Tax planning is one of the most fundamental aspects of financial planning. In fact, many people would argue that financial planning without respect to taxes is not really financial planning. Yet, in order to fully understand how tax planning works, it’s important to understand what your marginal tax rate is.
What is a Marginal Tax Rate?
Before we can discuss marginal tax rates, it’s important to understand how income tax brackets work. For federal tax purposes (and most states that do not have a flat income tax), income tax brackets state the amount of tax that is paid for income earned within that bracket. For example, in 2017, a married couple (filing jointly) making under 18,650 is taxed at 10% of their income. Thus, they’re in the 10% tax bracket. Once they make over $18,650, they are taxed at 15% of the income above $18,650. Now, they’re in the 15% tax bracket, and will be until they earn over $75,900. Then, they’ll move up to the 25% tax bracket, where they’ll pay 25% on the income above $75,900, and so on.
Once you determine what income tax bracket you’re in, then your marginal tax rate is simply the applicable tax on your next dollar of earned income. For example, if you’re in the 25% tax bracket, then your marginal tax rate is 25%. For every additional dollar you earn, you’ll pay an additional 25 cents in tax. Conversely, for each dollar of decreased taxable income, you’ll save 25 cents in tax. It’s this understanding that helps define a sound tax planning approach.
What does the Marginal Tax Rate mean?
Now that we know what the marginal tax rate is, we can think about how it applies in tax planning. Simply put, every decision that has a tax impact can now be evaluated to determine the tax savings, and the after-tax financial impact. Decisions that might be very tax-wise in one tax bracket (such as accelerating or postponing taxable income) might not be prudent in another.
For example, let’s assume that you just bought a stock six months ago. Since then, a series of developments and bad earnings reports have convinced you to sell. Now, you’re trying to decide whether to sell the stock at the end of the year or at the beginning of next year. If you’re in the 15% tax bracket, but expect to be in a higher tax bracket next year, you might want to sell now. If you’re in the 35% tax bracket, but expect to be in a lower bracket next year, you might want to wait.
This is a basic example of how marginal tax bracket affects tax planning. We’ll look at another example in more depth. First, let’s discuss how you can find your marginal tax rate.
How do I Find My Marginal Tax Rate?
To find your previous year’s marginal tax rate, you only need your tax return (Form 1040 for most people). Depending on the type of return, you’ll use the line that correlates to taxable income:
- Form 1040: Line 43
- Form 1040A: Line 27
- Form 1040EZ: Line 6
Once you determine your taxable income, you can refer to the IRS tax tables to figure your marginal tax bracket. Keep in mind your filing status (single, married filing jointly, married filing separately, or head of household), particularly if your status has changed. Since the IRS tax tables are updated as part of a revenue procedure that contains a lot of other annual updates (2017 rates are in Rev. Proc. 2016-55), they can be cumbersome. You may find a plethora of websites, such as taxfoundation.org that make this information easier to digest.
Marginal Tax Rate Case Study
Let’s consider a young couple that is looking into converting their traditional IRA to a Roth IRA. To summarize, a Roth conversion is simply transferring funds from a traditional or non-deductible account to a Roth account. The benefit is that you do not pay taxes on earnings in a Roth account. However, you have to pay taxes on any traditional IRA funds that you convert. It makes sense to do this if you expect to be in a higher tax bracket in your retirement years when you are drawing from your IRA.
Joe & Jane have a traditional IRA account valued at $50,000. They’ve been saving diligently since they got married 5 years ago. They feel like they’re doing pretty well, especially since they’re only 30. At some point, they heard that a Roth IRA would be better suited for their financial goals, especially if they can convert at a relatively low tax rate. In order to do so, they have to pay ordinary taxes on the converted amount.
Let’s calculate their tax bracket. Since Joe is an O-3, and has been in for 8 years, their monthly income is $5,940.90. Assuming they have no other taxable income, this puts their 2017 annual taxable income at $71,291.00 (rounded up to the nearest dollar). Exemptions and deductions notwithstanding, this puts them squarely in the 15% tax bracket. This is their marginal tax rate.
Let’s assume that Joe & Jane want to convert as much as they can, but stay within their current tax bracket. A quick look at the tax tables shows that they’ll remain in the 15% bracket until their income reaches $75,900. In other words, they could convert $4,609 this year at 15%. After that, they would pay 25% for the amount above $4,609.
Without going into detail about what Joe & Jane SHOULD do, let’s talk about what they COULD do:
- They could convert the entire amount this year. They would pay a total of $12,039. This includes $691.35 for converting $4,609 at the 15% rate plus $11,347.75 for converting the remaining amount at the 25% rate.
- They could convert up to the 15% limit without going over. In doing so, they would pay $691.35 this year. They could always revisit this in future years to take advantage of their 15% tax bracket. Assuming they could fully convert at the 15% bracket, they would pay a total of $7,500. This would save them over $4,500 over the life of the IRA…with no substantial impact to their portfolio! Remember, we’re not talking about changing investments, we’re only talking about changing asset location from a tax-deferred to a Roth account.
- They could choose not to convert at this time. They could make this decision based upon any number of reasons. Perhaps they find a better opportunity. Maybe the tax rules change. Perhaps there’s an upcoming deployment that allows them to convert some of their money at the 10% bracket.
That’s an example of how understanding your marginal tax bracket influences your tax planning. It’s important to highlight that tax should be a consideration, but not the only consideration. Bad investments do not become sound ones because they’re tax-efficient. Bad purchases (such as buying more of a house than you need or can afford) do not become good ones just because there’s a tax benefit.
However, tax efficiency can make a good investment even more compelling, or it could make an otherwise ho-hum investment a better one. More importantly, it can help you think in more than one dimension. Instead of focusing on ‘either-or,’ tax-planning also should include ‘when?’
In Joe & Jane’s example, you can understand their approach if they decide to stretch out their Roth conversions over a 10-15 year period. Since they’re only 30, there is zero impact on their ability to use the money in retirement. However, that extra $4,500 could grow into much more over time. Of course, this could not happen if Joe & Jane didn’t take the time to understand their marginal tax rate or what tax bracket they’re in. Without understanding your marginal tax bracket, tax planning cannot take place.
There can be many opportunities to incorporate tax planning into your financial planning. Understanding your marginal tax bracket is the first step in being able to determine what tax planning decisions are best for your situation. While this article is not a substitute for tax advice, I hope it helps set an educational foundation for future planning efforts. If you need professional advice for your particular situation, you should contact a fee-only financial planner or tax professional.
What do you think? Are there other tax topics or financial planning topics you’d like to see a basic primer on? If so, feel free to post your comments, or to join the Military In Transition Facebook Group!