If your income changes from yearly, you may find yourself spending more in taxes than you anticipated. This is due to the fact that when your income rises, you may be forced into a higher tax band, resulting in greater tax rates for higher income levels.
So, how can you prevent paying higher tax rates when you have a larger-than-usual income year?
Federal income tax brackets for tax year 2023
The following chart shows your income tax rates at different income levels based on your filing status.
source: IRS Publication 505
|Tax rate||Single filers||Married filing jointly or qualifying surviving spouse||Married filing separately||Head of household|
|10%||Up to $11,000||Up to $22,000||Up to $11,000||Up to $15,700|
|12%||$11,001 to $44,725||$22,001 to $89,450||$11,001 to $44,725||$15,701 to $59,850|
|22%||$44,726 to $95,375||$89,451 to $190,750||$44,726 to $95,375||$59,851 to $95,350|
|24%||$95,376 to $182,100||$190,751 to $364,200||$95,376 to $182,100||$95,351 to $182,100|
|32%||$182,101 to $231,250||$364,201 to $462,500||$182,101 to $231,250||$182,101 to $231,250|
|35%||$231,251 to $578,125||$462,501 to $693,750||$231,251 to $346,875||$231,251 to $578,100|
|37%||Over $578,125||Over $693,750||Over $346,875||Over $578,100|
As you can see, the tax rate varies by as much as 10% from one level to the next, which might be considerable if your earnings increase during the year. But you can’t always battle your way into a higher tax rate, and you wouldn’t want to. The idea of purposefully choosing a higher tax bracket may seem illogical, yet it can be helpful in the long term. To stay in the lowest 10% tax rate, for example, you must have $11,000 or less in taxable income (after deductions), which is far from optimal for most people. As you go up the salary scale, you’ll inevitably wind up paying more in taxes. The true difficulty arises when your income fluctuates from year to year.
Dealing with variable income
If your taxable income is considerably higher in certain years, you may end up paying more tax on income than if your payments were distributed more equally throughout the years. Those years of increased income may cost you a lot in higher income taxes.
But don’t despair; there are ways you may employ to gradually balance out your taxable income and avoid higher tax brackets. You can, for example, postpone paying taxes on some income until retirement or shift income and deductions around. You can take charge of your money and feel secure about your tax status by being proactive.
If you reside or work in a state that has an income tax, don’t forget to factor in state taxes as well.
Five ways to avoid spiking into a higher tax bracket this year
Here is our top advice for avoiding being pushed into a higher tax rate if you expect to earn more than usual this year.
1. Contribute to retirement plans.
Investing in a typical IRA, 401(k), or other retirement plan lowers your income today, when you may be in a higher tax rate.
Sure, you’ll have to pay taxes on the money when you withdraw it in retirement. However, if you retire and are in a lower tax category, you will pay significantly less income tax.
Assume you are now in the 24% tax bracket while working. You make a typical IRA contribution, which reduces your taxable income by up to $6,500 in 2023. When you take the money after retirement, you may only be in a 12 percent or 22 percent tax rate, which means you’ll pay less tax than if you were taxed on your contribution immediately.
2. Avoid selling too many assets in one year.
Assume you have a stock that has just increased in value. You want to sell it and profit from the gains.
If selling the stock will place you in a higher tax rate, consider selling part of it this year and some next. This strategy might keep you in a lower tax band while also allowing you to take advantage of long-term capital gains rates, which are normally lower than ordinary income tax rates.
3. Time your income and business expenses.
When you work for yourself, you have some say over when you are paid and when you spend your money. For example, if you use the cash method of accounting, you claim income in the year you receive it, even though you conducted the job the previous year.
Assume you had a successful year and need to purchase company equipment. Consider acquiring the equipment before the end of the year so that you may deduct it in the next tax year, further decreasing your taxable income.
On the other hand, if you’ve had a sluggish year and anticipate to be in a higher tax rate next year, you might want to postpone making company purchases until January 1 or later.
As a self-employed individual, keep in mind that you have some influence over when you charge consumers and receive money.
4. Pay deductible expenses and make contributions in high-income years.
Do you intend to make a substantial donation to a nonprofit organization? Make sure you make that check or charge it to your credit card during the tax year in which you are in the highest tax rate.
To put that into perspective, if you are in the 32 percent tax rate and already itemize deductions, a $100 charitable gift will save you $32 in federal income taxes. If you make the same $100 contribution in a year while in the 24% tax rate, you will only save $24 in federal income taxes.
If your salary is higher this year, you can also choose to make your January mortgage payment by December 31. Because your January mortgage payment covers your December interest expenditure, you may as well pay it in December and get the mortgage interest deduction if you qualify.
5. If you’re a farmer or fisherman, use income averaging.
Some taxpayers can smooth their income over a three-year period by utilizing a technique known as income averaging. This can prevent income fluctuations from forcing you into a higher tax rate.
Prior to 1987, income averaging was available to all taxpayers. To benefit from it, you must now be in the farming or fishing industries.
What if I can’t avoid moving up to the next tax rate when my income increases?
It is sometimes unavoidable to be pushed into a higher tax rate. Keep in mind, all else being equal, you are better off producing more money and paying a bit more tax on it than making less. Remember that the higher tax bracket only applies to income that exceeds the previous tax bracket limit.
Luckily at PSACPA, you can have a professional handle your taxes from start to end. Simply contact us at 301 879 0600. Help is just a phone call away.