The other day, while my three-year-old and I were driving to school, we had the following conversation:
3 Yo: Daddy, why did that car [the one in front of us] cross over that yellow line?
Me: I know buddy. They aren’t supposed to do that.
3 Yo: Why?
Me: Because that’s the rules of the road, bud.
3 Yo: What are rules of the road?
Me: Well, they are things we are supposed to follow or do so that we don’t get into trouble.
3 Yo: And so we don’t bonk into any cars?
Me: Yeah, bud. That too.
My three-year-old has a basic understanding of some of the rules that we abide by when we get behind the wheel. He often tells me a light is red well before I come up to the intersection, or that I crossed over the solid line when entering a turn lane.
After dropping him off that day, I started to think through many of the places where we have “rules of the road” that are there to guide us in other areas of our lives. Like a true financial planner, I eventually thought through how the Internal Revenue Service has its own set of “rules of the road” for us to follow with our finances.
As we stare down the end of the year, I wanted to provide you with a few of those rules of the road to be aware of in case you need to take any action.
We see many signs that tell us to slow down and proceed with caution while driving. Well, there is an income range where it makes sense to do the same. While many are aware that there are seven different tax tiers that we navigate through with Ordinary Income each year, you might not be aware of the three different tiers that capital gains pass through for taxes.
Capital Gains, unlike the Ordinary Income tax brackets, has a 0% tier where you could have up to $89,250 ($44,625 if a Single filer ) and pay 0% in taxes on those realized capital gains.
The capital gains bump zone is a point where additional income will push some of your capital from 0% to the 15% tax bracket. Because capital gains are stacked on top of ordinary income (after deductions), it is important from a planning perspective to be aware of this zone as additional income may actually have an effective tax rate of 27% federally.
Suppose that we have a couple with ordinary income $49,250 after the standard deduction and $40,000 of long-term capital gains. That would put their total income right at $89,250, thus making all $40,000 of those long-term capital gains tax-free from a federal perspective.
Now, suppose that the same couple took an additional $10,000 distribution from their IRA before the end of the year, pushing their ordinary income after the standard deduction to $59,250, and total income to $99,250.
Since capital gains stack on top of ordinary income, they have now moved $10,000 from the 0% capital gains tax bracket to the 15% capital gains tax bracket. Not only did that IRA distribution get taxed at the 12% marginal federal tax bracket, but it also caused $10,000 of capital gains to be taxed at 15%, thus making the effective tax rate 27% on those dollars instead!
Sometimes you cannot help the additional income that pushes you through part of that capital gains bump zone, such as a Required Minimum Distribution, or an unexpected year-end bonus. If you have the ability to control your taxable income when around the capital gains bump zone, it might make sense to slow down, and proceed with caution.
Last week, I was driving to meet with a prospective client at a place I have driven to hundreds of times. And while I knew there was construction around there, I did not know that the road was closed. As I drove past the “Road Closed to Thru Traffic” sign, I thought that the entrance would surely still be open only to find out that I was completely wrong.
I then had to backtrack and go around the construction and enter the parking lot from a completely different road, adding probably 8-10 minutes to my drive. Normally, if I do not know exactly where I am going, I have my GPS pulled up on my phone, but if it is a place I frequent, not so much.
There were a couple of detour signs along my route that should have prompted me to pull up my phone and turn on the GPS to find a more efficient route, but because I did not plan ahead of time and look at the map beforehand, it cost me time. The same can be said with your retirement portfolio if you are overly focused with a one-year time horizon.
Suppose you are retired and diligently saved for most of your working career and, like most retirees, the majority of your assets are in tax-deferred accounts (traditional 401(k), 403(b), IRA, etc). In the years between your retirement and age 72, there may be lower taxable income years than when you must start pulling funds out of your retirement accounts and paying taxes on them.
If, like me last week, you are only focused on what is going on in the moment rather than looking ahead for a more efficient path, it might cost you. If you focus only on reducing the amount of tax due in the current year when funding retirement from your portfolio, it is possible that you are missing a more efficient route of accessing funds throughout your planning horizon.
Sometimes pulling additional funds out of an IRA, and paying taxes on those funds, even if you do not need them for your lifestyle this year, ends up costing less in overall taxes than pulling funds out in future years.
Let’s use the same couple from the previous example, but remove the capital gains income. If their current taxable income after the standard deduction is only $49,250 from either pension income, Social Security, or other means, then there is room for another $40,200 before touching the 22% marginal tax bracket.
If they are only focused on paying the lowest amount of taxes this year, they likely would not take any additional distributions from the IRA (especially if they have a taxable investment account to draw from).
Now, we could pull $40,200 from their IRA, pay the 12% in federal taxes, and convert the remaining $35,376 into their Roth IRA to not have taxes on those dollars again (Please note, I am over-simplifying in the fact that state taxes would impact this, if applicable).
In future years we can pull from that Roth IRA to fund additional living expenses for vehicle purchases, home renovations, medical expenses, and not have to worry about it triggering additional taxes. This is advantageous to waiting in future years to pull the additional funds from the traditional IRA when they might be in the 22 or 24% tax bracket. Paying $4,800 in taxes now, rather than $8,800 later would be a bit of a more efficient route.
When navigating through retirement, looking beyond the current year can save you money in the long-run. Similar to having a GPS can help you navigate road closures, slowdowns, and lane restrictions, having a good financial planner who can look ahead at where you are going and how to navigate that landscape.
It is difficult to teach a three-year-old all the different exceptions that come with driving, such as the ability to cross a double-yellow centerline, but only if turning left or passing a cyclist in some states  but understanding what those exceptions are can help you to have a more enjoyable, efficient trip.
Likewise, understanding how your situation applies to the “rules of the road” the IRS and other regulators have set for us affords different planning opportunities. At Market Street we love to dig into those opportunities and help be that GPS for your financial lives.
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