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How To Manage Your Tax Brackets Now And Later

Do you know what tax bracket you're in?  Not knowing could stand in the way of your year-end tax planning in 2014.  In fact, you'll likely miss out on some unique tax-saving opportunities.

From a planning perspective, it's not just this year's tax bracket that counts.  It also matters what bracket you'll be in next year, the following year, and for several succeeding years.  After several recent tax law changes, the time horizon for tax planning easily can stretch from five to 15 years.

Let's start with some basic principles.  The federal tax system is based on a graduated rate structure, with seven brackets and corresponding tax rates: 10%, 15%, 25%, 28%, 33%, 35%, and a top rate of 39.6%. Once your income rises into any of these brackets, additional earnings for the year will be taxed at your top marginal rate--in other words, your tax bracket.

Consider a married couple filing jointly in 2014.  Every additional dollar of taxable income up to $18,150 is taxed at the 10% rate; between $18,151 and $73,800 at the 15% rate; between $73,801 and $148,850 at the 25% rate; and so on.  The bracket thresholds are lower for single filers, especially in the lowest brackets.  The IRS adjusts tax bracket amounts annually.

Tax bracket management involves stuffing as much taxable income as you can into the lower tax brackets. That requires projecting your annual taxable income before the end of the year.  Even a rough estimate can be a valuable guideline for year-end strategies.  Depending on the results, you might try to accelerate future taxable income into 2014 or defer some of what you earn into 2015.

For instance, if you expect to have big losses from business activities this year that could mean lower-than-normal taxable income, it might leave room for you to pull in some high-bracket income from 2015 on which you now can be taxed at a lower rate.  If you project you'll be in a higher tax bracket five to 15 years in the future--accelerating income now makes even more sense. 

One of the best tax bracket management methods is to realize capital gains from selling investments at a profit.  Under current law, the maximum tax rate on net long-term capital gain is only 15% for everyone except those in the 39.6% tax bracket--and the 20% you have to pay then is still a pretty good deal. These rates also apply to most dividends.

Even better, the tax law provides a 0% tax rate on long-term capital gains and most dividends for taxpayers in the two lowest tax brackets of 10% and 15%.  This means that the portion of your long-term capital gains and qualified dividends falling within the 10% and 15% brackets is taxed at the 0% rate. This creates a unique tax-saving opportunity for investors at year-end.

Another possibility is to convert funds in traditional IRAs to a Roth IRA in a year in which you expect to be in a low tax bracket.  This minimizes your liability on the conversion tax--the amount you convert is normally taxed as ordinary income--and sets you up for future tax-free payouts from the Roth. 

Note that such tax planning strategies can't be implemented in a vacuum.  Your plan should take into account related items such as the Pease and PEP (personal exemption phaseout) rules.  The Pease rule reduces most itemized deductions for high-income taxpayers, while the PEP rule provides similar reductions for personal exemptions.  For 2014, the thresholds for those reductions are $254,200 of adjusted gross income (AGI) for single filers and $305,050 for joint filers. 

Another complication is the 3.8% net investment income (NII) tax for investors.  The tax applies to the lesser of NII or the amount by which modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers.  The accompanying chart provides a bird's-eye view of the applicable thresholds in 2014.

Suffice to say, you have your work cut out for you as year-end approaches.  However, with professional guidance, you should be able to develop a plan accounting for the current year and your personal time horizon.  Don't let these tax-saving opportunities go by the board.

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