A Word or Two About Tax Rates

Yesterday’s post and a number of prior posts somewhat facilely refer to your tax bracket—both current and future. Just what do I mean by tax bracket? It's time to enter that heart of darkness.

When you are trying to decide between two retirement planning strategies—how much to save, how much to spend, to Roth or not to Roth, which savings bucket to spend first, in which savings bucket to house your stocks, etc.—it often becomes necessary to guess at, and compare, your marginal tax brackets. “Marginal” means the tax bracket affecting your top dollar of income, rather than the average tax rate on all of your income. They’re not the same because we have a progressive tax system.

(A brief aside: “Progressive” means the tax rate gets higher as your income increases, as with the federal income tax. “Regressive” means the rate gets lower as your income increases, as with the Social Security tax [6.2% on the first $106,800 of compensation, 0% on the rest]. But these words are really loaded. “Progressive” sounds so modern, advanced and forward-thinking. “Regressive” sounds like you’re a troglodyte. But no value judgments are intended. The words just describe how the rates vary with the thing that's taxed, income in this case.)

Example. Mary is single and earns $150,000 as a TV news producer. She uses the standard deduction, and claims just herself as a personal exemption. Her 2009 federal income tax totals $33,102, so her overall average tax rate is 22%. But her marginal tax bracket increases with each tranche of income. The first slice of $9,350 of income is taxed at 0% (representing her personal exemption and standard deduction). The next $8,350 is taxed at 10%; then $25,600 at 15%; $48,300 at 25%; and the balance ($58,400) at 28%. Mary’s marginal tax bracket is 28%. So any moves she makes—to reduce or increase her taxed income—either saves or increases her tax by 28%. Sort of. Read on.

Often things are not so simple. Here are some of the complications you’ll run into as you try to figure your marginal tax rate.
• Crossing brackets. A big move might cause you to shift—up or down—from one bracket to the next. So some of your income is at one marginal tax bracket and some at a different one. For example, converting a large traditional IRA to a Roth IRA can easily cause you to straddle two brackets.
• Alternative Minimum Tax. If you have large deductions that are classified as “tax preferences” (such as state and local taxes) then you might be paying Alternative Minimum Taxes, in which case your marginal tax bracket becomes 26% or 28% regardless of what the regular tax rate tables say.
• State income tax. If your state has an income tax, your marginal state tax rate should be added to your marginal federal tax rate to figure your effective tax bracket. In our example, Mary lives in Minnesota, and figures her marginal state tax rate is 7.85%, making her total marginal tax bracket 35.85%.
• Effect of state tax on federal income tax. If Mary itemizes her deductions, then her state tax reduces her federal tax. So her effective marginal tax bracket would then be 33.65%. Unless she’s paying Alternative Minimum Tax. Oy.
• Hidden tax brackets. The federal tax code is just full of hidden tax brackets. Various tax deductions , credits and other such goodies are available only to those with lower income, and then get phased out for those with higher income. If you are within these phase-out ranges—which vary from one goodie to the next—then you are actually subject to a higher hidden tax bracket, as you lose the benefit of a deduction or credit. Gotcha!
• Capital gains. Some income—notably long-term capital gain—is subject to favorable tax treatment, resulting in a lower tax bracket for that type of income.

The message here is that it’s massively complex just figuring what tax bracket you’re in today, even after you’ve completed your tax return. And so what about projecting your bracket 20 years into the future? Forget about precision. Just take your best shot at an educated guess.

The horror; the horror!