What is income tax smoothing? Tax Bracket Arbitrage

Income tax planning and “income smoothing” is a multi-year strategy that can lower your overall income tax bills. Savvy high-income earners use it every year: why shouldn’t you? How to smooth income over multiple years to potentially reduce taxes. How to pay less income and capital gains tax: An introduction to tax bracket arbitrage.

By James L. Cunningham Jr., Esq.

In this ever-changing world of ours, we need to find ways to make our money work better for us. It starts with paying less income and capital gains tax, and it’s called income smoothing. Sounds fancy, right? Well, it’s not as complicated as it sounds. You’re just dancing around tax brackets to keep as much of your hard-earned cash as possible. It’s really all about keeping your taxable income from climbing up into those scary high tax brackets. Set up a call with us to learn more.

So what is income smoothing and how does it work? Well, income tax planning is about looking at taxes not just annually, but over time by playing the long game. It’s like saying, “Hey Uncle Sam, I’ll pay you…but just not right now because the tax isn’t due yet.” And you know what? If you play this game right, over time, you can end up saving a significant chunk of change. Isn’t that a strategy worth considering?

In this article, we’ll define income smoothing, explain how it can enable taxpayers to minimize their liability and increase their savings, and share five powerful accounting strategies.

How Does the U.S. Tax System Work?

To fully grasp the potential of income tax planning, you need to understand that the U.S. income and capital gains tax system is a confiscatory system. You pay tax and individually get no direct monetary benefit in return. Social taxes such as payroll/self-employment and Medicare taxes can come back to you in the form of Social Security and Medicare benefits and are not described as purely confiscatory.

The confiscatory tax system is fundamentally based on two factors: your income and your filing status. The more you earn, the more taxes you pay. Your filing status—single, married filing jointly, or an entity, or a non-grantor irrevocable trust—also affects the amount of tax you pay.

The tax system is graduated. As you earn more, you are pushed into the higher tax brackets. It’s crucial to note that tax deductions come off the top and are more valuable the higher your tax bracket. For instance, if you’re in a 37% tax bracket, a deduction of $10,000 means you pay $3,700 less in taxes. This is commonly referred to as “worst first”.

To save on taxes, it’s essential to get a handle on the different types of taxes that can impact your income and wealth, including income tax, estate tax, death tax, gift tax, generation-skipping transfer tax, capital gains tax, and property tax.

First, there’s income tax. Income Tax is based on your annual earnings (aka income) and is affected by the amount of money you make and your filing status. Basically: the more you make, the more you pay.

Then, there’s transfer tax. What is Transfer Tax? It covers several subtypes of taxes, including federal estate tax, state death tax, state inheritance taxes, gift tax, and generation-skipping transfer tax. These all apply to the transfer of wealth during your lifetime or upon death.

Capital gains tax applies to the profit made from selling an asset like stock or real estate.

And don’t forget property tax. It’s a significant consideration, especially in states like California where property taxes can be low under Proposition 13 even when property values are high—but where changes of ownership can trigger significant reassessments.  Learn more about our California property tax strategies here.

Understanding these critical types of tax can help you develop and implement effective income-smoothing strategies to optimize your financial situation

Navigating this complex system and implementing strategies to minimize taxes requires a deep understanding of the tax code and financial planning—and we are here to help you coordinate the team. We offer in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online. Now, let’s delve into some income-smoothing strategies that could potentially save you money.

How Can I Reduce My Income Taxes? What Is Income Smoothing?

Income Tax Strategies are essentially an effective method of tax bracket arbitrage and when deployed correctly, can significantly help reduce your overall taxable income. These strategies, which Robert Keebler, CPA, has called “Income Smoothing Strategies” can be particularly beneficial for those who find themselves in the highest tax brackets one year and in lower tax brackets another year.

Essentially, income smoothing is about deferring income tax, with the idea that paying tax in the future is usually more beneficial than paying it today.

The key strategies within this concept include the Roth IRA conversion, the Two-Year Installment Sale Strategy, oil and gas tax investments, a non-qualified tax deferred annuity and Commercial Solar. These are just as complicated as they sound, but done properly, they can lead to some significant savings.

Let’s explore five powerful types of income smoothing strategies:

Strategy #1: What Is a Roth Conversion?

A Roth conversion is a powerful tool for income tax benefits and could save you a ton in retirement. This strategy is all about converting a traditional IRA into a Roth IRA. You pay taxes on the conversion amount, but here’s the kicker: all future earnings and withdrawals in your Roth IRA are income & capital gains tax-free.

In its essence, a Roth conversion is a mathematical and actuarial analysis. Is it better to pay the tax now, and save later? Well, it depends on the taxes you will pay now versus later and how long you will live. This is where the actuarial component comes in.

Let’s look at an income smoothing example. Meet Tom. He Tom is single with an income of $200,000. He’s not subject to the Net Investment Income Tax… UNTIL he takes $75,000 from his traditional IRA to buy a new car. This adds an extra $2,850 to his tax bill. What happens when he needs to take out a larger amount? The taxes go up even more.

But say Tom had converted his traditional IRA to a Roth IRA before taking the $75,000 distribution. He wouldn’t be paying any additional tax because Roth IRA distributions aren’t taxable.

An important factor to note is that the tax on the Roth conversion cannot be paid from the IRA itself; other funds outside the IRA must be used to cover this. This strategy is especially useful in those years when your income is on the lower end or during early retirement years if you aren’t working. It allows you to fill up lower tax brackets with the converted amounts, optimizing the tax benefits of your retirement savings. But as with any major financial move, it’s always smart to chat with your A-Team to see if a Roth IRA conversion is the right move for you..

Strategy #2: What Is the Tax Benefit of Oil and Gas Investments ?

One of the most effective income tax deferral strategies is to invest in oil and gas. For the last century, the U.S. government has followed a “cheap oil policy,” promoting—and even subsidizing—domestic oil and gas production. The government allows a deduction of up to almost your investment. It’s like getting a two-for-one deal.

For example, if you invest $100,000 into oil and gas, you might deduct up to $80,000 or more. It’s putting money in your pocket while also investing in the future. That means at a 37% Federal Income Tax rate, a savings of $29,600 in income tax! This is especially attractive for W2 earners who have very few options available to reduce their income taxes.

Consider Able, who earns $100,000 in 2024 and sells $500,000 of Apple Stock which he originally bought for $100,000. This means he’s looking at a long-term capital gain of $400,000. Now, if Able does nothing different, his tax bill would be a hefty $71,000 with a “blended rate” of 17.9%. But what if Able decides to use a savvy income smoothing strategy?

Let’s say Able decides to invest $375,000 into an oil and gas partnership. Remember that “cheap oil policy” I told you about? Because of those “intangible drilling costs” like drilling the well and the concrete casing, he can take a hefty deduction in the year he makes the investment. So, he puts $375,000 in and he gets a $300,000 deduction. This completely wipes out his $100,000 ordinary income, taxed at 22%, 12%, and 10%, and then also puts a dent in his capital gain.

That’s a smart move, isn’t it? In the year that Able invests in oil and gas, he can score a deduction of, in this instance, 80% of those intangible drilling costs. And the best part is, this deduction isn’t just for federal taxes, but state taxes too.

Before the oil and gas investment, Able was paying $86,000 in tax. After investing in oil and gas, he’s paying only $23,000, saving himself $62,000! That’s why people invest in oil and gas. You get these payments back, and a depletion allowance cuts the taxable income by 15% as it comes back.

Strategy #3: How to Save Tax With an Installment Sale

A Two-Year Installment Sale Strategy involves the sale of property using a trust and an installment note. The idea is to sell a property to a trust and in return, take back an installment note. Then, you wait for two years. After waiting, the trust can sell the property to a third party. The great part is, there’s no gain because the trust’s basis matches the selling price. This strategy requires careful planning and timing, but can be a powerful tool for income smoothing and tax minimization.

Picture a piece of property known as Redacre. It’s owned by a couple, the parents, who bought it for $500,000, which is its basis. Over the years, the property has appreciated in value and is now worth $1 million.

Now, if the parents sell Redacre right away, they’d see a gain of $500,000 and a tax bill of $102,270! That’s a big bite out of their profit, right? But what if they did it a little differently, with the Two-Year Installment Sale Strategy?

The parents decide to use the Two-Year Installment Sale Strategy. They sell Redacre to a trust, taking back a 10-year installment note with annual payments of $100,000 plus adequate interest. With this sale, the trust’s basis in Redacre becomes the amount of the note, which is $1 million. The gain from the sale is spread out, realized at $50,000 per year over ten years, resulting in a total tax of just $75,000. And here’s where it gets interesting: If we consider the net present value of these payments, assuming a 5% discount rate, it’s around $57,180. Now, if we compare that with the original tax bill of $102,270, the Parents end up saving a whopping $45,090!

After making two payments to the parents, the trust sells Redacre to a third party for $1 million. Because the trust’s basis in the property equals the selling price, there’s no capital gain realized on the sale. The income from the sale is used to continue the installment payments to the parents.

The beauty of this strategy is that it allows the parents to spread their income from the sale of the property over several years, potentially reducing their overall tax liability. They only recognize income as they receive the installment payments, rather than in one lump sum. The parents effectively defer the tax on the gain, and the income from the sale is spread out, potentially keeping them in a lower tax bracket.

But BEWARE: While the Two-Year Installment Sale Strategy can offer significant tax advantages, there are certain pitfalls that need to be avoided. Firstly, don’t rush the process. You’ve got to hold that property in trust for at least two years before selling it to a third party. If you jump the gun and sell it within those two years, the IRS might hit you with tax consequences.

Secondly, don’t overlook the importance of setting up and managing the trust correctly. Any slip-ups could cost you those tax benefits you’re aiming for. This isn’t the time to cut corners.

Lastly, don’t attempt this strategy without seeking professional advice. The Two-Year Installment Sale Strategy is complex and requires a thorough understanding of tax law. Consult with an expert estate planning attorney—and your A-Team—to ensure that this strategy is suitable for your specific circumstances and implemented correctly. CunninghamLegal offers in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online.

Strategy #4: What Is a Non-Qualified Tax-Deferred Annuity?

A Non-Qualified Tax-Deferred Annuity is a strategy that can result in substantial tax savings by using annuities. Annuities are contracts that promise to pay a specified amount based on a metric of your choice. Here’s the kicker—any growth on your annuity isn’t taxed right away. The tax is deferred until you start to draw on the annuity, allowing your investment to grow tax-free for a while. Keep in mind, though, that when you do start drawing from the annuity, that’s when Uncle Sam comes calling. So, plan wisely!

Consider the case of Helen, a single 50-year-old woman earning $650,000 a year. She has a $1 million bond portfolio that generates $50,000 a year in taxable interest income. Helen expects to have the same income for the next 15 years and plans to retire at 65. If she puts her $1 million bond portfolio into a fixed deferred annuity, she could potentially save $12,000 in taxes every year for the next 15 years. That’s a total of $180,000 less in tax that she would have to pay.

This example demonstrates the potential tax advantages of annuities. However, it’s crucial to remember that annuities are complex products with many variables and it’s always recommended to seek professional advice before investing in an annuity.

Strategy #5: How Does the Solar Investment Tax Credit Work?

Commercial Solar Investments can be an effective income tax deferral strategy that can yield significant tax benefits. Since passing the Inflation Reduction Act, the U.S. government is all for renewable energy and they’ve got the tax credits to prove it. This creates a considerable incentive for individuals to invest in commercial solar projects.

Here’s how a smart investor plays the game. They reach out to us here at CunninghamLegal, create an Energy LLC, and purchase a project 95% complete, but not yet online. These are commercial enterprisers with an end user who buys the solar electrical power from the LLC. Because these projects can take three years or more to develop, most people purchase the nearly-complete projects because they don’t have the training or patience to do it from scratch.

Here’s the tax benefit: the Inflation Reduction Act of 2022 provides for a 30% to 70% Investment Tax Credit (ITC) for commercial solar projects. That’s a dollar-for-dollar reduction in tax due! Now, keep in mind, you do need to commit a bit of time—we’re talking about 100 hours+ of Active Participation in the first year for investors who are seeking to offset active trade or business activities. If the investor is offsetting passive business income, then there is no 100-hour material participation requirement. This can work for W2 earners as well, but there are limitations on the tax benefit.

Sally, a savvy investor, decides to put her money into a commercial solar project. She invests $10M into the project. Sally’s investment results in a total “tax benefit” of $6.4M (ITC plus depreciation). This reduces her taxes by $6.4M! Her net at-risk capital is $3.6M and this net investment returns $450K per year for 25 years. Her net present benefit means that Sally is $2M richer by making the investment in Commercial Solar.

What Is Tax Hygiene?

Tax hygiene is like washing your hands before you eat, but for your finances—and is an essential aspect of financial management as well as minimization of taxes. It involves a range of practices and habits aimed at optimizing your tax situation in any given year—and over the years. For example, in high-income years, it can be smart to reap losses by selling under-performing assets to offset a capital gain. On the flip side, during those years where you might not be working, it could be a good time to reap gains, and offload those profitable assets when your lower income puts you in a lower tax bracket.

If at any point you realize a gain on an investment, it’s time to comb through all your holdings to determine if you have a loss that can offset the gain. Remember, maintaining good tax hygiene isn’t a one-and-done job. It requires you to be proactive in managing your assets and income. It’s all about making sure your financial health is in its best shape. If you are a high net-worth family interested in long-term help, read about our Family Office Services.

With our team by your side, you can be confident that you’re making the most strategic decisions for your financial future. We offer in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online.

What Do We Do as California Estate and Tax Planning Attorney Specialists?

The lawyers and staff at CunninghamLegal help people plan for some of the most critical times in their lives and then guide them through when those times come. Income smoothing is not a one-time event but rather a habit that builds over time. By understanding and implementing these strategies, you can potentially save a significant amount of money over the long term. However, it’s crucial to remember that these strategies are complex and may not be suitable for everyone. It’s always recommended to seek advice before making any significant financial decisions.

We have offices throughout California with expert estate planning, tax planning, and real estate transaction attorneys. We invite you to contact us for help and advice. We offer in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online.

A key goal of our practice is client education. We invite you to keep updated with tax laws and regulations, as they often change. Subscribe to our YouTube channel and newsletter.

We look forward to working with you!

Best, Jim
James Cunningham Jr., Esq.
Founder, CunninghamLegal

At Cunningham Legal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.

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Income Smoothing Strategies are an effective method of tax bracket arbitrage and can significantly help reduce your taxable income.