How to Fill up Lower Tax Brackets Strategically

Managing your income around federal tax brackets can help you pay lower taxes in the long run.

Tax bracket filling can help investors lower lifetime taxes through careful income planning. vittaya pinpan/shutterstock

Many financially-savvy individuals manage their income around the federal tax brackets in order to secure lower rates in the present or avoid higher rates in the future.

Although there are many ways to do this, the broader strategy is generally known as bracket filling.

Let’s take a look at some examples.

Roth Conversion in Low-Income Years

Accounts like Roth IRAs and Roth 401(k)s offer the key benefits of tax-free qualified withdrawals in retirement. However, many people opt for their traditional counterparts in order to take advantage of tax deductions in their working years.

But there’s no rule saying you can’t have both. Here is where a Roth conversion comes in.

A Roth conversion is the process of transferring funds from a traditional IRA or 401(k) into a new Roth IRA or Roth 401(k).

But there’s a catch. You need to pay income taxes on the converted amount. And if you convert a large enough amount, it could bump you into a higher tax bracket. As a result, this move could trigger or increase taxation of your Social Security benefits, as well as Medicare premiums.

But you don’t need to convert your entire traditional IRA or 401(k) balance. You can convert as much or as little as you want. And that’s where bracket filling takes effect.

Say your taxable income after deductions is $60,000 and you’re a single filer. And you have $800,000 in a traditional IRA.

You are in the 22 percent federal income tax bracket. And the top of that bracket is $105,700. So through a Roth conversion, you can fill up that bracket by converting $45,700 ($105,700 minus $60,000) and stay within that bracket without spilling into a higher one.

Many financial professionals recommend people engage in a Roth conversion during low income years to lower the impact of the immediate tax burden. This can take place during the Roth conversion sweet spot. This is generally the time between early retirement and before age 73, when you’d likely need to start taking required minimum distributions (RMDs) from accounts like traditional IRAs and 401(k)s.

But the process can be very complex, and you need to do it effectively to truly benefit in the long run. So it’s crucial you engage in a Roth conversion with the guidance of a qualified financial adviser.

Zero Percent Capital Gains

Let’s say your income took a major hit because you’re in between jobs or under some other unforeseen circumstance.

But you also need cash and have stocks which have significantly grown in value.

Suppose that your taxable income after deductions is $45,000. That puts you in the long-term capital gains tax rate bracket of zero percent. The cap for that bracket is $49,450. So you can realize up to $4,500 in long-term capital gains and stay in the zero percent bracket.

Now let’s say that two years ago, you bought shares of Stock A for $1,000. Today, they have grown to $5,000.

If you sell those appreciated stocks, you have long-term capital gains of $4,000 ($5,000 minus $1,000). So you’d owe no capital gains taxes on that profit.

But this only works if you’ve held onto these stocks for more than a year. That allows you to take advantage of the more favorable long-term capital gains tax rates. And it only works if you have these assets in a taxable account like a regular brokerage account. Selling assets within a tax-advantaged account like an IRA doesn’t trigger a taxable event.

Tax-Gain Harvesting

This also involves selling appreciated assets. So let’s stick with the last example. Suppose you’re in the zero percent long-term capital gains tax bracket. And you’ve sold appreciated assets for a profit of $4,000 ($5,000 minus $1,000).

But what if you want to keep those stocks? And you immediately buy them back for $4,000. You’ve reset the stock’s cost basis on which future tax liability would be calculated.

Let’s break that down.

Suppose your $4,000 stock shares grow to $6,000 in two years. If you sold them at that time, you’d owe capital gains taxes on the $2,000 appreciation ($6,000 minus $4,000) instead of $5,000 ($6,000 minus $1,000).

But that can ultimately be very tricky as you’re relying on those stocks to keep growing.

Qualified Distributions

If you’re a retiree between the ages of 59 1/2 and 73, and you have substantial savings in a pre-tax account like a traditional IRA or 401(k), you may want to start withdrawing funds from those nest eggs. Here too, you can strategically withdraw just enough to stay within a desired tax bracket.

One of the main reasons why some investors do this is because they worry their future RMDs would be large enough to push them into higher tax brackets and potentially trigger tax torpedoes.

The Bottom Line

Managing your income around your federal tax brackets can help you pay lower taxes in the long run. This is often referred to as tax bracket filling. Examples of this include Roth conversions, tax-gain harvesting and qualified distributions to reduce future RMDs. But these strategies can be complex and must be done properly to truly benefit from. So it’s important to discuss these moves with a qualified tax adviser.

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