Trail Financial Planning, LLC is a fee-only financial planning and investment management firm located in Bellingham, WA

How about them Tax apples? Using your tax bracket and tax-diversified savings to harvest tax savings.

How about them Tax apples? Using your tax bracket and tax-diversified savings to harvest tax savings.

Tax.  I know of only two types of people who use the word with any sort of glee – accountants and Scrabble players.  As with many disdainful or boring subjects, we often pay as little attention to our taxes as possible.  This is unfortunate.  Taxes likely make up between 20 and 50% of our household budgets.  We should pay attention.  

Unfortunately, US tax code is complicated, and most people prefer to keep “tax” out of their mind’s eye.  We devote more time to deciding which apples to buy, “$2.79/pound for Fujis or $3.59/pound for Honeycrisp?” than we do to evaluating if we could save $100s or $1,000s in taxes.  There’s nothing wrong with being a thoughtful shopper, but my point is that you should devote some time to being a thoughtful taxpayer.  In this post, I describe a a key feature in how your taxes are calculated, and describe one strategy to use to create some value through tax planning.  But first, a quick primer on tax planning:

Tax planning – how and when?

The how is tricky.  The US tax code is complicated, and your situation will depend on…you!   There are many nuances, and unless you are willing to spend some time figuring it out, you probably want to consult with a tax expert who knows taxes AND is willing to learn about you (like a Financial Planner, Certified Public Accountant or other tax expert).  The when should be year-round, but I typically advise doing it twice per year – once after receiving the previous year’s return, and again in December or January.  I use the previous return to make a plan for the upcoming year, then in December or January check up on the progress of the plan, as many actions can continue until April 15 for the previous tax year.  In this column, I am going to discuss one tax planning strategy:  using your marginal tax rate and different styles of tax-advantaged investment accounts to harvest some nice tax benefits.  It is a strategy that continues to be relevant with the passage of the 2017 Tax Cuts and Jobs Act, or TCJA.  I am going to call the tax strategy “harvesting some taxapples.”    

Tax strategy:  Story Time!

In 2017, my wife and I fulfilled a dream – we took our family on a four-month-long trip through Southeast Asia.  The trip was incredible, and though not cheap, it was worth every penny (For a blogpost discussion of how much it cost, see note [2] at the bottom).   Since we weren’t working for four months in 2017, our taxable income was significantly lower than normal.  In 2017 we will be paying a lower tax rate than we expect to pay in the future.  So, we sought to maximize our contributions into tax-exempt (AKA “pay your tax now”) savings plans, such as our Roth IRAs, our kids’ Coverdell ESA accounts, and 529 college savings plans.  We went even further and converted some of our traditional IRA funds into Roth IRA money.  The anticipated results?  If our future tax rate is even 10% higher than today, we will realize around $2,400 in value creation through tax savings on $24,000 of contributions/conversions.  How about them taxapples!

Taxes 101 – tax brackets and your marginal tax rate

To explain the strategy, and for you to understand how you might use it, you must understand how the tax brackets work and what your marginal tax rate is.  Here is my explanation: 

When you fill out your personal federal income tax return, you start with all of your income, reduce it by a bunch of things like the standard deduction to arrive at your “taxable income.”  Note, that the “reduction by a bunch of things” has changed significantly.  I don’t go into detail here, see note [1] for a thorough treatment.  Your taxable income is found on line 43 on the Internal Revenue Service (IRS) Form 1040.  Now, imagine that your taxable income is water coming out of a hose from your household.  The IRS calculates your personal income tax due by pouring water into different buckets, called tax brackets, or more colloquially, tax buckets.  

To illustrate, I will use tax rates for the upcoming year (2018), for a couple who file as Married Filing Jointly.  The image below shows each of the buckets.  

Drawing by John Chesbrough

The first bucket is small, with only enough room for the first $19,050 of your taxable income.  You pay 10% in federal income tax on that money.  Once the bucket is full, the IRS will move the hose to bucket #2.  It is a larger bucket, and can hold the next $58,349 of your taxable income (up to $77,400 total).  You pay 12% tax on the money in bucket #2.  If you fill that one up, the IRS starts filling bucket #3, which gets taxed at 22%, and so on.  The bucket where your last drop of taxable income ends up is called, your marginal tax rate.  It is the tax rate you would pay on any additional income, or the tax rate you would save by reducing your taxable income.  

For example, consider Pat and Jen.  They will have a taxable income of $120,000 in 2018.  The total personal income tax they will expect to pay is $18,279.  Their income tax is calculated as:

  • $1,905 from bucket 1 The math:  $19,050 * 10% = $1,905
  • $7,002 from bucket 2.  The math:  ($77,400 – $19,050)*12% = $7,002
  • $9,372 from bucket 3.  The math:  ($120,000 – $77,400)*22% = $9,372

In this example, Pat and Jen’s marginal tax rate is 22%.  If they were to earn more taxable income, they would pay 22% income tax.  Conversely, if they could reduce their taxable income (perhaps by increasing contributions to a tax-deferred retirement account), they could reduce their tax bill today by 22% on every dollar reduction from bucket 3.  

Self-employed income tax and other income taxes.

Self-employed persons pay an additional “tax” on their business income:  12.4% of the first $127,200 goes to fund Social Security, and 2.9% on all income goes to pay for Medicare.  Most of us, if we are fortunate, will want to use these programs eventually.  So, we shouldn’t be too put out to pay for them.  Employed individuals pay the same amount for Social Security (called a FICA deduction) and Medicare.  But the employer pays half, so the employee sees paycheck deductions of “only” 6.2% for FICA, and 1.45% for Medicare.  And of course, since we are talking US tax code, there are many other types of tax, deductions and tax credits that will affect your true tax bill.  I did say I recommend you consult someone who likes to read about this stuff, right [3]?

Long-term savings 102:  Tax treatment of different accounts. 

This is the second class in saving for long term goals (like for retirement, college, or retirement home).  This cliff notes version of class #1 (Long-term savings 101) are six words: YOU SHOULD SAVE AND INVEST FOR YOUR FUTURE!  In this second class, I will very briefly mention types of long-term savings (and investment) accounts, and their impact on your taxes.  There are essentially two kinds of accounts that get any special tax treatment:

  1. Tax-deferred accounts.  I call these “pay your tax later” accounts.  When you contribute money into these accounts, you do not pay any tax on it now.  However, the money is not tax-free.  Eventually, when you withdraw the money, the IRS will ask for its income tax, and you report any withdrawal as income.  Example accounts of this type are 401ks, Simple/SEP IRAs, 457 deferred comp., traditional IRAs,  TRS3 defined contribution, etc.  If you are self-employed, you can see the amount you contributed into tax-deferred accounts for the last year on line 28 of IRS Form 1040.  If you are employed, and contribute into an employee-sponsored retirement plan, the contributions do not show up on your tax form(s).  You CAN see it on the end-of-year W-2, or by checking with your retirement plan.     
  2. Tax-exempt accounts.  I call these “pay your tax now” accounts.  You get no special tax benefit today from the IRS.  However, in the future, when you withdraw your funds, you will not owe any tax.  Even if the account doubles in size due to investment gains, you will not owe tax.  Example accounts of this type are Roth designated accounts like Roth IRAs or Roth 401ks.  Also, many college savings plans work this way – 529 plans and Coverdell ESAs for example.  

Using different tax-status accounts and your marginal tax rate

There is a lot to digest when considering which type of tax-treatment account is right for you.  I am not going to say much about it here (link [4] has a discussion of different types of retirement accounts).  I advocate a tax-diversified savings strategy for those who are still contributing to their long-term accounts.  There are two fairly straight-forward rules to consider when deciding which type to contribute to:  

  1. When your current marginal tax rate is higher than what you expect in the future, you should maximize your tax-deferred contributions. 
  2. When your current marginal tax rate is lower than you expect to pay in the future, you should maximize your tax-exempt contributions.

There is a tax planning strategy known as “filling your tax bucket” when your expect to be in position 2 with a lower-than-the-future current marginal tax rate.  The image below shows how someone might use the strategy over a 30-year period.  The two blue colored “dips” represent years where the household recognizes lower taxable income, and thus a lower tax rate.  This may be an example of a couple who traveled to Asia, then intends to retire early (hmmm, sounds familiar!).  In those years, they maximize savings in “pay your taxes now” accounts.

Illustration of “filling up the tax brackets.” Graph from Right Capital, the Financial Planning software we use.

Of course, there is a catch to this entire line of reasoning.  You need cash to save.  Often when you report lower taxable income, you have less money at your disposal. But, there are workarounds.  Perhaps you have a non-tax advantaged account with funds in it that you can use.  Of course, all retirement contributions are limited to the taxable income you claim from employment or self-employment income.  None of this stuff works if you don’t earn any US taxable income.   

When might you utilize this strategy?

In general, “filling up your tax bucket” is a smart strategy any time your current marginal tax rate is below your expected future marginal tax rate.  There are many reasons this situation could occur, for example:

  • you expect to earn more money in the future
  • you expect to receive future Required Minimum Distributions from tax-deferred accounts (like a 401k) that will push up your future taxable income
  • you expect to receive a one-time significant chunk of taxable income (by selling a property, or getting a big bonus)
  • you expect your investment income to increase significantly – through higher dividends or rental property income (say as a mortgage is paid off)
  • The tax reductions put into law by the TCJA go away.  In fact, the law already contains such language.  There is a “sunset provision” stating that in 2025 the reduced tax rates will revert to inflation-adjusted 2017 levels.  Thus, by current law, tax rates are poised to increase, unless of course future legislation changes the rules

How ’bout them tax apples?

In 2017, even though the tax rates were higher than they will be in 2018 (due to TCJA), my family expects to pay a lower tax rate than normal (15% vs 22%).  I used this fact to shift more of our long-term savings into “pay-your-tax-now” accounts.  We maxed out our Roth IRA contributions.  We added money into our kids’ Coverdell ESA accounts and 529 plans.  And, I performed a “Roth Conversion” whereby I converted some money from a Traditional IRA into a Roth IRA.  The conversion results in paying taxes on the amount converted at my current tax rate (a lower rate than normal).  As a result of these actions, we will realize about $2,400 in additional tax-related value on $24,000 on savings (assuming tax rates revert to pre-TCJA levels in 2025).  Apples grow on trees, and we planted some seeds this year.  In the future, I expect to harvest some tasty taxapples.    

John Chesbrough is a financial planner in Bellingham, WA.  He is also the co-owner of Trail Financial Planning LLC, an independent, fee-only Registered Investment Advisor in Washington State.  The information presented here represents the thoughts and analysis of John (that’s me!), but may not be appropriate for your situation.  Before undergoing specific tax planning strategies, you should consult with a qualified tax expert.

[1] For a detailed discussion of changes to the US tax code, I suggest you read Michael Kitces’ blog post, “Individual Tax Planning under the Tax Cuts and Jobs Act of 2017”  

[2]  Blogpost on travel costs:  How a teacher and counselor took their family to Asia for 4 months

[3] Who likes to read about tax laws?  Financial planners do (or they should).  Certified Public Accountants do.  Tax lawyers do.  Also, I do.  Click here if you would like to contact me about tax planning, or financial planning in general.  Or, email me directly: 

[4]  Nerd Wallet:   Types of retirement and long-term savings and investing accounts by Nerd Wallet

John Chesbrough

John is a financial planner and investment manager. He, along with his business partner Elizabeth Snyder, founded, a fee-only, independent financial advisory firm called Trail Financial Planning (Trail FP) in Bellingham, WA. John and Liz enjoy working with people who care for others and their community – parents, firefighters, therapists, doctors, nurses, and teachers. They work with people by appointment. To learn more, or to schedule some time with John or Liz directly, please visit