The VBC: Taking advantage of a lower income year

We’re starting a new article series called The VBC, or: “The Very Best Conversation.” This series will focus on the very best conversation we’ve had with a client recently.

These types of conversations touch on key financial planning details that we feel are relevant for other clients. So we’re going to start turning these engaging conversations into educational articles that other people can learn from. This month’s VBC has to do with taking advantage of a lower income year.

(This article is a little long, you can read an AI generated summary, here).

A married couple leaves corporate

No one likes making less money today than they did yesterday. However, income fluctuations are a fact of life. Retirement, changes in employment, or family priorities, are among the many reasons that your income may fluctuate year to year. Being aware of how changes in your income impact your tax bracket can allow for efficient tax planning.

Our story focuses on a married couple that left the corporate grind at the end of 2022. One left to start a new business, and the other to take a break and spend more time with family. The financial result of these changes meant that they were going to see a significant decline in their income in 2023 compared to 2022. Understandably, due to this new uncertainty, the clients wanted to raise their liquid savings.

Here’s some information on what they had to work with:

One spouse received a year-end bonus in early 2023
They also had restricted stock units (RSUs) in their former company’s stock that was vesting in early 2023
The other spouse held meaningful assets in taxable brokerage accounts, with unrealized long-term gains concentrated in a single stock

We mapped out how long the bonus would last based on their fixed expenses. We also recommended that they sell the company stock immediately upon vesting. Then, if necessary, we could tap assets in the brokerage account for additional cash as the year progressed.

Understanding changing tax brackets

There were two main tax items that we were able to identify and help the client take advantage of. The first came after the client exercised their RSUs and we noticed how much tax was withheld from the sale.

Their former employer withheld 22% on the sale of the client’s RSUs, for the purpose of federal taxes
This extra withholding created the effective benefit of a tax credit on their 2023 income taxes

Publicly traded companies will typically withhold at least 20-25% of the proceeds from an employee’s exercise of RSUs for federal taxes. But, based on the couple’s expected income in 2023, the client can expect to only pay 12% in federal taxes on the proceeds from their RSUs. This means there is a refund coming based on the excess tax withheld.

This extra withholding and reduced income gave them an incentive to sell some of the concentrated stock in the taxable brokerage account, especially as the stock market rebounded.

The extra withholding on the RSUs meant the clients had a projected refund of about $5,500 heading their way in April 2024. But why wait a whole year for that refund to show up? Instead, we recommended that the client use the $5,500 refund today instead of letting the government sit on it.

Why wait for a tax refund?

Incentivized by the stock market’s strong 2023 performance and an effective $5,500 tax credit for our client, we recommended they sell some of their concentrated stock from their taxable brokerage account. They would pay a 15% tax on any long-term capital gains based on their 2023 income. This meant they could take long-term capital gains up to $36,667. We arrived at this number by dividing the tax credit amount ($5,500) by the long-term capital gains tax rate (0.15%… $5,500/0.15% = $36,666.66).

Psychologically, this made it easier for the client to let go of the stock position. For if the tax was already paid on it, and you could use the extra savings anyway, why not sell some stock?

So far, the client has taken about $14,000 in long-term capital gains and has the cash they think they need to last until the end of the year. But, should they need more, they still have capital gains they can take without adding to their 2023 tax balance. This gives them flexibility as they get closer to the end of the year.

We’d like to add that our client almost qualified for a 0% long-term capital gains tax bracket, but their income was just a little too high. However, this is an important factor to be mindful of, especially for retirees! A single person or married couple who make, after deductions, less than $41,675, or $83,500, respectively, qualifies for a 0% long-term capital gains tax rate.

Making sure you get it right

We can’t emphasize enough that good planning takes good teamwork. In this particular case, we worked closely with our client and a tax professional to make sure we delivered accurate advice. The client’s communication was excellent and they furbished us with pay stubs, tax returns, brokerage statements from unmanaged accounts, and other documents that allowed us to verify the income situation we were dealing with.

The reason this was was the very best conversation we had with a client recently is twofold:

Our client trusted us with non-investment related information. Our initial conversation around their life changes had nothing to do with assets we were managing.
As we worked toward the goal of increasing their savings, we realized the vital role that tax planning was going to have. And taxes are relevant for everyone!

And here are a few lessons from this client’s experience:

Check your withholding! Your employer may be withholding too much if your income changes, or if you have a baby or other qualified dependent (such as an elderly parent who is living with you).
Consider if a change in income may allow you to tap liquidity from capital gains at a lower tax rate than prior years.
Work with trusted and ethical professionals! A good tax and/or financial advisor should have no problems working together to get you the information you need. If your advisor is not helpful, or wants to charge you immediately just for a phone call, find a new one!

Because of our conversation around this life-event, we were able to execute a plan that gave our clients the savings they needed to feel comfortable on their new journey. So the next time you have a major life change on the horizon, let’s discuss it together!