strategy for retirees are Roth Conversions.

Roth conversions are the ultimate form of tax bracket management and tax timing. Smart Roth Conversion planning requires finding tax rate imbalances.

Choosing to convert to a Roth is believing you are paying a lower tax rate today then you would tomorrow. It’s just like buying that household item when it’s on sale instead of waiting later to pay full price.

Below is an example of a tax projection of someone transitioning from work to retirement. During the last year of work their earnings are high. Following their departure they see a big drop in taxable income.

Why? Because the common path is to live off taxable investments or cash set aside for the first few years in retirement. By creating a retirement paycheck from those buckets taxable income drops significantly.

By selling stocks or bonds from a taxable account you only pay tax on the appreciation of the security and any dividends or interest paid. If someone needs $100,000 from their taxable account they could $0 of tax on that withdrawal.

In the example above, they were projected to have $30,000 of capital gains income. The green line shows that that capital gain income will be taxed at a 0% tax rate.

Over time this couple will see an increase in tax as they introduce Social Security income and Require Minimum Distributions.

Paying less tax prior to that peak might feel nice in the moment. However, it’s a trade-off for paying more tax later. This couple might be better off completing Roth Conversions or taking annual withdrawals from their IRA at a lower tax rate.

With Traditional IRA or other pre-tax accounts you’re in a partnership with the government. You want to consider taking money out whenever you can lose less of your hard earned money to taxes.

Whether you’re taking additional withdrawals or completing Roth Conversion, the Tax Bracket Manager is designed to help you confidently find your tax bracket target.

Happy tax planning!