Tax Bracket Management: A Great Way to Boost After-Tax Returns
Regardless of whether your investment objective is growth or capital preservation, maximizing your after-tax return should be a primary goal. One of the best ways to increase after-tax returns is to implement tax bracket management. This is a strategy utilized to reduce taxes in high-income years by possibly realizing additional income in lower income years if you expect to receive higher income in future years.
Currently, there are seven tax brackets (ignoring the alternative minimum tax, net investment income tax, Medicare surtax and long-term capital gain rates). President Trump has indicated he would like to simplify the tax code and reduce the current seven tax brackets to just three. Regardless of whether tax reform occurs, tax bracket management is still a great tool for helping develop a tax-efficient withdrawal strategy to boost your after-tax returns.
With tax bracket management, you usually aren’t eliminating income, but simply deferring income into another period. So it’s crucial that you consider when and how the realization of the deferred income will be taxed. If done poorly, short-term decisions may actually result in higher taxes at a later date. Therefore, we believe it is important to work with your CPA or tax advisor to develop a long-term plan that optimizes your cash flow while minimizing your tax liability.
Strategies During High-Income Periods
In general, we recommend considering the following strategies during high-income periods.
Take necessary withdrawals from after-tax asset accounts. These include Roth IRAs (if the five-year and age tests are met), savings and individual or joint investment accounts. Generally, you are not taxed on the money withdrawn from these accounts. However, you could be taxed on any net realized gains, taxable interest income and dividends. Therefore, it is important to generate the funds for withdrawal as tax-efficiently as possible.
Note that long-term capital gains tax rates are usually lower than ordinary income tax rates in higher income years. If you are subject to high-income tax, it should be more tax-efficient to realize long-term gains than withdraw funds from pre-tax accounts.
Sell positions whose current value is below the purchase price first to realize a loss. Commonly referred to as tax-loss harvesting, this strategy can be used to offset realized gains and potentially eliminate any taxes due on sales. If you have capital gains, especially gains that are taxed in the highest bracket and subject to the net investment income tax, harvesting losses reduces your tax liability. Note that if you repurchase the stock too close to the sale date, the loss could be deferred, so you should discuss this with your investment advisor before taking action.
Estimate the potential capital gains and income distributions from mutual fund investments. These distributions, which usually occur toward the end of the year, represent taxable income even if the shares aren’t sold. Mutual funds don’t pay taxes and all realized gains and income are passed to the shareholders who are responsible for paying the associated taxes. The projected taxable distribution may justify selling the fund prior to the distribution if the current unrealized gain is less than what is projected to occur. Generally, mutual fund companies provide distribution estimates in November and the distributions occur in December.
Defer discretionary income and avoid taking gains. One of the easiest ways to defer income is to delay a distribution from an IRA or 401(k) account, as long as you have satisfied the Required Minimum Distribution (RMD) rules for the year.
Self-employed individuals may also have the ability to defer collection of income or withdrawal of funds from their business. Delaying income could be beneficial if income in the following year is projected to be lower than the current year. Keep in mind that when you receive a check, that amount is considered to be income during the year it is received — even if the check is not deposited or cashed until the following year.
Meanwhile, if you have stock options that are expiring and must be exercised in a specific year, it may be advisable to increase retirement plan deferrals or pre-tax contributions to a deferred compensation plan. In these situations, it is better to defer income if you will be in a lower or similar tax bracket when the income is eventually realized.