There are not a lot of urban legends in the tax world. That is why when you hear one, it tends to stick in your mind. The one I heard on many occasions, particularly when I was new in the business, involved an unexpected paycheck late in the year that created a sizable tax hit.
The story begins when someone (usually an Uncle, but occasionally a neighbor) receives a bonus from work towards the end of the year. Before the bonus, the Uncle was in the 15% tax bracket. After receiving the bonus, he was pushed into the 25% tax bracket. According to the story, because he is now in the 25% bracket instead of the 15% bracket, his taxes increased by more than the amount of the bonus. Receiving the bonus at work actually cost him money because of the tax code!
If this story sounds suspect to you, there is a good reason. The key to understanding why this doesn’t work (in theory or reality) lies in understanding the difference between two boring terms we use in the tax business: marginal tax rates and effective tax rates.
Effective Tax Rates
Quite simply, your effective tax rate is the percentage of tax you pay on your income. This is income tax only and does not include payroll taxes, property taxes, or the numerous other taxes levied on you during everyday life.
For example, if you made $100,000, and had $20,000 in deductions and exemptions, you would have taxable income of $80,000. For 2017, the tax due on this amount would be $11,478. This works out to an effective tax rate of 14% if you are married and filing a joint return ($11,478 / $80,000).
Easy enough, except there is no 14% tax bracket. How did we arrive at that number?
Marginal Tax Rates
The key to understanding marginal rates is to realize that your Uncle in the story above is a moron. Once you pass a certain threshold of income, your entire income is not subject to that rate. Only amounts over the new bracket are taxed at the higher rate. To clarify further, let’s look at how we arrived at the $11,478 number above.
• Income up to $18,670 is taxed at 10% = $1,865
• Between $18,670 and $75,900 is taxed at 15% = $8,588
• Income over $75,900 (remaining $4,100) at 25% = $1,025
Total = $11,478
Sorry for the math, but the point is to let you visually see that all of your dollars are not taxed the same. As you make more money, your new dollars are charged at the higher level, but your earlier dollars are not. These are called marginal tax rates.
Your effective rate may be 14%, but how much will you pay on the next dollar you make? The next dollar will be taxed at 25%, meaning any additional income, whether it be from work, rental property, or investments, you will lose a quarter of what you earned.
Effective tax rate = 14%
Marginal tax rate = 25%
Uncle’s intelligence = 0%
It is one thing to know how the government takes advantage of you, but it is a lot more helpful if you can do something about it. If your taxes average 14% of your income, but the next dollar you make will be taxed at 25%, how can that information be used to your advantage? Here are just a few of the many available strategies that are used to help maximize your tax efficiency:
If you are in a high marginal tax bracket, consider increasing your 401(k) contribution at work. Any taxes avoided at 25% or higher are well worth the trouble of filling out an extra payroll form. Look for years where your income might vary. For example, if you are going to sell a property for a significant gain, try not to generate extra income in the same year by selling investments. Conversely, a low-income year is a great opportunity to convert money to a Roth IRA at a low tax rate. Pay attention to the timing of your income. If you are slaving away for the man, you may not have a ton of flexibility. If you are self-employed, you have a lot of control over when you can recognize income. Also, for those looking to retire, doing it in the beginning of the year will give you a partial year of income rather than the full one you are accustomed to, which will result in lower income taxed at a lower rate.
These are just a small sample of some of the tax strategies we use for our clients every day. Hopefully, your advisor is also a CPA and you aren’t told: “please consult with your tax advisor before implementing any investment strategies.”
Remember, the only bracket that matters in tax planning is your marginal rate; we only care how your next dollar is taxed, and what strategies we can use to reduce the amount you owe. If you do run into an advisor who focuses on your effective rate, please introduce him to your Uncle. I’m sure they will get along famously.