Moving up a tax bracket - when to avoid, when to give up

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sls239
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Moving up a tax bracket - when to avoid, when to give up

Post by sls239 » Tue Jan 27, 2015 10:20 am

We are pushing up against the 25% bracket after many years in the 15% bracket.

Knowing this might happen, we've always maxed our roth contributions so they currently make up a full third of our retirement savings.

There's no roth option for the 401k and the funds available are not the cheapest, but not absolutely horrible.

We can most likely avoid the 25% bracket by switching some or all of our roth contributions to be deductible contributions instead.

But because that entails giving up roth space, I'm wondering how long it would make sense to do that.

Also, because I don't know exactly how much will need to be traditional, I'm wondering when to start making contributions. Unless I wait until the end of the year, at some point I'll have to guess and I don't know if it is better to err on the side of too much roth or too much traditional.

We don't have any taxable investments that would produce capital gains so that isn't an issue.

savagehenry
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by savagehenry » Tue Jan 27, 2015 10:27 am

There are sure to be more elegant responses on how to limit your tax exposure, but in my opinion if you are maximizing all your tax deductible options and sticking to your savings plans i wouldn't go out of my way to avoid the progression from a 15% to 25% MARGINAL tax bracket. Only the amount you are over the 15% marginal rate will be taxed at 25% rate not the entire amount you earned. Making more money is always a good thing and moving up in a marginal tax bracket will not leave you with less money than you had when you were in the 15% bracket.

riverguy
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by riverguy » Tue Jan 27, 2015 10:30 am

All of your income isn't being subjected to the next highest tax bracket. If you are married, only the taxable income over $74,900 will be subject to 25% tax. So if you have taxable income of $75,000, $100 will be taxed at 25%. Doesn't seem like much to worry about.

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Leif
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Leif » Tue Jan 27, 2015 10:31 am

Congratulations on reaching the 25% bracket! Well done!

Roth vs. traditional is all about current versus future tax rates. If you rate will be higher in retirement then Roth. If higher now then traditional. But, it is really more than that. Roth has several features you may find desirable. One is no RMD requirement for the Roth. Another is if the Roth is inherited then it can currently be stretched through the person's life time.

I would use traditional IRA up to the point of the 25% bracket. After that place the rest in a Roth. Since it is near impossible to know future tax rates it would be good to have funds in both traditional and Roth IRAs.
Investors should diversify across many asset-classes so that whatever happens, we will not have all our investments in underperforming asset classes and thereby fail to meet our goals-Taylor Larimore

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Re: Moving up a tax bracket - when to avoid, when to give up

Post by JDDS » Tue Jan 27, 2015 10:33 am

sls239 wrote: Also, because I don't know exactly how much will need to be traditional, I'm wondering when to start making contributions. Unless I wait until the end of the year, at some point I'll have to guess and I don't know if it is better to err on the side of too much roth or too much traditional.

You could wait until your taxes are prepared in the following year. Then you would know the tax consequences of putting X dollars in a traditional vs. Y in a Roth. For example, if you have not yet made a 2014 IRA contribution, you can still do so now, until the tax filing deadline. With IRAs it seems easier to change the status of a contribution after the fact, but that seems like a hastle that can be avoided by figuring out the best strategy ahead of time.

Are you putting enough in your 401(k) type plans for the match? Are you maxing them?

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Aptenodytes
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Aptenodytes » Tue Jan 27, 2015 10:34 am

"avoiding the 25% bracket" seems like an overly narrow and not helpful goal. Your financial health depends not on whether or not you nudged into the 25% tax bracket, but on the aggregate tax hit compared to alternatives. So if you are just about to veer into the 25% tax bracket this year, the net effect is likely quite low and may not be worth worrying about. E.g. you might have $4,000 of income taxed at 25% instead of 15%, yielding a gross hit of $400. The net hit depends on what your viable alternatives are. How much time is it worth putting into reining in that $400?

There are some basic best practices you can exercise, and it sounds like many of them you already are. As a general proposition you are going to want to smooth out your deductions as much as possible, to avoid having too many of them offsetting 15% taxes and instead having the greatest percentage offsetting 25% taxes.

kaneohe
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by kaneohe » Tue Jan 27, 2015 10:48 am

Leif wrote:
I would use traditional IRA up to the point of the 25% bracket. After that place the rest in a Roth. .
Isn't this the opposite of the conventional thinking?

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Aptenodytes
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Aptenodytes » Tue Jan 27, 2015 10:49 am

kaneohe wrote:
Leif wrote:
I would use traditional IRA up to the point of the 25% bracket. After that place the rest in a Roth. .
Isn't this the opposite of the conventional thinking?
He meant what you mean. He should have probably said "down" to the point of the 25% threshold.

yosef
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by yosef » Tue Jan 27, 2015 10:52 am

The question, which I think is a good one because I'm in a similar situation, is essentially is it worth switching from Roth to Traditional to stay out of the 25% bracket. The Roth was an easy call when we were solidly in the 15% bracket. Now I'll have to switch my wife's IRA contributions to Traditional to stay there, and I'm much less certain that's the right call.

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Leif
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Leif » Tue Jan 27, 2015 11:36 am

Aptenodytes wrote:
kaneohe wrote:
Leif wrote:
I would use traditional IRA up to the point of the 25% bracket. After that place the rest in a Roth. .
Isn't this the opposite of the conventional thinking?
He meant what you mean. He should have probably said "down" to the point of the 25% threshold.
Sorry if I was not clear. I meant use a tax deducible IRA contribution to keep the income from going into the 25% bracket (keep marginal rate at 15%). Once that is done any remaining money (and IRA room) can be placed in a Roth that gives you no tax deduction. In any case, however, I don't think we are talking about a lot of money.
Investors should diversify across many asset-classes so that whatever happens, we will not have all our investments in underperforming asset classes and thereby fail to meet our goals-Taylor Larimore

rkhusky
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by rkhusky » Tue Jan 27, 2015 11:53 am

A couple other ways to avoid the 25% bracket are to have a bunch of kids and buy an expensive house with a large mortgage.

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Epsilon Delta
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Epsilon Delta » Tue Jan 27, 2015 11:55 am

What will your future income do? Will you bump along the 15%/25% divide for a decade and then drop back into the 15% bracket or will you blow right through on the way to 39.6%? Many of the responses you get will be tacitly assuming one or the other (or something else).

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Watty
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Watty » Tue Jan 27, 2015 12:16 pm

yosef wrote:The question, which I think is a good one because I'm in a similar situation, is essentially is it worth switching from Roth to Traditional to stay out of the 25% bracket. The Roth was an easy call when we were solidly in the 15% bracket. Now I'll have to switch my wife's IRA contributions to Traditional to stay there, and I'm much less certain that's the right call.
It would be good to see if you can plan to have some years in retirement when you can do Roth conversions in the 15% tax bracket. If so then this may not be much of an issue.

In looking at my numbers when I am retired I will be done with; retirement savings, mortgage payments, FICA taxes, child raising expenses, etc. There will be a few new retirement costs too but I will need a lot less income then so being in a higher tax bracket then is unlikely unless the taxes on social security cause extra taxes to be due.

http://www.bogleheads.org/wiki/Taxation ... y_benefits

If you have somewhat average income with no pension then your retirement tax bracket might be pretty low in retirement. I figure that for a couple that is is 66, has $35,000 in social security, $20,000 from IRA or other taxable income, and the rest form Roths or taxable accounts would owe no federal income tax, but the marginal rate above that would be an issue because of the taxation of social security.

https://turbotax.intuit.com/tax-tools/c ... taxcaster/

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mcrunyan
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by mcrunyan » Tue Jan 27, 2015 2:54 pm

For what it's worth, I find it helpful to keep in mind the difference between marginal and effective tax rates. I made the graph below of marginal vs effective tax rates (total tax / taxable income) for 2013 tax rates for married filing jointly and it might be of some interest. If you were just getting into the 25% bracket in 2013 then your effective tax rate was still around 14% if you look at total tax burden as a whole. Sure there's a kink in the effective tax rate when you hit 25%, but the effective rate is still around 14%.

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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Meg77 » Tue Jan 27, 2015 3:06 pm

Stick with the Roth! Your actual effective tax rate (which is much lower than your tax bracket) will probably not change at all if you are $10K or $20K into the 25% bracket. If your effective tax is under 20% I say go Roth every time - in later decades getting your tax rate that low might be a big challenge.
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MindBogler
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by MindBogler » Tue Jan 27, 2015 3:10 pm

That is an interesting graph, mcrunyan. It would be even more interesting with the addition of 7.65% FICA tax up to $117,000 for 2014.

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Re: Moving up a tax bracket - when to avoid, when to give up

Post by The Wizard » Tue Jan 27, 2015 3:24 pm

Most of us find ourselves paying more FIT in our later working years once the kids have left the nest, the mortgage is paid off, etc.
Not much can be done about it except for saving more in addition to paying more tax. Additionally, you can scheme to retire early to reduce your income...
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rkhusky
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by rkhusky » Tue Jan 27, 2015 3:37 pm

mcrunyan wrote:For what it's worth, I find it helpful to keep in mind the difference between marginal and effective tax rates. I made the graph below of marginal vs effective tax rates (total tax / taxable income) for 2013 tax rates for married filing jointly and it might be of some interest. If you were just getting into the 25% bracket in 2013 then your effective tax rate was still around 14% if you look at total tax burden as a whole. Sure there's a kink in the effective tax rate when you hit 25%, but the effective rate is still around 14%.
These types of federal income tax charts get really interesting when you add the child tax credit phase-out, capital gains, and/or taxation of social security.

I agree that many people don't realize how low their effective federal income tax rate is.

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dbCooperAir
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by dbCooperAir » Tue Jan 27, 2015 4:02 pm

I think we need more information, we know you have 1/3 in Roth and 2/3 traditional.

If you are only going to be the 25% bracket for 5 years I would favor tax deferred, if you will keep heading north on the pay scale it may look different. If you are going to be back to the 15% bracket in retirement with the option to do a few years of conversion tax deferred may win again.

Your state taxes may come in to play as well depending where you live now and where you may move in the future.
Neither a wise man nor a brave man lies down on the tracks of history to wait for the train of the future to run over him. | -Dwight D. Eisenhower-

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Watty
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Watty » Tue Jan 27, 2015 4:15 pm

mcrunyan wrote:For what it's worth, I find it helpful to keep in mind the difference between marginal and effective tax rates. I made the graph below of marginal vs effective tax rates (total tax / taxable income) for 2013 tax rates for married filing jointly and it might be of some interest.
To calculate the effective tax rate that should also include personal exemptions and the standard deduction.

For a couple in 2013 that would be;

2 personal exemptions, $7,800
Standard deduction, $12,200
Total $20,000

The top of the 10% tax bracket was $8,925 so they would pay $892.50 in taxes if their income was ($20,000+$8,925) $28,925 for an effective tax rate of ($892.5/$28,925) = 3.1%

(edited to correct math error)
Last edited by Watty on Tue Jan 27, 2015 6:30 pm, edited 1 time in total.

Enkidu
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Enkidu » Tue Jan 27, 2015 5:55 pm

Let's say you have been contributing $6,000 annually to a Roth and you are exactly at the top of the 15% bracket. Also assume that you have tax advantaged space in a 401K or similar plan. Now you get an $8,000 raise.

You could continue to contribute to the Roth and have 0.75*8,000= $6,000 in additional consumption + $2,000 in additional tax or

You could put all $8,000 in the 401K and discontinue the Roth, also yielding $6,000 for additional consumption and no additional tax.

So what is better? Depends on what you think your future tax rates will be. You should look at all the threads from people close to retirement who are interested in converting traditional IRAs to Roth, sometimes at high rates to avoid taxes on RMDs.

Another alternative that I like better is to increase your savings rate. Continue contributing to the Roth, but use all or part of the hypothetical $8,000 raise for 401K contributions.

Roth $6,000 + $8,000 401K, no new tax, and consumption remains the same, or
Roth $6,000 +$4,000 401K +$3,000 in additional consumption +$1,000 in additional tax, or something in between.

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Re: Moving up a tax bracket - when to avoid, when to give up

Post by fposte » Tue Jan 27, 2015 6:30 pm

I'm wobbling on that line myself. I tend to agree with those who say it's not really a difference worth spending a lot of energy on. Maybe your question is really a contribute pre-tax or post-tax question? It sounds like you might not be maxing out or even contributing pre-tax to the 401k, and that contribution would probably keep you in 15% if that, rather than Roth space, is your goal here.

ddj
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by ddj » Wed Jan 28, 2015 2:34 am

If you've got any long term cap gains in taxable and you'd like to realize them at that attractive tax rate of 0% and it's not impossible/too much effort to remain in 15% tax bracket to do so: makes sense.

Carl53
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Carl53 » Wed Jan 28, 2015 5:55 am

I would suggest not worrying about it if you are just a couple of thousand into the next bracket so as to simplify your situation. If you are going to be completely into the 25% bracket but think you will likely be in the 15% bracket upon retirement, then you need to minimize taxes now. Do a combination of 401k(if available) and TIRA contributions to get your income down to the top of the 15% bracket. Then you can do Roths with whatever IRA contributions you have left. You might also be able to reduce your pretax income and thereby top tax bracket by making pretax FSA and/or medical insurance payments. One last strategy would be if you were to try bunching deductions to make every other year a lower tax rate year. In the high tax rate year (when you use the standard deduction) you would do TIRA, while in the bunched year with the lower top tax rate you would do Roths. Of course if you have few deductions this will likely not be possible. I no longer have a house payment, but still manage to do bunching. It is kind of a pain but saves close to $1000 per 2 year period. BTW, you since you can make your IRA contributions right up to tax day, you can split them between Roth/TIRA to take you right to the top of the 15% bracket if necessary or desired.

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Re: Moving up a tax bracket - when to avoid, when to give up

Post by yosef » Wed Jan 28, 2015 9:44 am

ddj wrote:If you've got any long term cap gains in taxable and you'd like to realize them at that attractive tax rate of 0% and it's not impossible/too much effort to remain in 15% tax bracket to do so: makes sense.
The problem with this is that if you're otherwise in the 25% bracket it's likely going to be difficult to get down into the 15% bracket with enough headroom left to take any significant capital gains at 0%.

ddj
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by ddj » Wed Jan 28, 2015 11:10 am

yosef wrote:
ddj wrote:If you've got any long term cap gains in taxable and you'd like to realize them at that attractive tax rate of 0% and it's not impossible/too much effort to remain in 15% tax bracket to do so: makes sense.
The problem with this is that if you're otherwise in the 25% bracket it's likely going to be difficult to get down into the 15% bracket with enough headroom left to take any significant capital gains at 0%.
True. It's cusp stuff. A rare situation in which it makes sense: let's say someone contributes to 401k to get the match, maxes Roth IRA, then saves the rest in Roth 401k. Let's say this is a person/family just barely into the 25% tax bracket, by say $5k, after all tax considerations. Instead of those Roth contributions (of, say, a total of $10k), they instead contribute to tIRA/401k to bring taxable income $5k below the 15/25 threshold...they can realize $5k gains and not be taxed. That effort would save $750. There would be less Roth $$, but perhaps this is a 1-time or 2 or 3-time deal where in later years, Roth space is prioritized.

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Hub
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Re: Moving up a tax bracket - when to avoid, when to give up

Post by Hub » Wed Jan 28, 2015 12:18 pm

No matter what, make sure your tax deferred contributions keep you below the 25% if possible (by "if possible" I mean if it's at all possible to get down there without running out of room for pretax contributions then make yourself save more to get there.) From there, fill roth then switch back to tax deferred for further savings.

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