We are not strangers to the excitement (and sometimes disappointment) that comes along with March Madness basketball contests. A few years back, it was all excitement when we actually WON the company NCAA basketball tournament. The victory nothing more than a faded memory now, until we occasionally relive our moment of glory (and bore listeners with how we won) … so here’s how it happened: we filled out three NCAA basketball pool brackets:
- One for what we wanted to happen
- Another for what we thought would happen
- A third based on research and taking picks (more than a few, we’ll admit) from an analyst who knew way more about college basketball than we ever would
Guess which one worked ... of course the third option! The lesson? Two minds are better than one when thinking of ways to maximize your chances of success.
This brings us to another set of brackets that might be on your mind this time of year: TAX brackets. Usually by now people have collected the last of their W-2s, 1099s, receipts, spreadsheets and coffee-stained pieces of paper and have mustered enough courage to put together their tax return. At the other side of all this is something you either dread or look forward to — writing, or receiving, a check. At the root of it all is how your taxable income lands on the tax brackets.
At Sequoia, we’re believers that planning sets you up for favorable outcomes. Having awareness of both your marginal and effective tax bracket is the foundation of good tax planning.
Let’s start with the basics. Federal tax law uses a “progressive tax system” to determine what each taxpayer owes in annual income tax. The system is called progressive because as income increases, the tax rate gets higher. A “tax bracket” is a range of income taxed at a set percentage rate.
Picture a multi-layered cake, with each layer representing a tax bracket. This is a seven-layer cake because there are seven tax brackets. There’s a plate at the bottom of the cake where you pay no tax (generally under $12,000 if you are single and $24,000 if you’re married filing jointly). After that, the bottom first layer is the lowest tax bracket at 10%. The layer above it has a higher rate of 12%. Each layer above the last has a higher rate until we get to the top layer, which is 37%.
Now imagine a clear pitcher as tall as the cake, almost full of green punch (can you tell we’ve been to a kid’s birthday party or two?). If that punch represents your taxable income and you line up the top of it to the cake’s highest layer, you’ve just figured out your marginal tax bracket!
That top layer doesn’t mean ALL your punch (income) is taxed at that top rate, just the amount that lines up with that layer. The very bottom amount lined up with the bottom layer is taxed at 10%. Then, the amount lined up with the second layer is taxed at 12% and so on, until you reach the highest layer. When you sort out the amount of income you have within each layer, calculate the tax for each and add it all up, that amount will be your total amount of tax due. That amount relative to your income is your effective tax rate.
This is a very simplistic way of describing tax brackets. Your taxable income will be impacted by several things, like 401(k) and HSA contributions, contributions to qualified plans, and deductions that reduce taxable income, including the new pass-through deduction. Whether you file single or jointly will impact your brackets (think different size pitchers). The type of income you receive (like social security) will also impact your brackets (some of the punch falls out). But knowing where you fall in all this leads to the application of both simple and complex tax planning strategies that can adjust tax liability immediately or in the future.
Contributing to your company’s retirement plan could bring you down a layer. Making a deductible IRA contribution could make a difference; it can be a simple but effective way of reducing tax liability immediately. Tax loss harvesting or selling securities at a loss and using that loss to offset income, then “saving” the rest has an immediate and future impact on lowering taxes. “Bracket topping” or converting to a Roth IRA at an optimal time based on income level, while keeping tax bracket knowledge in mind, could lead to future years with lower taxes. Even making the right form of charitable contribution can make a big difference especially if you are over 70 ½ and use an IRA.
Knowing your tax brackets and applying that knowledge to tax strategies can have a big impact and should be a component of your overall financial plan.
Best of luck with all your brackets this spring!
Contact Noel Villajuan to learn more about this topic.
248.918.5936 | firstname.lastname@example.org