The tax man cometh

[Cooked]

I worked on a tax return recently for a couple of new retirees. It is volunteer work so it does not count against my retiree status. They retired in 2014 and they are the perfect retirement tax storm. I was hurt just looking at their numbers.


The most significant mistake that they made was not understanding SS tax-ability. It caused a triple taxation event. They cashed in some IRAs ( taxable) which pushed some SS into the taxable range (taxable) which put them over the top for ACA premium (taxable). It broke my heart.


The year that we retire can be a significant tax wake up. Get ready for it.


Wake up call number 1. SS may be taxable. If you are married and your other income plus ½ of SS exceeds 32k then 50% of SS becomes taxable and at higher income up to 85% becomes taxable. It your other income is below 50k then you need to understand this window. For example, non-taxable capital gains in this window cause SS to become taxable.


Wake up call number 2. For a married couple with AGI income below (roughly) 93k capital gains (CG) and qualified dividends (QD) are untaxed. Be careful, there is a trap here. If your income is ~93k and you have CG/QD)then they are taxed at 0. Cash in a 10k IRA that is taxable and watch what happens. The IRA gets taxed at 15% and the CG/QD gets taxed at 15%. An effective marginal tax rate of 30%.


What can we do?

1. Be aware of these windows.
2. Retire (lose the W2 income) early in the year.
3. Plan your IRA/401k withdrawals with a eye to the tax brackets and these two windows.
4. Run tax scenarios on some tax program, especially on the first transition year.
5. If you get a buyout, watch out for the tax man.

We have to pay taxes. We do not have to be surprised by the tax man. Please to be sure to include a little tax planning in your process. Do not trust the advice of SS administration or your benefits coordinators. They may be good people but they do not understand your complete picture.

 

[jebmke]

#1 is more well known than the hidden 30% bracket. But even so, one of our TaxAide volunteers did a Roth conversion last year and learned recently that because of the SS push, the tax on the conversion was brutal. Lesson learned. I reminded her that tax software is generally available around December 1 and that major discretionary actions (like Roth conversions) should usually be done in December after doing a pro forma tax return. By mid-December, most people know all they need to know to get pretty close to an accurate pro forma return (K-1 recipients being an obvious exception).

I agree with your point, when you prepare your tax return, there should rarely be anything that surprises you.

 

[audreyh1]

I disagree with the 30% tax bracket characterization, as each type of income is separately taxed at 15%, you've simply lost your 0% tax status on the long term cap gains and qualified dividends.

Otherwise, good advice.

 

[kaneohe]

Cooked.......excellent advice on being informed and aware of the traps.
You might want to reword the advice to make it clear that these are phased
events, not cliffs.......e.g. if you go $1 over the limits, it's not a tragedy.

audrey......the 30% bracket can be thought of in a number of ways. The fact is that if you are in the situation described by OP (at the threshold) and then add some amount of ordinary income that pushes some of the LTCG/QDIV over the limit, your marginal tax bracket will be 30% on that ordinary income addition until all of LTCG/QDIV is pushed over that threshold.

 

[audreyh1]

Cooked.......excellent advice on being informed and aware of the traps.
You might want to reword the advice to make it clear that these are phased
events, not cliffs.......e.g. if you go $1 over the limits, it's not a tragedy.

audrey......the 30% bracket can be thought of in a number of ways. The fact is that if you are in the situation described by OP (at the threshold) and then add some amount of ordinary income that pushes some of the LTCG/QDIV over the limit, your marginal tax bracket will be 30% on that ordinary income addition until all of LTCG/QDIV is pushed over that threshold.

Or you've simply hit the 15% tax bracket on your cap gains income.

 

[pb4uski]

....But even so, one of our TaxAide volunteers did a Roth conversion last year and learned recently that because of the SS push, the tax on the conversion was brutal. ....

Couldn't she recharacterize the amount necessary to avoid the SS push if she wanted to?

The 30% was going to bite me this year by a small amount, but I simply recharacterized enough to get me down to the top of the 15% tax bracket. It was sort of cool that my TI was exactly the tax bracket amount... I suspect I may get a friendly letter asking about that from our friends at the IRS.

 

[kaneohe]

Or you've simply hit the 15% tax bracket on your cap gains income.

yes, that's one of the ways of thinking about it so I'm not necessarily disagreeing with you. The same thing is true of SS taxation....people talk about marginal tax brackets of 1.5x and 1.85x nominal rates of 15% and 25%
when you're in the "zone".......but it's just 50% or 85% of SS being taxed at ordinary rates instead of at the protected 0%.....just depends how you want to think about it. The practical effect is that the marginal brackets increase when you add ordinary income in those situations. Both are ok ways of thinking about it............as long as you get the correct answer, it doesn't matter.

 

[athena53]

Thanks for the warning. DH and I learned the unhappy lesson about SS being taxable when we married in 2003. I was 50 and working FT, he was 65 and filed for SS. Our state grabs its share of SS, too.


Fortunately, with what I learned on this Board, I'll make good decisions tax-wise when it comes to filing for SS, withdrawing from taxable vs. after-tax accounts, etc.


Calculating the impact of certain actions on marginal tax rates is tricky; if you itemize, any addition to your Adjusted Gross also increases the threshold for Medical expense deductions, and a lot of us here have enough in premiums alone to deduct some of our Medical expenses.

 

[pb4uski]

Calculating the impact of certain actions on marginal tax rates is tricky; if you itemize, any addition to your Adjusted Gross also increases the threshold for Medical expense deductions, and a lot of us here have enough in premiums alone to deduct some of our Medical expenses.

I find TurboTax's What-If worksheet really useful for these kinds of calculations. It's a little quirky, but works ok.

 

[Jack_Pine]

I disagree with the 30% tax bracket characterization, as each type of income is separately taxed at 15%, you've simply lost your 0% tax status on the long term cap gains and qualified dividends.

Otherwise, good advice.

Thank you. I re-read that a few times and never thought "30%". It's 15% on different incomes which is 155 for the total amount...............

 

[Texas Proud]

Or you've simply hit the 15% tax bracket on your cap gains income.

When you talk about marginal tax rate, you do not look at it from the view you are...

IOW, the next dollar of income creates how much tax So, if you put a dollar more income in the example, you pay 30 cents more tax... a marginal tax rate of 30%.... it really does not matter where the tax came from, but what you are paying out of pocket...

So, that extra dollar has a marginal tax rate of 30%... the OP did not say a 30% bracket... it was from another poster.... so OP is correct...

 

[audreyh1]

When you talk about marginal tax rate, you do not look at it from the view you are...

IOW, the next dollar of income creates how much tax So, if you put a dollar more income in the example, you pay 30 cents more tax... a marginal tax rate of 30%.... it really does not matter where the tax came from, but what you are paying out of pocket...

So, that extra dollar has a marginal tax rate of 30%... the OP did not say a 30% bracket... it was from another poster.... so OP is correct...

Only if you expect ALL your capital gains to be taxed at 0%. IMO that is kind of silly.

It's quite clear that once you exceed total income of a certain amount, you start paying capital gains taxes of 15% on the amount that exceeds that threshold.

 

[Texas Proud]

Only if you expect ALL your capital gains to be taxed at 0%. IMO that is kind of silly.

It's quite clear that once you exceed total income of a certain amount, you start paying capital gains taxes of 15% on the amount that exceeds that threshold.

No... the example was that all WAS at 0%... so it is not silly as it happens all the time...

You seem to be looking at it from a whole... IOW, you pay 15% tax on the cap gain and 15% tax on the new income... that is true... no question about it.... but that is not what marginal tax is about...

But, what caused that cap gain tax What new dollar of income was earned to move it from a 0% cap gain to a 15% cap gain That is what the OP is talking about... know where that cliff is located... and if you need to delay earning that extra dollar then do so....

 

[pb4uski]

No audrey, TP is correct.... the marginal rate is 30%... it doesn't matter at all what your expectations are with respect to capital gains taxes or the character of the taxes. It's just plain math.

If your income exceeds the 15% tax bracket by $100 your total tax increases by $30 so that last $100 got taxed at 30%... purely math.

 

[Cooked]

Okay. I get the message loud and clear. If I ever post again, in the interest of clarity, I will not include any contrived examples to demonstrate the point.

 

[pb4uski]

FWIW I thought they are great examples and that it was a great post.

 

[adrift]

If your income exceeds the 15% tax bracket by $100 your total tax increases by $30 so that last $100 got taxed at 30%... purely math.

This is not necessarily true. Your tax (1040 line 47) does go up by 30%. Your total tax (1040 line 63) may go up by less.

If you use Form 1116 to compute a Foreign Tax Credit, the additional $100 may give you a larger credit which would reduce your total tax.

 

[Texas Proud]

FWIW I thought they are great examples and that it was a great post.

+1.... I think it was a great post and had great examples....

 

[ivinsfan]

+1.... I think it was a great post and had great examples....

+1 the message is important even if there is some squabbling about the numbers and %....

 

[audreyh1]

No audrey, TP is correct.... the marginal rate is 30%... it doesn't matter at all what your expectations are with respect to capital gains taxes or the character of the taxes. It's just plain math.

If your income exceeds the 15% tax bracket by $100 your total tax increases by $30 so that last $100 got taxed at 30%... purely math.

I don't understand. If I make $100 more in cap gains/qualified dividends to push the total income $100 above the threshold, it doesn't increase the taxes owed on the ordinary income at all, and you pay 15% on that $100 cap gains/qualified dividends instead of 0%. $15.

OK - I see that if your ordinary income increases $100 you will pay $30.

 

[kaneohe]

I don't understand. If I make $100 more in cap gains/qualified dividends to push the total income $100 above the threshold, it doesn't increase the taxes owed on the ordinary income at all, and you pay 15% on that $100 cap gains/qualified dividends instead of 0%. $15.

You are correct........you are now talking about the marginal tax rate of
LTCG/QDIV. The other discussion was about the marginal tax rate of ordinary income.

 

[pb4uski]

This is not necessarily true. Your tax (1040 line 47) does go up by 30%. Your total tax (1040 line 63) may go up by less.

If you use Form 1116 to compute a Foreign Tax Credit, the additional $100 may give you a larger credit which would reduce your total tax.

When I said total tax I was referring to taxes in a general sense rather and thinking of ordinary and capital gains taxes (which get included together on line 47) and not referring to captions for specific lines of Form 1040.

I concede that you are correct, but that is a bit of a nit-pick.

 

[Andre1969]

I don't understand. If I make $100 more in cap gains/qualified dividends to push the total income $100 above the threshold, it doesn't increase the taxes owed on the ordinary income at all, and you pay 15% on that $100 cap gains/qualified dividends instead of 0%. $15.

I'm a little fuzzy on where the 30% is coming from as well, but I wonder if this is it?

Firstly, in that example, let's say you pay zero taxes on capital gains/dividends, up to an AGI of $93,000. But, anything above that, you pay 15%. If you cash in a $10,000 IRA, that would be taxed at 15%. It would also push $10,000 worth of your capital gains/dividends above the threshold, and they would then get taxed at 15%.

Yeah, it's actually 15% on the IRA and 15% on the capital gains, but effectively, you're paying $3,000 more in federal taxes by cashing in that $10,000 worth of IRA.

It's not putting you into any kind of 30% marginal tax bracket...in fact, there is no 30% bracket, as they go from 28 to 33%. But in the case above, cashing in a $10,000 IRA triggers a $3,000 tax, overall, or 30%, on that money.

At least, I think that's what the logic is.

 

[audreyh1]

I amended my prior post:

I don't understand. If I make $100 more in cap gains/qualified dividends to push the total income $100 above the threshold, it doesn't increase the taxes owed on the ordinary income at all, and you pay 15% on that $100 cap gains/qualified dividends instead of 0%. $15.

OK - I see that if your ordinary income increases $100 you will pay $30.

 

[pb4uski]

I don't understand. If I make $100 more in cap gains/qualified dividends to push the total income $100 above the threshold, it doesn't increase the taxes owed on the ordinary income at all, and you pay 15% on that $100 cap gains/qualified dividends instead of 0%. $15.

Forget about ordinary income, ordinary tax, capital gains or capital gains taxes for a minute.

We are talking in the OP, item#2 about the marginal tax rate on Roth conversions if you breach the top of the 15% tax bracket. Take TaxCaster and create a hypothetical return for a MFJ couple under 65 with $20,000 of LTCG and $74,100 of pension income for this Roth conversion that we are hypothesizing about. The TI is $73,800 and the tax is $7,166. Now add $100 of pension income and the tax increases by $30 to $7,196. So the marginal tax rate on that incremental $100 of Roth conversion is 30%.

Now if the increase is $100 of capital gains rather than pension income then you are right that the tax only increases by $15 (15%)

Edited to add: I see now that you edited your post.