Income planning is the process we use to determine how to efficiently use the sources of income available to you to meet your income needs in the coming year and beyond.
The Process
As part of this process, we first need to determine your income needs. Your income needs will include your ongoing lifestyle expenses as well as less common expenses such as renovations, large purchases, or unusual travel expenses. The process of determining your income needs has likely already been initiated as part of your investment plan, but now we’ll be looking at the cash flows associated with your investments through a different lens.
The next area of focus is the various sources of income available to you. We need to consider wages and other compensation related to employment. Beyond your wages, there may be the vesting of restricted stock or stock options. These elements of compensation were probably awarded years ago and are only vesting over time. Other sources of income into the household may include withdrawals from your portfolio, pension or annuity income, social security income, trust distributions or retirement account distributions. Then we also want to consider other forms of passive income such as income generated by your investment portfolio, rental income, business ownership and possibly royalties and even gifts.
So where does the efficiency aspect of income planning come into play?
In a couple of places
Tradeoffs
First, everything is a tradeoff. If you meet your income needs with income earned as W-2 wages, you presumably need to go to work. That’s a tradeoff. Other tradeoffs may come from risks that you take on. The opportunity risk associated with using your funds for one purpose means they’re not available for other purposes. If your income is primarily from rentals, you are subject to changes in market rates, the hassles of dealing with tenants, and the risk exposure of being a landlord. If you are relying on income from your portfolio, you are subject to swings in the market and potential liquidity issues. Depending on your specific investments, there is legislative risk and other forms of risk that can affect the value of your portfolio or its ability to generate predictable income.
Every time you spend money you are giving up the option to spend those dollars somewhere else. Every time you go to work you are giving up your ability to use that time elsewhere – whether you could have been earning money elsewhere, relaxing, improving your skills or using your time in some other way. Every time you withdraw funds from your portfolio, you are giving up the opportunity for future investment returns on that portion of your portfolio. When you withdraw funds from an IRA or other tax-advantaged account rather than your taxable accounts, we are giving up the tax-advantaged nature of those funds in order to spend those dollars today.
We need to balance the tradeoffs in your income plan. How much of your annual income should come from employment income? How much should come from passive income? How well can we diversify your income sources so that you aren’t overly reliant on any single source of income? And how do we value the non-financial resources like your time and energy that may be traded for income?
Taxes
The next area we want to optimize is taxes. W-2 wages and withdrawals from tax-deferred accounts such as Traditional IRAs and pre-tax 401k accounts are taxed at ordinary income tax rates. Ordinary income tax rates are high compared to rates on other forms of income. You generally don’t have much control over the timing of wage income other than using non-qualified deferred compensation plans or qualified deferred compensation plans like 401k or 403b plans. We’ll consider these methods of managing income and taxes in our income plan. Capital gains on investments can be taxed at lower rates than ordinary income tax rates. And, qualified withdrawals from Roth accounts are not taxable for federal and most state tax purposes. What is an efficient mix of income from your various sources to minimize lifetime income taxes and preserve as much of your assets and income for your use?
Tradeoffs and Taxes Together
If you withdraw $10,000 from a Traditional IRA, then you will be subject to income tax on the full amount at ordinary income tax rates. On the other hand, if you withdraw $10,000 from your taxable brokerage account, you’ll only pay taxes on the gain from the investments that you sold in order to take the $10,000 withdrawal. And, if the investments that you sold qualify for long-term capital gains treatment, the tax rate is likely significantly lower than the ordinary tax rate. The portions of your income generated as interest from your savings and investments will generally be taxed at ordinary income tax rates, but certain dividends generated by your portfolio will be taxed at lower long-term capital gains rates. And, qualified withdrawals from your Roth accounts won’t be subject to federal income tax at all. But, once the funds are withdrawn from tax-advantaged accounts like IRAs and Roth IRAs, you can’t put them back. You’ll be ending the tax-advantaged nature of those funds. So, how do you choose appropriate amounts from each of the sources available to you to meet this year’s needs while keeping options open for the future?
Other considerations for efficiency
In addition to this puzzle, there are other aspects of tax planning that we want to keep in mind such as avoiding Medicare surcharges (IRMAA) or accidentally losing tax credits or deductions by exceeding certain income limits. And, remember that we have to determine not only how to provide the income for lifestyle needs and other goals but also how to pay the taxes for the income generated. Should the amount being withdrawn from the IRA account include enough to meet spending needs and the tax associated with the withdrawal? Or should you plan to pay the taxes from another income source?
Income planning is a major focus for us and our clients at the beginning of the year. As you work through your planning for the year, here are some things to consider.
- As a Married Filing Jointly couple, generating $100,000 in long-term capital gains in 2024 with no other income would incur a federal income tax bill of $892.50 leaving you with $99,107.50.
- Earning $100,000 in wages incurs a variety of taxes including FICA, Medicare, Federal income tax and, if applicable, state income tax. If you live in a state without state income tax, you can expect to pay $15,696 in taxes on $100,000 of wages leaving you with $84,312.
- Deferring some of your wage income into a pre-tax 401k will reduce your taxes in the current year. It also reduces the amount of money coming into your household during the current year. However, it may give you more options in future years.
- On the other hand, putting money into your 401k account as opposed to a taxable investment account limits the circumstances in which you can access the money without penalties. For instance, 401k withdrawals prior to age 59 ½ are usually subject to early withdrawal penalties.
- Remember that having investment income and Modified Adjusted Gross Income over $250,000 for Married Filing Jointly filers, $125,000 for Married Filing Separately filers and $200,000 for all other filers will subject you to an additional Net Investment Income Tax.
And, if you are on Medicare, the amount of your Medicare premium is dependent upon your Modified Adjusted Gross Income. Exceeding an income threshold can increase your Medicare premium by as much as $500 per month per insured. Being able to make up part of your income needs with tax-free income can help manage this issue. But, it requires planning in advance to have the options available to you.
Outcomes of the process
Ultimately, you have a puzzle to solve each year for the current year’s income needs. And, you also want to take steps to make solving the puzzle in future years easier. Going through this process also can help expose areas where your income may be too concentrated. For instance, it may be clearer after income planning that you need more passive income sources to reduce reliance on wages. As you iterate on this process each year, you’ll identify areas for improvement to make future years more and more efficient.
This article is intended to be educational and thought-provoking rather than legal, investment or financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.