It doesn’t make sense to let the threat of a higher tax bracket stop you from making more money. But it does make sense to consider steps that could subject less of your additional income to a higher tax rate.
Federal tax law offers several opportunities to lower your taxable income:
- Contribute more to retirement accounts.
- Push asset sales to next year.
- Batch itemized deductions.
- Sell losing investments.
- Choose tax-efficient investments.
Here’s an overview of each strategy and how it might reduce taxable income and help you avoid moving into a higher tax bracket.
Contribute more to retirement accounts
The simplest strategy, if you’re not employing it already, is to sock away more of your income in pretax retirement accounts. These include a 401(k), 403(b), 457(b), Thrift Savings Plan (TSP), traditional IRA, SIMPLE IRA, and self-employed plans, such as a solo 401(k). Every dollar you set aside in this type of account won’t be taxed until you withdraw it and will reduce your current-year taxable income dollar for dollar.
For the 2023 tax year (the tax returns you file in April 2024), you can contribute up to $22,500 to 401(k)s, 403(b)s, most 457(b) plans, and TSPs. If you’re 50 or older, you can make an additional catch-up contribution of $7,500. The SIMPLE IRA contribution limit is $15,500, plus a catch-up contribution of $3,500.
The traditional IRA contribution limit for tax year 2023 is $6,500, plus a catch-up contribution of $1,000. For married taxpayers where one spouse earns little to no income from work, contributing to a traditional spousal IRA can further reduce taxable income. Deduction limits may prevent you from using traditional IRA contributions to lower your tax bracket.
While many tax strategies must be implemented by year-end, IRA and self-employed 401(k) contributions can be made until the April 15 tax-filing deadline. Solo 401(k)s are an especially powerful way to reduce current-year taxable income because of their high contribution limits, but they’re only an option if you have self-employment or contractor income. (Learn more: 4 tax moves to consider before filing your return)
Push asset sales to next year
When you sell an appreciated asset that’s not in a retirement account, you must pay capital gains tax on the difference between the asset’s cost basis (what you paid for it) and its sale price. There are several ways to reduce your capital gains tax, however.
“Managing appreciated asset sales by splitting them over more than one tax year is a good practice and will help reduce tax liability,” said Keven B. Milgram, CFP®, director of financial planning for BLS Wealth Management in Fort Lauderdale, Florida.
Another option is to seek long-term rather than short-term capital gains by holding assets for more than one year. Long-term gains are taxed at 0 percent, 15 percent, or 20 percent, depending on your taxable income and income tax filing status. Short-term gains are taxed at your regular marginal income tax rate.
Putting off asset sales can also help you avoid getting into the 20 percent capital gains tax bracket, which, in 2023, applies when your income reaches $492,300 (single filers); $553,850 (for married filing jointly or qualifying widow); $523,050 (for head of household), or $276,900 (for married filing separately).
Finally, limiting your investment income in a given year may help you avoid the 3.8 percent Net Investment Income Tax.
Batch itemized deductions
When the Tax Cuts and Jobs Act doubled the standard deduction, many taxpayers who used to save money by itemizing were relieved of this administrative headache. Claiming the standard deduction became the bigger money saver.
Still, taxpayers who typically come out ahead by claiming the standard deduction might be able to lower their taxable income further by batching itemized deductions so that as many of them as possible fall into the same tax year and exceed the standard deduction. The goal is to itemize every other year to achieve tax savings. (Related: What is holistic planning and how can it help you?)
One batching strategy involves donating double to charity what you normally would in the year you plan to itemize, and reducing your charitable donations accordingly in the years you’ll claim the standard deduction. You can combine batching with a strategy for reducing taxes on investment gains by donating appreciated stock. The key is to donate the appreciated shares directly rather than selling the investment and donating the proceeds, as the sale will trigger capital gains tax.
Sell losing investments
Another way to prevent investment sales from pushing you into a higher tax bracket is to sell investments that have lost value since you purchased them.
“When looking to sell an appreciated asset or stock, you will always want to see if the tax can be offset by a loss,” Milgram said. “If this isn’t possible, then you can consider splitting the sale over multiple years.”
Taxpayers can offset their losses from their investment gains dollar for dollar from capital gains of the same type. If you don’t have investment gains to deduct a loss from, you can deduct your loss from ordinary income instead, but you’re limited to deducting $3,000 in realized investment losses per year ($1,500 if you’re married and filing separately). You can carry the excess over indefinitely to deduct against investment gains or ordinary income in future years.
Choose tax-efficient investments
“Generally, stocks and individual bonds are more tax efficient than ETFs and mutual funds,” Milgram said. “But understanding the makeup and turnover of a fund will help to project the tax liability. Choosing tax-free or tax-deferred investments will also help to reduce or eliminate taxes.”
Actively managed mutual funds tend to have more transactions. Their managers buy and sell investments often in pursuit of higher returns. Each purchase and sale has the potential to create tax liability for you, even if you don’t buy and sell shares of the fund during the year. Low-turnover funds are more tax efficient. Index funds typically fall into this category. (Related: Mutual fund and ETF basics)
Municipal bonds can be highly tax efficient because the interest they pay investors isn’t taxable at the federal level. It’s often tax free at the state and local level too, if you live in the state where the bonds were sold. Federal treasury bond income is taxable at the federal level but is generally not taxed at the state or local level.
Even though higher tax rates only apply to the part of your income that falls into the next bracket, and not to all your income as some people mistakenly believe, it’s still smart tax planning to look at reducing your taxable income and avoid paying a higher rate on as much of your income as possible.
That’s especially true when you’re looking at the biggest bump, which occurs when moving from the 24 percent to the 32 percent tax bracket. Increasing your retirement contributions, delaying appreciated asset sales, batching itemized deductions, selling losing investments, and making tax-efficient investment choices can help you avoid moving into a higher tax bracket.
Many people seek out advice from a financial professional to help consider what moves can be made and how they can fit into a broader financial plan. You can find a MassMutual financial professional near you here.
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