Running some income tax scenarios for when we finally retire in 2018, we ran into a situation where our ordinary income would be taxed at a whopping 30% marginal rate on our federal return, despite having a total income of “only” around $100,000 (married filing jointly). How is that possible? There is no 30% bracket, only 10, 15, 25, 28, 33, 35, and 39.6%. Moreover, the 30%+ rates don’t even start until $231,450 taxable income for married joint filers, right?
Wrong! If your ordinary income is in the 15% bracket (between $18,550 and $75,300 AGI for married filing jointly in tax year 2016, according to the Tax Foundation), but you have sizable long-term capital gains that bring the total taxable income to more than $75,300, then you will face a marginal tax rate of 30% on ordinary income and 15% on long-term capital gains. The 15% marginal on capital gains is obvious, because that’s their marginal rate in the third bracket. For every additional dollar of ordinary income you are taxed $0.15, but you also push one additional dollar of previously untaxed capital gains (or dividends) into the 15% bracket. The total impact is $0.30, see illustration below:
If you don’t believe it, check out the Turbotax TaxCaster tool (this is for 2015 taxes, though, but works just the same) and enter:
- Married filing jointly
- Ordinary income $50,000
- Long-term capital gains $50,000
This yields a 2015 estimated federal tax of $4,166. Changing the ordinary income to $51,000 increases the tax liability to $4,466. 30% marginal, for exactly the reasons laid out above. Very sneaky! For early retirees with ordinary income and sizable capital gains, proper tax planning and timing is even more important than we thought.
This is already the second instance of deceptive accounting in the IRS code. The other is the Alternative Minimum Tax (AMT) 28% marginal tax bracket, which is actually a 35% effective marginal tax rate for many tax payers because for every dollar of additional income you also lose $0.25 of the AMT deduction, so your taxes go up by $0.28+0.25*$0.28=$0.35.