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Tax Bracket Management Can Help Maximize Income During Retirement

| October 05, 2015
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October 5, 2015 Written By: Mike Hengehold, CPA/PFS MST RICP® 

One of the keys to living your Brighter Future™ in retirement is to squeeze as much “after-tax fun” as possible out of your various income sources.

These sources may include dividends, taxable and tax-free interest, Social Security, IRA distributions, annuity payments, capital gains, rents, part-time work etc. In addition, these income sources may come from fully taxable, partially taxable or tax-free sources.

While those still working generally have very little control over the amount and timing of their income, retirees can often "engineer" a combination of different types of income from different sources and tax environments creating the opportunity to manage their income into the lowest possible tax brackets, thereby creating the maximum after-tax income during their retirement years. 

For example, if John and Linda file a joint return and have taxable income of $74,900 from a job, their federal income tax will be $10,312. If they have the exact same amount of income from the qualified dividends and capital gains their federal income tax will be zero.

While this result may not seem fair, it is a good example of the opportunities that our tax system creates for tax bracket management which can help maximize income during retirement. The below table displays the probable income tax brackets for 2015 for different types of tax filers. Here is additional information about understanding income tax brackets.


How Do Tax Brackets Work

Before looking at strategies for reducing the amount of tax you will owe, it is worth reviewing how the tax brackets work. 

Here’s an example for married couples filing jointly (2015 rates). 
Let’s assume taxable income, after exemptions and deductions, is $175,000. The entire $175,000 is not taxed at 28%. It is broken down this way:
  • Every dollar of taxable income between $0 and $18,450 is taxed at a 10% rate = $1,845
  • Every dollar of taxable income between $18,451 and $74,900 is taxed at 15% = $8,467
  • Every dollar of taxable income between $74,901 and $151,200 is taxed at 25% = $19,075
  • Every dollar of taxable income over $151,200 and up to $230,450 is taxed at 28% = $6,664
  • For a total of $36,051 tax owed
The key to making tax bracket management work is to understand the following: 
  • How the various types of income will be taxed
  • When to recognize income 
  • How to manage around income sources that you can’t control 
  • How and when to take deductions so you can optimize between itemizing and taking the standard deduction
Working with Hengehold Capital Management's Tax Bracket Analyzer™ and your CPA, you can sort out many of the complications.

Below are two examples illustrating how to manage tax brackets to pay less tax next April 15th.

Taxable Income Over $75k for Married (Joint) 
If you are normally in the 15% tax bracket but find yourself in the tax 25% bracket, we want to find ways to drain income from that 25% bracket to reduce your tax liability.

As an example: 
For a married couple, with $85,000 of taxable income, the top $10,100 will be taxed at 25%. You will pay $2,525 of tax on that $10,100 of income. You may be able to use one or more of the following ideas to shift income to a lower bracket:
  • Rearrange your investments to reduce taxable income 
  • Take less money from retirement accounts 
  • Realize capital losses to offset capital gains
  • For high income earners, make deductible contributions to retirement plans 
  • Bundle expenses to maximize itemized deductions
  • Consider accelerating deductions from future years to reduce current income
Taxable Income Less Than $75k for Married (Joint) 
If your income may be higher in the future, you want to fully utilize the lowest brackets. Here are a few ideas you can use to your advantage: 
  • Fund a Roth IRA
  • Use low income years to take IRA withdrawals and pay little to no tax
  • Consider converting your IRA account, or a portion of it, to a Roth IRA
  • Structure your portfolio through proper asset location strategies to generate qualified dividends that may be tax free
  • Take enough capital gains that may be received tax free 
  • Defer deductions to a year when your income may be higher

Keep an eye on your projected Required Minimum Distributions (RMDs)

After adding up itemized deductions, such as mortgage interest and health care expenses, some retirees have more deductions than income. In years where this occurs, this can be a great opportunity to take gains, convert to a Roth IRA, withdraw funds from retirement accounts and pay tax at only the 10% or 15% rate.

Instead, many retirees often make the mistake of following conventional wisdom, letting tax deferred accounts grow until they are forced to take required minimum distributions at age 70 ½. If you wait until age 70 ½, the required minimum distribution may be large enough to push you into higher tax brackets. By taking IRA withdrawals in years where taxable income is low, you can potentially avoid paying an extra 10%-15% tax on withdrawals later down the road.

Below is a summary of the Brighter Future™ tax planning tools HCM can use to help you.
  • Tax Bracket Analyzer™  We will partner with your tax preparer to help you manage the recognition of your controllable income to improve your tax efficiency.
  • Tax Loss Harvesting System™ We will review your investment portfolio to determine whether or not there is an opportunity to reduce your tax liability by realizing losses on specific investments.
  • Tax Location Matrix™ Different tax environments generate different tax burdens on the same level of income.  We help you properly locate your assets to ensure they are generating income or are invested in a manner that generates tax efficient after-tax returns. 

Remember, it's not what you make that counts, it is how much you keep that matters!

Written by: Mike Hengehold, president of the Cincinnati retirement and financial planning firm, Hengehold Capital Management.

Content in this article is not intended to be financial advice. Instead, we think of it as educational, and financial education is important to us.

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