[Update: This post was written in 2016, but in light of the changes to the tax brackets starting in 2018, that 30% bracket became a 27% bracket!]
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 taxpayers 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.
Sneaky! These “little” details in the tax code aren’t so little.
Taxcaster is great for running different scenarios and learning the impact of incremental changes.
Best,
-PoF
Thanks for stopping by, PoF! Amazing how there are quirks hidden in the tax code. Kudos to TaxCaster! Cheers!
Ooh, I love stuff like this! Never thought about this scenario. Very interesting and nicely depicted with the bar graphs. I’ll have to start doing this type of analysis next year, when I may start rolling IRA dollars into a Roth, depending on the tax implications.
Yup, and it can go both ways: the 30% could hit you in retirement due to required minimum distributions and high dividend income and capital gains. That may make the Roth conversion more attractive to some people.
Thanks for the return visit! 🙂
Cheers!
Interesting calculation. Never heard of this issue before. This would be relevant for folks who do the Roth conversion and who may not realize that the marginal tax on the conversion is 30% rather than 15%. At 30% it may not be worth it any more! Very sneaky indeed.
Thanks! And it works both ways. You may have the 30% sneaky tax rate today and only 15% in the future, so you definitely don’t do the conversion. But it could also be the other way around: due to future required minimum distributions you might get into this situation in retirement, so you definitely want to do the conversion now at 15% and save 30% later.
Cheers!
But how much does your effective tax rate move?
Thanks for stopping by! Good question!
In the example used in Turbotax we have an effective tax rate of 4.166% going up to 4.4%. Not a big difference. But the whole issue is about *marginal* rates. The marginal dollar of ordinary income is taxed at 30%, which could have implications for how to time your ordinary income if you have a large unforeseen capital gain. By shifting your other income you could make 15% in one year with very little effort.
Or alternatively it has implications for the attractiveness of Roth conversions, see one of the discussions above.
Cheers!
What happens to your effective tar rate though?
See comment above 😉
Sorry for the double comment! I understand the insidiousness of marginal rates but if your effective tax rate is still under 5% when you are making more than 50% of the country not all that bad
Yup! And if you can push your ordinary income down to below ~$25k, which is the standard deduction for married filing jointly, plus 3 exemptions (2 adults plus one kid), then you can make another $75k in long term capital gains or dividends and pay no federal taxes at all. Not that we will be able to engineer that, but some people apparently can.
The current U.S. tax system is very advantageous to the early retirement crowd. Let’s hope it stays that way. 🙂
A similar situation exists with respect to Social Security. (Maybe not a concern for early retirees … yet!)
If your income is in the range where the taxable component of Social Security payments is less then 85%, but greater than zero, then your effective marginal tax rate can be much higher than the basic rate.
For instance, if taxable income falls in the 22% range (2018 tax year), then (for my case, filing single) the effective marginal rate is 38% in this zone. And BTW, (qualified) dividends, (long-term) capital gains and even tax-exempt interest are included in the amount used to calculate the taxable fraction of Social Security payments.
Yes, you are being taxed on tax-exempt interest- how crazy is that?
I believe these issues are much more of a problem for “higher income” retirees than might be imagined, Many of us find that a large fraction of our retirement needs can be generated from non-taxable items like return of principal from our retirement portfolio, Roth IRA distributions, etc. With careful management of tax issues, a person with even a 6-figure retirement “income” can end up well down in the tax scale.
Oh, my, thanks for sharing. Excellent point! There are probably more quirks like that in the tax code that I hadn’t thought about!
Cheers!!!
I discovered a similar phenomenon for those with kids who are thinking about “coast fi” involving the earned income tax credit. For 2017, the combination of decreasing credit and 15% marginal rate for those making $20k-$50k can create add much as an effective 36% marginal tax bracket. Also realized capital gains and dividends over $3450 can lead to a tax credit “cliff” of upto $6318.
Bummer! So many pitfalls in the tax code! Thanks for sharing!!! 🙂
why don’t you want to pay your fair share of taxes?
And now it’s even worse: the 30% bracket became the 27% (=0.12+0.15). 🙂
But, alas, I already paid more than a whole life worth of income taxes already.
Nice article. The phenomena you are describing is a special case of the Tax Hump caused by Parallel Taxation. Here is a good site: http://www.paralleltaxation.com/index.htm. In this site, there is a good spreadsheet (fully updated for 2019) and an interactive graph. Plus many special cases when the Tax Hump (= higher than expected marginal rates) occur and cause problems (e.g. Marriage Penalty, Widow Penalty, effect of Mortgage in retirement, effect of taxes on postponing SS Pension to age 70, etc. ) A short history of Social Security taxation is also included.
The author has suggestions for mitigating the effect of the tax hump. (e.g. instead of just going over the hump for required withdrawals for 2 years in a row, do a bigger (e.g. double) withdrawal in one year since once you are over the Tax Hump your marginal rate goes back down.) And the spreadsheet lets you calculate how close you are to the hump and do what if analysis for planning purposes.
For a longer term view (planning since age 50, and implementing his plan since age 66, now age 68) for avoiding/mitigating the Tax Hump, Dr. Gasem’s discussion on his website is very detailed with year by year tables of alternate approaches (Roth conversions, asset location, etc.). His goal is to minimize income tax on himself and wife and on his surviving wife after he passes away. He discusses his plan here http://mdonfire.com/2019/05/23/parsing-cash-flow-in-retirement/ in a 4 part series. (You may recall Dr. Gasem since he is a frequent commentator on Big ERN’s web site and other and recently did a guest post on Monte Carlo simulations for Retirement Planning ERN’s site.)
Wow, thanks for the links. Very interesting and relevant.
Yes, these tax humps call for some pretty advanced strategies. Similar problem when you’re dealing with the Obamacare subsidy cliff!
It’s even worse than that if you are getting ACA premium subsidies. In 2021 and 2022 every additional dollar that you convert will cost you 8.5 cents in ACA subsidies. So in the worst case if you convert an amount that exactly wipes out your subsides you will be getting taxed at 27% + 8.5% = 35.5%.
Roth conversions sound like such a good idea, but other than small conversions that fill up my remaining standard + HSA deduction space, I can’t get the numbers to work. Not even close.
Yeah, same here. I have zero space for Roth conversions until now. Maybe next year I’ll have more luck.
But it’s a good problem to have. Still too much income from deferred bonuses from my old job. 🙂