A Marginal Rate Surprise

Tax Planning

Think you understand Marginal Rates (aka “Tax Brackets”)? As this chart shows, it’s the amount of federal tax you pay on the next dollar of income, changing as that income goes up. But, this doesn’t quite tell the whole story about tax rates.

For example, there are other items that can impact your effective marginal rate, phase outs of credits or certain deductions. Today, I would like to focus on the taxation of social security benefits. Partially because it impacts so many people, and also because there are some strategies to minimize this extra tax hit. For those collecting Social Security benefits if half the benefit plus your other income exceeds $25,000 (if single) then up to half the Social Security Benefit is taxable. If half the benefit plus your other income exceeds $34,000 (if single) then up to 85% of the Social Security Benefit is taxable.

This can be quite confusing, so let me put it in simple terms. You are single, and collecting a pension and Social Security. Thinking you are in the 25% bracket, you withdraw an extra $1000 from your IRA, after all, you’re not going to be anywhere near that $83,600 income level, your total taxable income including the Social Security is barely $40,000. What you find, however, is that extra $1000 in income caused an extra $850 from Social Security to be taxed as well, and the result was a tax bill that was $462.50 higher, feeling like a 46.25% effective marginal rate.

With a bit of planning, however, you might be able to avoid or reduce this phantom marginal rate. The planning needs to start as early as possible, right after Thanksgiving will due, as TurboTax is available by then and there’s still time before year end. If you find you will be right in the midst of this high marginal rate, you can do a couple things to lower your income. If you itemize your deductions, pull in a bit of the donations you planned to make next year. If you still have a mortgage, pay the January payment before the month ends. If you converted any traditional IRA funds to a Roth this year, you can recharacterize back to traditional to take that money back out of your taxable income. In fact, if the recharacterization is part of the plan, you can wait until you file your return , extension included, so you can get your taxable income exactly where you’d like, and not worry some dividend or capital gain will put you back over at year end.

The other possibility is that you find that all your Social Security will be taxed and you can’t avoid it. Your RMDs (Required minimum distributions from your 401(k) or IRA) may be rising, and you’re back to a 25% marginal rate. Seeing that this rate extends right to a taxable income of $83,600, now may be the time to convert some IRA money to Roth. Just enough to “top off” that 25% bracket and help lower those future RMDs.

If you have any questions or thoughts on this articles, please feel free to leave a comment below.

Comments (1) Leave your comment

  1. Very interesting. Can Turbotax provide me with my nominal marginal tax rate as well as the effective tax rate which is currently provided.

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