Year-End Tax Planning, Part 2

Tax Brackets

A tax bracket is a range of incomes that are taxed at given rates based upon the tax filing status of (1) single (2) married filing joint (3) married filing separate (4) head of household or (5) qualifying widow(er). For tax years ending December 31, 2022 and 2023, there are seven (7) marginal tax brackets ranging from 10% up to 37%; and if subject to the net investment tax (NIT), an additional 3.8%. Your federal tax bracket is the percentage of tax you will pay the IRS based upon filing status and taxable income. Filing status is important because it helps determine qualification for certain tax deductions, credits and your standard deduction.

Tax Deductions vs. Tax Credits

Tax deductions and tax credits are incentives the government provides to stimulate the economy. Current year spending is required to utilize the benefit of either. Tax deductions are categorized as below or above the line tax deductions that reduce the taxable income by which marginal tax rates apply. Itemized deductions related to homeownership expense, state and/or property taxes are the most popular and widely known tax deductions. 

Tax credits are far superior to tax deductions because a tax credit will reduce your tax bill dollar for dollar; whereas, deductions only reduce your taxable income and tax bracket. Tax credits also fall in two categories; refundable or nonrefundable. You can benefit from a refundable tax credit even if you do not owe any taxes. A nonrefundable tax credit can only be utilized if you actually owe tax; however, the credit can be used to zero-out your tax bill. Neither tax credits nor deductions are allowed to be carried forward to future years but must be utilized for the current tax period.

Income

From a tax perspective, income can be categorized into three buckets: (1) taxable (2) tax deferred and (3) tax-free.

Taxable Income

Taxable income is earned and unearned income from all sources (except gifts, bequests, inheritances) that is adjusted for pretax, standard or itemized deductions and personal exemptions.  In our progressive income tax system, tax rates rise as taxable income increases; hence the importance of tax planning strategies around income deferral and acceleration.

Tax Deferred Income

Tax deferred income is most commonly associated with retirement plan contributions where income has been deducted and set aside without current taxes being paid or withheld. Tax deferred does not mean “no tax due; but only, “no tax due at this time”.  The premise behind trying to time when income is received, whether now (accelerating) or later (deferring), is the expectation of being in either a higher or a lower future tax bracket. The question then, is how do you get to that lower future tax bracket?

Tax strategy can provide a roadmap to get you there. Tax planning should be developed and implemented based upon your total wealth strategy picture; and will include tax acceleration, deferrals, deductions, exemptions, tax credit utilization, income shifting and re-characterizations, etc.

Tax-Free Income

Tax-free income is just that – income where no tax is ever due. There is currently only one avenue to 100% tax free income and that is health savings accounts (HSA). HSAs are pretax deductions and are tax-free when used for future medical expenses. Contributing to an HSA inevitably produces income re-characterization; where funds are repositioned from one category (deferred) to another (tax-free). Contributions to ROTH IRAs will also result in future tax-free income (zero taxes), as will converting existing IRAs over to Roth status. There are other advance planning strategies that can be customized for your particular situation to help you to achieve future tax-free income. Simply stated, max out your future tax-free income bucket and you are likely going to pay substantially less in taxes when creating a long-term wealth accumulation strategy.

A well designed tax strategy will leverage tax policy to lower your current period taxes while simultaneously repositioning your assets and income to permanently reduce or eliminate future taxes, by creating various sources of tax-free income within the context of your overall wealth building strategy. Please contact us know if you are interested in learning more about how to move from a “forever taxed to a never taxed” future environment.

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