Three Leading Tax Strategies for Higher Tax Bracket Taxpayers


by Robert Keebler, CPA, MST, AEP 

Published December 01, 2013

Editor: Theodore J. Sarenski, CPA/PFS, CFP, AEP

 Dear Clients,

Here is a great article to familiarize yourself with the finer tax strategies available for higher bracket folks.

Three leading tax strategies for eliminating or reducing taxable income in the higher tax brackets or net investment income subject to the net investment income tax are harvesting income and gains, Roth IRA conversions, and tax-efficient investing.

Harvesting Income and Gains

Harvesting losses has been a key part of financial planning for years, and with the advent of a four-dimensional tax system and seven individual brackets, advisers must also gain a finer understanding of when it is prudent to harvest income or capital gains.

Example 1: G and B, a married couple, have projected 2013 income of $150,000 and expect their 2014 income to be $500,000. They also expect to have $100,000 in long-term capital gain in 2014 (stock with a basis of $10,000 and a fair market value of $110,000).


If they choose to harvest the gain in 2013, the cost (or tax) would be $15,000 (15% × $100,000). If instead they wait until 2014, the cost will be $23,800 (20% capital gain plus 3.8% net investment income tax).

In effect, the taxpayer invests the tax payable on the 2013 gain ($15,000) to produce a return of $8,800. Thus, the ROI is 58.67% ($8,800 ÷ $15,000).

Roth IRA Conversions

Roth IRA conversions have always offered advantages, but now they may also help facilitate planning and income smoothing to avoid the 3.8% net investment income tax. Distributions from a traditional IRA are not considered net investment income, but they do increase MAGI and therefore could create or increase a taxpayer’s net investment income tax. By contrast, a Roth IRA distribution is neither net investment income nor MAGI, and therefore it does not create or increase a taxpayer’s net investment income tax. Thus, a taxpayer can use a Roth IRA conversion to keep future income out of higher brackets and eliminate all future net investment income tax on IRA distributions.

Example 2: F, a single taxpayer, has salary income of $100,000 and dividend income of $100,000. F is not subject to net investment income tax despite having $100,000 of net investment income (from the dividend income) because his MAGI does not exceed the applicable threshold ($200,000 for a single taxpayer). If F also receives a $50,000 RMD from his traditional IRA, the net investment income tax applies to the lesser of net investment income ($100,000) or the excess of MAGI over applicable threshold ($250,000 – $200,000). Thus, the traditional IRA distribution subjects F to net investment income tax on $50,000 of his net investment income.


Example 3: Suppose instead that F previously had converted a traditional IRA to a Roth IRA. If F receives a distribution of $50,000 from his Roth IRA, he is not subject to any net investment income tax. His MAGI would not exceed his applicable threshold because, unlike a distribution from a traditional IRA, a distribution from a Roth IRA does not count toward MAGI. Thus, F’s MAGI does not exceed his applicable threshold ($200,000), and F saves $1,900 in net investment income tax ($50,000 × 3.8%).

Another important factor to consider before converting is the taxpayer’s current and expected future income tax brackets. If the taxpayer is currently in a lower tax bracket than he or she expects in later years, the taxpayer will usually want to do a Roth IRA conversion. Also note that the conversion can be done in stages so that it does not push the taxpayer into a higher tax bracket, the net investment income tax, or the PEP/Pease limitation.

Perhaps most important, opportunistic conversions by asset classes must be considered. The ability to recharacterize an opportunistic Roth IRA conversion back to a traditional IRA if the assets drop in value eliminates much of the risk of the conversion. A taxpayer can recharacterize the conversion any time before the filing date of the current year’s tax return, i.e., as late as Oct. 15 of the year following the year of the conversion. If the taxpayer chooses to recharacterize, he or she must recharacterize the entire IRA, even if some asset classes have increased in value; thus, a separate IRA should be set up for each asset class, allowing the taxpayer to recharacterize only those IRAs that decline in value.

Tax-Efficient Investing

Until recently, proactive tax planning was not a major part of the investment process. However, with the new higher tax brackets for both income taxes and capital gains, and the net investment income tax, investors have increasingly realized that it is not what they earn that counts, but what they keep after taxes. The following example illustrates the dramatic impact of taxes on wealth accumulation over time.

Example 4: A young married couple plan to invest $10,000 each year for 40 years, at which time they will retire. Assume that their investments grow at a pretax rate of 8%. Exhibit 3 compares how much they will accumulate after 40 years, assuming different effective income tax rates.

Tax-efficient investing includes: (1) increasing investments in tax-favored assets; (2) deferring gain recognition; (3) changing portfolio construction; (4) after-tax asset allocation; (5) tax-sensitive asset location; (6) managing income, gains, losses, and tax brackets from year to year; and (7) managing capital asset holding periods. The following example illustrates planning with tax-favored assets.

Example 5: M, a single taxpayer in the 39.6% marginal income tax bracket, owns $1 million worth of corporate bonds that pay 4% interest ($40,000) per year. M could switch to tax-exempt bonds paying 2.5% interest and avoid both income tax and the net investment income tax. But is this a good idea?


M’s after-tax return on the corporate bonds is $22,640 ($40,000 [0.434 × $40,000]). This makes the after-tax return 2.264%. Her after-tax return on the tax-exempt bonds would be $25,000, or 2.5%. Thus, switching to the tax-exempt bonds would produce a better economic result. However, if the tax-exempt bonds instead produced only 2% interest, M would be better off keeping the taxable corporate bonds.


If you would like to discuss any of these strategies, please call Paul Barrett, CPA at Southern Cloud Accounting at 850-208-3356.


Very Truly Yours,