Proactive Income Tax Planning – Why Does Your Tax Bill Have to Be a Surprise?
At the end of 2021, Director of Wealth Planning Jeff Deiss followed up our year-end planning webinar with an article highlighting some action items to consider after strong market performance led to larger realized capital gains for most investors compared to past years. If you followed his advice, you would have felt prepared as you filed your 2021 Income Taxes by the April 18th deadline.
We are already 4 months into tax year 2022, but we still can get a head start for understanding your income tax situation for 2022, and implement some proactive tax planning strategies instead of waiting until year end.
Everyone with income has to pay taxes, but proactive investors who forecast ahead can have much more input as to how they pay their taxes in a given year. When looking to cover a client’s cash flow need from their investments, we try and focus on ways for distributing income where they can pay preferential tax rates, like from qualified dividends and long-term capital gains. As part of that planning, we tend to look a few years out, not just in the current tax year to consider not just lowering their tax bill for a given year, but over their anticipated lifetime.
Harvesting Capital Gains
We educate our clients on multiple types of “tax brackets” they need to be cognizant of as part of their overall plan. Most are familiar with the marginal income tax brackets used in calculating ordinary income. The IRS gives preferential treatment to income from qualified dividends and long-term capital gains. Ordinary income and long-term capital gains are taxed separately when filing, where capital gains income “stacks on top” of ordinary income to determine it’s appropriate tax rate.
The concept of realizing capital gains on purpose seems counterintuitive. In theory, why would someone want to pay taxes electively before the would otherwise have to? Investing is an endurance race not a sprint, so we apply this same philosophy to planning for income taxes. In a situation where an investor retires, it may make sense to defer taking social security or their pension, and harvesting their capital gains to live off of in those early retirement years. For tax payers with no ordinary income, the effective federal income tax rate on capital gains income earned up to the 12% marginal tax bracket is 0%.
If they have significant capital gains to take, accelerating them before guaranteed income from social security or a required minimum distribution from an IRA could also avoid them having to pay the net investment income tax surcharge of 3.8% which kicks in once Modified Adjusted Gross Income reaches $200,000 for single filers/$250,000 for those married filing jointly.
Accelerating Distributions from an IRA
The income tax code is written in pencil. It has changed and will continue to change as provisions sunset or Washington proactively passes modifications. It’s important to factor in those changes to your overall plan as they come into focus. One change that has been telegraphed unless addressed by Congress is the Tax Cuts and Jobs Act sunsetting after 2025, raising some marginal tax rates starting in 2026.
Investors who have not yet taken required minimum distributions from retirement accounts, or are only living off their RMD, might consider accelerating more income into their current tax years. If they have room to distribute funds up to the top of their current marginal tax bracket, they might save on taxes in the long run. For instance, an investor currently in the 22% marginal tax bracket, would be paying a federal income tax rate of 25% beginning in 2026 on the same amount of income, a 14% increase. Just a reminder, the S&P 500 has averaged an annualized return of 10.5% through 2021 since its inception in 1957.1
Another benefit of implementing this strategy year after year could be reducing the account value of your IRA or Qualified Retirement, potentially avoiding a marginal tax bracket jump late in retirement as your required minimum distribution increases with age. Earlier this year, ACM’s Director of Wealth Planning Jeff Deiss addressed the changes the IRS made to calculating RMDs. By consistently only withdrawing your RMD each year you may end up leaving too much growth in the account, resulting in higher RMDs and eventually a higher corresponding marginal tax bracket. You don’t necessarily have to spend your entire distribution, but instead could pay the lower tax rate and then reinvest in your taxable account or even consider a Roth conversion for the monies in excess of your RMD. Both taxable assets and Roth assets are better for future generations to inherit, as they are not subject to income tax for beneficiaries, unlike inherited Traditional IRAs.
At some point taxes will come due on all income. Advisors who render advice that considers relative tax rates, and not just a client’s tax rate in a given year but effective rates going forward, are in a great position to complement what a CPA provides in looking back to prepare your return. By providing a copy of your tax return to your Wealth Advisor, they can make sure your distribution strategy matches up with your goals, both to meet in your income needs and estate planning intent, without paying more taxes than you have to.
1Moneychimp. “Compound Annual Growth Rate (Annualized Return).”http://www.moneychimp.com/features/market_cagr.htm
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