If you want to lower your taxes (and who doesn’t?) income shifting is a smart financial tax planning strategy you might consider using. This is an important concept and one which will be increasing valuable to you if tax rates rise in the future.
What is income shifting?
This is a simple technique that moves income away from someone in a high tax bracket (you) over to a person in a low income tax bracket like a child or retired parent that you support. Let’s say you are in the 30% marginal tax bracket and your retired mother is in the 10% marginal tax bracket. Further assume that you give her $10,000 a year to help defray her cost of living each year.
If you declare that $10,000 in income before you give her the money, you’ll pay $3,000 in income tax because you are in the 30% marginal tax bracket. But if you pay your mother as an employee instead, she’ll only pay $1,000 in income tax. That’s a sweet $2,000 savings. That is an example of income shifting and why it’s so cool.
Another way to do this is to gift assets to a person in a lower marginal tax bracket. Assume you are still in the 30% bracket but your college student daughter is in the 10% bracket this time. Let’s say you have an investment that generates $10,000 in taxable income. If you transfer that asset to your daughter, she’ll only pay $1,000 on that income rather than the $3,000 you’ll have to pay.
Under the right circumstances, either strategy can really work without raising any IRS audit flags.
Why is this important?
As I hinted above, taxes are going up – there are no two ways about it. By historical standards, our marginal tax rates are low. Also, long-term capital gains rates and taxes on dividends are a juicy target that Congress has their eyes on. Of course nobody knows for certain what is going to happen with taxes in the future but it’s a good bet that they’ll be higher than they are today – especially when you consider the budget crunch that Washington faces.
That’s why looking into shifting your income can be smart. Sure you’ll save money now. But you’ll save even more money down the line and the sooner you start using these tools the more valuable they become.
Where does it work best?
If you are self-employed and /or have a professional practice and have low-income relatives you support, this is a no-brainer. As I pointed out, the people you shift the income and/or assets to can be children or parents – or anybody that you would otherwise support.
Giving your loved ones jobs is the best option – especially if you have younger children. That’s because earned income isn’t subject to the kiddie tax. Of course, you actually have to employ your child and you have to compensate them fairly. You cannot pay them $10,000 for doing nothing or very little. You must be able to justify the wage or you’ll become a tax cheat and get in trouble with the IRS. I don’t recommend this at all.
What if you aren’t self-employed or otherwise can’t offer someone a job?
This is where asset shifting comes into play. One way is to gift assets as I mentioned above. You can gift up to $13,000 per year per person without filing a gift tax return. But you can gift up to your lifetime exclusion of $5,000,000 if you are willing to file the gift tax return.
Whoever you gift to gets your cost basis and holding period. That means the recipient can even sell the asset and possibly pay no capital gains whatsoever if they are in a low enough tax bracket.
If you transfer assets to children you have to tread more lightly. Investment income above $1900 is taxed at the parent’s rate for children 18 or younger. And if your child is a full-time student, she’ll be subject to the kiddie tax until age 23.
No one tax tactic works for everyone. It may simply not be appropriate to shift assets or to offer a job to low-income tax payers even if they are part of your family. But it’s nice to know about the option just in case it is workable.
Would these tactics work for you? Why or why not? What other tactics have you used to reduce your tax burden?
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I am interested in learning all I can regards to owing the IRS and what I can do to get rid of back end tax penalties (2001-2005) and interest. I would also like to further educate myself in any and all tax breaks that can be utilized for single 1099 worker, no dependents. Tax shifting makes good since. Does it have to be used with family members only? Or can I utilize this with a friend?
Thanks for the wisdom!