I talk a lot about using taxable income disparity in order to dramatically reduce your overall taxes. For clients building wealth, we focus on creating tax diversification. For divorcing couples, we carefully allocate taxable income to create the lowest combined household taxes so more money is available to meet each individual’s goals and interests for themselves and their children. For clients near or in retirement, we make careful use of the low income “gap years”, from retirement to the start date of required distributions, to complete tax strategies that can save very large sums of taxes in the coming decades.
Each of these is the same fundamental concept. That is, using a disparity in taxable income, either across years or across households, to dramatically reduce your lifetime taxes and increase your access to various tax credits and benefits.
Let me quantify just some of these tax savings for you:
$11,600 per year in tax bracket savings during the retirement gap years or across divorced households (1)
$9,250 per year in savings by not having Social Security benefits taxed (2)
$6,000 per year in premium reduction credits for health insurance (3)
$694 – $4,164 per year in Medicare premium savings by not triggering income-related adjustments (4)
$6,557 per year earned income credit for the lower-income spouse in divorce (5)
$24,000 reduced income taxes per $100,000 converted during gap years to avoid required minimum distributions (6)
$6,000 per year capital gains tax avoided by triggering $40,000 gains at lower income rates (7)
Depending on your unique circumstances, the aggregate tax savings from a combination of these strategies can easily exceed $100,000 over a five year period. Over longer-term periods, I’ve previously demonstrated that just one of these approaches (tax diversification during the saving years) increases lifetime wealth by an astounding 58%, and that’s before we even consider many of the additional tax credits and savings listed above.
It all comes down to simply structuring your assets so that you can strategically pull income from various sources to reduce taxable income at key points in time. If you’re divorcing, it’s the exact same thing, but across your two new households in addition to across time.
One of the most prevalent common knowledge beliefs I hear is that contributing to a Roth IRA or Roth 401(k) doesn’t make sense if you’ll be in a lower tax bracket in retirement. In reality, the fact that you will likely be in a lower tax bracket in retirement is precisely the reason why we need to have assets in tax-free Roth and tax-advantaged investment accounts! This mix of income sources is the only possible way to employ the tax strategies afforded to you in the lower taxable income years of retirement.
Another common perception is that the recent change in the tax treatment of support payments in divorce is a net loss for both families. In reality, this change in the tax code serves to increase the disparity in taxable income between households, and opens up pandora’s box for a myriad of tax reduction strategies that are far more beneficial than simply deducting payments.
This is the first weekly letter I’ve written in 2 years that needed footnotes, so please accept my apologies! While perhaps a little more complex than other topics, these are powerful planning strategies that require our attention as we work to build and preserve wealth.
(1) Taxable income of $100,000 vs. $20,000 by using tax-free and tax-advantaged income sources during gap years, or using various strategies to shift income in divorce.
(2) $50,000 joint SS benefit, subject to 85% taxation at a 22% tax bracket.
(3) Estimated ACA premium credit for a household of 3 with a $50,000 taxable income.
(4) IRMAA adjustments begin at $87,000 for individuals.
(5) Earned income credit with 3 children; phases out as income approaches $50,162.
(6) $100,000 conversion spread over 5 gap years in retirement, completed using various income offsets to avoid conversion taxes.
(7) Realization of capital gains at the 0% gains rate versus 15% gains rate.