Most people are familiar with the concept of the progressive income tax system in the U.S. As your income goes higher, you pay a higher tax rate on your additional income.
Some people mistakenly think that getting a bonus that pushes them into a higher tax bracket will make them worse off than not getting the bonus. That’s not true because a higher tax rate isn’t imposed on the entire income. It only applies to the portion of the income that crosses the line and lands in the higher tax bracket. That’s why the phrase “tax bracket” in common parlance is really the marginal tax bracket. It applies to the income on the margin.
Marginal Tax Rate >= Tax Bracket
If you paid more attention to taxes, you would also know that your marginal tax rate isn’t necessarily those in the published tax brackets — 10%, 12%, 22%, 24%, 32%, etc. Other parts of the tax laws can give you a high marginal tax rate even when you don’t have a high income.
I showed this effect in Receive EITC, Contribute to Traditional 401k Not Roth 401k. People with a low enough gross income to qualify for the Earned Income Tax Credit (EITC) face a marginal tax rate as high as 41%. Mike Piper also explained this phenomenon well with more examples in his blog post Marginal Tax Rate: Not (Necessarily) The Same As Your Tax Bracket.
Some authors (not Mike Piper) use incendiary language and call it the tax torpedo, tax time bomb, etc., especially when it relates to taxation on retirement income such as Social Security income.
The Root Cause
An unusually high marginal tax rate at a modest income almost always results from losing some tax benefits as your income goes up. The additional income gets taxed at the normal rate but losing some other tax benefits at the same time compounds the effect.
For instance, if an additional $1,000 of income normally gets taxed at 12% but you also lose $300 in other tax benefits due to this higher income, your taxes will go up by $120 + $300 = $420. That’s a 42% marginal tax rate, not 12%. People caught by this are naturally upset. They say they’re paying a higher tax rate than the rich.
The thing is, when you have an unusually high marginal tax rate, you’re actually paying lower taxes than other people with the same income. In other words, the unusually high marginal tax rate is a blessing, not a curse.
Glass Half Full
You pay lower taxes than other people with the same income because when you’re losing some tax benefits, you have something to lose to begin with. As you lose some of those tax benefits, you still get to keep a part of them.
Income isn’t the only qualification criterion for tax benefits. Keeping some tax benefits makes you pay lower taxes than other people with the same income who aren’t eligible for those tax benefits for other reasons.
It’s a classic story of a glass half full or half empty. Losing some tax benefits gives you an unusually high marginal tax rate, bad! Keeping some tax benefits lowers your taxes, good! Should you lament the loss or savor the part that you keep?
Let’s look at some real-world examples.
Tax Credit Phaseout
The American Opportunity Credit is a tax credit for people paying college expenses. The maximum credit is $2,500 per student. For a married couple in a specific range of income, they lose $125 per student for every additional $1,000 of income. People with income below the phaseout range get the maximum credit. People with income above the phaseout range get nothing.
Suppose a married couple has two kids going to college in the same year. They would normally qualify for a $5,000 tax credit but they lose $3,000 of it because their income is in the phaseout range.
Their marginal tax rate is the normal rate from their tax bracket plus 25% but they still receive a $2,000 tax credit after losing $3,000. They pay $2,000 less in federal taxes than another couple with the same income whose kids don’t go to college. Higher marginal tax rate, yes, but lower total taxes in dollars. Getting a tax credit when your kids go to college (and presumably will have a better future) is great.
A similar effect exists in many other tax credits and deductions with an income phaseout, such as the child tax credit, the child and dependent care credit, the earned income credit, the saver’s credit, the student loan interest deduction, and so on. In each case, a higher marginal tax rate from losing some tax credits and deductions means lower taxes compared to others with the same income who don’t qualify for those credits or deductions due to other reasons.
Dividends and Capital Gains Bump Zone
Michael Kites wrote about a “bump zone” in his blog post Navigating The Capital Gains Bump Zone: When Ordinary Income Crowds Out Favorable Capital Gains Rates. This happens when a part of your qualified dividends and long-term capital gains is taxed at 0% and the remaining part is taxed at 15%, as shown in this chart below:
The red line in the chart represents the cutoff point for the 0% rate on qualified dividends and long-term capital gains. It doesn’t move. The space below the red line is shared between ordinary income and qualified dividends and long-term capital gains taxed at 0%. As the ordinary income (the yellow part) expands, the qualified dividends and long-term capital gains (the blue part) are pushed upward by the same amount.
Any additional ordinary income will be taxed at the normal tax rate in addition to bumping an equal amount of the qualified dividends and long-term capital gains out of the 0% rate into the 15% rate. The combined effect is that the additional ordinary income is taxed at 25% or 27% instead of 10% or 12%.
Suppose a married couple has $40,000 of income taxed at ordinary rates plus $60,000 in qualified dividends and long-term capital gains. If they withdraw an additional $1,000 from their Traditional IRA, it’s taxed at 12% but it also bumps $1,000 of their qualified dividends and long-term capital gains out of the 0% rate to the 15% rate. Their marginal tax rate on this $1,000 of additional income is 12% + 15% = 27%.
Compare that to another couple with $90,000 of income taxed at ordinary rates and $10,000 in qualified dividends and long-term capital gains. If they receive an additional $1,000 in ordinary income, it’s taxed at 22% with no bumping effect because all of their qualified dividends and long-term capital gains are already taxed at 15%.
Both couples have the same total taxable income of $100,000. Although the first couple’s 27% marginal tax rate is higher than the second couple’s 22%, the first couple pays a much lower amount of total taxes in dollars because a big part of their income is still taxed at 0% after a small part is bumped out to 15%.
Again, a higher marginal tax rate means lower total taxes at the same income.
“Tax Torpedo” on Social Security Benefits
Retirees don’t pay federal income tax on their Social Security benefits when their income is low. As their income goes up and crosses a threshold, they start paying taxes on a part of their Social Security benefits. This works similarly to the bumping effect in the previous section on qualified dividends and long-term capital gains. Additional income is taxed at the normal rate plus it bumps another amount of the Social Security benefits out of the 0% rate.
It’s a little different than the dividends and capital gains bump zone in two ways:
1. The bump isn’t dollar-for-dollar. Each dollar of additional income only bumps 50 cents or 85 cents of Social Security benefits out of the 0% rate.
2. Social Security benefits can never be completely bumped out of the 0% rate. The maximum amount of the Social Security benefits that can be taxed is 85% of the benefits. The bumping ends when the maximum amount of the Social Security benefits that can be taxed is already taxed. At least 15% of the benefits will stay tax-free even if your income is $1 million a year.
The effect of this bumping is that for some Social Security recipients in a narrow range of income, their marginal tax rate on additional income is 1.5x or 1.85x of the normal rate. Some people call this the tax torpedo.
Suppose a married couple has $30,000 of income taxed at ordinary rates plus $50,000 in Social Security benefits. If they get another $1,000 from interest on their savings account, this $1,000 is taxed at 12% but it also makes another $850 of their Social Security benefits taxable. Their marginal tax rate on this $1,000 is 12% * 1.85 = 22.2% because they’re being “tax-torpedoed.”
Compare that to another couple with $80,000 of income taxed at ordinary rates who are not receiving Social Security benefits. If they get the same additional $1,000 from interest on their savings account, it’s taxed at 12% with no torpedoes.
Both couples have the same total income. Although the first couple’s 22.2% marginal tax rate is higher than the second couple’s 12%, the first couple pays a lower amount of total taxes in dollars. After taking on all the torpedoes, a part of their income stays tax-free.
Knowing your marginal tax rate is important for tax planning on things to do on the margin — making Traditional vs. Roth contributions, realizing capital gains, Roth conversions, etc. — but having an unusually high marginal tax rate doesn’t mean you’re paying high taxes. You’re not being penalized. You’re actually rewarded with paying lower taxes.
If you see people trying to rile you up by pointing to an unusually high marginal tax rate, they’re either misinformed or trying to mislead. What matters to your bottom line is the total amount of taxes you pay in dollars. We spend total after-tax dollars, not marginal tax rates. An unusually high marginal tax rate coupled with low total taxes in dollars sure beats a low marginal tax rate coupled with high total taxes in dollars.
If you find yourself with an unusually high marginal tax rate, don’t dread it. Celebrate. It means you’re paying lower taxes than other people with the same income. It also gives you bigger incentives to lower your taxable income and lower your taxes even further. You get much higher tax savings from your pre-tax contributions. Doing less work for a better work-life balance costs you less in after-tax income. It’s a great position to be in.
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