Have you ever heard someone say something like “I don’t want to realize more taxable income this year because it will put me into the next tax bracket and my taxes get a lot higher”?
This sentiment is common, and understandable, but it’s usually based on a misunderstanding of the way income is taxed at the federal level. Take a quick look at the chart below:
Let’s take an example of a married couple filing a joint return with an income of $94,301. Notice above that for this couple that puts them in the 22% tax bracket. In fact, they are over the upper bracket limit by $1! It’s easy to assume that this unfortunate couple made $1 too much and now their entire tax rate jumps.
Fortunately, this is not how it works. In fact, taxes are based on a graduated rate. They pay 10% on the first block of money, then 12% on the next….and so on. Only on that last $1 does our couple pay 22%. They do not pay 22% on the whole amount.
Understanding this helps us take a more educated approach to two tax strategies – both of which actually trigger more tax today, but can mean less tax over your lifetime.
Strategy 1. Converting IRA’s to Roth IRA’s over Time.
This requires taking a withdrawal out of your pre-tax IRA, paying taxes now, and converting funds into a Roth IRA where it can grow tax free from there forward. It can make sense to trigger more tax within your current bracket, or even into the next one, if you are maximizing the power of your overall assets.
Strategy 2. Diversifying the Tax Treatment of Your Retirement Savings.
Most of us are hard wired to follow the conventional wisdom of maximizing contributions to our workplace retirement plans. This makes sense if your income in retirement drops into a lower tax bracket. Then, as you withdraw from retirement savings, and pay taxes from your pre-tax assets, you’d be paying less in taxes.
Yet, there are lot of reasons why you may not be in a lower bracket into today’s world. What if, you are a good saver, or have a company pension plan, or have rental property? These all may put you into the same or a higher tax bracket in retirement. What if when you reach retirement, you have chosen to put all your savings in a pre-tax bucket which in retirement comes with an additional tax burden? What if tax rates rise? For these reasons, we find ourselves more often recommending that you diversify HOW you are saving – both inside and outside the company.
Taxes are one of the most misunderstood topics and something we continually assess to maximize the overall effectiveness of your financial plan.