Under-the-Radar Tax Strategies
You may have heard the old saying: the only certainties in life are death and taxes. I think we all know there is a third certainty to be added in there: Change. Â
While both death and taxes may be inevitable, the amount of time we live and the amount we pay in taxes is not set in stone. Both problems have complexity and many moving parts that can impact the final outcome.
Tax brackets are not static, and the brackets you’re in now may not be the same ones you’ll be in down the road. So let’s dive into the nuances that exist in the current tax landscape, as well as the potential changes in 2025 when the Tax Cuts and Jobs Act (TCJA) of 2017 is scheduled to expire.
Why “Brackets” and Not “Bracket”?
First, let’s clarify why I use the term “brackets” instead of “bracket.” It’s because there are multiple categories of tax brackets that may apply to you.
The first designation you are probably familiar with depends on your filing status:
- If you are married, you will generally use the married filing jointly designation (MFJ)
- If you are single, or not yet married, you will usually use the ‘head of household’ designation
Then, there is a separate tax treatment depending on where the funds are coming from that you may be less familiar with:
- Income Brackets: This is not just a tax on the salary you earn from your job. When you have assets in accounts like a traditional IRA, 401(k), or any other pre-tax account, you haven’t paid taxes on those funds yet. When you withdraw money from these accounts, the entire withdrawal becomes taxable income for that withdrawal year. (The government gave you a tax break when you put the money into the account, but now it’s time to pay the piper. Except in cases of post-tax IRA contributions.)
- Capital Gains Brackets: These apply to the profits you make from selling investments such as stocks in a brokerage account (Non-retirement account), or selling real estate. These gains are taxed differently from regular income and can also vary depending on how long you held the asset. (For primary homes, there is an exemption that you may qualify for)
Diversification Doesn’t Just Apply to Investments
The future is uncertain, and potential changes in tax laws can seem daunting. However, this uncertainty also brings opportunity. By taking a bird’s eye view of the tax landscape, we can identify potential tax strategies and position our assets to navigate that landscape with the probabilities in our favor. Â
Diversification Across Accounts: Generally, you have the most long-term flexibility when you have assets spread across different types of accounts that are all treated differently. There are 3 main account types to consider for most people:
- Roth
- Traditional
- Taxable
To further elaborate on the importance of diversification in your tax strategy, let’s explore how those accounts are treated differently by Uncle Sam.Â
- Roth Accounts: Contributions to Roth accounts (like a Roth IRA or Roth 401(k)) are made with after-tax dollars. The benefit is that qualified withdrawals, including earnings, are tax-free. This can be a powerful tool, especially if you anticipate tax rates increase in the future.Â
- Traditional Accounts: Contributions to Traditional accounts (such as a traditional IRAs and 401(k)s) are made with pre-tax dollars, reducing your taxable income for the year that you contribute. However, withdrawals are taxed as ordinary income. This can be advantageous if you expect to be in a lower tax bracket in retirement or if tax rates happen to decrease in the future.Â
- (In both Roth and Traditional IRAs, withdrawals prior to age 59.5 come with a penalty unless they meet certain specific qualifications.)
- Taxable Accounts: Investments in taxable accounts do not have the same tax advantages of retirement accounts. However, they do offer one benefit over those accounts. Unlike tax advantaged retirement accounts, you can move any amount in or out as you please with no penalty at any age. You pay taxes on dividends, interest, and capital gains in the year they are realized at the capital gains rate, not the income rate. There is a tax on your profits when selling the investments, but there is no penalty for removing funds from the account.Â
The Marginal Tax System Explained
To fully understand how tax brackets work, it’s essential to grasp the concept of a marginal tax system. The U.S. income tax system is progressive, meaning that income is taxed at increasing rates as it rises through different brackets.
Here’s how it works:Â
- Marginal Tax Rates: In a marginal tax system, different portions of your income are taxed at different rates. For example, the first portion of your income might be taxed at 10%, the next portion at 12%, then 22%, and so on, up to the highest bracket applicable to your income. This system ensures that higher earners pay a higher percentage of their income in taxes, but not all of their income is taxed at the highest rate.Â
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Here is an example of how it works (This example is NOT using the actual current tax rates – just using simple #s for easy-to-follow math):Â
- 10% on income up to $10,000
- 12% on income from $10,001 to $40,000
- 22% on income from $40,001 to $85,000
- 24% on income from $85,001 to $160,000
- 32% on income from $160,001 to $200,000
- 35% on income from $200,001 to $500,000
- 37% on income over $500,000
If you earn $50,000 in the hypothetical example of the above tax brackets, your income is not taxed at a flat rate of 22%. Instead, the first $10,000 is taxed at 10%, the next $30,000 is taxed at 12%, and the remaining $10,000 is taxed at 22%.Â
Now that the basic math is understood, let’s explore the real current rates that exist, and how that might change if the law expires in 2025.
The Projected ‘Sunset’ of Current Rates in 2025
The Tax Cuts and Jobs Act (TCJA) of 2017 introduced lower tax rates for individuals, which are set to expire (Or sunset) at the end of 2025 unless Congress acts to extend them. At the time of writing this article, we do not know whether these rates will stay in place via an extension of the current act, or if they will expire.
Below is a comparison of the current tax rates under the TCJA and what the rates will be if the law sunsets.
The very left side of the chart highlighted in dark blue compares the 2024 tax rate change %s for each bracket to the 2026 projections for those same brackets.
To middle of the chart highlighted in medium blue is for taxpayers who are filing ‘Single’, and it shows the dollar amount comparison of 2024 to 2026 projections.
The right of the chart highlighted in light blue is for taxpayers who are filing ‘Married, Filing Jointly’ or (MFJ). Â
Key Differences
- The TCJA introduced lower tax rates across most income levels
- The 12%, 22%, and 24% brackets under the TCJA would revert to 15%, 25%, and 28% respectively
- The top marginal rate would increase from 37% to 39.6%
- The income thresholds for several of the brackets also change
Under-the-Radar Tax Strategies
Tax Planning is not only relevant for navigating current tax burdens but also can help build a strong foundation for a tax-efficient financial future.
As tax laws change, as your financial situation changes, and as your goals change, new strategies can present themselves such as opening different types of accounts, backdoor roths, roth conversions, tax loss harvesting, direct indexing, gifting assets, asset location, choosing which assets to withdraw first, choosing which assets to pass on to the next generation, etc.
Don’t worry if you don’t know all the details of any of the strategies I just mentioned. The point is, there is a lot to consider, and generally speaking, the more options, the better.Â
Let’s go over a few of them:
- Roth Conversions: One strategy to consider is converting funds from a traditional IRA to a Roth IRA. While you’ll pay taxes on the converted amount, this can be beneficial if you expect tax rates to rise or if you want to reduce required minimum distributions (RMDs) in the future. Roth conversions can be particularly advantageous during years of lower income or if you have significant deductions that reduce your taxable income.Â
- Harvesting Gains and Losses: In taxable accounts, some people can find themselves with a large amount of profits. Those profits are going to be taxed as capital gains when withdrawn, but you can use strategies like tax-loss harvesting to offset gains with losses. Conversely, tax-gain harvesting involves selling appreciated assets in years when your income is lower, taking profits while also taking advantage of lower capital gains rates.Â
- Timing Withdrawals: For retirees, strategically timing withdrawals from different accounts can help manage your tax liability. In any given year, the tax liability of withdrawing from one account vs another can result in a different tax due. It may make sense to even do partial withdrawal from one account and partial from another rather than all from one. Â Â
- Planning for the Next Generation: Different accounts are treated differently when inherited by the next generation. For example, heirs generally benefit from a step-up in basis for assets in taxable accounts and real estate, potentially reducing capital gains taxes. As opposed to IRA assets where they will often be forced to deplete the entire account within a 10 year timeframe, with each withdrawal counting towards income during the year that it occurred. Understanding these nuances can help in legacy planning not just for your own life but especially for your heirs.Â
The Need for Guidance
Taxes can be complex, and navigating them requires not just information, but careful planning, and this is where we come in. We don’t just educate our clients about taxes; we oversee the big picture of their financial lives alongside their tax professionals so they can focus on what truly matters to them. After all, most people want to spend less time thinking about taxes and other complexities and more time on the things that they love doing.
- Comprehensive Financial Management: When seeking guidance, we recommend that you consult with fiduciaries who take holistic approach to financial planning. Ideally, this should include cashflow projections into the future, investment management with downside protection as the priority, tax awareness and planning, and assessing overall financial health.
- The Importance of Staying Proactive: In many areas of life, including finances, taking a proactive approach can have advantages compared to taking a reactive approach. Given the dynamic nature of tax laws, we believe there are benefits to regular reviews of your financial situation, staying informed about legislative changes, looking before you leap, and being ready to adapt your strategy.
- Annual Reviews: Conducting annual reviews of your tax situation could help you identify potential opportunities for tax savings. This includes assessing income, expenses, assets, debts, and how that all aligns with overall financial goals. Regular check-ins with your financial advisor are prudent to assess if your strategy remains aligned with your objectives and the current environment.Â
Practical Steps to Take Now
Here are some simple and practical steps you can put on your to-do list to take some steps in the right direction:Â
- Review Your Accounts: Take stock of your current assets noting how much is in pre tax, post tax, taxable accounts, and other assets.
- Consult Professionals: Work with a tax professional and a financial advisor who can help you navigate some of the complexities and solidify your overall financial plan.
- Consider Future Needs: Think about your future financial needs and put together a plan for retirement and other major life events.
Conclusion
The impact of tax rate changes will likely change with time, but with a thoughtful and diversified approach, you’ll be better prepared to manage your own finances in an ever-evolving world.Â
You don’t need to understand all of the intricacies of the tax system. Remember, the goal is not just to minimize taxes but to understand your financial health and to be able to make informed decisions. With the right strategies and guidance, we believe you can navigate the complexities and focus on what matters most to you.
The information presented in this blog is the opinion of the author and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation, tax, or legal advice. Past performance is no guarantee of future performance.Â
