Summer is here. Tax season has come and gone and even those of us that extend can probably ignore our taxes for a few months. However, I thought I would take this ignoring of taxes issue head on with a discussion of income taxes. Over the years, I have noticed that typically, my friends, family, acquaintances and clients have at least a few misconceptions of income taxes.
- Marginal tax rates generally don’t apply to all income
- Deductions and income tax credits aren’t equally beneficial
- Itemized deductions often have less impact than expected
First things first. The United States has a progressive income tax system which means higher levels of income are taxed at higher rates. The Tax Policy Center has a nice compact graphical presentation (https://www.taxpolicycenter.org/briefing-book/are-federal-taxes-progressive) of progressive and regressive taxes in the U.S. Below are the brackets for individual, married filing jointly, and head of household filers. We’ll be referencing it as we go.
2019 U.S. Income Tax Brackets
|Rate||For Unmarried Individuals, Taxable Income Over||For Married Individuals Filing Joint Returns, Taxable Income Over||For Heads of Households, Taxable Income Over|
Marginal vs. Average Effective Rate
Meet Morgan. Morgan is a single tax filer for 2019 who will earn $100,000 this year. We’re going to start by assuming Morgan doesn’t receive the benefit of any deductions, credits, etc. That is, every dollar Morgan earns this year will get taxed. As we’ll discuss later, this is a convenient simplification, and fortunately, not every dollar we earn gets taxed.
According to the table above, Morgan’s total income tax can be calculated by summing the following subtotals:
|$9,700 – 0||= $9,700 x 10%||= $970|
|$39,475 – 9,700||= $29,775 x 12%||= $3,573|
|$84,200 – 39,475||= $44,725 x 22%||= $9,840 (the IRS doesn’t do decimals)|
|$100,000 – 84,200||= $15,800 x 24%||= $3,792|
Note that Morgan could have earned an additional $60,725 and that income would still be taxed at 24%. Morgan’s Marginal Tax Rate is 24%, the highest rate applied to any of Morgan’s income.
Now, if we divide the total tax bill by Morgan’s income, $18,174.50 / $100,000.00, we obtain Morgan’s Average Effective Tax Rate of 18%. While Morgan’s last dollar of income was taxed at 24%, the average rate was lower. The Marginal Rate doesn’t apply to all income (Misconception #1).
There are two more misconceptions to ferret out, but first we need to set the stage a bit.
Outline of Income Tax Calculation
As I referenced above, the tax calculation has multiple steps, including deductions and credits. Below is an outline of the calculation of U.S. personal income taxes:
+ All taxable income (wages, business income, interest, capital gains, etc.)
– Above-the-line deductions (HSA contributions, IRA contributions, etc.)
= Adjusted Gross Income (AGI)
Adjusted Gross Income (AGI)
– Itemized/below-the-line deductions (charitable contributions, mortgage interest, property taxes, etc.), or Standard deduction if higher
= Taxable Income
Calculate Tax utilizing Taxable Income from Step 2 and the appropriate filing status tax bracket (see previous section for simple example).
– Tax credits
= Total Tax
As you might imagine, there are lots of details glossed over or ignored by the outline above, including the parallel calculation of Alternative Minimum Tax, the potential of additional tax such as self-employment tax, etc. Staying out of the weeds, let’s touch on a couple more misconceptions.
Deductions vs. Credits
$1 of tax credit is more valuable than $1 of tax deduction.
Back to Morgan’s situation. For simplicity, we’ll continue to ignore the existence of the standard deduction. However, let’s give Morgan a $1,000 above-the-line deduction. Now Morgan’s Taxable Income has been lowered by $1,000 to $99,000. If we re-calculate Morgan’s total tax bill, we will obtain $17,935 ($240, or 24% of $1,000, less). Now, let’s take the $1,000 above-the-line deduction away and instead give Morgan a $1,000 tax credit. Our original total tax calculation of $18,175 still applies, however in the last step we subtract the full $1,000 credit from the tax calculation to obtain a Total tax bill of $17,175. The $1,000 tax credit saved Morgan the full $1,000 while the $1,000 deduction only saved $240.
Both deductions and credits lower taxes, however they are not equal in their benefit (Misconception #2).
The Value of an Itemizable Expense
Keep your eye on the Standard Deduction.
We have been trained correctly by society to be aware of the tax benefits of certain expenses, most notably property taxes, mortgage interest, and charitable contributions. However, often I find that the value of the deductible expense is overestimated by the tax filer. Below is an example to illustrate.
But first, a note on the Standard Deduction. The IRS gives a minimum tax deduction to individual U.S. tax filers: $24,400 for Married Filing Jointly, $12,200 for Individual or Married Filing Separately, $18,350 for Head of Household for tax year 2019. That is, a filer could have zero property tax paid, zero mortgage interest paid, zero charitable contributions, etc. and they would still be able to deduct the appropriate Standard Deduction from their Adjusted Gross Income (AGI) to arrive at a lower Taxable Income number.
Morgan is still a single filer. Morgan doesn’t own a home and the total of Morgan’s itemized deductions prior to charitable contributions is $4,000.
December arrives and Morgan has been approached by a good friend to contribute $5,000 to a great cause. Besides supporting the charity, the friend suggests that the contribution will be deductible and help lower Morgan’s tax bill. While supporting charities is a worthwhile endeavor without tax benefit, in this case the gift would provide no tax benefit to Morgan. Morgan’s total itemized deductions including the $5,000 charitable gift would be $9,000 which is less than the Standard Deduction of $12,200 for Individual filers. Morgan’s AGI will be lowered by the Standard Deduction of $12,200 unless the charitable contribution is $7,201 or greater.
Let’s assume Morgan is feeling generous and makes a cash gift of $10,000 to the charity. The larger gift takes Morgan’s total itemized deductions to $14,000, greater than the Standard Deduction of $12,200. The larger gift triggers itemization thus the gift will lower Morgan’s tax bill. However, in this case, the $10,000 gift lowers Morgan’s AGI by an additional $1,800 ($14,000-12,200).
Since Morgan is in the 24% Marginal Tax Bracket, the gift only provides an additional benefit to Morgan of $432 (24% x $1,800).
Of course, if Morgan had $13,000 in other itemized deductions and then made the $10,000 charitable gift, the tax savings caused by the contribution would be $2,400, the full 24%. Incurred itemizable expenses may have a far lower actual tax benefit than expected (Misconception #3).
The Tax Cuts and Jobs Act of 2017 (TCJA) considerably increased the Standard Deduction, starting in tax year 2018. Now more than ever, it’s important to be aware of the marginal impact of a deduction when judging the tax benefit of incurring certain expenses like a home purchase or charitable contribution. The TCJA also put a $10,000 cap on State and Local Tax (SALT) deductions, specifically property and sales taxes. This deduction capping paired with the higher Standard Deduction will make it difficult for many to benefit from itemization.
One strategy that is growing in popularity is Deduction Bunching (or Deduction Lumping). Deduction Bunching is the deliberate shift in the timing of certain deductible expenses so that more expenses are bunched together in the same tax year. Given the general inflexibility of mortgage payment timing and the new SALT cap, charitable contributions remain a primary tool for bunching.
Fortunately, cash contributions to charities are generally deductible up to 60% of AGI while contributions of appreciated assets like stock are deductible up to 30% of AGI. This generous cap will not be a limitation for most filers. Tax filers may want to consider making charitable contributions every other year, bunching two years’ worth of gifting in one tax year. Consult with your advisor to determine if this might help lower your tax bill.
It is important to note that above-the-line tax deductions don’t compete with the Standard Deduction; i.e., a filer will get benefit from HSA contributions, IRA contributions, and other above-the-line deductions even if they elect the Standard Deduction.
Even if you outsource your tax preparation to a tax professional, it will likely benefit you to understand the concepts underlying the three misconceptions above. In future posts, we’ll build on this article to discuss some next-level tax planning strategies.
Neither cSquared Wealth Advisors nor Sunbelt Securities offer tax or legal advice.