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Understanding Tax Brackets
The United States has a progressive Federal income tax. This means that as the income of a taxpayer grows larger, the higher amounts are taxed at progressively higher rates. In other words, the first dollars earned are taxed at lower rates than the latter dollars earned which are taxed at higher and higher rates as the amount of income increases. The rate of tax paid on the last dollar is referred to as the “marginal tax rate.”
Tax legislation passed by the U.S. Congress includes specific tax brackets that are used by the Internal Revenue Service (IRS) to assess the Federal income tax. Knowing what these brackets are and understanding how various financial decisions ultimately impact the amount of tax owed is foundational to financial planning.
Let’s start by taking a look at the tax brackets that are currently in play for tax year 2020:
source: Tax Foundation; click to enlarge
By “tax bracket” I am referring to the different tax rates paid on different levels of earnings. For example, John & Mary expect to have Taxable Income of exactly $100,000 in 2020. Using the Tax Brackets and Rates, 2020 table above, we can see that their first $19,750 of Taxable Income is taxed at 10%, their next $60,500 is taxed at 12%, and their last $19,750 is taxed at 22%. This puts John & Mary in the 22% “marginal tax bracket.” Note that they do not pay 22% on the entire $100,000. They only pay 22% on the amount of earnings that falls within the 22% tax bracket which is anything over $80,250 but less than $171,051 (for a married couple filing jointly). John & Mary would end up paying $13,580 in total tax on their $100,000 of taxable income. This $13,580 would be comprised of $1,975 from the 10% bracket, $7,260 from the 12% bracket, and $4,345 from the 22% bracket so their actual or effective tax rate would be 13.6%.
A key term to understand here is “Taxable Income” which is not the same thing as simply your total salary or your net take-home pay after taxes. Taxable Income is a specific level of income shown on line 11b of Form 1040 of your Federal tax return as shown here:
click to enlarge
Taxable Income is Total Income minus Adjustments to Income (from Schedule 1) minus either the Standard Deduction or Itemized Deductions minus the Qualified Business Income Deduction (if applicable). In equation format:
Total Income - Adjustments to Income - Standard Deduction / Itemized Deductions - Qualified Business Income Deduction = Taxable Income
It is this Taxable Income amount that determines your “marginal tax bracket.”
Reducing Taxable Income
As you can see from the equation above, taxpayers can reduce their Taxable Income through various Adjustments to Income. Because the U.S. has progressive tax rates, reducing your Taxable Income will conversely reduce the amount of tax you owe at a progressively higher rate! In other words, reducing Taxable Income begins removing income that is taxed at the highest margin rate(s) and not at the lower rates (e.g., only 10% or 12%).
Continuing with our previous example, John & Mary decide to setup a Health Savings Account and contribute the maximum $7,100 allowed in 2020 for a married couple (note: the maximum is $9,100 for a married couple where both spouses are age 55 or older). The Health Savings Account contributions are an Adjustments to Income that can be deducted from Total Income. This $7,100 contribution reduces their Taxable Income to $92,900. Most importantly, since this $7,100 would otherwise be taxed at the 22% marginal rate, they save $1,562 in taxes which reduces their overall taxes due by 11.5% and brings their effective tax rate down to 12.9%.
“Because the U.S. has progressive tax rates, reducing your Taxable Income will conversely reduce the amount of tax you owe at a progressively higher rate!”
In general, there are 4 things the average taxpayer may be able to do to proactively lower Taxable Income, and thus, potentially reduce income taxed at a higher marginal rate. These include:
Contribute more to an employer provided retirement plan, such as a 401(k), 403(b), 457, or Thrift Savings Plan (for those in the military). Regular, pre-tax contributions to these plans directly reduce the income reported on the W-2 (Line 1 on Form 1040) which reduces Taxable Income by the same amount.
Contribute to a Health Savings Account (HSA) - if eligible and if it makes sense from a healthcare cost perspective. To be eligible for an HSA you must be in a High Deductible Health Plan (HDHP). In 2020, the IRS defines a HDHP as one having (1) a $1,400 minimum annual deductible for self-only coverage or $2,800 for family coverage and (2) a $6,900 out-of-pocket maximum for self-only coverage or $13,800 for family coverage. Many healthcare plans are purposely structured so that participants are eligible for HSAs and are often called a High Deductible Health Plan or something similar.
Contribute to a Traditional IRA. Traditional IRA contributions are tax deductible for many individuals and in such cases are included with Adjustments to Income. Deductible Traditional IRA contributions directly reduce Taxable Income.
Take capital losses in a taxable brokerage account. Individuals can deduct net capital losses up to $3,000 per year. If you are underwater on a stock in a regular (taxable) brokerage account you could sell some or all of the shares to register a capital loss. Capital losses are first used to offset capital gains. If they exceed capital gains, then the remaining net loss can be deducted (up to $3,000). For example, if you have $5,000 of capital gains and sell stocks for $3,000 of capital loss, then this will reduce your capital gains to $2,000. You would not get a tax deduction but only having to report a net capital gain of $2,000 would ultimately reduce Taxable Income by $3,000. For another example, assume you have $5,000 of capital gains and $7,000 of capital losses. This would give you net capital losses of $2,000 and, in this case, you could deduct $2,000. Although the maximum tax rates for capital gains are generally lower than the regular marginal income tax rates for most taxpayers, capital gains still increase Taxable Income so they can push more income into higher marginal tax brackets.
These financial decisions are often driven by other factors, but being aware of all the tools in the toolbox can come in handy during a year where you have an irregularly higher amount of income. One or more of these tools can be used to reduce your marginal tax rate.
It is worth noting that there is an additional tool available just during 2020 for those age 72 or older who would normally be required to take a Required Minimum Distributions (RMD) from a retirement plan. The recently passed Coronavirus Aid, Relief, and Economic Security (CARES) Act made RMDs optional (not required) in 2020 so affected individuals do not have to take a distribution this year. For many, not taking an RMD can lead to a substantial reduction of Taxable Income and quite possibly a lower marginal tax rate. For some in this camp, it might be a good idea to drawdown savings (earning barely any interest) for income needs and avoid taking taxable RMDs.
Common Financial Planning Applications
IRA Selection
Investors looking to capitalize on the tax saving benefits of Individual Retirement Accounts (IRAs) typically have to choose between the Traditional IRA and Roth IRA. This is a great example of where understanding your marginal tax bracket is beneficial for planning purposes.
The Traditional IRA is funded with pre-tax contributions which means you get a tax deduction up front and eventually pay tax years later when you withdrawal funds. Conversely, the Roth IRA is funded with after-tax contributions which means you do not get a tax deduction up front but withdrawals that are taken years later are entirely tax free. Given this, the current marginal tax bracket versus an estimate of the future marginal tax bracket is a key consideration. If an investor is in a higher marginal tax bracket now than they expect to be in in the future, then contributing to a Traditional IRA may make more sense. Conversely, if an investor expects to be in a higher tax bracket in the future, then contributing to a Roth IRA may make more sense.
The marginal tax bracket for married couples (filing jointly) with less than $80,251 of Taxable Income in 2020 is only 12%. For couples in this situation, I find that the Roth IRA makes more sense now, especially if they expect to have a much higher level of future income (i.e., a higher future marginal tax bracket). They can pay the 12% tax now and be done with it. This is a common example of how marginal tax brackets influence planning decisions that I help clients make.
401(k) Selection
Many Americans have an employer-provided 401(k) plan where they can choose between pre-tax, deductible contributions in a Traditional 401(k) option or after-tax, nondeductible contributions in a Roth 401(k) option. The same marginal tax bracket logic in the previous section that applies to the Traditional IRA vs. Roth IRA decision applies here.
Impact of Required Minimum Distributions
At age 72 (or 70 1/2 if you turned age 70 1/2 before January 1, 2020), individuals owning any type of IRA, except for the Roth IRA, or an employer-provided retirement plan, unless they qualify for the “Still-Working” exception, have to begin taking Required Minimum Distributions (RMDs). RMDs are taxable so if your retirement plan(s) have large balances this can lead to significant new chunks of taxable income that can push you into a higher marginal tax bracket.
One strategy for retirees to deal with this and consistently keep themselves in a lower marginal tax bracket is to begin withdrawing funds from such retirement plans before they are required to instead of withdrawing funds from regular (taxable) investment accounts where the tax impact may be much less (or can be made much less with the right investment planning).
Final Thoughts
As we all know, it is a Presidential election year (although it really doesn’t feel like one). New Presidential administrations often bring new tax plans with them that include proposals for tax bracket changes. I mention this because it is important to remember that your current marginal tax bracket is not set in stone. They change over time as political winds shift. Pay attention to tax bracket changes so that this can inform your important financial planning decisions.