A strategic approach to taxes

At the end of the year, we often think about taxes.

• Should I withdraw more money from my IRA or brokerage account?
• Should I contribute to a Roth IRA?
• How can I lower my taxes for this year?
• How much should I give to charity?

The answers depend on how much and what type of income you already have and also what you expect to receive by December 31.  Year-end projections can be tricky, though. For example, a surprise bonus in December could make someone ineligible for a Roth IRA contribution.

An “old school” approach to taxes is “delay, delay, delay.” Someone following this approach may think “whenever taxable income can be pushed to a future year, it should be pushed out.” A consequence of delaying income can take decades to manifest, and eventually there may be large tax bills. The classic example is traditional IRAs. A diligent investor saves for decades and then faces large Required Minimum Distributions (RMDs) in retirement, pushing the retiree into a higher tax bracket and potentially paying more in taxes over their lifetime.

An alternative is to strategically realize income with the long view in mind. This often means (voluntarily!) paying more in taxes now to reduce the expected tax bill a decade or more in the future. We can think of the current tax brackets as low/medium/high. (Note: For simplicity, this is focusing on ordinary income, excluding capital gains, AMT, and other tax situations.)

A strategic approach is to fill up the low brackets with income and delay income when in the high brackets.

Example: Maybe you spend several years in the medium tax brackets while building a career. With a promotion, you leap into the high tax brackets and make the most of strategic deductions. If you semi-retire or take a sabbatical, you may have low tax bracket years during which you could strategically pay more in taxes.

The tax code is a mash up of rules and formulas (piecewise linear functions, for the mathematically inclined). Sometimes they combine in ways that have a big impact on taxes. For retirees, this means checking for a tax torpedo (Social Security taxation is complicated at lower income levels) and IRMAAs (Medicare surcharges at higher income levels). For someone taking a mid-career sabbatical or a downshift decade before retirement, this may mean checking for the impact on tax credits related to health insurance. Part of year-end tax planning is looking out for these situations.

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