Investments Personal Finance Retirement Taxes

Q&A: What is bracket-topping?

Bracket-topping is the process of going to the top of a tax bracket, but not going into the next one. This is often done with Traditional IRA distributions or Roth conversions, but can also be done by taking distributions from an inherited Traditional IRA. The purpose of doing this is to strategize when income is taken in order to minimize taxes in the long-term, and therefore, increase income.

Captain Case Study
A friend around the age of 30 inherited a Traditional IRA with a value of about $250,000 from a relative who passed away. This friend asked their relative’s financial advisor what they should do with it and the advisor said they could just take their beneficiary RMD out each year and stretch the distributions over their lifetime. But, beyond that, the advisor couldn’t offer anything else and advised my friend to talk to a tax professional.

This advisor must know what they are talking about, being that they are an experienced financial professional working for a firm with over $500 billion in assets under management, right? Turns out that’s not necessarily how the world of comprehensive financial planning works…

My friend asked for my thoughts and I told him how the stretch idea would be a great strategy, however, it is now no longer an option because of the SECURE Act which was passed in December of 2019…! The SECURE Act took away the ability to do that and made it so my friend must take the entire account out within 10 years.

Being that any amount my friend takes out each year will be added to their taxable income, it is important to try to estimate the next 10 years of income, and strategize the best we can. So, my friend came up with their and their spouse’s projected income from 2020 to 2030. My friend is in graduate school until 2024, so their income over the next few years will be relatively low compared to when he begins working and begins earning about $90,000 per year.

With that information, I estimated what their taxable income would be for each year after their standard deduction, found what tax bracket they would be in, and used that information to bracket-top. This is the table we came up with:

YearTotal Income– Standard Deduction=Taxable IncomeTop of 12% bracket*Distribution
*the 12% bracket was created as a result of TCJA and expires after 2025

Some factors that were not taken into account for the sake of simplicity:
– annual increase to standard deduction
– annual increase to tax brackets (12% bracket included)

The total distributions ($248,600) are under the total balance of the account ($250,000), but this is just a projection and we don’t know what will happen every year. This is just the first step to finding out the best years to take distributions from the inherited account and how much to take. What is done with the money will depend on their goals.

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