The media is filled with tax-overhaul news as Congress considers materially re-shaping the byzantine tax code for the first time since the 1980s. Chances are it will continue to be excruciatingly complex. Whatever happens, however, it behooves all taxpayers to have a basic understanding of how the federal tax brackets work, and recognize that we have control over our taxes in significant ways.
A key thing to understand is what “marginal” tax brackets are: They tax income within a range at different levels. In today’s code, the brackets are 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. In practice, this means that, if you’re married and filing jointly for the 2017 tax year, the first $18,650 of your taxable income is taxed at 10%, the next $57,250 (up to $75,900) is taxed at 15%, the next $77,200 (up to $153,100) is taxed at 25%, and so on. The ranges of the brackets vary based on whether you’re filing single, married, married filing separately or head of household.
To simplify this discussion, let’s focus on the 15% and 25% brackets, since those represent a significant slice of the American taxpaying population, and the jump from 15% to 25% is quite large.
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First, you must know where you fall within the brackets. It is driven by taxable income, not gross income. If you file the standard 1040, look at line 43 (for the 1040EZ, line 6) from your 2016 return. If your income/deductions had only minor changes in 2017, it gives you a “ballpark” expectation for your tax liability for 2017. If you are married and Line 43 is below $75,900 ($37,950 if single, $50,800 if head of household), you are unlikely to have income going through the 25% bracket for the 2017 tax year. The IRS announces marginal tax rates for the next year late in the prior year — in this case, 2018 bracket information is already available to help you begin your planning for next year (i.e., the tax bill you’ll pay in April 2019).
So, how can you help avoid reaching that 25% bracket? You have a few options:
Save to pretax retirement accounts: If you have income going through the 25% bracket, it may be wise to add to a traditional IRA and/or 401(k) to have those dollars avoid the 25% pain. Yes, you are kicking the tax can down the road to retirement, but taxes can be less arduous in retirement.
Save to a Roth IRA and/or Roth 401(k): If you are in the lower tax bracket, it’s possible the Roth solution is preferable, particularly if you are young with many years until retirement. Roth dollars go in after tax, but grow tax-free indefinitely.
Consider where you are in today’s tax brackets and where you are destined to be in retirement: If you expect to be in a lower tax bracket in retirement, you may want to emphasize contributions to the pretax traditional IRA/401(k). If you expect to be in the same or a higher bracket in retirement, the Roth solution may have more appeal. A financial adviser can help with this process.
Know that qualified dividends and capital gains are treated favorably for those in the 10% and 15% brackets: As an example, let’s say a married couple has $100,000 in a bank savings account. The interest income is treated as ordinary income. It adds to line 43. But if that $100,000 is invested in a mutual fund that provides qualified dividends and capital gains, those earnings are taxed at a 0% rate for those in the lower brackets. Even if one is in the 25% or higher bracket, they receive a favorable 15% to 20% rate. Granted, the mutual fund will have more risk, and the decision to invest has to be made carefully, but the current tax code clearly provides benefit to the well-informed taxpayer.
Consult your tax adviser: Millions of taxpayers see their tax preparer once a year for 15 to 30 minutes. That tax expert has limited time in the spring — the height of the tax season — to educate you on some key issues. Schedule an appointment in the summer or fall to gain that education. Ask for a 30- to 60-minute dialogue on what you can do to be more efficient in managing your tax burden.
Many people go through their lives without understanding how taxes work and what we can do to manage them. Making yourself a well-informed investor is a crucial step.
Representative is not a tax adviser. For information regarding your specific tax situation, please consult a tax professional. Securities sold, advisory services offered through CUNA Brokerage Services Inc. (CBSI), member FINRA/SIPC, a registered broker/dealer and investment adviser. CBSI is under contract with the financial institution to make securities available to members. Not NCUA/NCUSIF/FDIC insured, may lose value. No financial institution guarantee. Not a deposit of any financial institution. FR-1951535.1-1117-1219