Staying in the 15% (or Lower) Tax Bracket

Most retirement tax planning and tax discussions have the wrong focus. They look at marginal tax rates, or the tax rate on the next dollar of ordinary income earned. If you’re married and earning $50,000 annually, for example, your next dollar will be taxed at the 15% rate.

That’s a fine approach during the working years of most people. For retired people, some self-employed people, and a few other taxpayers, that’s the wrong approach. Different types of income are taxed at different rates. You also might have control over when income is received and what type of income it is.

A better approach is to focus on your effective tax rate. This is the percentage of all your sources of income that is paid in income taxes. Many retirees can structure their income so that the effective tax rate is much lower than during their working years and than the effective tax rate on someone earning the same amount in salary.

A savvy retiree can keep the tax rate around 15% without taking a drop in income by making adjustments in investments, retirement plan withdrawals, and other income sources.

Take a look at the important factors. For married couples filing jointly, ordinary and earned income are taxed at the 15% rate until taxable income exceeds $72,500 in 2013. (For single taxpayers the ceiling is $36,250.) Qualified dividends and long-term capital gains are taxed at the 20% rate, regardless of their amount. (Long-term capital gains on collectibles, including precious metals, are taxed at a maximum 28% rate.) For taxpayers in the 15% or lower marginal tax bracket, long-term capital gains and dividends are taxed at 0%. In the 25% and 35% tax brackets, long-term capital gains and qualified dividends face only a 15% rate.

Social Security benefits are tax free until adjusted gross income reaches $32,000 for a married couple filing jointly or $25,000 for a single taxpayer. Distributions from Roth IRAs and interest from state and local bonds generally are tax-free.

Don’t forget those rates are on taxable income. Before getting there, you have exclusions, exemptions, and deductions. You reduce gross income by personal and dependent exemptions. Then, you have either the standard deduction amount or your itemized expense deductions, such as state and local property and income taxes, medical expenses, and charitable contributions. You also might qualify for tax credits, such as the foreign tax credit on foreign investments.

Now, let’s look at how you can use these features of the tax code to minimize your effective tax rate.

– Wait to take Social Security benefits. We discussed strategies for beginning Social Security benefits in past visits. As a general rule, delaying the benefits not only increases the amount of benefits but also increases your tax-exempt income.

– Defer traditional IRA distributions until you have to take them after age 70½. As we’ve discussed in the past, your nest egg lasts longer when taxable accounts are spent first.

If you’re relatively young consider the opposite, emptying your traditional IRA early. Some strategies for doing this are discussed on page three of this visit.

– Make charitable contributions from your IRA. For 2013, the special tax treatment of charitable contributions from IRAs still applies. You must be over age 70½, and the charitable contribution must be made directly from the IRA to the charity. You don’t receive a deduction, but the distribution isn’t included in gross income. This can be used only up to $100,000 for the year.

– Seek tax-advantaged income in taxable investment accounts. Consider receiving some of your income from stocks or mutual funds that pay qualified dividends. Most U.S. corporate dividends qualify (though real estate investment trust distributions don’t) and many foreign corporate dividends are qualified.

Also, consider master limited partnerships, which pay a lot of tax-advantaged income in the early years of ownership. The taxable income can climb after a decade or more or when you sell the shares, but the taxes can disappear when you leave the shares to your heirs, who get to increase the tax basis.

For fixed income, consider purchasing tax-exempt bonds instead of corporate bonds or treasury bonds.

– Managed taxable accounts to minimize taxes. Of course, you should avoid taking profits until you’ve held an asset for more than one year, if that makes investment sense, so the sale qualifies as long-term capital gain. Look for assets that have lost value. Sell them to capture the capital loss. It offsets capital gains for the year dollar-for-dollar and up to $3,000 of additional losses offset other income. Any excess losses can be carried forward to future years to be used in the same way.

When you still like the asset, you might be able to re-purchase it. For stocks and other securities you have to wait more than 30 days before repurchasing a substantially identical asset, if you want to deduct the loss now. To stay in that sector or market, instead you can purchase the stock of a competitor or a sector ETF. For mutual funds, you can purchase a fund of a competing mutual fund company that has a similar style or investment approach.

– Capture all your tax benefits. If you have foreign investments that pay taxes, take the foreign tax credit when it’s allowed. Take all the itemized expense deductions you’re permitted to reduce your taxable income.

– Be careful about annuities. I recommend that most people have a portion of their retirement portfolio in immediate annuities. These provide guaranteed income for life. When you purchase them with after-tax money, such as from your taxable accounts, a portion of each distribution will be tax-free for your life expectancy.

But don’t overload your portfolio with annuities. All income and gains distributed from them is ordinary income. Some people are putting a high percentage of their portfolios into annuities with various guarantees and other features. Not only do these features come with high fees, but you’re also converting potential tax-advantaged income such as long-term capital gains into ordinary income.

As always, don’t let the tax code alone dictate your financial strategies. But instead of focusing on income, focus on after-tax income. Be sure that an investment or strategy really is more attractive after considering its after-tax effects.

RW August 2013.