Tax 'brackets' are NOT what they seem!

[ERD50]

I was tempted to title this thread something along the lines of "Tax Planning, Shmanning!", but I'll start with this:

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. Now, say I'm considering converting some IRA from Traditional to Roth (the conversion counts as income). One might think that as long as I stay within that magic 15% bracket that I would pay $15 in added tax for every $100 I convert. One might be very wrong.

As you increase your income, many other things can be affected. Medical is only deductible above 7.5% of AGI, so as your AGI increases, not only do you pay more tax on the dollars, but fewer dollars are deductible. Limits come into play on other things as well (college credits/deductions, and who knows what else). This raises the effective marginal rate that you pay.

I ran the preview version of TaxAct over the past two days, and found that I could stay in the 15% marginal bracket with an IRA conversion, but I would increase my taxes at a 22.5% rate for the money converted. Hmmm.... if I'm thinking in terms of a 25% tax rate in the future, that does not strike me as worthwhile, considering all the ifs/and/buts.

It could take dozens of runs in the tax program to figure out the optimum points, as there are so many interactions. With two kids in college, even the tax program could not find the optimum set of the three eduction credits/deductions to take for my scenario. I over-rode their automatic optimizer, and my tax bill dropped by over $900! Now, how many people are going to analyze the laws for that? How many paid tax preparers would bother? They would be more likely to say "Hey look - I saved you $2600 by running this deduction!", never mind that they could have spent a few more minutes to save you $3528 instead!

But they will brag to their friends - "my tax guy saved me $2,600!".

So, don't be fooled by simplistic tax planning based on static 'marginal rates' - reality may be very different.

Subtopic: taxes are far, far too complex. Sub-subtopic: the least Congress could do is have the laws for 2008 finalized on Jan 1 2008, so the tax software places had time to code this stuff so we could actually do 'tax planning' for the year. The AMT limits and a few other things were not finalized until, OCtober 2008! Sub-sub-subtopic: I'm gonna invite my Congressperson to sit down with me and do my taxes with me. I bet they have no idea what people go through.

-ERD50

 

[haha]

I'm gonna invite my Congressperson to sit down with me and do my taxes with me. I bet they have no idea what people go through.
-ERD50

I bet they don't care either.

Ha

 

[NW-Bound]

...
Subtopic: taxes are far, far too complex.
...
-ERD50

YES.

We have been through a few threads like this before. I don't know if a flat tax is the answer, but what we have is a big mess. Layers over layers of deductions, exclusions, and allowances. Since everybody is going to get some little deductions, we all think we are ahead of the guy next door. We all pat ourselves on the back for having saved ourselves some money.

I think the guvmint intends for it to be this complex, so that we spend all our time to "optimize" our taxes, and forget to ask the question: WHY??

 

[ERD50]

I bet they don't care either.

Ha

Not unless a significant block of voters got up in arms about it, but...

YES.
... Since everybody is going to get some little deductions, we all think we are ahead of the guy next door. We all pat ourselves on the back for having saved ourselves some money.

I think the guvmint intends for it to be this complex, so that we spend all our time to "optimize" our taxes, and forget to ask the question: WHY??

Yes, I'm afraid that just too many people see those 'crumbs' they get and get all excited, and miss the big picture (or the big loaf, not to mix metaphors?).

I could go on and on about tax complexity (and I have ), so maybe I'll save that for the soapbox, I dunno. But I did want to point out that a 15% tax bracket isn't really a 15% tax bracket, and it might help some people to consider that while attempting the futile effort of 'tax planning'.

Arghhhh.

-ERD50

 

[dex]

If you really want to get upset add up all the taxes you pay
Sales
Real estate
Income tax
Gasoline tax
State
City
County
Then there are the ones you don't see:
Corporate income taxes
Stock, bond, etc transfer taxes
We like to think that this country has a progressive tax structure but it is really pretty regressive when you look at all the taxes paid.
So if you live in NYC for example you are paying
City tax 10%
State Tax 15%
Federal 28%
Add in all the other taxes seen and unseen and the effective rate can be closer 70% - depending upon your income.

 

[SecondCor521]

Subsubsubsubtopic: This is why I strongly disagree with those who consider their taxes to be a fixed, uncontrollable expense and work from their net paycheck instead of their gross paycheck. Minimizing taxes is probably one of the most profitable ways to spend one's time.

2Cor521

 

[retire@40]

If you really want to get upset add up all the taxes you pay
Sales
Real estate
Income tax
Gasoline tax
State
City
County
Then there are the ones you don't see:
Corporate income taxes
Stock, bond, etc transfer taxes
We like to think that this country has a progressive tax structure but it is really pretty regressive when you look at all the taxes paid.
So if you live in NYC for example you are paying
City tax 10%
State Tax 15%
Federal 28%
Add in all the other taxes seen and unseen and the effective rate can be closer 70% - depending upon your income.

I don't get it. If you live in NYC, you are paying 28% in Federal tax?

 

[ERD50]

If you really want to get upset add up all the taxes you pay

Federal 28%

Add in all the other taxes seen and unseen and the effective rate can be closer 70% - depending upon your income.

Well, just to address federal tax - TaxAct says my 15% 'marginal rate' comes out to about 5% of AGI. So that's not so bad, right? But even that is totally misleading. I just looked again, and since the education and some other items are tax *credits* (after the tax/AGI calculation), my actual federal tax bill is... zero. I get everything back (based on this 'preview' version and my quick estimated entries).

Weird.

-ERD50

 

[NW-Bound]

Minimizing taxes is probably one of the most profitable ways to spend one's time.
2Cor521

"The avoidance of taxes is the only intellectual pursuit that carries any reward." John Maynard Keynes

Perhaps the guvmint knows that too well, therefore puts in the complications to frustrate our friend ERD50, to dilute his marginal rate of dollar gained per hour expended.

 

[jIMOh]

I was tempted to title this thread something along the lines of "Tax Planning, Shmanning!", but I'll start with this:

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. Now, say I'm considering converting some IRA from Traditional to Roth (the conversion counts as income). One might think that as long as I stay within that magic 15% bracket that I would pay $15 in added tax for every $100 I convert. One might be very wrong.

As you increase your income, many other things can be affected. Medical is only deductible above 7.5% of AGI, so as your AGI increases, not only do you pay more tax on the dollars, but fewer dollars are deductible. Limits come into play on other things as well (college credits/deductions, and who knows what else). This raises the effective marginal rate that you pay.

I ran the preview version of TaxAct over the past two days, and found that I could stay in the 15% marginal bracket with an IRA conversion, but I would increase my taxes at a 22.5% rate for the money converted. Hmmm.... if I'm thinking in terms of a 25% tax rate in the future, that does not strike me as worthwhile, considering all the ifs/and/buts.

It could take dozens of runs in the tax program to figure out the optimum points, as there are so many interactions. With two kids in college, even the tax program could not find the optimum set of the three eduction credits/deductions to take for my scenario. I over-rode their automatic optimizer, and my tax bill dropped by over $900! Now, how many people are going to analyze the laws for that? How many paid tax preparers would bother? They would be more likely to say "Hey look - I saved you $2600 by running this deduction!", never mind that they could have spent a few more minutes to save you $3528 instead!

But they will brag to their friends - "my tax guy saved me $2,600!".

So, don't be fooled by simplistic tax planning based on static 'marginal rates' - reality may be very different.

I took HR blocks tax course this fall.
They have a special page (for the preparer) to calculate the education credits, probably for the reason you specify above. It iterates and tells the preparer which credit(s) work the best for a given situation.

$3528 with two kids- would that be a $1650 hope credit for one, and close to a $2000 lifetime learning for the other? $3650 would be the max credit for two people... I assume your older kid had slightly less than $10k in tuition?

 

[riskadverse]

Every year I convert some of my traditional IRA's over to Roth IRAs. I used to try and use newer turbotax software which I had to obtain early copies of, or I even used the previous years copy, plugging in 'what if' numbers. This was extremely cumbersome at best. I found the following calculator, which simplified the whole process. While I can't verify it's accuracy yet, as this is the first year I have used it, I seriously doubt it could be worse than the previous way I used to calculate how much to convert.



1040 Tax Calculator

 

[freebird5825]

...I could go on and on about tax complexity (and I have ), so maybe I'll save that for the soapbox, I dunno. But I did want to point out that a 15% tax bracket isn't really a 15% tax bracket, and it might help some people to consider that while attempting the futile effort of 'tax planning'. Arghhhh.
-ERD50

this post really hit home with me. 2008 is the first year i had predictable known income. in 2007, i had 1Q08 earnings, a delayed annuity income, and a known pension amount. i had no way of knowing what my tax bill was going to be and paid the price big time in April 08. ouch!
for 2008, my income is known. but my year end cap gains and dividends are not. i doubt the fund companies will even know that with all the panic going on. it is indeed a moving target.
so i see tax planning as shifting sands, where a person can guess general boundaries for numbers, but never really know until after Dec 31st.

 

[ziggy29]

As you increase your income, many other things can be affected. Medical is only deductible above 7.5% of AGI, so as your AGI increases, not only do you pay more tax on the dollars, but fewer dollars are deductible. Limits come into play on other things as well (college credits/deductions, and who knows what else). This raises the effective marginal rate that you pay.

Another glaring example: Even staying in the 15% bracket with the conversions, you can trigger taxation of 85% of Social Security benefits even as they may have been taxed only 50% -- if at all -- without the conversion.

This is also something people on SS who are considering a conversion and have less than 85% taxation of benefits need to consider.

 

[Architect]

Great post - thanks! I was thinking this year of actually opening my wallet to pay for a tax preparer, because of the potential complexity of buying Treasuries at auction and selling them (due to the auction rules they oddly get sold at a discount or premium). Maybe I'll just do it myself again and work it.

I've used HR Block TaxCut in the past, I don't recall that fiddling with it gave significantly different answers - I'm not sure the optimizer could be overridden. Have to check into that.

 

[ERD50]

Another glaring example: Even staying in the 15% bracket with the conversions, you can trigger taxation of 85% of Social Security benefits even as they may have been taxed only 50% -- if at all -- without the conversion.

This is also something people on SS who are considering a conversion and have less than 85% taxation of benefits need to consider.

Good point. I should emphasize, this is not just a Roth Conversions issue - people also make decisions about muni versus taxable bonds, tax loss sales and other things. W/o running the numbers, you can't just assume that the marginal tax rate applies.

-ERD50

 

[ziggy29]

Good point. I should emphasize, this is not just a Roth Conversions issue - people also make decisions about muni versus taxable bonds, tax loss sales and other things. W/o running the numbers, you can't just assume that the marginal tax rate applies.

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.

 

[ERD50]

I took HR blocks tax course this fall.
They have a special page (for the preparer) to calculate the education credits, probably for the reason you specify above. It iterates and tells the preparer which credit(s) work the best for a given situation.

$3528 with two kids- would that be a $1650 hope credit for one, and close to a $2000 lifetime learning for the other? $3650 would be the max credit for two people... I assume your older kid had slightly less than $10k in tuition?

Close, but no cigar! This just goes to show - even someone who took courses in the Fall of this year doesn't get it 100% correct (not picking on you- picking on Congress).

- The max Hope credit for 2008 is $1800.

- Child A in 2nd year of College, so qualifies for the Hope Credit (good for only years 1 & 2). Hope is 100% credit for first $1200, 50% for next $1200, so $1,800 maximum benefit if you have over $2,400 in expenses (which we do of course).

- Child B graduated (yea!) so had only one semester expenses. So you are correct there, max for LLC (lifetime Learning Credit) is $2,000, we hit $1,728.

Here is what the tax program appeared to do:

Saw that child A had the highest expenses, so assigned those to the LLC to get the maximum credit. Makes sense, except...

Child B does not qualify for Hope Credit (being past the 2nd year), so they assigned those expenses to a (for me, with the current entries) a $4,000 deduction (reduces your AGI by that amount).

And the tax program pick was not optimum. Produced a $621 larger tax bill. UPDATE of first post: I see my original $900 was incorrect, that was using the old 15% of $4000 AGI reduction thinking ($600 plus LLC $2000 = $2600 versus $3528 = $928). I have not fully analyzed it, but the reduction was less - maybe because I actually hit the zero tax level in between somewhere?

-ERD50

 

[jIMOh]

My tax course used 2007 tax code... one of my pet peeves (I kept messing up hand calculations because I do 2009 tax planning for myself now).

 

[ERD50]

My tax course used 2007 tax code... one of my pet peeves (I kept messing up hand calculations because I do 2009 tax planning for myself now).

Well, there is probably a reason for that - which plays into my rant about how complex our tax code is, and what a bad job Congress does with it. IIRC, the limits were NOT updated by Congress until later in 2008 - so really, all you have to work with is current law.

In the case of the AMT it *really* messed things up. The 2007 'inflation adjustment' was just for 2007. So, for estimating 2008 you had THREE choices:

1) Use the current law in effect, which means NO inflation adjustment.

2) USe the 2007 numbers, because that is what you have.

3) Use the 2008 numbers that are being proposed, but not signed into law yet.

This is a BIG DEAL! Under #1, I would owe $2668 MORE taxes than under #3 (with the scenario I entered at the time, that number might have changed up/downas I did different things along the way).

Now, here is the conundrum - what is a law abiding, good, honest, tax paying citizen to do? At the start of 2008, since the laws were not passed, the most 'correct' thing to do would be to adjust your W4 and/or estimated payments to take out that additional $2668. So, you get 'forced' into giving Uncle Sam a loan. Of course, if you are a gambler, you could assume that Congress would get the law passed, and put in less over the year. But...

if Congress did NOT update the law - you could end up paying an underpayment penalty! All because Congress dragged their feet.

That ain't right, says I. Congress should have the tax laws finalized by absolutely no later than Jan 1 of the tax year. I see this as a breach of contract - you can't go changing the rules along the way in a business contract, and don't I (sort of) have a contract with Uncle Sam to pay my taxes for 2008? So I think it should be treated as a contract, and lock the contract at the start of the deal - Jan 1.

Right?

-ERD50

 

[jIMOh]

My understanding was an AMT patch was attached to the bailout plan already approved?

 

[Animorph]

The exemption and deduction rollbacks have been my bane for a few years now, making my capital gains rate higher than 15%. There's sort of a "doughnut hole" effect there too, with cap gains returning to 15% when all of the rollbacks have limited out. A couple of years I actually took extra capital gains because I was getting the 15% rate back.

ESPP's, stock options, self employment income, home equity loans, foreign taxes paid by mutual funds, end of year fund distributions and estimated taxes have all been just so much fun. I had to retire to spend enough time on my taxes. I'm hoping to simplify in retirement, but I'm sure time will bring more interesting fun. I'm looking forward to Roth conversion, SS taxation, RMD's, medicare...

 

[ERD50]

My understanding was an AMT patch was attached to the bailout plan already approved?

Right, they passed it on Oct 3rd, 2008.

Reform AMT - Home Page

But that was awful late in 2008. And it was no 'sure thing'. That is my point - you can't "plan" your W4 and/or estimated Quarterly payments throughout the year, if the rules are not defined until October of the tax year. That is why I say they should be finalized Jan 1 of the beginning of the tax year in which they are due. Jan 1 , 2008 for 2008 taxes.

-ERD50

 

[TromboneAl]

Thanks, ERD. I downloaded TaxACT preview a few days ago to figure out how much I should convert to a Roth.

How much did you decide on?

 

[ERD50]

Thanks, ERD. I downloaded TaxACT preview a few days ago to figure out how much I should convert to a Roth.

How much did you decide on?

I decided on no conversion. To keep my 'effective marginal rate' at under 17%, I could convert only ~ $10K, and I just felt it was not worth the hassle. At $30K converted it was up to 22.5%. It usually involves converting more than that, because you don't have final numbers, and then re-characterizing before April 15th, so you end up with the actual amount you would have wanted converted. But the conversion needs to be done before EOY.

The re-characterization is more 'fun'. You need to go in and adjust the amount of the re-characterization for any change in value that the fund had since you converted it. I never get the calculation right, though the diff is small and not really an issue. It just bugs me that all these hoops are required, esp when a Roth conversion has so many unknowns associated with it.

Did I mention that I think our tax code is far, far too complex?

Also, since DW is still working, I set it up so that she is contributing most of her paycheck to a Roth 403B (she was thrilled with that!), and I can still use her earned income to contribute to Roth IRAs. Which seems like 'double dipping', but from everything I can tell, that is allowed. So I am getting money into Roths from other means anyhow.

Did I mention that I think our tax code is far, far too complex?

An unintended consequence of me paying zero Fed tax this year is... I will probably cut my Charitable contributions somewhat, to the point that I pay a small amount of tax, to get the full deduction. Yes, that stinks, but I did boost them in a year that I had high earnings, so this is my cut back year. I don't think tax issues should affect what people give to charity. Yes, I think charitable contributions should NOT be tax deductible. Give for the reason of giving, not to get some % back.


Did I mention that I think our tax code is far, far too complex?

Let me know how TaxAct preview works for you. I'm running the online version. I don't like it. The forms are not finalized (thanks Congress), so they don't allow printing/viewing of the forms. So I am very much in the dark - I put numbers in, see the result in the 1040 form, but I can't see any of the intermediate form calcs, to see how/why they got that number - so I can't tell what is limiting it. What a royal pain.

Did I mention that I think our tax code is far, far too complex?


-ERD50

 

[ERD50]

Every year I convert some of my traditional IRA's over to Roth IRAs. I used to try and use newer turbotax software which I had to obtain early copies of, or I even used the previous years copy, plugging in 'what if' numbers. This was extremely cumbersome at best. I found the following calculator, which simplified the whole process. While I can't verify it's accuracy yet, as this is the first year I have used it, I seriously doubt it could be worse than the previous way I used to calculate how much to convert.



1040 Tax Calculator

Thanks, I just tried it and it is a nice tool for 'quick and dirty' calcs.

One potential problem though is - if you itemize deductions, it just asks you to enter your deduction amount (in total, not by category). Since different categories are affected by different % of AGI - this won't really be accurate. If you take the standard deduction, or if your situation is close to last year, probably OK.

Same with those edu credits - they just ask for a number. That number interacts with other entries so you can't really tell.

But it is easy to use and quick for some things. I bookmarked it - thanks.

-ERD50