Monday, December 23, 2013

What’s My Marginal Tax Rate? (followed w/discussion)

A guest writer over at TheFinanceBuff writes: What’s My Marginal Tax Rate?

Did you know that the highest marginal tax rates are paid by families with students in college? The modern tax code has made it very difficult for Americans to know their marginal tax rate. Marginal rate is a critical criterion for making investment and personal finance decisions: Should I contribute to a Roth IRA or a Traditional IRA? Should I sell this mutual fund now or wait until January? Is a Flexible Spending Account worth the hassle? Is my employer’s post-tax disability insurance premium a good deal or a bad deal?
Your marginal rate is how much income tax you’ll pay on your next dollar of income.* How do you determine that? First you need to determine your nominal tax bracket. Nominal tax brackets are based on taxable income, NOT gross income. A two-earner family with three kids might have taxable income $80,000 lower than gross income.
That’s only part of the story, however. Increasingly, the tax code looks to your Adjusted Gross Income (AGI) rather than your taxable income. Your AGI is at the bottom of page 1 of your Form 1040. Tax credits, eligibility for certain IRA contributions, the Affordable Care Act tax on investment income, the American Taxpayer Relief Act phaseouts of personal exemptions and itemized deductions, some college expense deductions, and many other tax benefits and penalties are based on AGI or Modified AGI (basically AGI adjusted in some way specific to the credit or eligibility). Some of these phaseouts create very high marginal tax rates — even approaching 100% — so it’s important to know which ones affect you.
Here’s how that happens: Imagine a $2,000 tax credit that is linearly phased out over a $20,000 range of AGI. That means each $100 increment of AGI costs you $10 in taxes, so the phaseout creates an incremental 10% tax — you thought you were in the 25% bracket, but it turns out your marginal rate is 35%.
Here’s a real example: The Child Tax Credit phaseout adds 5% to your marginal rate. The phaseout is based on AGI and is not inflation-adjusted, so that now, more than a decade after its introduction, the Child Tax Credit phaseout almost completely overlaps the 25% bracket for American families with three or four children — they jump straight from a 15% marginal rate to a 30% marginal rate … and if their income goes up their marginal rate drops to 28%. Throw in a deductible 6% state tax and these numbers are roughly 20% -> 35% -> 32%.
Many of these phaseouts target families making $125,000-$200,000, so they often overlap, yielding very high marginal rates — higher than anybody pays outside this band.
* Aggregating tax rate across major blobs of income is also useful for major life decisions. For example, a family with three kids pays about 5% federal income tax on its first $125,000 of income, but 30% on its next $75,000 of income. When you’re used to paying almost no income tax, giving up a third of your income may come as a surprise. Understanding this will help with major decisions such as: Should we move to a high cost of living area to accept this higher paying job? Now that the kids are all in school should I return to work for the second income? Thanks to the bull market, we finally have enough money to buy a house – is there any problem with selling all our stocks immediately?
Read the following sections to see which AGI-based taxes affect your marginal rate. These sections are by no means complete (I left out some of the low income credits, and also the ACA insurance subsidy, since Harry just covered that in a column), but I hope this covers the AGI-based taxes that affect most readers. MFJ refers to Married Filing Jointly, S to Single or Head of Household, except where HoH is different and is listed separately.All numbers are for 2014. The student loan deduction will also reduce state tax, so I assumed a 5% effective state tax to show the aggregate effect of the phaseout on your total marginal rate. Finally, note that the incremental rates listed pile on top of your 15% long term capital gains rate, too.

De Facto College Financial Aid Tax

Amount at Stake47% of income net after federal tax
AGI or MAGI phaseoutAbout $100,000 – $200,000 gross income, depending on school and number of students in family
Incremental tax rateUp to 35%
Inflation-
adjusted?
N/A
CommentsNot technically a tax and not AGI-based, but has the same effects

Lifetime Learning Credit

Amount at Stake$2,000
AGI or MAGI phaseoutMFJ $108,000 – $128,000
S $54,000 – $64,000
Incremental tax rateMFJ 10%
S 20%
Inflation-
adjusted?
Yes

Child Tax Credit

Amount at Stake$1,000 per child under 17
AGI or MAGI phaseoutMFJ > $110,000
S > $75,000
Incremental tax rate5%
Inflation-
adjusted?
No
CommentsNon-overlapping, so the top of the phaseout is $110,000 + (number of kids * $20,000)

Education Savings Bond Program

Amount at Stakeinterest on cashed savings bonds
AGI or MAGI phaseoutMFJ $113,950 – $143,950
S > $76,000 – $91,000
Incremental tax rateIn theory up to 33%, typically far lower
Inflation-
adjusted?
Yes
CommentsDivide total interest by $30,000 (MFJ) or $15,000 (S)

Student Loan Interest Deduction

Amount at Stake$2,500 deduction, worth up to $800
AGI or MAGI phaseoutMFJ $130,000 – $160,000
S $65,000 – $80,000
Incremental tax rateMFJ up to 2.5%
S up to 5%
Inflation-
adjusted?
Yes
CommentsMaxed out for $37,000 of debt at the typical 6.8% interest rate

Alternative Minimum Tax

AGI or MAGI phaseoutMFJ $156,500 – $484,900
S $117,300 – $328,500
Incremental tax rateReplaces normal brackets with a 32.5% or 35% rate and the full weight of your state income tax
Inflation-
adjusted?
Yes

American Opportunity Tax Credit

Amount at Stake$2,500 per student
AGI or MAGI phaseoutMFJ $160,000 – $180,000
S $80,000 – $90,000
Incremental tax rateMFJ 12.5% per student
S 25% per student
Inflation-
adjusted?
No
CommentsCreates huge marginal rates for multi-student families

Adoption Credit

Amount at Stakeup to $13,190
AGI or MAGI phaseoutAll $197,880 – $237,880
Incremental tax rate33%
Inflation-
adjusted?
Yes

Affordable Care Act Investment Income Tax

AGI or MAGI phaseoutMFJ > $250,000
S > $200,000
Incremental tax rate3.8%
Inflation-
adjusted?
No
CommentsEffectively applies to earned income if investment income straddles the threshold

ATRA Personal Exemption Phaseout

AGI or MAGI phaseoutMFJ $305,050 – $427,550
S $254,200 – $376,700
HoH $279,650 – $402,150
Incremental tax rate1% * number of dependents (5% for family of five)
Inflation-
adjusted?
Yes
CommentsAbsorbed by AMT (i.e., non-additive)

ATRA Itemized Deduction Phaseout

AGI or MAGI phaseoutMFJ > $305,050
S > $254,200
HoH > $279,650
Incremental tax rate1%
Inflation-
adjusted?
Yes
CommentsAbsorbed by AMT
[Photo credit: Flickr user Horia Varlan]

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Comments

  1. Wow our taxes are confusing haha but I guess it’s not always such a bad thing when you have to pay more taxes since that means you’re earning more. I’m all for avoiding taxes though 
  2. MarkT says
    This is why I read your posts, since you are one of the few folks that can teach me something I don’t already know.
    I believe I am solidly middle class, but losing ~44% of each dollar at the end makes me want to cut back a few hours.
    • Bob's not my name says
      No I didn’t: “These sections are by no means complete (I left out some of the low income credits …”
      I also left out the Earned Income Tax Credit, the Child and Dependent Care Credit, and taxation of Social Security, and, as mentioned, IRA eligibility and ACA subsidies.

BabyCenter.com picked up on the article and had the following exchange:


Posted 7 hrs ago
This lines up with alot of what Mayor explains to folks about increasing above the line deductions(deductible IRA, 401k, HSA)  to reduce taxes

Comments (17)

 1 2 

Group Owner
Posted 7 hrs ago
Great article.   He deliberately omits the impact at the lower end of the income scale, which is understandable, and he discloses it.  
But I don't want anyone to get the idea that this kind of wonkiness can't happen if you make $30-$60K.
Speaking in generalities, taxes are more simple from $70-$125K, then they get crazy again for a while, and then the AMT happens, and then......I go cross eyed and lose all perspective.  

--
j -- with 4 tweens and a new little one due Feb 2014
Concerned about Family Finances?  Join the conversation.

Posted 7 hrs ago
Thanks for sharing! It is indeed very complicated. The AGI/MAGI phaseout really doesn't help a lot of middle class families.

Posted 7 hrs ago
Amt sucks. 

Posted 7 hrs ago
I think I need to learn a lot more about the AMT.
--
Mom of a beautiful girl and 3 boys under age 5!

Posted 7 hrs ago
Taxes for dummies here. What is AMT? Obviously never been an issue for us, but I'm curious.

Last edited 7 hrs ago
Re AMT: When you make more than a certain amount of money they tax you at a higher percent than in the tax codes - by taking away most deductions. From the above article- "Replaces normal brackets with a 32.5% or 35% rate and the full weight of your state income tax"

Makes me angry.

Posted 6 hrs ago
AMT = Alternate Magic Taxland.
You calculate your tax liability under the regular rules and then under AMT.  Whichever creates a higher tax liability is what you pay.
At least the 2012 Tax Relief Act finally fixed teh AMT standard deduction.  It rebased it to a new amount and pegged it to adjust with inflation.  This means no more panicking on my part every December over whether congress would pass another patch or not.
Teresa

Posted 6 hrs ago
I have no fear of normal taxes.  The AMT monster scares the hell out of me because it's the one thing I haven't taken the time to fully understand. I look at the worksheet and get a headache.
--
DS 06/20/2010
DD 03/05/2012
( o ) ( o ) and counting

Posted 6 hrs ago
Lmao teresa. I will be using that phrase for sure!!

AMT monster scares the hell out of me because it's the one thing I haven't taken the time to fully understand
^^ and as far as this goes, let me know when you figure it out. We've dealt with it for almost 10 years now and every time I think I've got it, I realize I don't. I need to sit down with the actual worksheet again this year I think. But then, I also realize it doesn't really matter of I understand it or not because there's not a thing I can do to change it. :(. And then I feel like crying.

Group Owner
Posted 6 hrs ago
I really wish your DH could talk his employer into doing an automatic contribution to their 401k in exchange for lower pay.  But I'm guessing that there are enough non-highly compensated employees at the employer that this is a no go for them.  

--
j -- with 4 tweens and a new little one due Feb 2014
Concerned about Family Finances?  Join the conversation.

 1 2 

Posted 5 hrs ago
As far as AMT, looks like I can stop panicking if we are under 156k MFJ gross? I understand there is not much to be done, but I don't want to be withholding thinking I have exemptions that one day I may not have.  I also need to study the de facto financial aid tax.  Thanks for the article.  This board helps me remember how much I still need to learn. 
--
Mom of a beautiful girl and 3 boys under age 5!

Posted 5 hrs ago
What is the De Facto College Financial Aid Tax that he mentions?

He starts the article by saying "Did you know that the highest marginal tax rates are paid by families with students in college?" We are likely going to cash flow some tuition so what does this mean?

Last edited 5 hrs ago
I complete agree with this.  We live in SoCal, which commands a high salary due to HCOL, but the tax is a killer.  28% federal + 5% (child tax phase out) + 9.3% California + 1.45% Medicare = 43.75% of the "extra salary" goes to taxes.
We are trying to move to a LCOL, DH will only work 9 months out of the year, and we will probably come out ahead or at least break even.
The low-end is the same. $60K is SoCal is like $30K elsewhere.  One gets EITC, one doesn't.
The federal tax code doesn't care about COL.  

Group Owner
Posted 4 hrs ago
What is the De Facto College Financial Aid Tax that he mentions?
The Expected Family Contribution from the FAFSA goes down as income goes up.
If your child goes to a university that provides need based aid up over the EFC, then an increase in the EFC is another hit to the bottom line for a family in that window.  
But I believe the EFC counts certain non-taxed income, so I'm not sure that the strategies that many of use to lower Adjusted Gross Income (and thus taxable income) would help there.  

--
j -- with 4 tweens and a new little one due Feb 2014
Concerned about Family Finances?  Join the conversation.

Posted 3 hrs ago
I'll have to read this article again when I have time to process...although I'm in AMT as well so it is really just depressing. I'm also in CA (Bay Area) and that "high income" we earn doesn't go very far. I hate tax season...
--
Samantha and Hubby - After 2 losses, our rainbow baby boy arrived 8/7/12.

Posted 3 hrs ago
Lmao teresa. I will be using that phrase for sure!! AMT monster scares the...
So far we have never been subject to the AMT...but I have no idea why, which always keeps me wondering if this will be the year that the screws get put to us.
From what I do know, it is harder to manipulate than the "normal" tax calculation. Whatever we're doing by accident right now seems to be working in our favor.
--
DS 06/20/2010
DD 03/05/2012
( o ) ( o ) and counting

Group Owner
Posted 1 hr ago
AMT: When you make more than a certain amount of money they tax you at a higher percent than in the tax codes
The problem is AMT does *not* have an income threshold that triggers it. Otherwise it would just be another weird marginal tax rate. We grossed well over 200K last year and did not trigger AMT. People with much lower incomes and, say, a lot of kids, could trigger it. 90K and 6 kids could easily do it.
IT's the combination of your income and your deductions/exemptions that triggers it. Also, the exercise & hold of incentive stock options triggers it automatically. And then you get an exemptted amount of income, very few deductions, you start getting taxed on 1.28 for every $1 you earn above a threshold. It's lunacy. But a permanent patch was put in place last year to include inflation indexing.
--
... farting rainbows on Family Finances since 2003...
... running like a girl with Running Mamas since 2009...

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