Tax Planning Strategies to Shift Income To Lower Brackets

Smart tax planning will save you money in retirement.

Couple adding up receipts for tax planning.
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No one wants to pay more than they have to during tax season. In order to engage in tax planning that can reduce the amount of tax you will owe, you must understand how the tax brackets work. 

How Tax Brackets Work

Here’s a quick primer on how tax rates work. This is an example for married couples filing jointly (2017 rates):

  • Every dollar of taxable income between 0 and $18,650 is taxed at a 10% rate.
  • Every dollar between $18,651 and $75,900 is taxed at 15%.
  • Every dollar of taxable income over $75,901 and up to $153,100 is taxed at 25%.

The chart below illustrates the tax brackets, rates, and liability for those married and filing jointly in 2018.

Next, Put Together a Tax Projection

Once you understand how the tax brackets work, you must do a tax projection before the end of each year. This projection is an estimate of what you think your taxable income will be. This estimate is necessary for you to determine which strategies will work best for you.

If your taxable income will be $75k or higher, read on to find ways to drain income from the top brackets. If your taxable income will be $75k or lower, read below to learn why you want to be sure to fill up the bottom tax brackets.

The chart below illustrates the tax brackets, rates, and liability for single filers in 2018.

Taxable Income Over $75k Married / $38k Single

High-income filers need to find ways to drain income from the top tax brackets.

Example: Using the tax brackets at the top of this article, for a married couple, if you had $82,500 of taxable income, the top $6,600 of that income will be taxed at 25%. You will pay $1,650 of tax on that $6,600 of income.

Use the following ideas to shift income to a lower bracket:

  • Rearrange your investments to reduce taxable income. You want investments that generate interest income to be held inside retirement accounts, and investments that generate capital gains and qualified dividends to be held outside of retirement accounts.
  • Take less money out of retirement accounts in years where other sources of income are higher.
  • Realize capital losses to offset capital gains.
  • For high-income earners, make deductible contributions to retirement plans. This makes great sense if you fall in the 33% or 35% tax bracket. Why? Most likely when you retire and begin taking withdrawals, your tax bracket will be lower, in the 15% to 28% range. If you can deduct money today at 35%, and pay tax later at 15%, that results in big savings.
  • Increase retirement plan contributions as limits rise. Each October the IRS announces the new contribution limits for 401(k)s, IRAs, and other retirement plans. Each year, be sure to adjust your payroll contributions to put the maximum amount into your plans. In 2016 and 2017, for example, the 401(k) contribution limit for those age 50 and older is $24,000 including the $6,000 catch-up provision.

Taxable Income Less Than $75k Married / $38k Single 

Lower income taxpayers should make different choices to maximize tax savings. A few options:

  • Perhaps you should not contribute to a deductible retirement account. Instead, fund a Roth IRA, or make Roth contributions to your 401(k) plan.
  • Use low-income years to take IRA withdrawals and pay little to no tax. See details about this tax planning strategy below.
  • Consider converting your IRA account, or a portion of it, to a Roth IRA.

1. Use low-income years to fund tax-free Roth accounts

In years where your taxable income will be low, Roth IRA or Roth 401(k) contributions make sense.

Example: A real estate agent I know routinely made annual tax-deductible contributions to her 401(k) plan. At the end of a slow year, we looked at her tax situation and realized she would be in a low tax bracket that year.

It made no sense for her to make a deductible contribution in order to save 10% in taxes now, only to make withdrawals ten years from now, and pay tax at a projected 15% rate then. So she contributed to a Roth IRA instead of making deductible contributions to her 401(k) plan.

2. Take IRA Withdrawals

For those age 59 1/2 or older, you might consider taking IRA withdrawals during low income years, even if you are not required to. Here's why this can work. 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 withdraw funds from retirement accounts and pay tax at only the 10% or 15% rate.

Instead, many retirees follow conventional wisdom, and let 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 that the extra income then shifts you into the 25% tax bracket.

By taking withdrawals in years where taxable income is low, you can potentially avoid paying an extra 10% - 15% tax on withdrawals later down the road.