Your Marginal Tax Rate Is Higher Than You Know. That’s Gonna Cost You.

Your marginal rate is the tax you pay on the next dollar of income, expressed as a percentage. This rate may be your single most powerful financial planning tool.

• It tells you how much of your next pay raise can be spent, versus how much will go to the government.
• It tells you how big a discount you can expect on any tax-deductible expense, like mortgage interest, or a charitable deduction, or a Flex spending plan for healthcare.
• It helps you decide how advantageous any tax shelter might be: whether you should hold municipal bonds or regular bonds, whether a 529 college savings account offers enough advantage to be worth the hassle, or whether you should look into a variable annuity.
• It helps you decide whether to make traditional 401(k) contributions or to make Roth contributions.

You can’t make any of these determinations unless you know your marginal tax rate.

Too bad most taxpayers haven’t a clue. If forced to guess, you will probably low-ball your rate. You will under-estimate how much the government will either take from you, or give back to you, as a subsidy for favored actions.

That’s gonna cost you. Not least because it makes you vulnerable to bad financial advice from people who are just as clueless about your true rate, including too many financial writers, who should know better.

In my experience, ignorance is greatest among the prosperous middle class. These are families living on the West Coast, or in the Northeast, or in a big city anywhere, with two wage earners making good money.

I can help.

Unfortunately, it’s complicated

This should be simple.  Pick up a tax table , look up your income, and note the percentage associated with your bracket.

Here’s a visual depiction of our progressive tax structure, for taxable incomes between $100,000 and $1 million (married couples). Looks simple enough:

chart#1 tax table rates (open to see detail)

If you perform that exercise, most of you will think you are in the 25%, 28%, or 33% bracket. Few readers of this post will be in the top, 39.6% bracket, which now begins at $466,000 for married couples. And few can expect to be in the 15% bracket, where the ceiling for a married couple is about $75,000.

But your marginal rate is not between 25% and 33%—especially not if you live in California.

But let’s start slow, with a Texas or Florida or New Hampshire or Washington state resident, where there is no state income tax to complicate matters. I’ll assume throughout a married couple, each earning half the family total from wages alone, with two kids at home, who can itemize, and who deduct mortgage interest, property tax, and charitable donations. Furthermore, I make these deductions scale with income. In later examples, state taxes will also be deducted.

*Scaled deductions create a larger and larger dollar gap between adjusted gross income, before deductions, and taxable income, after deductions. AGI is a key threshold for some but not all changes in marginal tax rate.

I submit that such a family situation is utterly typical within the prosperous middle class.  The IRS reports that 80 to 90% of the taxpayers who report income over $100,000 were married.

Now here is a second chart, showing the true marginal tax rate throughout this range of income.

chart #2 total Federal marginal rates (open to see detail)

Scary, huh?  Why so many bumps and dips? And why is the gap between assumed tax bracket and actual marginal rate so much larger at lower incomes?

This is your tax code on drugs, the drug of social engineering and a well-meaning but misguided distributive impulse. I’ll develop the political implications at the end of the post.

Here is a dollar example of how to interpret the marginal tax rate, to show its importance. I’ll invent three couples to dramatize my point. Jack and Jill have taxable income in the vicinity of $120,000, implying AGI of around $150,000. The chart shows them to be in one of the bumps, paying a marginal rate of 37.65%.

Next door live Bob and Sue, with taxable income of around $150,000, implying an AGI north of $180,000. The chart shows them to be in one of the dips, with a marginal rate of 32.65%.

Further down the street live Charles and Lisa, with taxable income of around $170,000, implying AGI north of $200,000. The chart shows them to be in one of the bumps, paying a marginal rate of 40.15%.

I submit to you that a suburban street suitable for one of these couples would be suitable for any of them; you would likely observe that range of income on any one street. There may not be any noticeable difference in lifestyle, especially if Charles and Lisa bought later with a bigger mortgage, or Jack and Jill bought years ago with a large down payment.  In terms of lifestyle, these couples are interchangeable.

But their tax rates are rather different.  Here is how much money each would keep if they got a raise in salary of $3000 (about a 1.5% to 2% raise, depending).

Family	Amount of $3000 raise they could spend:
Jack and Jill	$1870.50
Bob and Sue	$2020.50
Charles and Lisa	$1795.50

 

In other words, a $3000 raise yields $2000 or less in spending power. Useful to know.

In more positive terms, if Charles and Lisa elect to contribute $3000 to a Health Savings Account (HSA), it will only cost them, out of pocket, less than $1800. In effect, they get a 40% discount on medical expenditures made through this account. The government picks up that portion, by lowering their tax obligation.

*HSA and FSA accounts are one of the few expenditures deductible against FICA as well as income taxes.

My beef with too many newspaper accounts is that they stop with the Texas or Florida case.  True, each of the 41 states that imposes an income tax applies a different rate structure.  I understand the difficulty that creates for a publication with a national audience.  But the overall effect of this omission is highly misleading.  About 80% of America pays higher marginal rates than in my examples thus far.

If you are in one of those 41 states, you need to know your total marginal tax rate, Federal and State.  Are you sitting down?

Hi owe, California!

Now things start to get really complicated. That’s why I could start this post in that cheeky way: few readers will have puzzled out their total marginal rate.

Once State taxes enter the picture, to get the total marginal rate, we have to calculate the effective state tax rate, after deducting these state taxes against the applicable federal income tax rate. And, we have to remember not to deduct state taxes for any couple within the range of the Alternative Minimum Tax.  State taxes are not deductible against the AMT. Got it?

By the way: every California couple that fits my description will be subject to the AMT: it’s a direct function of being married, having kids, owning a house, and living in California.  Or New York, or Oregon, or Washington DC, or any state with a top rate either side of 10%.  There’s nothing these couples can do to avoid the AMT; I’ve concluded over the years that someone in Congress hates us.

Here are two equations to help explain the next chart.

No AMT:	Total marginal rate =	Federal % + [(1 – Fed %) X State % ] + Other taxes %
AMT:	Total marginal rate =	Federal % + State % + Other taxes %

 

For AMT sufferers, the calculation is simple: just add the rates. Outside the AMT, you have to adjust the state rate.  If the Federal bracket is 33%, and the State rate is 9.3%, than the effective state rate is [(1 – 33%) * 9.3%], or 6.2%.

*Bonus point: if you do not itemize, it’s the same as being in the AMT zone: you bear the full cost of your state taxes, and of your property taxes. These are deductible in principle, but you didn’t / couldn’t deduct them. Hence, you can’t apply the first formula if you don’t itemize.  For that matter, if you were just barely over the threshold for itemizing, then, more or less, you aren’t able to apply the first formula either.

Now take a look at Chart #3, where the top line has the same shape as in Chart #2, but is much higher, plus has a few additional wrinkles, mostly due to changing California rates above income of half a million dollars or so.

chart #3 Federal State total rates (open to see detail)

First take away: most California couples with AGI between $180,000 and $500,000 will have a marginal tax rate north of 45%. Ouch.  Here’s what happens to that $3000 raise if the three example couples go west to California.

Family	Amount of that $3000 raise they could spend as Californians:
CA Jack and Jill	$1661.25
CA Bob and Sue	$1811.25
CA Charles and Lisa	$1516.50

 

In more positive terms, if CA Charles and Lisa contribute $2500 to a Flexible Spending account, it will only cost them $1263.75 out of pocket.  In effect, they get an almost 50% discount on eyeglasses, dental work, insurance copays, and anything else they pay for through the FSA.

That’s the good news in this post: who wouldn’t want to take advantage of a 50% discount on medical services—if they knew of it?

The tragedy: not every couple in CA Charles and Lisa’s situation chooses to take advantage of an FSA. Ignorance of your marginal rate will cost you.

More good news: let’s give a bonus to CA Charles and Lisa, taking their AGI up north of $250,000.  That takes them out of the peak rate, but still leaves them paying about 44.3% in Federal and State income taxes (plus 2.35% in Medicare tax, but that’s not relevant to this next point).  Suppose they are over 50. How much spending power will they have to give up, to contribute the maximum $48,000 to a traditional 401(k), at $24,000 each? Answer: only $26,736. Uncle Sam and Uncle Cal toss in the other $21,264 as a subsidy to encourage them to save for retirement.

And how much spending power would they have to give up, to contribute to a Roth 401(k)?  Answer: the full $48,000.  And how much would they have to earn in wages, to pile up the $48,000 needed for the Roth contribution?  Answer: almost $90,000 in wages subject to Federal, State, and Medicare tax.

Remember that, next time someone pitches you on a Roth account.

That Crazy AMT

Take a look at that big, extended dip in the center of the chart. Families with taxable income between about $400,000 and $625,000, corresponding to AGI between $500,000 and $750,000, pay a lower marginal rate than that unfortunate family with taxable income just north of $100,000.  How can this be?  How did our progressive tax system turn into a two humped camel of an ugly travesty?

The devil’s work is done by phase-outs.  It’s the phase-out of the child tax credit above AGI of $110,000 that hikes the rate so high at the left side of the chart.  It’s the phase-out of the AMT exemption that hikes rates to that plateau in the left middle of the chart. And indirectly, it’s the high rates that AMT phase-out imposes, on families in the $250,000 to $500,000 AGI range, which produces that big belly in the right middle, to the benefit of families earning more than half a million.

Whenever Congress phases-out a tax benefit, it produces a bump in marginal rates, a humpback where rates are higher than at incomes just below or above the phase-out zone. Families making $600,000 benefit from the phaseout imposed on families making $300,000. The successful pay, to fund the very successful.

Phase-outs do the devil’s work.

The Most Hellish Phase-Out

Take a good look at the second, sharp bump near the left side. These poor folks are still paying the full FICA tax rate of 7.65%, which doesn’t end until a dual income couple gets above $237,000 of wages (twice the social security ceiling of $118,500).  Plus, they’ve edged into the AMT zone, where the marginal federal rate, due to the phase-out of the AMT exemption, is 32.5%. Plus, because they are in the AMT zone, the full state tax rate is added.

I’ve shown it as a peak, because I plot the line at $10,000 intervals, but it’s actually a narrow plateau either side of $230,000.

Now get this: ten years ago, that peak was a valley. The full FICA rate ceased before a typical family entered the AMT zone.  You saw a sharp dip in marginal rates at that point, instead of today’s peak.

And ten years hence, the current peak will stretch to be a butte top.  Here’s why:

• Tax brackets, including the AMT zone, increase with inflation.
• But the social security ceiling increases with wages. Hence, given any real wage growth (1-2% is the long term historical norm), the social security ceiling must rise faster than tax brackets
• With the added wrinkle that the $250,000 threshold for extra Medicare tax is not adjusted for inflation.

By 2019 or so, the social security ceiling should be above $125,000, which will put a dual income couple over $250,000, which means the extra Medicare tax of 0.9% will be tacked on to the full FICA rate of 7.65%.  These couples will still be in the AMT zone, so that bottom line, in 2019 a couple with income of $235,000, in 2016 dollars, will pay a marginal rate over 50%.

That butte top will grow ever wider with time, so that more and more couples earning in the middle $200,000s, in 2016 dollars, will pay marginal rates over 50%.

Lovely.

How to Find Your Own Marginal Rate

If you are comfortable with the adage, “close enough for government work,” then you can locate yourself on chart #2 or chart #3, round to the nearest 5%, and go to work. (If you live in a state with a middling income tax rate, such as Massachusetts, where the rate is about 5%, use chart #2 and always round up; or, if the chart shows a rate that doesn’t need much rounding, add another two and a half percentage points, that will get you close enough.)

In locating yourself on the chart, remember to keep straight your taxable income versus your AGI; both can be found on last year’s tax forms.

If you need accuracy to the decimal point, or find yourself near one of the inflection points in the charts, try this:  open last year’s return in Turbo Tax.  Resave the file under a new name, like “2015 Smith Simulation.” Note your actual Federal and State tax owed last year (given in large numbers at the top of the Turbo Tax screen). Next, go into your W-2 form and increase your income in box 1 by $1000. Now total the increase in Federal, State, and Medicare tax (and social security tax, if your income was under $118,500), relative to what you originally paid.  Divide that total by $1000, and you have your marginal tax rate on wage income.

Three Handy Formulae

Once you know your marginal rate, you can put it to work, in your personal financial planning, as follows:

Marginal rate X TDexpenditure  =	Dollar discount or subsidy received on a tax deductible expenditure
TDexpenditure X (1 – marginal rate) =	Net dollar cost to you of any tax deductible expenditure
Non-TDexpenditure / (1 – marginal rate) =	Wages required to fund an expenditure that is not tax-deductible

In applying these formulae, keep in mind that you have two marginal rates. Your total marginal rate includes FICA taxes.  This total rate, shown in the charts, applies to wages, and to FSA and HSA expenditures, but not much else. Your marginal income tax rate does not include FICA taxes. This rate applies to most tax-deductible expenditures, including contributions to IRA and 401(k) type accounts, as well as mortgage interest, charitable donations, and, unless you are in the AMT zone, state and local taxes plus property taxes.

*If your income is above $250,000, you have a third marginal rate, which applies to ordinary investment income: bank interest, bond interest, short term capital gains, non-qualified dividends, and withdrawals from variable annuities.  Here the Net Investment Income Tax of 3.8% substitutes for the FICA tax of 2.35%.  To obtain this marginal rate, use chart #2 or chart #3 as appropriate, and add 1.45% to the top, red, dashed line.

Here is an alternative application of the third equation, using your non-FICA marginal rate. You may have savings that you want to keep in some kind of bond fund or even a bank Certificate of Deposit.  Interest payments would be fully taxable.  Your alternative is to put the money in a municipal bond fund, where the interest is free from Federal and state tax.

Normally, the interest rate on a municipal bond will be lower than on a fully taxable bond. But the municipal bond may be a better deal, after-tax, if it is not too much lower than the fully taxable corporate bond or bank CD.

Once you know the rate you can get on a municipal bond investment (most people will use a mutual fund), take that rate and divide by (1 – marginal tax rate).  That gives you the hurdle that a regular taxable bond has to pass to be a better deal for you.

Or, if you are in the painful middle of chart #3, just use this rule of thumb: a taxable bond or bank deposit has to pay an interest rate more than twice as high as the municipal option to be a better deal for you.

*Caution: be sure to compare apples to apples. If it’s a money market fund, compare to a municipal money market fund; if it’s an intermediate term corporate bond fund (5-10 years), compare to an intermediate municipal bond fund; and if it’s a long term bond fund (20-30 years), compare to a long term municipal bond fund.  Else, you are mixing up term premium with tax shelter, to no good end.

**Second caution: use your third marginal tax rate, enhanced by NIIT as described earlier, which will be about 1.5% higher than the top line in Chart #2 or #3.  Bottom line: many married professionals in California can expect to pay a 48.1% rate on bank and bond interest. Ai yi yi.

Political Implications

I’m a lifelong Democrat.  I support a system of progressive taxation.  I believe the better off you are, the more in tax you should pay.

For that reason, I despise a humpbacked camel system, which capriciously taxes people in the middle at unduly high rates.

And speaking as a Democrat, I think humpbacked tax systems are dangerous to my party. The people who bear the pain of the humps are mostly prosperous, educated households whose social values are aligned with the Democratic party.

But these families are also economic actors who seek their own self-interest; a father owes his family no less. Hence, every victim of a hump is a Republican convert in the making. Every hump victim is vulnerable to the Republican siren song of lower taxes.  Every hump victim is ready to be rolled down the primrose path of lower tax table rates, not realizing that lowered statutory rates won’t help them much.

In fact, if I were a Republican troll buried deep in the tax machinery of Congress, I would strive to muck up progressive tax brackets exactly as shown in charts #2 and #3.  I would calculate that I could best preserve the appeal of lower taxes by sneaking in extra taxes on large numbers of prosperous voters, because these far outnumber the truly wealthy, who are my actual masters. Diabolical!

Or it would be, if I didn’t fear that innumerate Democratic lawmakers were in unwitting cahoots with this scheme.

I wish my Democratic party would get smarter about taxes. Item:  in 2013, when the Medicare tax threshold was not made adjustable for inflation, I have to think Ronald Reagan smiled with glee, there in his grave.

Have my Democratic colleagues forgotten how they lost to the Reagan Revolution? It happened when the inflation of the 1970s pushed ordinary taxpayers into brackets that had been the province of the rich.  Taxes became too high on the ordinary person.  The promise of a progressive tax system was sullied in their eyes. Republicans rode the resulting rage to victory.

Please, let’s not do that again?

Remember: phase-outs are wicked. The misguided attempt to restrict tax benefits to the “truly deserving” inevitably bumps up the marginal rate of those doing just a bit better. Under progressive taxation, the only sane way to benefit poorer taxpayers is to make lower rates, low, while keeping higher rates, high. Any other tinkering does the devil’s work.