Our tax structure is progressive which means the more you make then the more as a percentage that you will pay in tax.
For example, if you are married and make $400,000 after deductions, you are in the 32 percent marginal tax bracket. This means if you make an extra dollar you will have to pay 32 cents in tax on that extra dollar. You did not pay 32 cents on the first dollar you made because the first bracket starts at 10%. So, instead, you paid 10 cents of tax on the first dollar you made all the way up to about the first 20,000 dollars.
Minimal Tax Strategy
If we knew how much money we will make in our lives and we could control when we will make it, there seems to be an optimal strategy to pay minimal tax. By shifting your income across the years to have exactly the same income each year, you would pay the least amount of tax versus having income move up and down each year.
Now, we don’t have this option with all the income we have but sometimes we can move income from one tax year to another and this is the theme we should be considering.
For example, putting money in your 401k is so often accepted as something everyone should do.
If we can shift when we will be taxed on the income we put into our 401k from today to some day in retirement, we expect we would be in a lower tax bracket then and will ultimately pay less tax. We also get the growth in the meantime, but the lower tax rate makes a huge difference.
This works with capital gains as well as regular income – we want to smooth this out over time. Even though capital gains tax rates are lower, they are still progressive in nature and if you want to get into the details, you must make your capital gains work with your regular income in order to minimize tax.
Highest Tax Bracket
If you’re thinking, I’m already in the highest tax bracket so I don’t think it matters for me.
Yes, it does. And here’s how.
If you are consistently in the highest tax bracket and you are planning on passing some of your money on to others either through inheritance or charity, you’ll want to defer taxes as much as possible. For both charitable gifts and inheritances, there are special tax treatments that you’ll want to take advantage of and the best way to do that is to not pay tax today on the income you will be giving away. Or at least to defer as much of it as possible.
In addition, you may believe you will always be in the highest tax bracket but that may not end up being the case. What if you decide to take a full year off work as a sabbatical? You could use that year to realize income you’ve pushed forward from previous years and have it taxed at a lower rate.
I realize life is too messy to have a completely level income over the years, but as a rule, you’ll want to even out your income from year to year.
Here’s this week’s Best Financial Life tip of the week: Level Your Income to Minimize Your Taxes.