Will your income tax go up or down in the future? If you believe it will increase, chances are you think there is nothing you can do about it. Wrong! Consider these strategies to pay tax at a lower rate today in order to reduce the possibility of a greater tax impact in the future.
No one enjoys paying taxes. Most of us do everything within our power to reduce taxable income each year. However, these decisions can impact our tax situation years into the future. Though we cannot predict how future legislation may impact tax rates, we can use current information and historical perspective to devise strategies to better position our overall financial situation.
As a financial planner, my focus is on helping our clients achieve their goals, which means maximizing every dollar. I accomplish this by limiting the tax exposure a client endures on distributable income from their retirement or brokerage accounts. This measure requires a complete understanding of the client's current tax situation, foresight on how their taxable income will look in future years, and some educated guessing on where tax rates may be. The goal is to pay as little tax as possible.
A couple of strategies that should be considered are the Roth conversion and harvesting of capital gains. Both strategies involve the recognition of income, though the tax impact of each is quite different. Here's why and when Roth conversions and capital gain harvesting might make sense.
A Roth conversion involves transferring funds from a traditional retirement account to a Roth IRA. Any income tax due on the transferred dollars must be paid in the year of the transfer. Once in the Roth IRA, investment growth is tax-free. Therefore, no income tax is owed when distributions are received from the account.
The driving force for doing a Roth conversion is the prospect of paying taxes at a lower rate now, compared to paying taxes during your retirement years.
For example, let’s assume a family has a projected income of $75,000 and plans to file (married filing) jointly in 2020. Assuming the couple takes the standard deduction ($24,800), they will have a taxable income of roughly $50,200, which puts them in the 12% tax bracket. Based on current tax brackets, they have a buffer of nearly $30,000 before they jump into the next tax bracket. Income sources, such as social security, pensions, and required minimum distributions (RMDs) from IRAs during retirement years, can push taxable income into higher tax brackets.
The strategy here would be to convert IRA assets to a Roth IRA in an amount that keeps you inside the 12% tax bracket. This action ensures you pay less in taxes on that income now than you would after retirement. We are currently in a period of low tax rates, so historically speaking, taking advantage of them before they sunset is also sound planning.
Capital Gain Harvesting
Capital gain harvesting is conceptually similar to the Roth conversion, though the strategy differs slightly. The goal is to sell appreciated securities in a non-retirement investment account to realize long-term capital gains in years when taxable income is low. The sale proceeds would then be re-invested in the same or similar investment to increase your cost basis.
Let's revisit our above example with the couple who had a taxable income of $50,200. In this case, they can exchange or sell securities and recognize up to $29,800 in realized gains without paying any taxes on the transaction(s). You read that correctly! In the quirky world of taxes, you will pay no taxes on long term capital gains if your taxable income is below $80,000 (in 2020).
Another way to benefit from this strategy is when there is a need to raise cash for a large purchase, say, $50,000. Using the figures from our previous example and assuming income remains static in the coming year, the couple could sell securities this year to free up half the desired proceeds, and the remaining half the following year. As long as they are below the $80,000 threshold in both years, they won't owe any capital gain tax in either year.
Both strategies have their place in financial planning, whether they are used independently or in combination. Other factors should be taken into consideration when exercising either tactic, so it's best to coordinate with your financial planner and tax advisor when making decisions that can have a long term impact on your financial outlook. Remember, taking strategic action now to lower your tax liability in later years will hopefully produce disposable income for you and your family to enjoy after retirement!
Please remember that past performance may not be indicative of future results. Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.
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