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By strategically managing your tax payments, both in amount and timing, you can significantly enhance your chances of achieving your financial goals. This is why tax planning is such an integral part of financial planning.

In this article, we will explore five essential tax concepts that the planners at Core Wealth Management consistently utilize. While incorporating these concepts into planning can require considerable time, effort, and complex calculations, the benefits are often substantial. We view this work as essential to what we do and an important way to serve our clients’ best interests.

Now, let’s dive into these five crucial tax concepts.

Average Rate versus Marginal Rate

When discussing taxes, two important terms often come up: the average (effective) tax rate and the marginal tax rate. The average tax rate is the percentage of your total income that you pay in taxes, calculated by dividing your total tax liability by your total taxable income. In contrast, the marginal tax rate is the rate at which your next dollar of income will be taxed.

The marginal tax rate is generally determined by your tax bracket, which increases as your income rises. However, the marginal rate can be influenced by more than just your income tax bracket. Factors like the loss of a deduction (e.g., the “QBI” deduction), the triggering of a surtax (e.g., the “Net Investment Income Tax”), the reduction or loss of a government benefit (e.g., ACA subsidy), or an increase in the cost of a government program (e.g., Medicare Part B premiums), all act as additional “taxes” and impact your true marginal rate.

While the average tax rate provides a general idea of your tax burden, the marginal tax rate is crucial for financial decision-making. It’s the marginal rate that helps you evaluate the true financial impact of almost all financial activities, such as earning additional income, claiming a deduction, and determining the true rate of return on your investments.

Adjustments, Itemized Deductions and Credits

Another critical aspect of tax planning involves understanding the differences between adjustments, deductions, and credits.

Adjustments, also known as “above-the-line” deductions, reduce your Adjusted Gross Income (AGI) and do not require itemization. Common adjustments include contributions to retirement accounts and Health Savings Accounts.

Deductions, on the other hand, reduce your taxable income, but only benefit you if you itemize. Common deductions may include charitable gifts, property taxes and medical expenses.  To itemize, your eligible deductions must exceed what is known as the “standard deduction,” which in 2024 for those under age 65, is $29,200 for Married Filing Joint taxpayers and $14,600 for Single filers.

When it comes to adjustments and deductions, the dollar value of tax savings is calculated by multiplying the dollar amount of the deduction by the taxpayer’s marginal tax rate. For example, a $3,000 IRA contribution produces tax savings of $720 if you are in the 24% bracket.

Tax credits work differently than adjustments or deductions, in that they offer a dollar-for-dollar reduction of your tax liability. For instance, a $2,000 credit reduces your total tax liability by $2,000. Credits are generally considered the most valuable tax benefit. However, most tax credits are reduced or eliminated as income levels increase.

Implicit Taxes, Tax Equivalent Yield, and Tax Clienteles

Implicit taxes, tax equivalent yield, and tax clienteles are all terms used when evaluating the tax implications of different investment alternatives.

Implicit taxes represent the reduced investment returns on tax-favored investments and reflect the tax benefits already priced into the investment. For instance, when comparing municipal bonds, which are often tax-exempt, to taxable bonds, you need to consider what is known as the taxable equivalent yield.

To illustrate, suppose a taxable bond yields 4% and a municipal bond yields 3%, and you’re in a 12% tax bracket. The taxable equivalent yield of the taxable bond would be 3.52%, calculated as 4% multiplied by (1 – 12%). In this case, the investor in the 12% bracket would be better off owning the taxable bond because the taxable bond would produce a higher after-tax yield (3.52%) than the 3% on the tax-free bond.   However, if the taxpayer was in the 32% bracket, the taxable equivalent yield would be 2.72%.  In that case, the investor in the 32% bracket would be better off owning the municipal bond.

This example also illustrates the concept of “tax clienteles,” which refers to the preference of different investors for various types of investments based on their individual tax situations. As shown in the example above, investors in higher tax brackets generally prefer tax-exempt municipal bonds, while those in lower brackets generally benefit more from taxable bonds.

Understanding implicit taxes is central to comparing the real benefits of different investment options.

Preferential Tax Rates on Investment Income

Not all investment income is taxed the same. Ordinary income tax rates apply to most forms of taxable income, but certain types of investment income, such as qualified dividends and long-term capital gains, benefit from preferential rates. This distinction is crucial when determining how to allocate your investments across different accounts.

Here’s a breakdown of the different tax rates on various types of investment income:

Type of Investment Income Tax Rate
Interest Income Ordinary
Realized Short-Term Capital Gain Ordinary
Qualified Dividend Income Preferential Rate
Realized Long-Term Capital Gain Preferential Rate
Unrealized Capital Gain Deferred

Now let’s consider an example. Suppose you have two accounts worth $100,000 each, with a marginal income tax rate of 24% and a preferred capital gains rate of 15%. Account 1 earns a 5% return entirely in interest income (all of which is taxed at ordinary rates), resulting in a total tax of $1,200. After taxes are paid, the taxpayer is left with $103,800 at the end of the year ($105,000 – $1,200 in taxes = $103,800).

Account 2 also earns a 5% return but in different forms: 1% in interest income (taxed at ordinary rates), 1% in qualified dividend income (taxed at preferred rates), 1% in realized long-term capital gains (taxed at preferred rates), and 2% in unrealized capital gains (no current taxes). In that case, the total tax at the end of the year would be just $540. After taxes are paid, the taxpayer is left with $104,460 at the end of the year.

Changes in Tax Rates Over Time (“Intertemporal Tax Arbitrage”)

Tax rates change over time, not just due to legislative changes but also due to changes in a taxpayer’s income and financial circumstances. This concept, known as intertemporal tax arbitrage, involves shifting income and deductions between different tax periods to take advantage of lower tax rates. For example, contributions to a Traditional IRA provide a tax deduction today, but withdrawals in retirement are taxed.

Suppose you make a $5,000 contribution to a Traditional IRA today with a tax rate of 24%. The after-tax cost of the contribution is $3,800, because you are saving $1,200 in taxes by making the contribution. If the $5,000 grows at 5% annually for 20 years, the future value will be approximately $13,266. If the tax rate in retirement is 12%, the after-tax value of the account would be $11,675. Therefore, on a tax-adjusted basis, $3,800 turned into $11,675 in 20 years. This represents an after-tax rate of return of 5.77%, higher than the nominal investment return of 5%!

Conclusion

Understanding these tax planning concepts is central to making informed financial decisions. At Core Wealth Management, our advisors are well versed in these concepts which we have built into our approach, philosophy, and investment strategy. We have seen first-hand how the savings produced bring our clients closer to their financial goals.


Core Wealth Management is a fee-only wealth management firm located in Jupiter, FL.  Our CFP® professionals provide investment management, financial planning and advisory services, while always strictly abiding by the highest fiduciary standards.  For more information, contact us today at 561-491-0231.

Todd Schanel, CFP®, CPA, CFA, CVA is the Principal and Director of Investment Advisory Services at Core Wealth Management. He is a member of the CFA Society of South Florida.


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