Bracketology & Buckets: Tips to Keep Yourself in a Lower Tax Bracket Over Time.

By: Allie Schmidt, Financial Advisor, CFP®, CPA

The annual celebration of college basketball, March Madness, is about to tip off. With that in mind, I thought it appropriate to focus on Bracketology and Buckets…with a twist: Tax Brackets and Income Buckets. How an investor manages both elements can greatly affect long term retirement success.

Managing your taxable income year to year may help to keep yourself in a lower tax bracket over time. In unusually high or low earning years, it is important to have a good game plan so that in retirement, you avoid paying higher taxes and ultimately, keep more of your own hard-earned money.

We all know that investing money for your retirement is smart, but let’s take it one step further and consider the tax consequences of the accounts you invest in.. Early planning (making decisions based on high or low earning years) can allow you to develop multiple buckets of investments that provide income that is taxed differently. These buckets generally consist of: Tax-Deferred (standard 401(k)s, Traditional IRA, etc.), Taxed Now (Roth IRA, Roth 401(k)), and Taxable (individual/joint savings account, investment account, etc.)

If all of your money is saved in qualified accounts like Traditional IRAs and standard 401(k)s, you won’t have the flexibility to manage your tax bracket, as all of the income from qualified accounts is taxed as ordinary income. Individuals saving for retirement must balance the benefits of saving money on taxes today versus saving money on taxes later. The following scenarios illustrate this idea:

• Brandon & Laurie are 60 years old and just retired.  The couple has the majority of their money in qualified tax-deferred investment accounts, such as IRAs & standard 401(k)s. They require $5,000 per month or $60,000 per year to live, play, and enjoy themselves.  At age 66 they’ll start receiving social security of $45,000 per year.  Every year from today to age 66, Brandon & Laurie should consider taking additional income out of their qualified tax-deferred investment accounts to actually increase their income and taxes paid today since they will likely be in a lower tax bracket compared to when they begin drawing social security and required minimum distributions.  In this case, even if they don’t need the income to live, it may make sense to withdraw from their tax-deferred investment to create the taxable event and put the extra money into their taxable investment bucket. In this scenario, Brandon & Laurie are withdrawing from their Tax-Deferred Bucket.

• Tanya & Roxanne both work full-time; however, Roxanne has decided to take some time off to help take care of her mom, resulting in a reduction in the taxable income for their family that year. Tanya & Roxanne should consider increasing income in the current year to take advantage of the likely lower tax rate by utilizing a Roth 401k at work (if available), Roth IRA (if applicable), or increase their investment account outside of retirement.  In this scenario, Tanya & Roxanne are paying tax today, adding to their Taxed Now and Taxable Buckets.

• Matt works at Google and over his employment he has received a variety of stock options.  In the year that these options vest and he decides to exercise and sell, his annual income is likely going to be substantially higher than in the past or future years.  This year he would want to consider maxing out his 401k, maybe pushing charitable contributions into the current year as opposed to future years, and not withdrawing any money from IRAs or standard 401(k)s that would continue to increase his annual income. Matt is maximizing his Tax-Deferred bucket.

These are, of course, are just a few examples to manage your income buckets and tax bracket over time. To oversimplify: manage your tax bracket consistently, and odds are, you’ll be successfully keeping more of your own money.  Everyones situation is different, so be sure to sit down with your financial advisor and CPA to determine what the right long-term strategy is for you and your family.

Join HD Wealth Strategies at our event,“Bracketology and Buckets” on March 16th. Where we will focus on strategies based on this concept to optimize your retirement investments.  Join us on March 16th for a “Lunch and Learn” at 11:45 am or a “Brews and News” at 5 pm and enjoy hearing some smart retirement planning strategies.

Register here to reserve a seat at the event.

Please note: Changes in tax laws or regulations may occur at any time and could substantially impact your situation. While we are familiar with the tax provisions of the issues presented herein, as Raymond James financial advisors, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.