When tax rates go up and tax benefits phase out
This is a little bit of a “good news, bad news” story. It’s when a taxpayer learns their income has gone up but it is now so high that many of the tax breaks they have claimed in the past are no longer available to them.
It’s important to note that a major element of tax planning strategy starts with income. Taxpayers’ income and filing status help determine what tax benefits they qualify for and what tax bracket they fall in. Although income might seem outside their control, taxpayers may be able to influence their income to achieve the best overall financial result. One key to this tax planning strategy is to know when it is possible to lower income for a tax benefit.
Most tax benefits aren’t what taxpayers might think of as a “blank check.” They generally phase out, usually as an individual’s income increases. At a certain point, the tax benefit may be eliminated altogether or it may be available only at a small amount. If taxpayers are close to a phaseout range of a tax benefit they’re otherwise eligible for, they could try to lower their adjusted gross income (AGI) so they can claim the tax benefit.
For example, an engineer getting a Master of Business Administration could have enough student loan interest payments and qualified tuition payments to max out two tax benefits: a $2,500 student loan interest deduction and a $4,000 tuition and fees deduction. However, if she is single and earning $82,000, she would be phased out of both deductions. But if her employer offers a 401(k), she could make contributions to bring her modified adjusted gross income (MAGI) down into or below the phaseout range. Contributing $5,000 to her 401(k) would allow her to deduct a maximum of $500 in student loan interest payments and $2,000 in tuition and fees for a total tax savings of $1,875. Contributing $18,000 would bring her below the phaseout range entirely and allow her to deduct all $2,500 in student loan interest and $4,000 in tuition and fees for a total tax savings of $6,130.
Outputs lead to desired outcomes
“Tax outcomes aren’t always set in stone – you may be able to influence your tax outcome throughout the year. Looking at your tax and overall financial picture proactively will usually show you options to explore. Taxpayers should take a look, run the math and see what will get them the best outcome,” said Jackie Perlman, principal tax research analyst at The Tax Institute at H&R Block.
At the same time, tax brackets range from 10 percent to 39.6 percent of taxable income. Taxpayers on the edge between two tax brackets may want to find ways to decrease their taxable income, for example through charitable donations or pre-tax retirement plan contributions which lower both AGI and taxable income.
Similarly, taxpayers who forecast a change in income that will move them to a different tax bracket in the coming year could use that information to make other financial decisions. For example, it could influence the timing of converting a traditional IRA to a Roth IRA.
“Someone at the top of an income tax bracket might want to plan carefully when choosing to increase their taxable income, such as through a Roth conversion. Not only could that mean they fall into a higher tax bracket, but it may push them past the phaseout range for tax benefits they usually rely on,” said Perlman.
As with all other aspects of tax planning, taxpayers should always think of a minimum of a two-year horizon. That means if they defer income or do something else to lower this year’s AGI or taxable income they should consider the effect on next year’s return.