Bracket Hedging

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by on January 5, 2011 at 4:29 pm

Mariners should optimize the standard and itemized deduction

You just got a great job off the board. You just got your license. You just started shipping. You just graduated from the Maritime Academy. These events all scream change from a tax perspective. Our tax system takes a reverse psychology approach – the better we do, the more they get. It’s a disheartening blow that we wish we could alleviate. There are some planning tactics that can help. Where should we start looking for tax savings. Let’s look at our Uncle…

You get a very large, free deduction from Uncle Sam

It’s not unique to Merchant Seamen. It’s the standard deduction. Many years ago, our selfless leaders took it upon themselves to provide a deduction that would be representative of the cost of living. Now a days it’s about $6,000 for single individuals. You are allowed to use this deduction on your tax return as an offset.

Basic Tax Formula -

  1. Income – you take any income that is not excluded and combine it
  2. Adjustments – you deduct any adjustments (student loan interest, etc…) that you are entitled to
  3. Standard or Itemized Deduction – you subtract your standard or itemized deduction (whichever is larger) from your adjusted gross income (AGI)
  4. Taxable Income – After the previous offsets we go into the tax tables and determine your tax… We’ll stop at this point…

Important terms…

  1. Marginal Tax Rate (MTR) – the rate at which the next dollar you earn will be taxed. This is your “tax bracket”. Mariners tend to have a 25% MTR.
  2. Average Tax Rate (ATR) – the overall tax rate (bottom line tax vs. gross taxable income)
  3. Standard Deduction – a tax deduction which can be taken against gross taxable income
  4. Itemized Deduction – a deduction that can be taken in lieu of the standard if deductions exceed the standard (or if filing married separate)

If you can’t itemize – you get the standard

Our Example

  • Single Taxpayer
  • Year 1 income of $50,000
  • Year 2 income of $75,000
  • Massachusetts Resident
  • Rents their home

Year One Tax

Year Two Tax

 

When we look at the first two returns we see a year 1 tax of $6,106 and a year 2 tax of $12,206. A total tax of $18,312. What if we change the timing of certain deductions. Let’s try shifting.

Shifting

We’re going to push some of our deductions into year 2.

  • excise bill $500
  • charity $500
  • initiation fee $2000
  • business expense $1000
  • tax prep $270
  • year 1 state taxes of $2,500

Year One Adjusted

Year Two Adjusted

What happened?

This simple adjustment creates a $1,060 advantage. This is solely due to timing. We haven’t changed any of our deductions. In this case we were planning to optimize deductions for a higher MTR year (25%).

How does this work?

We’re utilizing the standard deduction and pushing itemized deductions to alternate years. This is a great technique to use before purchasing a home. More advanced strategies can be developed when anticipating tax events (high/low income years, marriage, home, investment, etc…).

Just remember – there’s more to tax planning than magic numbers.

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