Just about every financial decision and transaction that we make has an income tax component or consequence. With federal marginal rates currently as high as 37%, state income tax rates as high as 13%, and additional surcharges for high-income earners, being efficient with income tax planning is paramount in accumulating or conserving wealth.
Moreover, President Biden is planning the first major federal tax hike since 1993 that appears likely to be passed this year, at least in part. If passed, tax measures would likely take effect in 2022, with the potential for some measures to be applied retroactively even into 2021.
At The Center, we have a long history and experience working with our clients and their tax preparers to drive down tax costs as much as possible. Our planning team may address the following for our clients’ benefit:
Marginal Tax Rate: The marginal tax rate is the tax rate paid on the next or last dollar of income. Current federal marginal rates go from 10% up to 37%. Your current, and expected future, marginal rate provides insight into decisions such as accelerating or delaying income as well as whether municipal bonds or taxable bonds are most efficient. Your marginal bracket also determines what long-term capital gains rate is applied. The current highest marginal bracket is 37% (and current proposed tax legislation could raise the upper rate to 39.6%).
Average or Effective Tax Rate: In addition to your marginal tax rate, the average rate helps us understand your overall tax picture. To determine your average rate, divide the total tax paid by your total income. For example, one might be in the 35% marginal tax bracket, but their average tax rate might be closer to 25%.
Itemized vs. Standard Deduction: Are you itemizing deductions, or does the standard deduction provide a greater benefit? With current limitations on itemized deductions, such as state & local income taxes and real estate taxes capped at $10k, many find that they no longer itemize deductions unless they “bunch.” For instance, bunching may involve grouping five years’ worth of charitable donations into one year. Many people do this by gifting to a vehicle like a Donor Advised Fund so the tax deduction may be recognized immediately, but the funds then get divvied out to charity more slowly over time. Essentially, bunching itemized deductions, such as charitable gifts, every other or few years typically provides the most efficient tax strategy.
Long Term Capital Gains: Under current law, long-term capital gains (securities held longer than 12 months) receive preferential tax rates vs. ordinary income tax rates. There are three brackets 0%, 15%, and 20%. Current proposed tax legislation could raise this rate to 25% for the highest income earners.
Carry Forward Losses: The goal of investing is to make money. One strategy to use when an individual investment loses value is to “harvest the loss.” Harvesting losses can be valuable as they offset capital gains dollar for dollar. If you have extra or additional losses, up to $3,000/year can also be used to offset ordinary income. Ideally, this harvesting of losses should be done on an ongoing basis rather than only at the end of a quarter or year.
Qualified Dividends: Qualified dividends are dividends taxed at a long-term capital gains rate instead of your ordinary income tax rate, which is generally higher. All things being equal, we would rather have dividend income that is considered qualified to achieve greater tax efficiency.
Roth Conversion Opportunities: Sometimes paying tax today versus later is a tax-efficient strategy. If you feel that you will be in a higher bracket later, or even that your beneficiaries may be at a higher tax bracket, full or partial Roth conversions can be employed to recognize that income today at a lower rate. Roth money can be used to provide tax-free and RMD free retirement income. Having Roth dollars also provides opportunities to optimize your current marginal bracket as part of a comprehensive retirement income plan.
IRMAA Surcharges: Our tax code contains provisions that may be described as “hidden taxes.” One such tax includes the Medicare income-related monthly adjustment amount (or IRMAA), which is an extra surcharge based on your total income (specifically Modified Adjusted Gross Income). Meaning, depending upon your income, you might pay a higher premium for Medicare (Part B and D). For example, in 2021, a joint couple pays $148.50/month when their income is less than $176k. Once you go a dollar over, the premium now becomes $220.20/month per person and is added to your Medicare premiums – a hidden tax. There are additional thresholds, and the current maximum premium for those with income over $750k is a total of $582/month each. Managing brackets by limiting or decreasing income, such as using Qualified Charitable Distributions from an IRA, can reduce your surcharge.
Net Investment Income (NII) Tax: Another so-called hidden tax applies to single taxpayers with MAGI above $200k and $250k for couples filing jointly. Investment income over these thresholds contains an additional 3.8% tax. So, while the stated maximum capital gains rate is 20%, the highest long-term capital gains rate is actually 23.8% with the surtax (before taking state taxes into account).
Phase-outs: At last count, there are over 50 tax credits that may be available to taxpayers. Unfortunately, they are subject to a variety of income phase-outs, so careful planning is required.
The Biden tax plan, if passed, contains additional income and estate tax provisions that we are closely monitoring including, but not limited to:
New tax increases on households earning more than $400k, including upping the top tax rate to 39.6% and lowering the amount of income needed to reach that top bracket
Increasing the top long-term capital gains rate from 20% to 25%
Restricting many tax and estate planning techniques, including backdoor Roth IRA conversions, the ability to convert pretax IRA dollars into Roth IRA dollars for high earners, and eliminating intentionally defective grantor trusts (a strategy used to move assets out of one’s taxable estate)
While the Biden plan appears to exclude any “wealth tax” such as proposed by Senator Elizabeth Warren, there may be changes to estate tax provisions such as decreasing the Estate Exemption Equivalent from $11.77M per person to $5M
Introducing and expanding additional child tax credits
Lastly, we find that efficient tax planning considers not only your current year taxes, but a plan that considers several years or even several generations. Assuming an increase in individual (and corporate) tax rates, the stakes will be even higher and proper planning can help put more in your pocket.
Stay tuned for an upcoming video message in November intended to keep you in the loop with proposed tax changes. Learn more about the American Families Tax Plan proposal HERE.
Contributed by: Center for Financial Planning, Inc.® 
