Talking Taxes - Part 2

Welcome to part 2 in the taxes conversation for 2022. The original plan was to talk about two topics today. We are still going to talk about two tax-related items, however, I am calling an audible. One of the items I was planning on discussing today will be shifted to next week. It is the sunset of the TCJA of 2017. I realized there is too much to cover today and will instead cover it next week in its own article. With that, let’s get to the two tax topics for today.

Today I want to cover the taxation of dividends and also bracketology. At least this is what I call it. Let’s start with the latter as it is easier to explain. I hope.

I like to talk bracketology with clients. And this has nothing to do with March Madness. It is simply paying attention to tax brackets. Last week I covered marginal and effective tax rates. I am not going to repeat myself. Instead, I am going to expand on that and talk about how you need to pay attention to tax brackets and use them to your advantage.

The concept of bracketology in my world is simple to explain and tougher to execute. It is simply taking advantage of lower tax rates by filling up respective tax brackets without pouring over into the next bracket which is at a higher rate.

Let’s look at an example for someone filing Married Filing Jointly (MFJ). Your taxable income for 2022 is $300,000. You are near the top of the 24% federal tax bracket. You have another $40,100 of income before you roll into the next tax bracket, which is a big jump to 32%. So, for every dollar of additional income you recognize in 2022 it is taxed at the marginal rate of 24%, until you recognize more than $40,100.

Here's where knowing this information and how much gap you have comes into play. Maybe you want to do a Roth Conversion without hitting the next tax bracket. Or you want to sell some stock options. Heck, maybe you have the ability to bring forward some additional income from a future year into this year as your future tax rates would be higher. On the flip side, you may be wanting to decrease your taxable income to get back into the 24% marginal rate from the higher 32% tax bracket. In these cases it may be doing some charitable giving or recognizing deductible business expenses.

Regardless of the situation, it is important to know before the end of the tax year what tax bracket you are projecting to be in and if there is a need to do some work to take advantage of lower bracket. This is where you need to pay attention to your taxes throughout the year and use tax bracketology to your benefit.

The next tax topic I want to cover is on dividends. Specifically, I want to quickly explain the differences between qualified and ordinary dividends.

Qualified dividends have actually not been around that long. About two decades now. The basic concept is they were created to reward longer-term investors and have the dividends taxed at a more favorable capital gains rate. Unlike long-term capital gains, which must be held more than 365 days, qualified dividends must be held for more than 60 days during a 121-day period that starts 60 days before the ex-dividend date. Fun, right.  Fortunately, you don’t have to figure out if your dividends are qualified or ordinary as you will get tax forms letting you know.

The other type of dividend is the old ordinary dividend. The simplest way to think about ordinary dividends is these are stocks and bonds you have not held for at least two months. Also, other investment types such as real estate investment trusts and master limited partnerships (MLP) are almost always ordinary dividends. Although their actual tax rates may be lower. Talk about confusing.

Taxation of these two types of dividends is easy to remember. Ordinary dividends are taxed like ordinary income. Qualified falls under capital gains brackets of 0, 15 and 20%. The actual capital gains rate depends on your overall taxable income.

Again, knowing how your investments are being taxed at the dividend level is key for tax planning purposes. Maybe it makes more sense for your MLPs to be held in a tax-deferred account while your qualified dividends are held in taxable ones. Additionally, having a good idea of how much will be coming in from dividends annually is helpful when you want to do things like being sure you don’t roll into the next higher tax bracket and tip Uncle Sam.

This seems like a good place to stop. Next week I will talk about sunsetting tax rates. Get out the popcorn!

I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.