Under our current tax code, The Tax Act of 1986, as amended to date, the income that we earn for income tax purposes can be subject to either ‘no taxation’, ‘regular income taxation’, or an ‘alternative rate of taxation’ know as capital gains rates.
For some taxpayers the regular income taxation rate will be defaulted to a ‘parallel’ tax system known as the Alternative Minimum Tax (AMT) and an alternative tax rate on that income which is a flat tax rate of 26 or 28%.
For individuals who are not subject to AMT, their income would be subject to one of the following tax rates – 10%, 15%, 25%, 28%, 33%, 35% and 39.6% ($400,000 single or head of household or $450,000 if married filing jointly). Well technically one who is subject to the 33% tax rate, for example, is subject to each of the 10, 15, 25, and 28% tax rates because we have a progressive tax system that taxes us at various levels as we fill up those lower income tax rate buckets with income. If we took each bucket’s tax and income number, we could calculate a weighted average tax paid from all of those buckets of income and we would call it the taxpayer’s ‘effective tax rate’. The lower one can get that effective tax rate for a given level of income, the better one will have done to ‘manage’ their tax liability on income.
For taxpayers making over $200,000, as single or head of household, and $250,000, as married filing jointly there will be an additional 3.8% tax on investment income which could be either regular income, called ordinary income, like interest earned, or capital, like capital gains. This new tax will alter how we manage our income resources.
Capital gains taxes could be 0%, 15%, 20% (taxpayers making over $400,000 single or head of household and $450,000 married filing joint), 25% (real property depreciation unrecaptured gain) or 28% if a collectible is sold at a gain.
Social Security income is tax free if we do not earn too much income so for those who are receiving social security benefits managing income and the taxability upon it is crucial. Too much income annually is defined by the IRS as $25,000 for single, head of household, qualifying widow or widower with a dependent child or married individuals filing separately who did not live with their spouse at any time during the year; $32,000 for married couples filing jointly; and $0 for married persons filing separately who lived together at any time during the year. For every dollar of income earned over those thresholds a dollar of otherwise tax free social security benefits becomes taxable. For a taxpayer in the 35% tax bracket, for example, the loss to taxes from social security benefits becoming entirely taxable would be 32 cents on a dollar – (85% maximum of benefits that could be taxed) times (35% the marginal tax bracket). The least amount of benefits that could become subject to taxation if you go over the threshold is 50%.
3.8% Investment Tax Effect
Interest Income from a bond taxable at 35% or interest free? What is better? The formula for determining net yield after tax would be (yield) times (tax). So to determine the tax equivalent of a municipal (tax free) bond to a corporate bond we would divide the tax free yield by (one) minus (marginal tax rate). For example, before the 3.8% extra tax a taxpayer in the 35% tax bracket would have been indifferent between a corporate bond that paid 5% and a tax free bond that paid 3.25%. Now, after the 3.8% tax, the same taxpayer would be indifferent if the tax free rate was only 3.07%. Alternatively stated, to earn equivalent of a 3.25% tax free now, the taxpayer would be looking for a taxable bond earning 5.29%.
Social Security Income Taxability Management
When one is receiving social benefits it is even more important to manage the timing and character of income (ordinary, tax free, capital) so that one minimizes the impact of taxation on those benefits. Municipal bond income is tax free but it is considered taxable for purposes of determining whether or not, and how much of, your social security benefits could become taxable. To the extent the muni bond can provide more income than the taxable bond considering all of these factors it may (always run the numbers) be a tax optimizing investment choice when one is drawing social security benefits. Alternatively, an investment that provides cash flow without large taxable components to the cash flow might be a very good strategy to manage social security benefit’s taxability. An immediate annuity purchased with after tax dollars will have an exclusion ratio to the payments received that will then provide cash flow without taxation.
Concluding Thoughts and Observations
Wealth accumulation and wealth management require vigilance in both tax and risk management from an investment perspective. Tax rates have a huge impact on our net returns so strategizing for optimizing our tax impact with our own risk tolerance, and need to take risk, if any, for investment returns is an ongoing responsibility. Choices of tax-free, tax deferred, ordinary or capital gains income are very important in achieving optimal results with our resources earned over our lifetime. I hope you are maximizing and keeping all that you have worked so hard to earn.
David Bergmann, CFP®, EA, CLU, ChFC
The David Bergmann Group
Marina Del Ray, CA