How to use investment accounts to control your taxes.
What is your taxable income?
The amount of federal income tax you pay is based on your taxable income--line 43 of the 1040. Examine line 43 to determine your taxable income.
What is your Marginal Tax Bracket?
Review the federal tax brackets and determine what marginal tax bracket you are in. Also examine where you fall within the range (are you at the higher end of the bracket, lower end, or somewhere in the middle?) It is important to understand that tax brackets are progressive. This means you pay a higher tax rate on each additional dollar of taxable income as you bump into higher marginal tax brackets.
How does your current marginal tax bracket compare to your future marginal tax bracket?
We can't predict the future, but we can make an educated guess as to our current tax bracket relative to the future. If I am just starting my career, for instance, I may assume I am in a lower tax bracket now than I will be during my peak earning years. If I am in my peak earning years, my tax bracket may drop once I decide to retire. If I own investment properties, the income may currently be offset by depreciation and other deductions, resulting in a lower tax bracket, but I can predict that future rents may be higher and the deductions will be gone, forcing me into a higher tax bracket. Analyzing our current situation relative to the future allows us to build a plan around when we should pay tax.
Where to save?
One of the best ways to control your tax bracket is to take advantage of the tax incentives provided by the government for retirement savings. Qualified retirement plans all have the benefit of tax-deferral (income generated annually through dividends, interest, and gains is not taxed annually), but some offer an immediate tax deduction. Qualified Retirement Plan accounts that offer an immediate tax deduction we call "tax-deferred" and those that don't we call "tax-free". Contributions to tax-free accounts are made after you pay tax on the income, but are withdrawn tax free later as long as you make a qualified distribution. Withdrawals from tax-deferred accounts will show up as ordinary income in the year in which they are withdrawn. Tax-deferred accounts include traditional IRAs, 401(k)s, 403(b)s, deferred compensation plans, simple IRAs, SEP IRAs and solo 401(k)s. Tax-free accounts include roth IRAs, roth 401(k)s and roth 403(b)s.
Once you know your taxable income, marginal bracket, and have estimated future tax brackets, you can use your knowledge of qualified retirement accounts to control your future tax brackets.
For example, if I am a single filer and my 2014 tax return reveals I have a taxable income of $50,000 I would be in the 25 percent marginal tax bracket. If I believe I will be in the 15 percent marginal tax bracket in retirement and I have $18,000 to save in 2015,1 may want to save my first $12,550 in a tax-deferred account like a 401(k) that avoids current income tax and the remaining $5,450 in tax-free account (Roth) that I pay tax on now, but will grow tax free. The end result would be dropping my taxable income to $37,450, thus putting me in the 15 percent bracket and saving $3,137.50 in current year taxes. By saving in both tax-deferred and tax-free accounts I create tax diversification which will open the door for additional withdrawal strategies in retirement.
Where to withdraw?
What if I am a single retiree and I need $50,000 a year of inflow to maintain a comfortable retirement? In that case I might withdraw the first $36,000 from a tax-deferred account that shows up as ordinary income and the remaining from a source that wont generate any income tax like a bank account or tax-free account. This strategy results in keeping me in the 15 percent marginal tax bracket and avoids spiking income into the 25 percent marginal tax bracket, reducing current year taxes by $3,137.50.
By understanding your current tax situation and just a few tax basics, you can make informed decisions regarding where to save or withdraw assets in a way that enables you to keep more of your hard earned money.
W. Devin Wolf is the chief investment officer and leads the 401 (k) branch at Financial Plan Inc He partners with business owners, CEOs and executives to create comprehensive financial solutions. Learn more at www.financialplaninc.com
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|Title Annotation:||On Financial Planning|
|Author:||Wolf, W. Devin|
|Date:||Apr 1, 2015|
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