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Year-End Financial Planning: Bracket Management [PODCAST]

Because of the multi-dimensional tax environment that now exists post-American Taxpayer Relief Act, CPA financial planners must look at the tax impact on clients’ financial plans through a 5 to 10 year horizon. Ordinary income tax rates from the Bush Administration were made permanent. The capital gains rate increased from 15% to 20% for taxpayers with income greater than the threshold amounts. Phase-out of personal exemptions and limitations on itemized deductions (Pease) become critical in managing tax brackets by shifting income and deductions into certain years. This podcast from Bob Keebler provides a overview of theory, strategies and case studies in bracket management. Visit the AICPA PFP Section’s Post ATRA & NIIT Toolkit for more in-depth resources on planning in preparation for year-end. (Email subscribers can listen to the podcast on our website.)


Year-End Financial Planning: Bracket Management

This podcast was originally recorded Oct. 2.


ROBERT S. KEEBLER, CPA:  On behalf of the Personal Financial Planning Division of the AICPA, this is Bob Keebler and thank you for joining us for "Year-End Planning: Bracket Management."

Today what we're going to walk through is the new taxes and how those are going to apply to your clients and what has shifted. Basically, we used to be able to do tax planning in a three- to five-year time horizon, and now, because of the many different tax brackets we have and the different types of taxes, we're in a three- to ten-year horizon, maybe even a little bit longer.

And in the past, we've had a two-dimensional tax system, the regular tax and the AMT. But today we are in a four-, perhaps five-dimensional tax system -- regular tax, AMT, the 3.8% surtax, the super-bonus rates when your income goes over 400,000 or 450, depending on whether you're a single or married person, and then the PEP and Pease limitations. And that's some of what I want to talk about today.

We've worked very hard over the past year to come up with the software to show these points, and we'll talk about some of that, too, and graphically illustrate why this is so important.

So on the screen in front of you; you have the ordinary tax rates. And basically, we now have 10, 15, 25, 28, 33, 35 and the 39.6% tax rates. We also have three different capital gains rates, that being 0, 15 and 20%. So basically, there's a lot of dynamics going on about whether you should take gains early, whether you should take income early. What is the value of deferral if rates are going to go up? So a lot of emphasis is going to be on bracket management, and that -- the complexity of when you go from a two-dimensional tax system to a four- or five-dimensional tax system is not linear. It's exponential, okay? It's not linear, it's exponential. And when we're starting to do year-end planning for clients, this is just jumping off the page, how complex it is.

Now -- Now, for many clients in the 20% rate, their rate is actually 23.8 because of the 3.8% net investment income surtax. Remember, though, maybe one of the most important things you should keep in mind is, you have a 0% rate for capital gains if you're still in the 15% overall bracket.

Now, the phase-out of PEP and Pease. Basically, you start to lose some of your personal exemptions and itemized deductions when your income goes over the thresholds of 250 for a single person, 275 head of household, 300,000 for filing jointly, and 150,000 for married filing separately. All these amounts will be indexed for inflation.

What's happening with PEP and Pease is, we lose our personal exemptions, and we lose our itemized deductions. Basically, on the PEP side of things -- and you can do the math on a handheld calculator -- but for every $2,500 of income above the threshold amount, you're going to lose 2% of your exemptions.

And on the Pease side, what's happening on the Pease side is -- I'm on page 10 -- you lose 3 -- you're going to lose 3% of your itemized deductions up to a maximum of 80%. And what happens is, when you cross a threshold, when a married couple's income exceeds $300,000, you start to phase out of your itemized deductions. So what that means, your itemized deductions are less valuable.

Now, this requires some planning. It requires trying to get itemized deductions maybe on Schedule E, not on Schedule A, your itemized deductions. So deductions not included would be your interest expense, your medical expenses, casualty, theft and wagering losses and basically what we're talking about is, it drives the effective tax rate up higher than 39.6%. And we'll talk about that a little bit.

Now, on page 11, I just took an example just to illustrate what happens when we start losing our itemized deductions, okay? And you can lose up to 80% of your itemized deductions.

Now -- So the key management issues. When we get into bracket management, the key issues we're confronting are managing for capital gains, always seeking to be in that 0 or 15% rate, if at all possible. Managing income tax rates, not trying to get trapped where we're at the bottom of the 25% bracket while -- from age 60 to 70, but then at 70 and a half, when we start our required minimum distributions, we're suddenly jumping up into the 35% rate or even higher.

Now, as a general principle, not always true, but ordinary income should equal at least your itemized deductions. Those itemized deductions are valuable under the law right now, and we do not want to waste those on offsetting capital gains. Also, watch out for tax credits that are available. Many credits are refundable, but some aren't, and -- Most aren't. And you're going to want to make sure you have enough income to offset those credits.

Now, what we did is, I actually -- This is out of a client presentation, and this client doesn't have -- He has a lot of money in his IRAs, well over $5 million, but he's been living off a very modest lifestyle. And when he turns 70 and a half, he's going to be pushed up into a higher tax bracket. And the dark blue -- or the medium blue line, which is your taxable income, you can see what happens in 2017 to 2018. It just jumps so much, from about 250 of income up to about $600,000 of income, pushing him well into the 39.6% bracket.

So the issue becomes from today forward, for the next five years, what do we do? How do we fill up those brackets, and when does that make sense mathematically? And there are software tools that are coming out that will help us figure that out. And we're working hard on that, and we're getting a lot of support from the AICPA.

Now, what we did is, I put together for this client -- I showed him what was happening, how much of his income was exposed to the 39.6% bracket versus the bracket he's in today. And, you know, that's kind of an alarm bell. So when you can show it like this, the one thing is, the software that's out there right now, that's out there by the mainstream software publishers -- and you know who I'm talking about -- it's very good for a CPA who's willing to have a calculator in their hand and do the diagnostician stuff, run the diagnostics by hand. The software gives you a lot of data, but it doesn't really tell you like how much you left in a bracket, or ideas of what you could do.

Now -- So, we're in the 28% bracket today up on page 16, but we're jumping up into the 39.6% bracket in the future. The issue is, what do we do in the meantime? Do we fill up that 28% bracket? Do we even go into a little bit higher bracket, perhaps, with a Roth conversion? That's all about the bracket management.

Now, capital gains rate in his case is 15 today, but jumping up to 20. So the issue becomes, do we harvest any capital gains at 15% knowing that we're in essence going to be in a 20% rate tomorrow, but it's really not 20 because of the health care surtax, it's more like 23.8%?

Now, income per bracket. I'm just showing here bracket-wise where we end up. And you can see, if you look at the orange, that's the 35% bracket. So we're showing, you know, where do we stand, and how much room do we have? If you know the numbers, you're going to know how much room you have left in each bracket.

In his case, there's still a lot of -- He's in the 33% bracket, but there's a lot of room there. And the distance from 33 to 39.6 often is going to justify actions like Roth conversions, or perhaps taking money out of IRAs and buying life insurance. It's all about the math.

Now, itemized deductions. Once he gets it where he starts his required minimum distributions, left unchecked, unless we do something in the meantime, he is going to lose quite a bit of those itemized deductions, because, you know, what transpires here is his income goes up above that Pease limitation, he starts to lose those itemized deductions. So instead of having itemized deductions of, in this case, 12, $13,000 -- again, a real client example -- that his fall down to about $5,000. So we lose out on the benefit of the difference, okay, the tax benefit.

So what I basically did, I looked at someone earning $150,00o of wages, 50,000 in long-term capital gains, 20,00o of itemized deductions, and then looked at their RMDs opening up in 2015. So basically, you know, what we have is, this example just shows where income's going. Now, the real important point on this is in 2015, you can see his IRA opens up and everything changes. His income, in essence, doubles, okay? And the issue is, what can you do by pulling distributions into earlier years? Does any of that make sense?

Now, here's the page that's important. We show marginal tax rates. We show the capital gains rate each year. And then we basically determine whether or not you're subject to the net investment income tax. On the marginal tax rate, if the net investment income tax applies, and the marginal capital gain rate with the net investment income tax, and then finally, looking at the distance to the next bracket.

Part of what we've made a great emphasis on doing is making the tax planning easier. Normally, you'd do all these same calculations, but you'd do them all with a handheld calculator. And then, so we're looking at the difference to the next tax bracket, and then the difference to the following tax bracket.

So basically, we're also looking at, how do we compare to PEP and Pease at the bottom of the chart? And the tax loss to PEP and Pease, the tax rate impact of PEP and Pease, and the percentage of the itemized deductions that we're actually losing along the way. Okay? So this is very fascinating, when you actually get in and run these numbers.

So on the next page, again, we do kind of the same thing with capital gains and look at the alternative minimum tax basically to determine if you're subject to AMT. And we also are looking at the distance in your income until the AMT applies. So maybe in those earlier years we could generate more income if that made sense, if it wasn't going to have an AMT impact and it would save us money later. Those are the kind of questions that all of us ask every time we do a tax projection. But it's something that, because of the new dynamics with all these brackets and a four-dimensional tax system, that we need to do a better job on going forward.

So there is a lot to think about here, but bracket management is going to become so important to you as a CPA. And I think it's going to require just a lot of attention on your part.

We've covered a lot of ground. And just to go back through some of this, keep in mind that we are now in a four-dimensional tax system. And many of us that teach a lot for the PFS group really do believe that bracket management is going to mandate more attention. And we'll come back and we'll talk about in some of the other podcasts capital gain harvesting and how to efficacy harvest capital gains. If you're going to be in the 15% bracket this year, harvest that gain rather than paying tax at 23.8% in the future. We'll also talk about how PEP and Pease plays into this, and basically when you should take money out of IRAs and do Roth conversions.

There's a lot to know. This is an exciting time. I want to thank you for joining us today. On behalf of the PFP Division of the AICPA, this has been Bob Keebler discussing year-end tax planning bracket management.


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