Perspective :

Five insights to better understand the tax code

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The U.S. Constitution has 4,543 words. The Lord of the Rings Trilogy by J.R.R. Tolkien clocks in at just over 550,000 words. The King James Bible has 783,137 words. The U.S. Tax Code? If one includes both volumes, we are talking about over 1,000,000 words. No one person can be expected to know the entire tax code. Lord of the Rings? Maybe, but not the entirety of the tax code. 

And your clients don’t expect you to know all things tax related. But you should have a foundational understanding of the intersection of your client’s investment accounts and impact on their tax bill. Being a tax-smart advisor can make a meaningful difference to your clients’ success in achieving their long-term financial goals. 

1. Two separate tax schedules

The starting point for understanding the intersection of investments and taxes is how the progressive tax code works for both ordinary income and capital gains/qualified dividends. Remember that these two categories of income are not only taxed differently but often have materially different tax rates.  

For 2024, tax rates for someone with a filing status of Married Filing Jointly (MFJ) are often shown in the format below. 

2. Progressive tax rates

The challenge of the view above is that it’s easy to miss how the income flows between tax brackets and how to apply the rates for capital gains.

If a couple has $240,000 of taxable income with no capital gains, many people will look at the column of $201,051 – $383,900, see the 24% tax rate and think the tax is $240,000 x 24%. While easy, this is incorrect. The $240,000 of taxable income flows like water in a waterfall from tax bracket to tax bracket – filling up each bucket.

 

Adding these calculated amounts together gives the correct total tax liability of $43,685. The effective or average tax rate (Total Tax/Taxable Income) is 18%. Not the 24% marginal tax rate.

Recognizing how income flows through tax brackets can lead to more accurate estimations and better-informed financial decisions.

3. What about the addition of Long-Term Capital Gains (LTCGs) and/or Qualified Dividends?

These tax rates start where the ordinary income tax rates stop. Think of the LTCGs as standing on the shoulders of ordinary income. While there may be limited ability to impact the timing of the recognition/receipt of ordinary income (wages), the recognition of capital gains and amount of dividends do offer some control on actual timing of gains. A solid understanding of these may help improve your clients’ after-tax returns.

Let’s consider a couple with $510,000 in ordinary income and $80,000 in LTCGs, totaling $590,000 in taxable income. The $510,000 of ordinary income flows through the taxable income on the left. The $80,000 of LTCGs starts at $510,000 with part of the LTCGs taxed at 15% and part at 20%.

In this scenario, the taxpayer has two different marginal tax rates: one for ordinary income, interest income, short-term capital gains, and non-qualified dividends, and another for LTCGs and qualified dividends.

If the taxpayer is considering investing in a Certificate of Deposit (CD), Money Market Fund or similar interest-bearing asset, it would be taxed at the marginal rate of 35%. That is a lot. Over a third of the income will be taken by Uncle Sam. And that is only federal taxes. If the taxpayer is considering investing in a U.S. dividend paying mutual fund, the dividends would generally be taxed at 20% – the other marginal rate. At these marginal tax rates, the taxpayer in search of income may want to consider municipal bonds which generally provide interest income that is exempt from federal taxation.

Same total income / Different tax bill

Now let’s keep the total taxable income the same but switch up the character of the income. Consider a scenario where the $590,000 taxable income consists of $80,000 in ordinary income and $510,000 in Long-Term Capital Gains. This situation could represent various circumstances, such as selling a business, receiving Carried Interest (private equity related) compensation, or liquidating portions of taxable accounts.

In this case, the taxpayer still has the same total taxable income, but a tax bill that is $47,720 lower and an effective tax rate of 14% (from 22%). Sign me up for Carried Interest and/or Dividend income!

4. The power of understanding these differences

The examples provided illustrate the substantial effect on a tax bill based on changing the character of the income and highlight the importance of understanding tax brackets. It shows just how much taxable income one needs to even cross into the top tax bracket (> $732,200) and only the amount above that is taxed at that top tax rate.

These insights can help you guide your clients in the following areas:

A. Identifying marginal tax rates for new investments: By considering the tax brackets, you can better evaluate how interest income and qualified dividends will be taxed for your clients. Focus on the marginal rate and the capacity within each tax bracket.

B. Optimizing capital gains recognition: By evaluating the timing of capital gains recognition, you can potentially save on taxes by accelerating or deferring specific transactions to different calendar years.

C. Managing holding periods for Short-Term and Long-Term Capital Gains: By delaying the realization of Short-Term Capital Gains to qualify for Long-Term status, you may achieve more favorable tax rates and reduce your clients’ tax bills. Keep in mind the 365-day holding period requirement for Long-Term Capital Gains.

D. Planning for retirement and possible lower Ordinary Income: With potentially lower Ordinary Income during retirement, the tax rates on Long-Term Capital Gains (0%, 15%, 20%) may become more attractive for your clients.

E. Evaluating municipal bond investments: Municipal bonds can provide tax benefits but consider your clients’ marginal tax rates to determine if this investment is appropriate for their situation.

Remember that these tax calculations do not account for the impact of the Net Investment Income Tax. This is the additional 3.8% tax tied to unearned income when Modified Adjusted Gross Income is greater than $250,000 (married filing jointly).

5. And who can forget this is an election year? What about taxes?

See our recent blog (What Advisors Need To Know) about possible changes to the tax code after 2025 with the planned expiration of parts of the Tax Cut and Jobs Act. Know that absent government action (like agreement across the executive and both legislative branches), many individual tax items and rates will change on January 1, 2026.

Putting it together

This blog comes in at just over 1,400 words. No Lord of The Rings nor U.S. Constitution, but by understanding the intricacies of the tax code, you can provide even greater value to your clients. With a 25-year track record, Frontier Asset Management is dedicated to helping you manage risk and maximize after-tax returns. If you have a tax case for an existing client or a prospect, please reach out. We’d love the opportunity to review the facts and help you put you in a positive light for tax opportunities.

 

Footnote:

Tax math for someone filing status of MFJ with ordinary income of $510,000 and LTCG of $80,000:

+ ($23,200 – $0) = $23,200 x 10% = $2,320
+ ($94,300 – $23,201) = $71,099 x 12% = $8,532
+ ($201,050 – $94,301) = $106,749 x 22% = $23,485
+ ($383,900 – $201,051) = $182,849 x 24% = $43,884
+ ($487,450 – $383,901) = $103,549 x 32% = $33,136
+ ($510,000 – $487,451) = $22,549 x 32% = $7,892
Ordinary Income Tax $119,248
Plus: Tax on Long-Term Capital Gains
+ ($583,750 – $510,000) = $73,750 x 15% $11,063
+ ($590,000 – $583,751) = $6,249 x 20% $1,250
Tax on Capital Gains $12,312
Total Tax $131,561
Marginal Tax (Tax on next dollar earned) 35% / 20%
Effective or Avg Tax Rate (Total Tax/Taxable Income) 22.3%

 

Information provided herein reflects Frontier’s views as of the date of this presentation and can change at any time without notice.

This information has been prepared by Frontier based on data and information provided by internal and external sources. While we believe the information provided by external sources to be reliable, we do not warrant its accuracy or completeness. Nor should their use be construed as an endorsement.

Frontier does not provide tax advice. Please consult with a CPA for recommendations pertaining to individual circumstances.

Past performance is no guarantee of future returns. Performance shown represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Frontier is not responsible for any trading decisions, damages or other losses resulting from this information, data, analyses, opinions or their use. Diversification does not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses.

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