Ann Landers once said, “A person doesn’t know how much he has to be thankful for until he has to pay taxes on it.” While we encourage everyone to be thankful in abundance, we take tax planning very seriously as the results from doing it properly can be measured and meaningful.
Income Optimization
The benefits of tax planning are most pronounced when there is flexibility in either sourcing your income or optimizing income depending on the tax bracket you are in. To elaborate, not all income is taxed in the same manner, so if you have more than one source of income, you likely have tax flexibility. Income from a traditional IRA, wages from a job, and most interest will be taxed as ordinary income and is subject to a graduated tax rate schedule, which for most people, is between 12% and 37%. Long-term capital gains and qualified dividends (dividends for most domestic companies) receive preferential tax treatment of either 0% or 15% for most people. Roth IRA income is not taxed at all. A combination of these income sources in retirement is often ideal because of the enhanced tax savings benefits.
Aim for Your Best Bracket
Another area of focus when tax planning is optimizing the tax bracket you are in. If it looks as though you have room before spilling into the next tax bracket, it may make sense to proactively incur additional income in the current year to take advantage of the existing tax bracket you are in. Our clients do this in the form of Roth conversions, exercising capital gains, or IRA withdrawals. Conversely, if you are just tipping into the next higher tax bracket, it may make sense where possible to incur capital losses, contribute to a tax-deductible plan (e.g. HSA, 401k, etc.), defer income, or take another tax maneuver that helps limit your taxable federal income.
Medicare Considerations
Once you become eligible for Medicare, keep in mind that Medicare premiums are based on your income. Unfortunately, it only takes exceeding the IRS income limits by one dollar, and you could face increased Medicare premiums. If you do tip over into the next Medicare income tier, it will affect you for one year, provided your income the subsequent year doesn’t also cross that threshold.
As your income increases, there are more watchouts than just the potential for increased Medicare costs. Certain taxes, such as those on dividends or capital gains, can increase as well. There is also an income threshold over which you may end up paying an additional 3.8% tax on investment income.
The takeaway from all of this is that planning is key when it comes to managing your tax liability, especially in retirement or semi-retired years. We have long said it is not how much you make or have accumulated, but how much of that you keep that ends up being your true financial net worth.
One of our goals has been and will continue to be helping you maximize your net worth, both pre- and post-tax. As always, your HCM advisor would be happy to discuss this topic further with you at your convenience