As tax season ramps up, we wanted to provide some useful information on tax rates and a few strategic moves that may help lower your taxes each year. Even though 2023 is behind us, some of these moves can still be made to reduce your 2023 tax burden!
How do tax brackets work?
There are two main tax brackets that are important and will impact your tax bill: income tax bracket and capital gains tax bracket.
Your income tax rate is applied to ordinary income, like salary, bonus, ordinary dividends, short-term capital gains, interest etc. Income tax rates are progressive, meaning the higher your income the more tax you will pay. There are currently seven different income tax brackets (10%, 12%, 22%, 24%, 32%, 35% and 37%). Your marginal rate is your top bracket. For example, if you are in the 22% marginal tax bracket, it does not mean all your income is taxed at this rate. Your income is taxed at each lower bracket (10% and 12% rate) until it surpasses the income limit for each rate. Your effective rate is a more precise way to express the blended or progressive tax you are paying on your income. To calculate your effective rate, you can take your total tax divided by your taxable income.
Your capital gains tax rate is applied to long-term capital gains (investment positions you have held for over a year and sold at a higher value) and qualified dividends. The capital gains rate is always lower than your marginal tax rate and more favorably taxed.
Your tax bracket is dependent on how you file – single, married filing jointly, married filing separately etc. Your filing status will dictate the income levels for each tax bracket. The filing is decided on your status on the last day of the year, so even if you get married on December 31st, you will file married filing jointly or separately.
What moves can you make to lower your taxes?
There are some strategic opportunities to lower your taxes and that can be very impactful if you are hovering right above a tax bracket limit for your marginal or capital gains tax bracket.
- Retirement Contributions: if you contribute pre-tax dollars via payroll deductions to your 401(k) through your salary/bonus, this not only helps save for retirement tax efficiently, but it also lowers your current taxable income by these contributions. Also, you may be eligible to give a deductible contribution to an IRA, but you will need to be under certain income limits set by the IRS or not covered by an employer plan. If you are eligible, you have until you file your prior year tax return to make an IRA contribution. So it’s not too late to contribute for 2023!
- Utilize Tax-Efficient Investments: If you are in a higher marginal tax bracket, consider investing in tax-efficient investments like municipal bond funds which provide income that is free from federal tax (and sometimes state tax).
- Health Savings Account (HSA) Contributions: If you contribute to an HSA account, these contributions are deductible and help lower your taxable income by what you contribute. In addition, these accounts can grow and be withdrawn tax-free for eligible medical expenses. If you make direct contributions to an HSA (i.e. not through payroll deduction) you have until you file your taxes to complete a 2023 contribution.
- Charitable Contributions: If you itemize your tax deductions and are charitably inclined, consider making a charitable contribution (i.e. cash, stock) to lower your taxable income at your marginal rate through charitable deductions. Keep in mind there are parameters like how much you can deduct due to factors like type of charity and gift type (cash, stock, property, etc.).
- Harvesting Losses: Do you have embedded investment losses that you can take in your portfolio? If you sell the positions, you can harvest losses to offset up to $3,000 of ordinary income (at your marginal rate) and any capital gains you have realized during the year (at your capital gains rate). If you don’t use the full loss in that year, you get to carry forward to use in future years.
- Review Asset Location of your Portfolio: Think about putting high income-producing investments in your retirement accounts versus in a taxable account that you will have to pay tax on each year.