Managing your tax bill can increase your investment returns

We’re heading into the men’s and women’s NCAA basketball tournament, and every fan is carefully studying the brackets. Many – Old Peak included – have an office pool. Some fans will pore over the brackets for hours, searching for that extra edge.

If you spend even a fraction of that time understanding your tax brackets and what drives your annual tax bill, you can increase your long-term investment returns.

Here are a few strategies to consider.

If you are in a high-income year …

Max out your contributions to a traditional 401k or IRA.

You lower your tax bill this year and the money grows tax-deferred for years. If your tax rate is high enough, it’s likely your rate will be lower when you eventually must take the money out in your 70s, 80s and 90s.

Max out your other deductions.

Typical strategies include charitable donations and contributions to a Health Savings Account or Flex Spending Account. But make sure to manage your itemized deductions. With the current higher standard deduction, you may receive no tax benefit from your charitable giving without combining several years’ donations into one tax year, for example with a donor-advised fund.

Minimize capital gains from your taxable investments.

The best way is to use more passive, “buy and hold” strategies instead of active trading. More passive trading defers gains for years.

If you are in a low-tax year …

Roth contributions.

In a low-income year, a Roth IRA contribution is often the best place to put excess savings. You aren’t missing out on a large tax deduction by contributing to a traditional IRA. At higher income levels, you cannot contribute to a Roth IRA, so you should do it when you can.

Roth conversions.

You can move any amount from a traditional IRA to a Roth IRA. It generates a tax bill: the entire amount is ordinary income. But if you are in a lower tax bracket, it can make sense – especially if you anticipate being in a higher tax bracket in a few years.

Harvesting capital gains.

Usually we speak with our clients about harvesting losses when the market is down – losses which can offset gains for the balance of the tax payor’s life. But if you are in a low-income year, harvesting gains can make sense. If you can generate income in a lower tax bracket than you will have in a few years, consider doing it now.

A couple facts which you may not realize about your tax bracket:

• Capital gains can be tax-free. Most capital gains are at 15%. At high income levels, they are at 20%. But if you are in the lowest two brackets, they are at 0%. If your taxable income is below $89,450 (married filing joint) or $44,725 (single filer), you pay no federal tax on capital gain.
• Unless you are in the top tax bracket, your bracket may not go down much in retirement. If you have a large retirement account, you will be required to withdraw about 4% annually starting at age 73 or 75. That, combined with Social Security, income from brokerage accounts and a pension, if you have one, may keep you close to your tax bracket when employed. That means putting money into a Roth 401k or IRA while you are working may be smarter than you thought.
• Tax brackets stack: ordinary first, then capital gain. That means anything you can do to minimize ordinary income can potentially help you reduce your capital gains tax by moving you into the 0% or 15% capital gains bracket instead of the higher 20% bracket.
• The Additional Medicare Tax makes tax bracket management even more critical. If your gross income is over $200,000 (individual) or $250,000 (married), capital gains above that attract an additional 3.8% Medicare tax.

The tax code is complex, to say the least. But if you study it the way some people study their NCAA basketball brackets, you can probably generate a nice return on the investment of time through a lower tax bill. That will help you move from March Madness to April Happiness.