Tax planning looks different for each investor as income sources, tax brackets, financial objectives, and other factors shape the investor’s approach. But tax planning can also be a starting point for determining what financial planning techniques may be appropriate for an investor’s portfolio. 

A fundamental element of tax planning is threshold planning. In a progressive tax system, tax rates increase with income. For example, Sam is a single taxpayer with an annual taxable income of $110,000. Based on the 2023 IRS income tax bracket guidelines, the first $11,000 of Sam’s taxable income is taxed at 10%, the next $33,725 at 12%, the next $50,650 at 22%, and the final $14,625 at 24%. 

A tax threshold is the last dollar of income in each income tax bracket. Upon earning an additional incremental dollar, the investor enters the next bracket at a higher tax rate. Accelerating or deferring income to remain in a targeted tax bracket supports the premise that each incremental dollar should be taxed at the lowest possible rate.

When planning around an investor’s tax thresholds, it’s best to take a long-term approach. Assess the structure of the investor’s portfolio, which may include account types such as an Individual Retirement Account (IRA), a 401(k) plan, or a Health Savings Account (HSA). Depending on an investor’s goals and income outlook, it may make sense to incorporate tax-free income—such as Roth distributions and municipal bond income—to remain under the targeted threshold. It may also make sense to lower current taxable income by taking advantage of income deferrals into a 401(k) plan, a traditional IRA, or an HSA. Deferring income can mean lower taxes today and in the future when they eventually make withdrawals.

On the other hand, it may make sense to increase taxable income today as part of a threshold-planning strategy. Accelerating income in an investor’s earlier years—when income tax rates are likely lower—could significantly reduce taxes in the future, such as in a Roth conversion strategy.

For example, Daphne is a single taxpayer with an adjusted annual gross income of $140,000. She anticipates that her income will rise significantly over the next few years and wants to take advantage of her current circumstances to do some Roth conversions. In this situation, Daphne will accelerate income to the top of her current 24% marginal tax bracket. She can convert up to about $40,000 from her traditional IRA to a Roth this year without paying a higher tax rate.

“The process of evaluating an investor’s current income versus future expectations informs the degree and magnitude of income adjustments to target,” said Ashley Greene, a Vanguard wealth planning specialist and co-author of the new research paper Fundamentals of tax planning: Going beyond the basics. “The question then becomes how to adjust an investor’s taxable income.” 

Capital gains and losses offer a notable opportunity for such adjustments; proper management of these gains and losses can affect an investor’s net return and total tax liability.

Understanding the triggers of any taxable capital gains is a key starting point to determine what tax-planning strategies may be appropriate. For example, an investor who needs to draw from investment accounts to fund spending needs can direct proceeds from their annual rebalancing or mutual fund distributions to a cash account for future use rather than automatically reinvest the proceeds. This can help avoid additional transactions—and the taxes on them—in the future.

Also, “pay particular attention to short-term gains,” said Garrett Harbron, Vanguard’s head of global wealth planning methodology and coauthor of the research paper. Short-term gains “do not receive the preferential tax rates that long-term capital gains do, so steps should be taken to avoid them.”

Other capital gains takeaways to keep in mind:

• Watch out for cost basis. The default cost basis treatment for a given transaction may not be optimal for the investor, as other available options might be more tax-efficient. Evaluating positions at the tax-lot level, while time-consuming, may reduce the investor’s current-year capital gains tax liability and provide hidden opportunities for tax-loss harvesting.
• Take advantage of capital loss carryforwards. Ensure that capital losses are accounted for. They can be carried forward indefinitely, but you must use them when you have the opportunity or else they’re lost. An investor who has $10,000 in capital losses and $8,000 in capital gains needs to subtract the losses at tax-filing time; they are not subtracted automatically. If the losses aren’t subtracted, the IRS will consider them lost anyway. In other words, losses cannot be stockpiled for future use. Whether they’re used in a tax calculation or not, the IRS treats an investor as having used them.

Everyone wants to pay less in taxes. To achieve that, Greene said, “you have to look at it in the context of what you’re paying over a lifetime, because you might make sacrifices today so that, on the whole, you’re paying less in taxes,

“It’s still all coming out of your pocket, so if you can make adjustments today to lower tax totals in the future, you’re still lowering your overall taxes.”

• Fundamentals of tax planning: Going beyond the basics (18-page PDF, issued August 2023)
• How plan design tweaks can boost saving rates (article, issued July 2023)
• Maximizing household liquidity for today and tomorrow (article, issued June 2023)