Hidden Tax Brackets

Yesterday’s post described the difficulty of figuring your tax bracket. It mentioned the concept of hidden tax brackets—places where the Tax Code causes you to lose a tax goody because of additional income, resulting in an effective marginal tax rate that’s way higher than what the published tables would have you believe. I thought it would be informative to provide an example.

Informative, yes. Useful, no. Because the intricacies of how these hidden brackets work make it difficult to predict them or plan around them. With that disclaimer, read on.

Example. George is single. He earns $55,000 in 2009 working for the New York Yankees, where he’s covered by a pension plan. George contributes $5,000 to a traditional individual retirement account. And that $5,000 is deductible, as explained in February 14’s post. George’s federal income tax works out to $6,350, after taking into account his IRA deduction, personal exemption and standard deduction. And he’s solidly ensconced in the 25% federal tax bracket.

Lucky George! The Yankees pay him an unexpected year-end bonus of $10,000! George guesses he’ll owe $2,500 federal tax on his year-end bonus because he’s in the 25% bracket. Wrong as usual, George! George is gob-smacked by a nasty hidden tax bracket. The extra $10,000 of income causes him to lose his $5,000 IRA deduction (again, see February 14’s post). Which in turn causes him to pay tax on $15,000 of income rather than $10,000. At his nominal 25% tax bracket, that’s $3,750 of tax. So his actual hidden tax bracket on the $10,000 bonus is 37.5%.

That’s a pretty high tax rate for a poor schlep like George, who’s not even the CEO of a failing bank.