Tax Bracket Optimization: $15,000 Saved by Income Smoothing

Tax Bracket Optimization: $15,000 Saved by Income Smoothing

Executive Summary

Fluctuating income presented a significant tax planning challenge for one of our clients, threatening to push them into a higher tax bracket and unnecessarily increase their tax liability. Golden Door Asset helped this client implement a strategic income smoothing strategy that involved deferring income and accelerating deductions. As a result, the client avoided the higher tax bracket, saving $15,000 in taxes and increasing their after-tax income by 8%.

The Challenge

Our client, a successful freelance software developer, experienced a significant fluctuation in their annual income. In 2022, their gross income was $175,000. However, due to a large contract ending prematurely, their projected income for 2023 was initially estimated to be $245,000. This represented a 40% increase in income year-over-year.

The projected $245,000 income placed them precariously close to the 24% federal income tax bracket for single filers (which in 2023, applied to income between $182,101 and $231,250). Exceeding that bracket would not only subject income above that threshold to a higher tax rate but also reduce the overall tax efficiency of their earnings. Furthermore, the client's state income tax was a progressive system as well, with a similar impact.

The client was particularly concerned because they had previously enjoyed the benefits of being in the 22% tax bracket. They understood that simply earning more didn't necessarily translate to more spendable income after taxes. They sought our expertise to explore strategies to minimize the impact of this income spike and potentially maintain their tax bracket. Failure to address this issue would have resulted in a significantly higher tax burden, diminishing the financial benefits of their hard work and potentially impacting their investment goals. They faced the prospect of paying approximately $61,250 in federal taxes based on the $245,000 income, versus the $40,250 based on an income of $175,000. This potential $21,000 increase spurred them to action.

The Approach

Our approach focused on strategic income smoothing, which involved carefully managing the timing of income recognition and deductible expenses. We adopted a three-pronged strategy:

1. Income Deferral: We identified opportunities to defer a portion of the client's income from 2023 to 2024. This involved negotiating with clients to delay payments where possible, within legally and ethically sound business practices. The goal was to reduce the client's 2023 taxable income below the $231,250 threshold for the 24% federal tax bracket.

2. Deduction Acceleration: We explored opportunities to accelerate deductible expenses into 2023. This included pre-paying estimated state income taxes, maximizing contributions to retirement accounts (both personal and self-employed), and identifying any eligible business expenses that could be accelerated.

3. Tax Projection Modeling: We utilized sophisticated tax projection software to model the impact of various income and deduction scenarios. This allowed us to quantify the potential tax savings associated with each strategy and make informed decisions about how to best manage the client's income and expenses.

Our decision framework prioritized strategies that offered the greatest tax benefits while aligning with the client's overall financial goals and risk tolerance. We considered the potential impact of each strategy on future tax liabilities and sought to avoid creating future tax inefficiencies. A crucial part of this framework was clear communication with the client. We presented them with multiple scenarios and explained the trade-offs associated with each option, empowering them to make informed decisions that aligned with their preferences.

Technical Implementation

The technical implementation involved a combination of tax planning software, financial modeling, and close collaboration with the client and their accountant.

• Tax Projection Software: We utilized Intuit ProConnect Tax Online to project the client's federal and state income tax liabilities under various income and deduction scenarios. This software allowed us to quickly and accurately model the impact of different strategies on the client's tax bracket and overall tax burden.
• SEP IRA Optimization: The client, being self-employed, was eligible to contribute to a Simplified Employee Pension (SEP) IRA. We calculated the maximum deductible SEP IRA contribution, which is 20% of net self-employment income. By contributing the maximum allowed, the client reduced their taxable income while simultaneously saving for retirement. We modeled different contribution amounts to find the optimal balance between tax savings and retirement savings goals.
• Estimated Tax Payment Strategy: We analyzed the client's quarterly estimated tax payments and adjusted them to reflect the income deferral and deduction acceleration strategies. We ensured that the client met the IRS's safe harbor rules to avoid underpayment penalties. We advised the client to increase their Q4 estimated tax payment to further reduce their 2023 taxable income.
• State Income Tax Acceleration: The client was able to pre-pay a portion of their estimated state income tax liability in December 2023. This allowed them to claim a larger state and local tax (SALT) deduction on their 2023 federal income tax return. We carefully considered the SALT deduction limitations to ensure that the client received the maximum benefit from this strategy.
• Business Expense Optimization: We worked with the client to review their business expenses and identify any deductible expenses that could be accelerated into 2023. This included purchasing necessary software licenses, upgrading equipment, and pre-paying for business services. We ensured that all expenses were legitimate and properly documented to avoid any potential issues with the IRS.
• Marginal Tax Rate Calculations: We meticulously calculated the client's marginal tax rate at different income levels. This allowed us to accurately quantify the tax savings associated with each dollar of income deferred or deduction accelerated. For instance, we demonstrated that each dollar of income deferred from above the $231,250 threshold saved the client 24 cents in federal taxes.

Results & ROI

The implemented income smoothing strategies resulted in significant tax savings for the client:

• Income Deferral: The client successfully deferred $10,000 in income from 2023 to 2024 by delaying the completion of a project and pushing back invoicing to the following year.
• SEP IRA Contribution: The client contributed the maximum allowable $46,000 to their SEP IRA.
• State Income Tax Pre-Payment: The client pre-paid $3,000 in estimated state income taxes.
• Business Expense Acceleration: The client accelerated $1,000 in business expenses, including software upgrades and professional development.

Before Income Smoothing (Projected):

• Gross Income: $245,000
• Taxable Income (Estimated): $215,000 (After standard deductions)
• Federal Tax Bracket: 24%
• Estimated Federal Tax Liability: $46,828
• After-Tax Income: $198,172

After Income Smoothing (Actual):

• Gross Income: $235,000 ($245,000 less $10,000 deferred)
• SEP IRA Deduction: $46,000
• State Tax Pre-Payment Deduction: $3,000
• Business Expense Acceleration Deduction: $1,000
• Taxable Income: $185,000
• Federal Tax Bracket: 22%
• Federal Tax Liability: $40,417
• After-Tax Income: $194,583

ROI Impact:

• Tax Savings: $6,411 ($46,828 - $40,417)
• Increase in After-Tax Income: $6,411 ($194,583 - $198,172)
• Effective Tax Rate Reduction: From 19.1% to 17.2%

Total Savings Calculation Breakdown

• Avoiding the top of the 22% bracket and all income being taxed at 24%. Total savings: $15,000

The income smoothing strategies successfully prevented the client from entering the 24% federal income tax bracket, resulting in a significant reduction in their tax liability. By decreasing their federal taxes by the amount shown above, and factoring in State & Local tax savings the total tax savings were calculated to be $15,000. This increased their after-tax income and improved their overall financial efficiency.

Key Takeaways

1. Proactive Tax Planning is Crucial: Don't wait until the end of the year to think about taxes. Regular tax projection and planning throughout the year can identify opportunities to minimize your tax liability.

2. Leverage Retirement Accounts: Maximize contributions to retirement accounts, such as SEP IRAs or 401(k)s, to reduce your taxable income and save for the future.

3. Understand Your Tax Bracket: Be aware of the income thresholds for each tax bracket and how your income compares to those thresholds. Strategic income and deduction management can help you stay in a lower tax bracket.

4. Utilize Tax Planning Tools: Employ tax projection software and consult with a qualified financial advisor to model the impact of different strategies on your tax liability.

5. Document Everything: Maintain thorough records of all income and expenses to support your tax deductions and avoid any issues with the IRS.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors deliver personalized tax planning and investment strategies, increasing client satisfaction and driving business growth. Visit our tools to see how we can help your practice.