September 18, 2023

5 Ways to Avoid Bumping Your Income into a Higher Tax Bracket

Updated for tax year 2023.

If your income level fluctuates from year to year, you may find yourself paying more than you expect at tax time. This is because when your income increases, you may be pushed into a higher tax bracket, resulting in higher tax rates for higher income levels.

So, how can you avoid paying higher tax rates when you have a year with more income than usual?

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

Find out which IRS tax bracket you are in. Estimate your tax year 2022 and 2023 tax rates with our tax bracket calculator.

As you can see, the tax rate jumps as much as 10 percent from one level to the next, which can be significant when your earnings spike during the year.

But you can’t always fight the move into a higher tax bracket — nor would you want to.

The prospect of deliberately embracing a higher tax bracket might sound counterintuitive, yet this strategy can be beneficial in the long run. For example, staying in the lowest 10 percent bracket necessitates having $11,000 or less in taxable income (after deductions), which is hardly an ideal situation for most. Inevitably, as you ascend the income ladder, you’ll end up paying more in taxes.

The real challenge comes when your income varies from year to year.

Dealing with variable income

If your taxable income is much higher in some years, you may be paying more income tax than you would if your payment were spread out more evenly over the years. Those years with a spike in income may cost you plenty in higher income taxes.

But don’t worry — there are strategies you can use to balance out your taxable income over time and avoid higher tax brackets. For example, you can delay paying tax on certain income until retirement or move income and deductions around. By being proactive, you can take control of your finances and feel confident about your tax situation.

Don’t forget to consider state tax as well if you live or work in a state with income tax.

Five ways to avoid spiking into a higher tax bracket this year

Here are our top tips to avoid getting bumped into a higher tax bracket if you anticipate earning more income than usual this year.

1. Contribute to retirement plans.

Putting money into your traditional IRA, 401(k) plan, or other retirement plan reduces your income now when you may be in a higher tax bracket.

Sure, you’ll pay tax on the money when you take it out in retirement. But if you’re in a lower tax bracket after you retire, you’ll pay far less income tax that way.

For example, say you are in the 24 percent tax bracket now while working. You contribute to a traditional IRA, reducing your taxable income by up to $6,500 in 2023. When you withdraw the money after retirement, you may only be in a 12 percent or 22 percent tax bracket — meaning you’ll pay less tax when you withdraw the money than you would have if you were taxed on your contribution immediately.

2. Avoid selling too many assets in one year.

Say you have a stock that’s gone up in a short period. You’d like to sell it and cash in on those gains.

If selling the stock would put you in a higher tax bracket, consider selling some of the shares in one year and some the next. This approach could preserve your position in a lower tax bracket while unlocking the potential for long-term capital gains rates, which are typically lower than regular income tax rates.

3. Time your income and business expenses.

If you’re self-employed, you have some control over when you get paid and make expenditures. Using the cash method of accounting, for example, you claim revenue in the year you receive it, even if you did the work in the previous year.

Let’s say you have a banner year and need to buy equipment for your business. You might consider purchasing the equipment by the end of the year so you can turn right around and deduct that expense in the coming tax year, further reducing your taxable income.

On the other hand, if you’ve had a slow year and you expect to be in a higher tax bracket next year, you may want to put off making business expenditures until Jan. 1 or later.

As a self-employed individual, it’s important to remember that you can exercise some control over when you bill customers and receive payments as well.

4. Pay deductible expenses and make contributions in high-income years.

Planning to make significant contributions to a charitable organization? Make sure you write that check or put it on your credit card in the year you’re in the highest tax bracket.

To put it into perspective, a $100 charitable contribution will save you $32 in federal income taxes when you are in the 32 percent tax bracket and already itemizing deductions. However, if you make the same $100 contribution in a year when you’re in the 24 percent tax bracket, it only saves you $24 in federal income taxes.

You can also opt to make your January mortgage payment by Dec. 31 if your income is higher this year. Your January mortgage payment covers December interest expense, so you may as well pay it in December and take the mortgage interest deduction if that applies to you.

5. If you’re a farmer or fisherman, use income averaging.

Some taxpayers are allowed to smooth their income out over a three-year period, using a process called income averaging. This can help keep income spikes from pushing you into a higher tax bracket.

Prior to 1987, all taxpayers could use income averaging. Now, you must be in a farming business or working as a fisherman to benefit from it.

What if I can’t avoid bumping into the next tax bracket when my income rises?

Sometimes getting bumped into a higher tax bracket is inevitable. Just remember, all else being equal, you’re still better off making more money and paying a slightly higher tax on it than you would be making less. Don’t forget — the higher tax bracket only applies to your income that exceeds the last tax bracket limit.

To better understand how tax brackets work, check out How Tax Brackets Work.

This article is for informational purposes only and not legal or financial advice.

The post 5 Ways to Avoid Bumping Your Income into a Higher Tax Bracket appeared first on TaxAct Blog.

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7 FAQs about the Earned Income Tax Credit

Updated for tax year 2023.

The Earned Income Tax Credit, or EITC, is a tax credit designed to help low- to moderate-income working families and individuals get ahead and put more money back in their pockets. It can provide a significant boost to your federal tax refund each year if you meet certain criteria.

For instance, if you are employed, but your earnings fall into what the IRS considers a lower income level based on the size of your family, you may be eligible for the credit.

The maximum EITC credit available for tax year 2023 is $7,430.

At a glance:

The Earned Income Tax Credit is available for low- and middle-income workers.
The credit is refundable, meaning you can claim it even if you had no income tax withheld (you’ll still need to file a tax return to claim it).
Your credit amount depends on your income level, filing status, and the number of children you have.

How to calculate Earned Income Tax Credit (EITC)?

The easiest way to determine your EITC eligibility is to enter your information into TaxAct®, which will automatically calculate the credit based on the details included in your return.

Below are a few common questions and answers taxpayers often have about the EITC.

1. Do I qualify for the EITC even if I didn’t have any income tax withheld and I’m not required to file a tax return?

Yes! Thanks to the EITC, you can get money back even if you didn’t have income tax withheld or pay estimated income tax. This type of tax benefit is called a refundable credit.

However, you must file a tax return to qualify for the credit, even if you otherwise would not need to file.

2. Do I have to earn a very low income to claim the Earned Income Tax Credit?

If you have no qualifying children, you must earn a relatively low income to be eligible for the EITC. For tax year 2023, for example, income limits mean you must have earned less than $17,640 to meet the requirements for the credit ($24,210 married filing jointly) if you have no qualifying children.

However, if you have just one qualifying child and make $46,560 or less ($53,120 if married filing jointly), you might be surprised to find you qualify for the EITC when tax filing.

3. Who qualifies for the Earned Income Tax Credit?

You must meet the following qualifications to claim the credit for 2023:

Your earned income and adjusted gross income fall under these limits:

You (plus your spouse if you are married) and your children have Social Security numbers.
You earn income either working for yourself or as an employee.
You are a U.S. citizen or resident alien all year, a nonresident alien married to a U.S. citizen, or a resident alien and filing a joint return.
Someone else cannot claim you as a qualifying child for the EITC.
You do not have foreign earned income for which you must file Form 2555 or Form 2555 EZ.
You do not have more than $11,000 in interest, dividends, or other investment income (up from $10,300 in 2022).

If you do not have a qualifying child, you must:

Be between the ages of 25 and 65 at the end of the year
Have lived in the United States for more than half the year
Not be the qualifying child of another person

If you use the married filing separately filing status to claim the EITC:

You cannot file a joint tax return
You must not have lived with your spouse for the last six months (or you have a separation agreement)
Your child must live with you for more than half the year

4. Does military combat pay affect my credit?

If you receive combat pay, you can choose whether or not to include it in your taxable income.

Ordinarily, combat pay is not included in your taxable income. However, depending on your total earned income and family size, excluding combat income from your taxable income could reduce the amount of EITC for which you qualify. You may be better off counting the combat pay as taxable income in those cases.

Filers need to remember that this decision is all-or-nothing. You must include all your combat pay or none of it in your taxable income.

5. Can I have my Earned Income Tax Credit added to my paycheck throughout the year?

In past years, the IRS allowed taxpayers to receive the Advance Earned Income Credit throughout the year. However, in 2010 it was repealed and is no longer available.

6. Can I claim the Earned Income Tax Credit even if my child’s other parent claims him as a dependent?

If your child lived with you for more than half the year, you generally take the EITC based on the child, regardless of which parent claims the child as a dependent. The number of children you claim as dependents is not always the same number of children who qualify you for the EITC.

If you have joint custody of the child and split time equally between each parent, the parent with the higher adjusted gross income takes the credit.

Only one person can claim the same child. Noncustodial parents can’t claim children for purposes of the EITC.

Your qualifying child for the EITC must meet the following qualifications:

Age or disability. At the end of the filing year, the child was under age 19, or younger than 24 and a full-time student for at least 5 months of the year. The child must be younger than you (or your spouse if you file a joint return.) There is no age limit if the child is permanently and totally disabled.
Relationship to you. A child for the EITC can be your child, stepchild, brother, sister, half-sibling, stepsibling, foster child, adopted child, or a descendant of any of these.
Living arrangements. The child must have lived with you in the United States for more than half the year. If you file a joint return, you can include the time the child lived with your spouse.
No joint return. Your child must not have filed a joint return with his or her spouse unless it was only filed to claim a refund and they were not required to file a return.

7. I should have claimed the Earned Income Tax Credit in prior years, but I didn’t. Can I go back and claim the credit now?

If you filed your taxes from a previous year but didn’t claim the EITC, you can file an amended return and receive the associated credit.

If you didn’t receive the credit because you didn’t file, you must file a separate return for each year in which you qualified.

However, you can’t go back indefinitely. You can generally only file an amended return for the past three years. Use TaxAct to file Form 1040X, Amended U.S. Individual Income Tax Return.

8. Is the Earned Income Tax Credit the same as the Child Tax Credit?

The EITC (also called the EIC) is not the same as the Child Tax Credit, though it is possible to qualify for both. Low-income families often find they are able to get both tax benefits, though childless workers won’t be able to utilize the Child Tax Credit.

This article is for informational purposes only and not legal or financial advice.

All TaxAct offers, products and services are subject to applicable terms and conditions.

 

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Long-Term Capital Gains Tax: How Much Tax Will I Owe?

Updated for tax year 2023.

Did you profit from selling a house, some investments, or even a car this year? If so, you’ll likely need to report the sale on your income tax return due to the long-term capital gains tax.

Fortunately, if your sale qualifies as a long-term capital gain, the taxes are less than what you’d pay on your ordinary income, such as wages.

At a glance:

Long-term capital gains tax is lower than ordinary income tax.
You must own the asset for over one year to qualify for a long-term gain.
Tax rates for long-term gains range from 0-20%, depending on income.

Do I have a long-term capital gain?

To qualify as a long-term gain, you must own a capital asset, meaning that house, investment, or car you sold, longer than one year. In that case, you generally qualify for the special long-term gain tax rates. A short-term capital gain includes the profits of an item you sold that you owned for less than one year. That gain is taxed at the same rate as your ordinary income.

You do not owe taxes on assets you sold at a loss. However, you can use losses to offset capital gains. You’ll first use losses to reduce gains of the same type — for example, you must first use long-term losses to offset long-term gains. Once losses are applied against the same type, any remaining losses can then offset gains of the other type.

Most things you own, such as your car, investments, and real estate, are capital assets.  And when you sell those assets, a capital gain or loss is created.

Long-term capital gains occur when you:

Earned more from the sale of a capital asset than your basis in the asset
Kept the asset for longer than one year

Note: Gains on certain types of assets, such as collectibles and property for which you have taken depreciation deductions, are subject to their own special rules. For instance, long-term capital gains on collectible assets can be taxed at a maximum rate of 28%.

How much tax do I owe on my long-term gain?

You can pay anywhere from 0% to 20% tax on your long-term capital gain, depending on your income level. Additionally, capital gains are subject to the net investment tax of 3.8% when the income is above certain amounts.

Long-term capital gains rates are applied based on ordinary income amounts. The brackets for 2023 are:

Example: Say you bought ABC stock on March 1, 2010, for $10,000. On May 1, 2023, you sold all the stock for $20,000 (after selling expenses). You now have a $10,000 capital gain ($20,000 – 10,000 = $10,000).

If you’re single and your income is $65,000 for 2023, you would be in the 15% capital gains tax bracket. In this example, you pay $1,500 in capital gains tax ($10,000 x 15% = $1,500). That amount is in addition to the tax on your ordinary income.

Are there exceptions to paying taxes on long-term gains?

One caveat does exist with the sale of personal residences. You may not have to pay tax on a gain of up to $250,000 from the sale of your home. That rule applies if you have owned and lived in the house for at least two of the last five years or if you meet certain exceptions.

If you’re married, you can exclude up to $500,000 in gain from the sale of your home as long as you meet the IRS requirements. We discuss the requirements for this more in 5 Tax Tips for Homeowners.

Do I have to pay the additional tax on net investment income?

You may have to pay an additional 3.8% tax on net investment income.

You pay this tax if your modified adjusted gross income (MAGI) is $200,000 or more ($250,000 if filing jointly or qualifying surviving spouse and $125,000 if married filing separately). You can reduce your investment income for that tax by deducting investment interest expenses, advisory and brokerage fees, rental and royalty expenses, and state and local income taxes allocated to your investment income.

The 3.8% tax applies to investment income, such as interest, dividends, capital gains, rental, and royalties. It’s paid in addition to the tax you already pay on investment income.

What should you know before you sell?

If you’re considering selling assets, such as stock, it’s best to plan ahead. A little planning now can save you a lot of capital gains tax when you file your return.

Consider these options:

Don’t sell before the profit qualifies as long-term. Plan the sale of an asset that’s gone up in value to be a long-term gain. Make sure to hold the investment long enough to qualify for long-term status. For most assets, that’s more than one year. But don’t be too hasty to sell when the year is up. The IRS guides say you must own the asset for “more than one year.” If it’s exactly one year when you sell, there’s a good chance they could classify it as a short-term sale.
Don’t hang on to losing investments just to avoid taking a loss. Consider selling assets at a loss to offset capital gains. The IRS only taxes your net capital gain, and you can reduce your gains by deducting your capital losses. You can even deduct up to $3,000 in capital losses from your ordinary income if your losses exceed your capital gains.
There are worse things than owing taxes. One of them is Losing money or keeping it in something that doesn’t go up in value.
Give stock that has gone up in value to charity. Donating stock to charity gives you a tax deduction for the amount it’s worth now. Also, you don’t have to pay capital gains tax on it.
Don’t sell all at once. Even if you’re not normally in the higher income tax bracket, one large sale can place you there for the year if you’re not careful. You might want to sell some stock one year and wait until January to sell some more.
Take the proceeds as an installment sale. If you have real estate you’ve been holding for 30 years, don’t let the sale bump you into the top tax bracket in the year of the sale. Consider making an installment sale. Besides saving taxes, you’ll create a steady flow of income for yourself.
Plan for a 1031 exchange. If you sell an asset and purchase a “like-kind” property, you may qualify to put off paying tax on the gain from the first property. The idea behind this rule is that you don’t realize a gain when you sell one asset to buy another. Note that as of 2018, only “real property” (real estate) qualifies for this type of exchange — personal property does not.
Look for other ways to reduce your income tax bracket in the year of the sale.If you’re selling a substantial capital asset for a profit, that may be a good year to sell a different asset at a loss, contribute more to charity or a retirement account, invest in your business, or take other tax-saving steps.
Buy and hold. The simplest way to put off paying taxes on capital assets is to hang on to them. Perhaps the capital gain rate will come down, or you may be in a lower tax bracket in a later year, such as after you retire. In any case, you can let your investments continue to grow by simply leaving them be.

This article is for informational purposes only and not legal or financial advice.

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