Tax 'brackets' are NOT what they seem!

[NW-Bound]

At the risk of getting this thread thrown into the Soapbox, heck a guy got to speak his mind sometimes,

My income for the last several years has been all over the map. One year, AMT, no IRA, no college education credit. Next year, I scrambled to get some cash to fund the IRA.

You are talking about tax planning?

What tax planning if I cannot even plan my income

YES THE TAX CODE IS FAR TOO COMPLEX

 

[frayne]

As with any tax software program it is good if you have a basic understanding of the tax code and a Pub 17 handy for reference. The tax code changes every year and is somewhat complicated and arbitrary to say the least depending upon your situation. I took the H&RB course and currently work for Block during the tax season not for the money but to meet people and keep my brain from going into atrophy. I really like working on complicated tax situations as it is kind of like putting a puzzle together, and once the client sees and realizes you are working for them it can be a very rewarding experience as well.



From the H&RB website

Available Education Credits

There are 2 credits allowed for higher education: the Hope Credit and the Lifetime Learning Credit. You can claim the credits for eligible expenses paid on behalf of yourself, your spouse or a dependent for whom you can claim an exemption.

• Hope Credit — The credit is allowed for the first 2 years of college. It may not be claimed for more than 2 years, and the student must be enrolled in at least half of a full-time load in a degree program. Plus, the student can't be convicted of felony possession of a controlled substance.
• Lifetime Learning Credit — This credit can be claimed for any number of years. The number of hours the student is enrolled and drug felony convictions aren't factors for the Lifetime Learning Credit.

You can claim both credits for one year, but you can claim only 1 of the credits for any student. For example, you can claim a Hope Credit for 1 of your children and the Lifetime Learning Credit for another, but you can't claim both credits on behalf of either of the children.

To claim the credit, modified adjusted gross income (MAGI) must be less than $58,000 for Single, Head of Household and Qualifying Widow(er) ($116,000 for Married Filing Jointly), and the student must be attending an eligible institution. Those who are Married Filing Separately can't claim the credits.

If the parents are eligible to claim the student as a dependent, they claim the credit unless they choose not to claim the exemption for the student. The student can't claim his or her exemption even though he or she can claim the credit.

Note: For students who attended an eligible educational institution in a Midwestern disaster area, the Hope Credit can be as much as $3,600. The Lifetime Learning Credit for such students is 40% of eligible expenses with a maximum credit of $4,000. These provisions apply for 2008 and 2009.

Tuition and Fees Deduction

If your MAGI is $65,000 ($130,000 if Married Filing Jointly) or less, you can deduct up to $4,000 of eligible tuition and fees for yourself, your spouse or a person for whom you claim a dependent exemption. If your MAGI is between $65,000 and $130,000 ($130,000 and $160,000 if Married Filing Jointly), you can deduct up to $2,000 of eligible tuition and fees. If your MAGI is more than $80,000 ($160,000 or more if Married Filing Jointly) you can't claim the tuition and fees deduction.

You can't claim the deduction if you're Married Filing Separately, if another person can claim you as a dependent, or if you were a nonresident alien for any part of the year (unless you elect to be treated as a resident alien).

You can claim the tuition and fees deduction or an education credit for a student, but not both. Choose the benefit that results in the larger tax savings. You can't use expenses used to figure this deduction when figuring the exclusion for savings bonds interest or the exclusion for income from a distribution from a Coverdell ESA or QTP. You also must reduce the expenses used to figure this deduction by the amount of tax-free scholarships and nontaxable employer-provided educational assistance you received.

 

[ERD50]

I just realized how taxes could be dramatically simplified.

The complexity comes from gadzillions of deductions/credits built into the tax code. I say just separate them from our taxes. I'd rather see them eliminated, but this would be a baby step. Because there are gadzillions of deductions/credits, the tax software has to ask you gadzillions of questions, because they cannot know if they apply to you or not. That makes it complex.

My suggestion: Income Tax is just income tax. Standard deduction/exemption. That's it. Done in 15 minutes.

The offset: If Congress wants to offer an Education credit or mortgage credit or whatever (it does not seem like we can stop them from shuffling our own money around), fine - fill out a form, submit it and get a rebate. To keep it really simple, eliminate the means testing. To compensate, raise the marginal brackets a bit. IOW, yes, the 'rich' get the deduction too, but they are going to be paying more overall, so it is awash. Alternately, make it based on some simple number like a 3 year average AGI.

This way - it is all separate from our tax filing, tax software probably would not even be needed, and tax filing becomes simple. The only people affected by the other stuff are the people who make use of it. Simple?

Like that's gonna happen!

-ERD50

 

[NW-Bound]

We are heading to the soap box for sure, ERD50.

 

[ERD50]

My income for the last several years has been all over the map. One year, AMT, no IRA, no college education credit. Next year, I scrambled to get some cash to fund the IRA.

You are talking about tax planning?

exactly where I found myself when I mistakenly took a big cap gains hit last year (rubbing salt into the wound.... I decided to buy it back, and of course it is down 50% now, so I paid gains, and lost all my deductions/credits for nothing... )

From the H&RB website

Available Education Credits

To claim the credit, modified adjusted gross income (MAGI) must be less than $58,000 for Single, Head of Household and Qualifying Widow(er) ($116,000 for Married Filing Jointly), and the student must be attending an eligible institution. Those who are Married Filing Separately can't claim the credits.

frayne, thanks, but even that long article is incomplete. Yes, the MAGI must be below $116,000 for MFJ, but it does not mention that it is phased out starting at $96K MFJ. That is where one can see their 'effective marginal rate' creep up above the 'published marginal rate'.

I gotta stop posting - yesterday I told DW I spent all day on taxes, today I'm spending all day talking about taxes !

-ERD50

 

[jIMOh]

I just realized how taxes could be dramatically simplified.

The complexity comes from gadzillions of deductions/credits built into the tax code. I say just separate them from our taxes. I'd rather see them eliminated, but this would be a baby step. Because there are gadzillions of deductions/credits, the tax software has to ask you gadzillions of questions, because they cannot know if they apply to you or not. That makes it complex.

My suggestion: Income Tax is just income tax. Standard deduction/exemption. That's it. Done in 15 minutes.

The offset: If Congress wants to offer an Education credit or mortgage credit or whatever (it does not seem like we can stop them from shuffling our own money around), fine - fill out a form, submit it and get a rebate. To keep it really simple, eliminate the means testing. To compensate, raise the marginal brackets a bit. IOW, yes, the 'rich' get the deduction too, but they are going to be paying more overall, so it is awash. Alternately, make it based on some simple number like a 3 year average AGI.

This way - it is all separate from our tax filing, tax software probably would not even be needed, and tax filing becomes simple. The only people affected by the other stuff are the people who make use of it. Simple?

Like that's gonna happen!

-ERD50

This would put CPAs out of business and companies like HR block out of business too.

Then taxes go up to pay more unemployment...

the complex tax code keeps some businesses in business which is good for business.

 

[NW-Bound]

the complex tax code keeps some businesses in business which is good for business.

We Americans have been too efficiently productive, so have to slow ourselves down so that other countries can catch up.

Soapbox, here we come...

 

[ERD50]

This would put CPAs out of business and companies like HR block out of business too.

Then taxes go up to pay more unemployment...

the complex tax code keeps some businesses in business which is good for business.

I hope you are not serious.

Non value added 'services' do nothing for society. It isn't sustainable.

We might as well pay anybody who applies $100/hour to do nothing, and say that we have solved unemployment and poverty in one fell swoop. And we can pay for health care with the income taxes we collect on all these new 'rich' people.

It's a circle game. I don't wanna play.


-ERD50

 

[haha]

It's a circle game. I don't wanna play.
-ERD50

Sorry, but it's the only game in town.

Ha

 

[jIMOh]

I hope you are not serious.

Non value added 'services' do nothing for society. It isn't sustainable.

We might as well pay anybody who applies $100/hour to do nothing, and say that we have solved unemployment and poverty in one fell swoop. And we can pay for health care with the income taxes we collect on all these new 'rich' people.

It's a circle game. I don't wanna play.


-ERD50

If the tax code was simpler, would HR block be in business?
If the tax code was simpler would accounting firms need more or fewer CPAs?

I was serious.

 

[ERD50]

Sorry, but it's the only game in town.

Ha

Ha, I gotta commend you on your ability to bring me down to Earth. And in so few words! You are correct sir. I wish I could say you are wrong, but I cannot.

If the tax code was simpler, would HR block be in business?
If the tax code was simpler would accounting firms need more or fewer CPAs?

I was serious.

I don't mean to say this to offend, but if you are serious, you do not understand economics. You are not a member of Congress, are you? <j/k>

People employed in non-productive work are just a drain on society. The only reason they are employed is to do work that is not needed. It's a form of welfare. So that increases costs for everyone, and makes us non-productive as a nation. The money they 'make' is just shuffled from other people.

The country needs to *create* value. You need to do stuff like take iron ore out of the ground, and refine it into something more useful and valuable. Or plant seeds and collect more seeds in return to feed people. Things where the activity results in *more* than you had before, not less.

We already are having trouble competing in the world market - time wasted preparing taxes does not help.


-ERD50

 

[TromboneAl]

Think of the productivity gains with a simple tax system. Every taxpayer will have more time for other things. [I wrote this while ERD50 was writing his reply.]

 

[ERD50]

Here's an interesting document from a bipartisan panel ( for those who dislike the current/exiting admin, please ignore the source and please look at the content). It is just five pages, and I think it makes a good deal of sense.

President's Advisory Panel on Federal Tax Reform
http://www.taxreformpanel.gov/final-report/TaxReform_ExSumm.pdf

Federal Tax Reform

On January 7, 2005, President Bush announced the establishment of a bipartisan panel to advise on options to reform the tax code to make it simpler, fairer, and more pro-growth to benefit all Americans.
The Advisory Panel will submit to the Secretary of the Treasury a report containing revenue neutral policy options for reforming the Federal Internal Revenue Code as soon as practicable, but not later than November 1, 2005. These options should:

• simplify Federal tax laws to reduce the costs and administrative burdens of compliance with such laws;
• share the burdens and benefits of the Federal tax structure in an appropriately progressive manner while recognizing the importance of homeownership and charity in American society; and
• promote long-run economic growth and job creation, and better encourage work effort, saving, and investment, so as to strengthen the competitiveness of the United States in the global marketplace.

It does not go as far as I would like, but it would be progress.

-ERD50

 

[retire@40]

If the tax code was simpler, would HR block be in business?
If the tax code was simpler would accounting firms need more or fewer CPAs?

I was serious.

If tax preparers go out of business, then all the tax software companies go out of business.

If there is no longer a need for estate tax planning, then all the estate tax attorneys go out of business.

There would be a drastic hit to the paper companies, toner suppliers, printer and copier manufacturers and repairmen as well.

But the hardest hit would be the politicians. Think of all the extra free time they would have if there were no tax policy to reshape.

 

[frayne]

If tax preparers go out of business, then all the tax software companies go out of business.

If there is no longer a need for estate tax planning, then all the estate tax attorneys go out of business.

There would be a drastic hit to the paper companies, toner suppliers, printer and copier manufacturers and repairmen as well.

But the hardest hit would be the politicians. Think of all the extra free time they would have if there were no tax policy to reshape.

Even if the tax code were simple, some people just can't do percentages and tax companies would still be in business. Maybe not as much as they do now. And I would bet the tax prep companies have some serious lobbying power to keep the tax code as screwed up as possible.

 

[RustyShackleford]

I
So, anyone with a little tax smarts looks at those marginal tax brackets, and maybe even thinks they know what they mean. Well, I'm finding they mean far less than what they might indicate.

For example, say my income and other variables placed me in the 15% marginal bracket. ... as long as I stay within that magic 15% bracket that I would pay $15 in added tax for every $100 I convert ...

There are some people who don't even realize this. I've talked to
especially financially-naive people, otherwise reasonably intelligent,
who don't seem to understand tax brackets at all. To wit, they think
that if you move from the 15% into the 25% bracket, that it means that
suddenly ALL your income is taxed at 25%; it takes some care to gently
explain that no, only the income above the bracket boundary is taxed
at 25% !

 

[CuppaJoe]

.... Minimizing taxes is probably one of the most profitable ways to spend one's time.

2Cor521

Not sure I'm being logical, but I'm mulling over the idea of staying with the same ultra expensive state-of-the-art dentist and having some extra (put-off) dental work done next year and then enjoying a bigger tax write off along with longer-lasting teeth. I'm also saving the eye exam and expensive glasses for January.

This could balance a Roth conversion with about $10,000 in health insurance premiums and other medical expenses. 2009 will be my first full year of retirement with minimal taxes due.

 

[Koolau]

I've never done my own taxes and my accountant isn't much help in helping me through some of the tax minefields. So, I've done my own research (this forum has helped immensely - thanks guys and gals!)

The intricate nuances covered in the original post and others added DO give pause as I consider yet another Trad to Roth conversion (I'm half way through the process, but haven't decided on a final amount yet).

I've put off SS (could start in a few months) to put off the taxation of SS issue for a while longer. But here's my bottom line (mentioned in another thread). Though we don't know what the tax laws will be in a few more years, it is clear that they will change and probably dramatically. My bet is that the rates will go up. Way up. Future pay out of SS and Medicare to Baby Boomers are just two obvious reasons I suggest this. Based on this assumption (that rates will be much higher by the time I'm 70 1/2) I'm trying to convert as much Trad to Roth as possible. My back of the envelope calc. suggests that it's a good move for me - this thread's excellent points not withstanding. If I had it to do all over, I would never have maxed out my 401(k) and Trad. IRAs. If for no other reason than that I am now at the mercy of the ever-changing tax code, 401(K) etc. were very possibly my biggest financial mistakes. I won't know until it's too late, but - did I mention that the tax codes are too complicated - and capricious!

End of rant!

 

[ERD50]

There are some people who don't even realize this. I've talked to
especially financially-naive people, otherwise reasonably intelligent,
who don't seem to understand tax brackets at all. To wit, they think
that if you move from the 15% into the 25% bracket, that it means that
suddenly ALL your income is taxed at 25%; it takes some care to gently
explain that no, only the income above the bracket boundary is taxed
at 25% !

Yes, I've had that same conversation with bright people. It is interesting to see just what the awareness level is out there. I assume that most people on this forum 'get' that, but I'm sure some don't.

And further down the line, I'm surprised at how many people don't 'get' that a tax refund is just getting change back. No different than paying at the cash register with a $1 on a $0.90 purchase and getting a dime, versus paying with a $20 and getting $19.10 in change. Well, there is a difference - you need to fill out paperwork and wait until the next year to get your change back

The intricate nuances covered in the original post and others added DO give pause as I consider yet another Trad to Roth conversion (I'm half way through the process, but haven't decided on a final amount yet).

...

Though we don't know what the tax laws will be in a few more years, it is clear that they will change and probably dramatically. My bet is that the rates will go up.

Well, don't let me discourage you!

I agree in general, I expect rates to go up, and that is why I have converted in the past. And I am contributing to Roths now, as DW has earned income. Everyone needs to run the numbers for themselves. It looks like it is the credits that limit me this year. I see how this is working now - my actual taxes get me up pretty far into the 15% bracket, but the credits are subtracted after that calculation. Once the credits are absorbed, I'm near the 25% bracket - so my curve is zero for a long way up, and then very sharply jumps up. But I have three kids, two in college, so there are a lot of credits, and I have high deductions (modest mortgage, health ins, and high prop tax).

It probably is far from this extreme for you.

but - did I mention that the tax codes are too complicated - and capricious!

capricious! - nice add-on!

from wiktionary:

capricious

Impulsive and unpredictable; determined by chance, impulse, or whim; as, a capricious winterstorm, stringent rulers often act capriciously.

Yep, that fits! Now, I'll probably use that word in a sentence 20 times over the next few days, and the wife & kid will give me funny looks. Well OK, they do that any way!


-ERD50

 

[kaneohe]

The increase in taxation of SS is particularly insidious because unlike the income tax brackets themselves, the jump in tax rates is for the whole thing -- the ENTIRE benefit -- and not ONLY at the margin.

For a joint-filing couple, the AGI which triggers 85% taxation of SS is $44,000 (which, by the way, is in desperate need of inflation-indexing, but that's a side issue).

So if joint filers have an AGI of $43,500, let's say, and $20,000 of that comes from SS, then they pay tax on 50% of that $20K at a 15% rate. Their tax due from SS benefits is (0.15 * 0.5 * 20000) = $1,500.

Now they convert $1,000 from a Roth, still in the 15% tax bracket. Now their AGI is $44,500, and that means 85% of ALL their SS benefits -- not just the amount above the margins -- is taxable. The tax they now pay on SS is (0.15 * 0.85 * 20000) = $2,550.

By "converting" $1000, they pay $150 income tax for the conversion itself plus an extra $1,050 tax on their SS benefits. Adding $1000 to their AGI on the conversion results in a tax of $1,150. They are effectively in the 115% tax bracket on this conversion -- before any state income taxes!

So be careful out there. There are a lot of traps and pitfalls if you look only at marginal income tax brackets.

Ziggy......have you confirmed this w/ tax software? It's been a while since I looked at this but my impression is that is the transition is smooth and not a large step as you state. Your example is a little confusing to me. I think you do a pretest first to determine how much SS is going to be taxed. The pretest is like AGI (w/o SS) plus half of the SS. Then if that pretest amount
is between 32 and 44K, you take 50% of the excess over 32K. If the pretest amount is over 44K, you take 6K plus the 85% of the excess over 44K. So..if you're only a little over 44K, there is just a gradual increase, not a step increase in the amount exposed to tax. The real test would be to stick the example on TT or something like it.

edit: need to add tax exempt income to pretest number

 

[Independent]

The increase in taxation of SS is particularly insidious because unlike the income tax brackets themselves, the jump in tax rates is for the whole thing -- the ENTIRE benefit -- and not ONLY at the margin.

For a joint-filing couple, the AGI which triggers 85% taxation of SS is $44,000 (which, by the way, is in desperate need of inflation-indexing, but that's a side issue).

So if joint filers have an AGI of $43,500, let's say, and $20,000 of that comes from SS, then they pay tax on 50% of that $20K at a 15% rate. Their tax due from SS benefits is (0.15 * 0.5 * 20000) = $1,500.

Now they convert $1,000 from a Roth, still in the 15% tax bracket. Now their AGI is $44,500, and that means 85% of ALL their SS benefits -- not just the amount above the margins -- is taxable. The tax they now pay on SS is (0.15 * 0.85 * 20000) = $2,550.

By "converting" $1000, they pay $150 income tax for the conversion itself plus an extra $1,050 tax on their SS benefits. Adding $1000 to their AGI on the conversion results in a tax of $1,150. They are effectively in the 115% tax bracket on this conversion -- before any state income taxes!

So be careful out there. There are a lot of traps and pitfalls if you look only at marginal income tax brackets.

I think you should check your math with the SS Benefits Worksheet in the 1040 Instructions (it's also available on page 16 of Publication 915: http://www.irs.gov/pub/irs-pdf/p915.pdf)

The way I do the math, there are no cliffs.

 

[kyounge1956]

We are heading to the soap box for sure, ERD50.

Y'all come on over. I started a poll inspired by this thread.