Wage increases are generally a great thing, but the added benefit of an income increase can be offset by the higher prices of goods in times of high inflation and the possibility of being nudged into a higher tax bracket. This phenomenon is known as tax bracket creep. The result? Not only do rising expenses stretch your budget, but that extra income could potentially amplify your tax dues and leave you with less net income than anticipated.
Although federal authorities adjust tax brackets yearly for inflation, many credits, deductions, and exemptions aren’t recalibrated, or they are lagging at best. This can subtly push up your effective tax rate, whether you opt for the standard deduction or itemize. For instance, the net investment income tax (NIIT) levied on gains, dividends, and interest hasn’t seen adjustments since its introduction in 2013. With a 3.8% surtax on items like home sales or interest on CDs, it’s essential to monitor any additional taxable income that may push you past $200,000 for a person filing single or $250,000 for a married filing jointly household. To help alleviate the tax pressure and counteract this tax bracket creep, consider these strategies:
1. Increase retirement contributions.
Lower your taxable income by maximizing yearly pre-tax contributions to 401(k) plans, IRAs, and other retirement accounts. In 2023, you can contribute up to $22,500 with an additional $7,500 catch-up contribution for those 50 or older into an employer-provided retirement plan. This is an increase from the $20,500 plus $6,500 catch-up in 2022. Regarding a traditional IRA, the limit is $6,500 plus a $1,000 catch-up for those 50 and older in 2023 (previously $6,000 plus $1,000 respectively). Just be mindful of the IRA deduction income limits.
2. Don’t forget your health savings account (HSA).
If you qualify to contribute to an HSA, the contribution ceilings for 2023 are $3,850 for individuals and $7,750 for families, with an added $1,000 for those 55 and above. Remember you have until the tax filing deadline (4/15/2024) to maximize these contributions.
3. Defer taxable income.
If you anticipate a year-end bonus, receiving stock options or grants, selling a house or anything of value, harvesting stock gains, or even possibly collecting a severance payment, consider exploring if you can defer realizing/receiving that income until the following year or further into the future if it makes tax sense for you. It’s worth sitting down and listing all of the taxable events that could occur from now until year-end and strategizing how you can split it all up to spread out the tax burden and avoid tax bracket creep or the NIIT surtax. If your company issues nonqualified stock options (NSOs), another thing to consider is to wait until the end of the year before you begin exercising them. NSOs are typically taxed as ordinary income when they are exercised. By delaying, you can strategically exercise just enough to stay within your tax bracket instead of exercising them all at once and succumbing to the creep.
4. Harvest tax losses strategically.
Consider tax loss harvesting to balance out capital gains with capital losses. If investments dip below their cost basis and a similar (but not identical) asset is available, you could replace the sold asset without a major impact on your investment strategy. Also, if you plan on diversifying out of a large, concentrated stock position, remember to evaluate tax lots (the individual purchases you made by date and price) to identify strategic ways to reduce your exposure and minimize your tax bill. Remember to consult your tax advisor to ensure this is done correctly and be wary of the wash-sale rule.
5. Optimize your asset location.
Ensure you allocate high-tax investments like bonds (which pay income) or high-turnover mutual funds (which distribute their capital gains annually) in accounts with tax benefits such as IRAs and qualified accounts. Tax-efficient investments such as low turnover mutual funds, municipal bonds, and passive investments like ETFs and index funds distribute less tax friction which makes more sense in a taxable account.
6. Make the most of your charitable giving.
If charitable giving is part of your financial plan, consider leveraging these approaches to do it in a tax-efficient manner.
Charitable donations: In general, you can deduct cash donations to qualified charities worth up to 60% of your adjusted gross income (AGI), which is your total gross income minus certain deductions such as contributions to retirement plans. Donating appreciated long-term investments like stock via a donor-advised fund can be an especially tax-efficient bunching strategy. You don’t have to recognize the capital gains and you can receive a tax deduction for the full fair market value of the donation (up to 30% of your AGI) at the time of your deposit, thereby front loading your future donations.
Qualified charitable distribution (QCD): If you’re 70½ or older, you can donate up to $100,000 to a charity directly from your IRA using a QCD. You won’t receive a tax deduction for the donation, but the gifted amount can be used to offset all or part of your required minimum distribution (RMD) without adding to your taxable income. As an added bonus, this limit will be indexed for inflation starting in 2024.
Summing it all up
For now, it seems like inflation is showing signs of easing and that federal tax brackets, and the standard deduction are likely to increase. With all that said, it would be prudent to keep these tax-saving strategies at your disposal to help offset the potential burden of tax bracket creep both now and in the future. Just be sure to consult with a qualified tax advisor or qualified financial professional to help you develop a plan that works best for you.