income planning

More money is good, right? Then, why would I want to take less income? 

Sometimes, in the process of financial planning, we talk about income planning. For some people, there are few opportunities for income planning because it depends on the types of income they have. But for people with the flexibility, income planning can help them keep more of what they make.

What is income planning?

Income planning is managing the timing and types of income to be taken each year. Here’s a simplified example of income planning. 

Let’s say that you’re married and filing as Married Filing Jointly, and this year, you will have $400,000 in taxable income due to your regular earnings and bonuses for you and your spouse and from a side gig. That means that the first $23,200 of your income is taxed at 10%, from $23,200 to $94,300 will be taxed at 12%, from $94,301 to $201,050 will be taxed at 22%, and from $201,051 to $383,900 will be taxed at 24%, and the remainder will be taxed at a whopping 32% for a total of $83,373 or 20.8% – and that’s only federal income tax.  

Managing your taxable income

Now, let’s say you already know that you won’t be getting a bonus next year, and your taxable income will be closer to $370,000. Your side gig contributes about $10,000 per month to your taxable income, and you invoice your customers with payment due 30 days from the date of the invoice.

income planning for tax purposes

Based on the numbers above, if you send out your November invoices on November 28 and your customers pay within 30 days, it will contribute $10,000 to your taxable income this year. But after the federal government takes its portion at your 32% marginal tax bracket, you will only keep $6,800 of that money. On the other hand, if you don’t invoice your November clients until December 3 and your clients don’t pay until next year, it will contribute $10,000 to next year’s taxable income. You’ll be able to keep $7,600 of that money due to the difference in your marginal tax bracket, which is due to the lower income.

By delaying the income to next year when you’ll be in a lower marginal tax bracket, you saved $800 or $80 on each $1000 of taxable income. That may seem like small potatoes, but these factors compound each other. Read on for another example.

Managing the types of income

In this scenario, we rely on different types of income to reduce the overall tax rate. Long-term capital gains from your investment portfolio are taxed at 0%, 15%, or 20%. Those tax rates are much lower than the tax rates applied to ordinary earned income. Let’s say it is December, and your income for the year so far consists of $330,000 in wages and bonuses. You’re renovating the house and plan to sell stock from your portfolio to pay for the renovation. The sale of the stock will cause a $300,000 gain (long-term gains on Apple stock held for decades). If you sell the entire amount in December and take the capital gain this year, the long-term capital gain rate applied to the gain from the stock sale will be 20% or approximately $60,000.

However, if you break that sale into two different transactions and take only $270,000 in gains this year and a second sale next year for the rest of the funds needed for the renovation, your long-term capital gains rate could be 15% in each year, saving you about $15,000. Furthermore, if you were in a position where you could defer compensation from your wages, you could potentially reduce your effective tax rate even further by reducing the proportion of your income that is subject to ordinary income tax (at the 35% marginal tax bracket) in exchange for income at the 15% capital gains tax bracket.

Managing taxes with your portfolio

Investment income provides many opportunities for income planning and management. As mentioned above, long-term capital gains are generally taxed at lower rates than short-term capital gains. Simply holding an investment for a little longer before selling could make a big difference in how much of your gains you get to keep. There are additional taxes on investment income to consider as well. Let’s say we know that your Modified Adjusted Gross Income will be below the Net Investment Income Tax threshold this year, but next year, you will be over the threshold. The Net Investment Income Tax is an additional 3.9% tax applied to net investment income. We may consider taking investment gains just up to the point where you’ll stay under the threshold this year. That way, you avoid the tax to the extent that you can. (Avoiding taxes is ok. Evading taxes is not.) You can use the proceeds from selling the investment this year to purchase another or even the same investment again. If you need to sell it again next year, at least the gain will be smaller (because we took part of the gain this year). You will have paid taxes at a lower rate on the gain this year and only pay supplemental tax on any additional gains that you take next year.

Why We Do Income Planning

The goal of income planning, like the goal of most financial planning, is to have options that put you in the best position possible to achieve your financial goals. While it may seem counterintuitive, sometimes limiting current income provides the best long-term result.

Income planning for retirement is also key. Read our next post for more income planning considerations to help grow and protect your wealth as you plan for and enjoy your retirement.

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.

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