Have you ever wanted to make a financial decision and in the process realized you needed to know the income tax effect before making that decision? Is there a good way to “get close” to the tax effect of a financial decision by doing some simple calculations? If you just look up your income tax bracket on the IRS’ tables or take last year’s 1040 tax return and calculate your effective tax rate shouldn’t that work? The answer is “maybe.” Let’s look at some of the variables that go into determining the amount of tax you pay on your income:
1. The basic income tax table rates are graduated from 0% to 39.6%. Your bracket increases as your income rises. When you hear the phrase “marginal tax bracket” this is the tax table that is being referred to. Not all income is taxed at this rate, however.
2. Tax rates on long-term capital gains vary between zero and 20%. If you add your taxable income (with the capital gain excluded) to the capital gain amount and the total taxable income is below the top of the 15% bracket (see #1 above) then your capital gain rate is 0%. But to the extent that total is over the top of the 15% bracket your capital gain rate is 15%. The 15% capital gain rate stays flat until your total taxable income reaches the bottom of the 39.6% bracket. All capital gains in that bracket are taxed at 20%. These same calculation rules apply to “qualified” dividends. You must also be aware that the capital gain rates for collectibles and depreciable real estate are exceptions to these rules and both are taxed at a higher rate than those described.
3. If you are self-employed or owner of an interest in partnerships or LLCs you must also consider the effect any financial decision might have on self-employment tax. The 2015 rate is 15.3% on the first $118,500 of self-employment income. The rate drops to 2.9% on income over that threshold.
4. If your income exceeds the threshold for your filing status you would become liable for an additional .9% surtax on your earned income and you would also become liable for the 3.8% net investment income tax on the excess investment/passive income.
5. As your adjusted gross income exceeds $309,900 (2015 Married Filing Joint) the tax code starts to decrease the amount of itemized deductions and personal exemptions that you are allowed. This disallowance has the effect of raising the marginal income tax rate higher than what is stated in the tax tables (#1 above).
6. If you are retired and receiving social security benefits, any increase in income should be considered in light of its impact on the taxable portion of your social security benefits. The formula for determining the taxable portion of social security benefits has the potential, in some instances, of driving the marginal tax rate on that increased income well above the rates in the tables.
7. If you are a qualified farmer or rancher you may also benefit from income averaging. This calculation can potentially lower your tax bracket in the current year by averaging the current year’s income with the income of the previous two years.
8. Alternative minimum tax (AMT) is another tax that sometimes becomes applicable. The tax rate is 26%-28%. It applies only to the extent that the AMT exceeds the tax calculated under the other tax rules.
The instances that allow for a quick shortcut to determine the tax effect of a financial transaction are becoming very rare. The more significant the transaction the more significant the risk of having an “unplanned for” tax result. We would be glad to assist you with the tax components of any contemplated financial decisions. Please contact our office any time – we are here to help.