A key to tax planning is knowing your marginal tax rate. That's the rate that applies at the margin, to your top dollar of income. Under our graduated income tax system, as income rises, not only does your tax bill go up but the percentage of that income claimed by the government also increases.
Your marginal rate is affected by your filing status. While everyone faces the same six tax brackets, the brackets hold different amounts of income depending on whether you file as a single person, for example, or you are married and file a joint return with your husband or wife. The wider the brackets, the slower you march up into higher rates. To complicate things — but in a good way — tax rates have been coming down lately. The IRS take used to start at 15% but now the lowest bracket imposes a gentler 10% rate. At the other end of the spectrum, years ago, rates ran up as high as 70%; now the top rate is 35%.
Knowing your marginal rate is essential because it lets you determine how much of any extra earnings – from investments, a raise or moonlighting – you get to keep. It also measures the saving power of deductible expenses. Only if you know your tax bracket can you pinpoint what a charitable contribution or business expense really costs you after your tax savings are taken into account.
The bottom line is this: knowing how high your tax bracket really is can greatly energize your tax-planning efforts by enhancing the potential rewards.
Here are the official tax rates for 2006.
Up to $7,550
Tax: 10% of every dollar
$7,551 to $30,650
Tax: $755 plus 15% of amount over $7,550
$30,651 to $74,200
Tax: $4,220 plus 25% of amount over $30,650
$74,201 to $154,800
Tax: $15,107.50 plus 28% of amount over $74,200
$154,801 to $336,550
Tax: $37,675.50 plus 33% of amount over $154,800
Over $336,550
Tax: $97,653 plus 35% of amount over $336,550
Up to $15,100
Tax: 10% of every dollar
$15,101 to $61,300
Tax: $1,510 plus 15% of amount over $15,100
$61,301 to $123,700
Tax: $8,440 plus 25% of amount over $61,300
$123,701 to $188,450
Tax: $24,040 plus 28% of amount over $123,700
$188,451 to $336,550
Tax: $42,170.50 plus 33% of amount over $188,450
Over $336,550
Tax: $91,043 plus 35% of amount over $336,550
Up to $10,750
Tax: 10% of every dollar
$10,751 to $41,050
Tax: $1,075 plus 15% of amount over $10,750
$41,051 to $106,000
Tax: $5,620 plus 25% of amount over $41,050
$106,001 to $171,650
Tax: $21,857.50 plus 28% of amount over $106,000
$171,651 to $336,550
Tax: $40,239.50 plus 33% of amount over $171,650
Over $336,550
Tax: $94,656.50 plus 35% of amount over $336,550
Up to $7,550
Tax: 10% of every dollar
$7,551 to $30,650
Tax: $755 plus 15% of amount over $7,550
$30,651 to $61,850
Tax: $4,220 plus 25% of amount over $30,650
$61,851 to $94,225
Tax: $12,020 plus 28% of amount over $61,850
$94,226 to $168,275
Tax: $21,085 plus 33% of amount over $94,225
Over $168,275
Tax: $45,521.50 plus 35% of amount over $168,275
The tax brackets are adjusted each year for inflation, so that as dollars you earn decline in purchasing power so will the government's take. Basically, for example, if the inflation rate in 2006 is 3%, the top of each bracket will rise by 3%, meaning more dollars will be taxed at lower rates.
We say these are the "official rates" because, as noted below, there's more here than meets the eye. In the table for joint returns, you'll see that 2006 taxable income between $61,300 and $123,700 falls in the 25% bracket. Does that mean if you make $90,000, 25% of it – $22,500 – goes to Uncle Sam? Absolutely not.
Part of your earnings isn't taxed at all. If you claim four exemptions on your 2006 tax return – one each for yourself, your spouse and two dependent children – that knocks $13,200 off taxable income because exemptions are worth $3,300 each in 2006. Deductions will reduce taxable income by at least $10,300 more. That's the standard deduction for 2006 joint returns (it's higher if either you and/or your spouse is age 65 or older); if you itemize deductions, even more of your income will escape tax. So your $90,000 of earnings is pared down to no more than $66,500 of taxable income. Does the government get 25% of that amount – $16,625? Nope.
On a joint 2006 return, the tax bill on $66,500 of taxable income will be $9,961. That's about 15% of $66,500. . .and about 11% of $90,000.
While you're said to be in the 25% bracket, the portion of your income that falls in the 10% bracket – the first $15,100 on a 2006 joint return – is taxed at 10%. The $46,200 that falls in the 15% bracket is taxed at that rate. Only the dollars that fall in the 25% bracket – the $5,200 between $61,300 and $66,500 in this example – are clipped by the 25% rate.
Still, unless you're affected by one of the bubble brackets discussed below, you should still keep the 25% rate in mind for tax–planning purposes. Because it's your marginal rate—25% in this example — that determines how much of any extra taxable earnings will go to the IRS. And extra deductions – such as a deductible contribution to an individual retirement account or a charitable gift – will produce tax savings at a rate of 25%. For example, a $1,000 charitable donation knocks $250 off your tax bill when you're in the 25% bracket.
The nice, neat, six-rate schedule is the official line. Unfortunately, reality can be more painful. Due to the interaction of various parts of the tax law, you could face a much higher "unofficial" marginal rate.
Say hello to the bubble brackets. These are hidden rate increases used to take away certain benefits from taxpayers whose incomes fall within various income ranges. At certain income levels, each extra dollar you earn adds more than $1 to the amount the IRS gets to tax. That hikes your effective marginal rate – the share of that extra dollar that winds up going to the IRS.
If your 2006 adjusted gross income (AGI, which is basically income before subtracting exemptions and deductions) is over $150,500, the law takes away part of your itemized deductions. (The trigger point is $75,250 if you're married filing a separate return.) For every $1,000 that you're over the threshold, you lose $30 worth of deductions – so the IRS really gets to tax an extra $1,030. The result is the same as raising the tax rate – to 28.8% if you're officially in the 28% bracket, 34% if you're ostensibly in the 33% bracket and 36% if you're in 35% bracket. This bubble applies until 80% of your deductions for taxes, interest, charitable gifts and miscellaneous expenses are wiped out. Only then does your rate fall back to its advertised level.
When AGI passes another threshold – $150,500 on a single return, $225,750 on a joint return, $188,150 on a head of household return or $112,875 on a married filing separately return – the law begins gnawing away at the value of your exemptions. Ostensibly, each exemption you claim for yourself and each dependent knocks $3,300 off your 2006 taxable income. But for every $2,500 your AGI exceeds the trigger point for your filing status, you lose 2% of each exemption's value. For 2006. the amount by which these amounts can be reduced is two-thirds of the amount that would otherwise apply. Example: The maximum reduction of the $3,300 personal exemption for 2006 is $2,200. The minimum exemption allowed after the phaseout is $1,100.
This rate bulge takes away the deduction for contributions to an individual retirement account. If you and your spouse are both covered by retirement plans at work and your 2006 adjusted gross income on a joint return is between $75,000 and $85,000, every $100 of extra income squeezes your allowable IRA deduction by $80. (This assumes you and your spouse each make the maximum $4,000 contribution allowed for taxpayers under age 50.) An additional $100 of income lets the IRS tax an extra $180 in the 25% bracket. That costs you $45, for an effective tax rate of 45%. If you file a single return and your income is in the 2006 IRA phase-out range – $50,000 to $60,000 – the effective rate is 35%. It's lower because, since you have only one IRA deduction to lose, each $100 of added income reduces the write-off by just $40. This bubble ends when income is $10,000 above the threshold and the full value of the IRA deduction has been eliminated.
If you receive social security benefits, you could face a marginal rate of 42% or 51.8%. Above certain levels, extra income causes social security benefits to lose their tax-free status. When income – defined for this purpose to include 50% of social security benefits – is between $25,000 and $34,000 on a single return or between $32,000 and $44,000 on a joint return, earning an extra dollar causes 50 cents' worth of benefits to be taxed. Adding $100 to your income, then, could allow the IRS to tax $150. In the 25% bracket, that costs you $37.50 – the same as applying a 37.5% rate to the extra $100 of income.
If your income is higher than the ranges cited above, an extra $100 of income can make $85 of benefits taxable. Taxing $185 at 25% costs you $46.25, the same as taxing your extra $100 of earnings at 46.25%.
If your income is below the $32,000 or $44,000 threshold, no more than half of your social security benefits can be taxed. Even above those levels, no more than 85% of your benefits can be taxed. Once your income hits the point at which the maximum percentage has been taxed, these bubble brackets end.
The new child and college credits also brought the potential for new, and extremely painful, bubble brackets because these credits are phased out as adjusted gross income rises. And, to the extent that rising income costs you such breaks, you're living in a bubble bracket. The $1,000 per child credit for example, is phased out as income rises above $110,000 on a joint return. You lose $50 of the credit for each $1,000 or part thereof that your AGI exceeds the threshold. AGI of $110,001, then, would cost you $50 of credit – meaning that extra $1 of income is effectively taxed at a rate of 5,000%.
The bottom line is this: knowing how high your tax bracket really is can greatly energize your tax-planning efforts by enhancing the potential rewards.
For years, one of the hottest political issues was the "marriage tax penalty" and some of the overheated rhetoric made it sound like the Congress and the IRS favor "living in sin" over "matrimonial bliss." Nothing could be further from the truth. Over the years, Congress has packed the tax law with provisions favoring families. And, in the 2003 tax cut, the lawmakers finally delivered on long-promised relief. First, take a look at the issue:
Yes, it is true that some married couples pay more tax on a joint return than they would if husband and wife were still single and each filed his and her own return.
The reason is simple to understand, if not to accept. On a joint return, a husband’s and wife’s income are combined. Since our graduated tax system applies higher tax rates to higher incomes – under the theory that the more you earn, the more you can afford to pay – your combined income can be nudged up into a higher tax bracket. This is so even though the tax brackets are wider for joint returns than for single returns. The extra tax you pay on a joint return, compared to the combined bill if you and your spouse were filing individual returns, is the marriage tax penalty.
Moving from single filing status to a joint return doesn’t always work to your disadvantage. Assume, for example, that one of the betrothed has a taxable income of $75,000 and the other has no income at all. On a single 2006 return, the breadwinner would owe a tax of $15,339. Marriage to a non-earning spouse would slash that bill. On a joint 2006 return, the tax on $75,000 of taxable income would be $11,871, for a marriage bonus of $3,468.
To relieve the marriage tax penalty (and increase the marriage tax bonus for those who enjoy it) Congress has widened the 15% bracket on joint returns so that it now holds exactly twice as much taxable income as the 15% bracket as it is for single returns. (There will still be a disparity for higher tax brackets; for example, the top of the 25% and higher brackets for joint returns is not twice as high as for single returns.)
The lawmakers also eliminated another cause of the marriage tax penalty: the fact that the standard deduction for married couples was not twice as big as the standard deduction for singles. Before the law change, for example, the 2003 standard deduction for single returns was $4,750, while on joint returns it was $7,950. Under the new law, the standard deduction for 2006 joint returns is $10,300 — exactly twice that on single returns.
While the changes go a long way toward relieving the marriage penalty, there's even better news: The changes help all married couples — even the 20 million or so who have been receiving a marriage bonus. That bonus is even bigger now. (Just don't tell the single people.)
Getting a divorce switches your filing status. If the divorce is final before the end of the year, the IRS considers you single for the whole year. You can't file a joint return with your ex-spouse even if you were married for the first 364 days of the year. It's your marital status on December 31 that matters to the IRS.
With the growing value of exemptions, it's more important than ever to protect your right to claim exemptions for your dependents. Exemptions are worth $3,300 in 2006, meaning each one knocks $800 off the tax bill of those in the 25% bracket. We estimate that in 2007 exemptions will be worth $3,400 each.
There are various tests you must pass to claim someone as your dependent. The two most likely to trip you up — that you can't do anything about at year-end — are the support test and the gross-income test.
In most cases, the support test demands that you provide more than half of a person's support in order to claim him or her as your dependent. That's usually no problem when your children are involved, but it can be dicey if you are supporting an elderly parent. In fact, starting in 2006, if the person you are claiming is a "qualifying child," you no longer have to provide more than half of the child's support -- as long as the child does not provide more than half of that support him- or herself.
Money a dependent puts into savings doesn't count as support, but cash that's pulled out and spent on support does.
The gross-income test blocks you from claiming as your dependent someone with gross income that exceeds the exemption amount ($3,300 in 2006 and a projected $3,400 in 2007). This test does not apply, however, to a qualifying child who is either under age 19, or under age 24 if he or she is a full-time student for at least part of five calendar months during the year.
The exception for children means that here, too, the most likely threat is to dependency exemptions posed by the income test is to the taxpayer's parents. Nontaxable Social Security benefits or other tax-exempt income don't count as income for purposes of this test.
Keep an eye on the earnings of potential dependents from savings, investments or jobs. It may pay off to recommend that a dependent parent move money out of a taxable savings account and into a tax-free money-market mutual fund, for example, if doing so would preserve the dependency exemption. Your tax savings might outweigh the slightly lower yield your parent would earn in the tax-free investment.
As with year-end investment decisions, factors other than taxes come into play here. You have to weigh the potential tax savings against other considerations. And remember this: If you can arrange things so that you claim someone as a dependent, that person may not claim a personal exemption on his or her own tax return.
Although we all think of April 15 as tax day, taxes are actually due as income is earned, and employers have become the country's primary tax collectors by withholding taxes from our paychecks. By far, most of the money paid in individual income taxes each year is withheld from employees' paychecks. The government also expects its share of income not covered by withholding – including income from self-employment, investments and alimony – in installments during the year. In both cases, Social Security taxes as well as income taxes are due on a pay-as-you-go basis.
As part of your year-end planning, compare your tax payments so far with what you expect to owe. If your payments will be at least as much as the tax you owed for the previous year or at least 90% of what you'll owe this year, you're probably safe from the penalty. If you will fall short, however, some year-end maneuvering can save you some money.
Unlike Estimated tax payments – which are considered paid when they are actually paid, so a big year-end payment won't make up for earlier missed deadlines – withholding from your paycheck are considered to be made evenly throughout the year. That means overwithholding in November and December can make up for earlier underpayments. If you have a job, then, arrange with your employer to withhold extra amounts from the final paychecks of the year. And, remember in January to have withholding readjusted downward.
Despite all the worrying, grousing and remonstrating we do about high taxes and all the planning and conniving we do to minimize what we owe Uncle Sam, the millions of tax-refund checks the Treasury mails out each spring are proof positive that employees had too much withheld from their payroll checks.
Keep your withholding down to the legal minimum. The point is for you to get the use and enjoyment of more of your money when you earn it rather than making an unintentional – albeit generous – interest-free loan to the government.
The extent of overwithholding is as massive as it is ironic. In 2006, the government churned out over 100 million tax-refund checks. The total amount sprinkled on appreciative taxpayers was around $200 billion. The average size of the checks was over $2,200. (The interest you could earn each year on the average overpayment in a 4% savings account would easily pay for this program and a nice dinner.)
On the flip side of the coin, a growing number of taxpayers are tripped up each year by having too little withheld or failing to pay enough estimated tax. This is a particular problem for two-earner married couples.
Undoubtedly some taxpayers who are hit with underpayment penalties really don't have to pay. The law includes exceptions, but since the IRS computers don't know who might have a valid excuse, penalty notices go to those who appear to be guilty. For information on the exceptions to the underpayment penalty, see help for Underpayment: Exceptions.