Knowing Your Brackets Will Better Protect Your Assets

Did you get sticker shock when you found out what your 2013 income tax bill was? No? Then read no further--this doesn’t pertain to you.

On the other hand, if you find yourself wondering why your taxes are so much higher, that tells me you are “wealthy” least in the eyes of the federal government.

No matter that it takes two incomes and at least $250,000 just to afford a modest home with three kids and a two-hour commute from your jobs in L.A., San Francisco, New York City, Washington, D.C., Boston, Chicago or other high-rent, high-tax areas of this country. According to President Obama and this Congress, you can afford to pay more to Uncle Sam.

If you fall into this category, Green Bay, Wisc., Certified Public Accountant Robert Keebler says whether you are planning for college, retirement income, inheritance issues or any other facet of your financial life, thanks to the changes that took effect at the start of 2013, everything boils down to managing tax brackets. As he puts it, the question you should be asking yourself is, “How am I going to be a good steward of my assets?” It all comes down to something he calls “tax alfa.” That is, the ability to understand what “buckets” to put your assets in and which ones to pull income from in order to maximize your income on an after-tax basis?

At the very least, this means knowing at what level a higher tax bracket kicks in and what kind of income can trigger this. Now that we have seven individual income tax brackets and three capital gains brackets this is no easy feat. Add to this the fact that, "it’s very, very hard to beat the stock market,” says Keebler, at least on a consistent basis- and the challenge can be overwhelming. And, it’s not something your average tax preparer can help you with--seek out an experienced CPA.

On top of an array of income and capital gains brackets, if you receive income from investments- dividends, capital gains, interest, etc.- and your modified adjusted gross income exceeds certain thresholds, you will be hit with an additional 3.8% tax on Net Investment Income (NII). If you work, your earnings could be hit with a Medicare surtax of 0.9%.(2)

For instance, say you’re married, retired and both of you are 67 years old. You’ve got $300,000 in IRAs, a million bucks in your combined 401(k)s and $250,000 in mutual funds and individual stocks. Developers have offered you $5 million for the 200 acres you bought 40 years ago, but selling will subject you to the 3.8% NII tax. Ten years ago you set up a trust for your grandkids and you just learned that it too could be hit with this tax. You’re getting $40,000 a year in Social Security and would like another $60,000 this year to make some necessary modifications to your home and for travel.

From what account(s) should you draw this money in order to minimize the tax consequences?

Call it The Tax Game, if you’d like. Critical strategies involve smoothing out your income from year to year and maximizing the 15% bracket. “Typically, we have someone fill us the lowest bracket with ordinary income or Roth conversions,” says Keebler. As you move into higher brackets, to the extent possible, you want to pull your income from “buckets” holding tax-free or capital gains assets as opposed to those that generate ordinary income (see above). Instead of selling all at once, strategically sell off pieces of appreciated assets so that you prevent your income from spiking above the threshold that will make you subject to the 3.8% investment income tax.

If you are still working, maximize your contributions to any tax-deferred retirement account your employer offers and IRAs. As you approach the thresholds at which the Net Investment Income tax kicks in, consider life insurance, limited partnerships in oil and gas, real estate and tax-exempt municipal bonds.

If you want to make charitable gifts, do so in a “smart way,” says Keebler. The key: avoid using cash. For instance, say you want to give several charities a total of $500. Transfer $500 in appreciated stock to a DAF(3) and then direct the DAF to make the gifts out of your account. Since a donor-advised fund is, itself, a charity, you get an immediate tax deduction for your gift. The DAF then sells the securities and distributes the proceeds to the other charities according to your directions. Since it’s a charity, your DAF pays no capital gains tax on the sale of the appreciated assets you contributed.

A similar strategy works if you are providing income for other family members who are in a lower tax bracket than yours: transfer appreciated assets; don’t give them cash. While this advice has been around for years, it’s more important now than ever because if you sell the assets, you will not only potentially pay more in capital gains tax, you could also get snagged by the additional 3.8% investment income tax.

“Got a 25-year old living in your basement who you’re giving $500 a month?, asks Keebler. “Transfer securities to them and let them sell them. Your kid is probably in a lower tax bracket than you are.”  Or, say you are helping your 87-year old mom with her bills. Transfer stock to her. She could be in a 0% capital gains bracket. When she sells the shares, none of the money is lost through taxes. (Of course, when gifting assets to others, you also need to keep the annual gift limits in mind.)

As the saying goes, it’s not how much you earn. It’s how much you keep. Arranging your assets in the right buckets can mean you are able to reduce the risk in your overall portfolio. If you manage your taxes correctly, you should be able to invest in things that earn a lower, less risky return, and still generate the same amount of income on an after-tax basis.

2. The thresholds at which both the Net Investment Income and Medicare Surtax kick in are the same and depend upon your filing status:

  • Single, Head of Household or Widow(er) w/dependent child: $200,000.
  • Married, filing jointly: $250,000
  • Married, filing separately: $125,000  

3. Donor-advised fund. A DAF enables you to make contributions to an account in your name that holds various investments- typically mutual funds- that you select. Because a DAF is a legal charity, your contributions are deductible in the year that you make them. However, you direct when you want distributions made from your DAF account to the charities of your choice. Contributions that are not distributed remain invested and can increase in value so that you potentially have more money to distribute in the future. Finally, the costs involved in creating and maintaining a DAF are significantly less than those associated with a trust or private foundation.