All Things Financial Planning Blog


Keeping What You Make – Managing Taxes Owed on Income Received

The Debt Crisis Isn't Over YetTax Rates Overview

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’ known 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 related 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 (1) regular income, called ordinary income, like interest earned, (2) qualified dividend income, like income on your NYSE traded stock, or (3) capital, like capital gains. This new 3.8% tax will alter how we manage our income resources for those at these income levels.

Capital gains and qualified dividend 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) minus [(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% additional tax is imposed, the same taxpayer earning the taxable 5% would be indifferent if the tax free rate was only 3.07%. Alternatively stated, to earn the equivalent of a 3.25% tax free, now the taxpayer would be looking for a taxable bond earning 5.29%.

Strategy Considerations

For Investment Income: Interest, Qualified Dividends and Capital Gains

The first thought is to re-allocate your CD type money into a dividend paying stock. For a single person in the 28% tax bracket ($87,850 to $183,250) that would save .13 cents on every dollar of earnings (.28 – .15). For a single person in the 15% tax bracket ($8,925 to $36,250) that would save .15 (.15 – 0) cents on every dollar. But is that penny wise and pound foolish? It might be because unlike your CD investment where your principal is secure, and most likely FDIC protected, the stock price associated with your investment paying that dividend may decline. A 1% negative move in a $20 dividend paying stock, 20 cents, would wipe out the tax gain you were trying to achieve by seeking out dividend income over ordinary income. So consider both your personal ability to tolerate risks of loss and determine the appropriateness to your financial circumstances of putting your principal to that risk.

To ensure that your capital gains get the favorable 0, 15%, or 20% (plus 3.8%, if applicable) tax treatment the investment must be held for more than one year. Knowing that the market does not go straight up, it might not be appropriate to seek capital gains by investing in the stock market if the money you are investing might be needed in the short to intermediate term – 3 to 5 years. Again, risk tolerance and diversification should always be taken into consideration.

For those subject to the 3.8% tax muni bonds can avoid that tax so they have become somewhat more attractive (as illustrated above a tax free rate of 3.25 is now equivalent to 5.29% rather than 5% without that tax being imposed. There are a significant number of strategies with regard to the 3.8% tax so consult with your advisor if you are subject to the tax.

For Social Security Taxability

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 portfolio risk management from the investment perspective. Tax rates have a huge impact on our net returns so strategizing for optimizing our tax impact with consideration of 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
Managing Principal
The David Bergmann Group
Marina Del Ray, CA

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Tax Planning for the Balance of 2010

As we went into the weekend of the Fourth of July holiday of 2010, the Congress failed to pass an extension of unemployment benefits that would eventually impact over 2 million Americans who were receiving benefits. At the same time, there is legislation that is stalled to deal with various aspects of the income tax law that will impact many more of us in 2010 and 2011.

While there may be many reasons for why the legislation is not getting passed, a significant reason gets tied to the “cost” of such legislation to our national debt if there are not offsetting reductions in spending to pay for these issues.

This blog will deal with the major issues of income tax rules that will impact all of us as we prepare our tax returns over the next several years. With only six months left to plan in 2010 on how much our tax bill will eventually be, it is important to understand what is scheduled to happen in 2010 and 2011 if Congress does not act to deal with the issues.

A major issue in 2010, that has also been an issue in the past several years, is the Alternative Minimum Tax (AMT). In 2009 there were about 2.9 million taxpayers who paid more taxes due to the AMT rules. If Congress were to take no action to change the AMT allowance in 2010, there would be 26 million taxpayers impacted. The price tag alone for this item is $66 Billion of revenue that the Treasury would not get if Congress were to make the AMT allowance the same in 2010 as it was in 2009.

Other issues that have expired that Congress would need to extend include the $1,000 additional standard deduction for taxpayers who have property taxes but do not itemize (tax cost to you between $150 and $250, depending on your tax bracket and filing status), the $250 educator expense adjustment to income, and the $4,000 college education deduction. Each of these have a tax “cost” to the Treasury in lost revenue if these are extended so we can claim them if they apply to us.

If any of these apply to you, you need to consider what the impact will be on your return if Congress does not extend these for your 2010 tax return. These could cause your tax liability to increase leading to a tax being due versus getting a refund when you file your return. This could also cause you to incur a penalty for underpaying your taxes, so you should be sure to have your tax withholdings for 2010 as least equal to 100% of what your tax liability was for 2009. If your adjusted gross income in 2009 was more than $150,000, the 2010 withholding needs to be 110% of the 2009 tax liability.

Failure to have the proper withholding in 2010 will result in an underpayment penalty that would require you to use Form 2210 to figure the amount of the penalty.

Beyond the changes in tax laws for 2010 is the bigger issue of tax law changes between 2010 and 2011. Tax rates for 2010 are the last year of the rates under the so-called “Bush Tax Cuts” from the early years of the 2000s. If Congress takes no action then the tax rates for 2011 will be higher for all taxpayers.

In simple form, the 10% tax bracket will disappear and income will be taxed at 15%. For taxpayers with income above the 15% tax bracket, this will mean a higher tax liability of $837 for those filing as Married Filing Jointly (MFJ) and $419 for those filing in Single status.

For taxpayers who were in the 25% tax bracket in 2009, the rate goes up to 28%. If you were in the top of this bracket, the additional tax cost will be $2,070 for MFJ and $1,440 for Single. These amounts are in addition to the amounts in the previous paragraph.

For those with incomes in the 28%, 33%, and 35% tax brackets, they will see all that income taxed at 3 to 4.6 percentage points higher in 2011 than what the 2010 income was taxed at if Congress makes no changes to the current tax laws.

Two other tax categories are set to change in 2011. Dividend income in 2010 is taxed at 15% as will be capital gain income. In 2011, the capital gains rate is 20% and dividend income is taxed at the ordinary income tax rate that you are in, as noted in the previous paragraphs.

This requires that you look at your investment portfolio to see what capital gains you may have in your investments that you might want to harvest in 2010 so you can pay a lower tax. You may also want to shift your portfolio from a dividend paying portfolio to one more oriented towards capital appreciation, assuming that capital gains tax rates will be lower than ordinary income rates in the future.

The final issue to address in this blog is the question of taking the opportunity to convert IRA amounts into Roth IRAs in 2010. While you can do the conversion in 2010, you have the option when you file your 2010 tax return next year to either pay the tax entirely in 2010 or to spread the tax payment over the 2011 and 2012 tax years by reporting half of the converted amount on each of those two years’ tax returns. As noted above, the tax rates could be as much as 3% higher in 2011 and 2012 versus the rates for 2010.

The only good news in all this is that you have time left to see what Congress will do between now and the end of this year to see how they deal with these issues. On the IRA conversion to the Roth IRA, you could have until October 2011 when you file your 2010 tax return that you put on an extension in April 2010 before you need to make that election on reporting the income from the conversion that you did between now and December 2010.

Yes it has been very difficult trying to explain this coherently to clients while we wait for Congress to act on these important issues. I remain hopeful that we will be able to make rational decisions on these important matters to all of us. I would suggest that you keep in close touch with your tax professional to be sure that these complex issues are properly interpretated so you pay the least tax under the various scenarios.


Francis St. Onge, CFP®
Total Financial Planning, LLC
Brighton, MI