Did I Just Pay Too Much Tax?
I’m never more aware of my effective tax rate – the average rate paid on all income – and my marginal tax rate – the rate at which my last dollar of income is taxed – than in mid-April.
Having just filed my return, this headline from the Wall Street Journal, of course, caught my eye.
How You Can Grab a 0% Tax Rate
I’m skeptical by nature, so I typically believe the, “If it seems too good to be true, it probably is” mantra. And a 0% tax rate certainly sounds too good to be true.
The article is worth a read, but for those of us with short attention spans, here is the punchline: income from long-term capital gains and qualified dividends may qualify for the 0% tax bucket for many taxpayers, even for taxpayers with substantial assets.
Not all income is treated equally by the IRS. Ordinary income, like that from W2 wages or traditional IRA distributions, is taxed at ordinary income rates, with the highest rate currently sitting at 37%. Here is a breakdown for married filing jointly (MFJ), separately (MFS), single filers, and heads of household (HOH).
Federal income tax brackets
Compare that to the chart below. The highest tax rate for long-term capital gains and qualified dividends is just over half that, at 20%.
Tax brackets for long-term capital gains and qualified dividends
Maybe you’ve heard how Warren Buffet pays a similar tax rate as his assistant. This is largely why. He doesn’t have much of what the IRS considers “ordinary” income. And I suspect most of his assistant’s income is made up of W2 wages.
Just about everyone I’ve ever met would prefer to legally pay less tax.
To that end, late April is a great time to start thinking about 2023’s taxes, while last year is still very fresh in your mind. We like to look for potential tax planning opportunities with clients this time of year. After all, the only returns clients should care about are the after-fee, after-tax, after-inflation returns.
Here are a couple topics that are common considerations:
Roth conversion?
Tax rates were reduced as part of the Tax Cuts and Jobs Act of 2017 (TJCA). However, those lower rates are scheduled to sunset in 2025. Taxpayers in the 24% marginal bracket, for example, may wish to convert enough traditional IRA dollars to a Roth account to essentially fill up the 24% bucket, taking advantage of today’s lower tax rates. For those married filing jointly families, that includes income up to $364,200. After 2025, those converted dollars may be taxed at 28% instead of 24%.
different structure?
Investments held in taxable accounts often come with unique tax consequences. Some give the investor control over when and how gains and losses are realized. Others make that decision on your behalf.
As an example, when mutual funds realize capital gains, those gains are distributed and taxed to the shareholder each year. Most exchange traded funds (ETFs) and individual stocks, on the other hand, give the investor power to decide when to realize gains and losses. Having a low-income year and want to take advantage of the 0% capital gain bracket? Want to reduce dividend income to limit the tax paid on your social security benefits or the amount of Medicaid surcharges? Some structures make tax control easier than others.
This may not seem like a big deal, but we’ve run into many situations where clients paid significantly more tax than expected due to distributions from mutual funds and other managed products.
Direct indexing is a relatively new concept for many investors and can add an element of tax efficiency to taxable accounts.
Location, Location, Location?
This mantra applies to more than just real estate. Consider an investor with a 401(k), a Roth IRA, and a taxable brokerage account. Which investments belong in which accounts to get the highest after-tax return? Withdrawals from a 401(k) will be considered ordinary income, while Roth IRA withdrawals are tax-free. And tax treatment on income from a taxable brokerage account – an underrated account, in my opinion – will depend on the type of investment and income.
summary
Whether you just wrote a check to the U.S. Treasury or cashed a refund, most people still wonder, “Did I pay too much?” Tax planning is an important part of the puzzle to ensure you pay as little as legally required.
Clients, please reach out to me or your Divvi advisor if you’d like to discuss an in-depth analysis of your tax return, including strategies that could potentially help reduce tax liabilities in future years.
You can email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversations.
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