Fun With Marginal Tax Rates

If your income increases by $1000, is that the end of the story? Does it matter where the $1000 comes from? Does it matter who you are and where you live? (No, Yes, Yes)

Everybody(?) knows that your marginal tax rate depends on your income level. Let's see if the same income level produces the same marginal tax rates.

To simplify things, we will ignore things like payroll taxes and itemized deductions, etc. In fact, we will assume a single, retired individual with with $45,000 in pretax ordinary income who lives in Massachusetts.

First, assume that all $45,000 comes from taxable distributions from a traditional IRA. The results would be the same for any combination of $45,000 in Roth conversions or private pensions or part time work (ignoring any payroll tax).

If we add an additional $1000 in income from various sources, at what marginal tax rate (Federal and State) is it taxed? All results provided by TurboTax for TY2005.

If we just increase the IRA distribution (or part time work, etc.) by $1000, the total marginal rate is 30.3% (25% + 5.3%)

If instead we add $1000 of Social Security benefit, the TMR is 21.3% (21.3% + 0%).

A $1000 Long Term Capital Gain gives a TMR of 20.3% (15% + 5.3%).

A $1000 Short Term Capital Gain gives a TMR of 37.0% (25% + 12%)

So we see a TMR range of 20.3% to 37%.

Now let's take Social Security at its word and provide one third of the $45,000 in SS payments, or $15,000, so that the total is still $45,000.

If we just increase the IRA distribution (or part time work, etc.) by $1000, the total marginal rate is 47.3% (42% + 5.3%).

If instead we add $1000 of Social Security benefit, the TMR is 7% (7% + 0%).

A $1000 Long Term Capital Gain gives a TMR of 37.3% (32% + 5.3%).

A $1000 Short Term Capital Gain gives a TMR of 54% (42% + 12%)

So we see a TMR range of 7% to 54% when one third of the $45,000 is provided by SS.

If there was any doubt that one of the purposes of Social Security was to keep retirees from stealing jobs from younger workers, the 47.3% total marginal rate helps to remove it.

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A lot of work went into

A lot of work went into this, but I am not sure how you reached your conclusions. Maybe if you reposted it with better section and subsection labels, it would be a little clearer.

In either of the two base cases, why does the base tax rate change given the different instances of the incremental $1000? Shouldn't the base tax rate stay the same and only the incremental $1000 have different tax rates?

This is a entirely different topic, but isn't something like your first $25,000 of SSI taxed at regular income rates and everything after that taxed at 85%? This is regardless of alternative income.

For me, I am planning my finances on the belief that, sometime in the future, SSI will be taxed at 100% for retirees who have alternative income over a certain amount like $50,000. Despite being forced to contribute will young and working they will be considered "too rich" for SSI when they retire.

Patinator, ...but I am not

Patinator,

...but I am not sure how you reached your conclusions....

All of the numbers come from TurboTax for TY2005.

The only thing that is clear is that 99.999% of the population has no idea how SS payments are taxed, or worse, they believe the words provided on the subject. I don't know either, but some things have emerged.

If your only income is SS, you'd have to reach over $50K (single) to incur any tax at all. I'm not sure, but I don't think that anyone currently comes close to this under normal conditions. I believe that a new full term retiree cannot have earned payments more than about $2000 per month.

The problem occurs when you have other taxable income in addition. At first, SS increases the effective marginal rate on the other income by 50%, i.e. a 10% rate becomes 15%, a 15% rate becomes 22.5%, etc. However, soon, the rate is multiplied by a factor of 1.85X, nearly a double. At some level, the effect of SS has been completely phased out, and marginal rates return to normal.

There's still a lot of room for explanation and interpretation.

Regards, Don

Don, I understood where the

Don,

I understood where the data came from although the figures in paranthases are confusing. I am a long term capital gain kind of guy so I recognize the 15%, but I thought 30% was the short term tax rate. I have no clue where the 5.3% or 12% came from. 50% of 15% and 30% are 7.5% and 15% (although 12.5%, which is close to your 12%, does equal 50% of 25%). Not trying to be a pest, this is good stuff and I am just trying to get a handle on the numbers.

Patinator, I understood

Patinator,

I understood where the data came from although the figures in paranthases are confusing. I am a long term capital gain kind of guy so I recognize the 15%, but I thought 30% was the short term tax rate. I have no clue where the 5.3% or 12% came from. 50% of 15% and 30% are 7.5% and 15% (although 12.5%, which is close to your 12%, does equal 50% of 25%). Not trying to be a pest, this is good stuff and I am just trying to get a handle on the numbers.

I could hardly consider the lone commentor a pest.

The figures in parentheses are the (Federal + Mass State) marginal rates that add up to the total rate. All Mass. income is taxed at 5.3% except for 12% for short term capital gsains and maybe some other things. Dividends used to be taxed at 12% up to a few years ago.

Regards, Don

Got it. I can't believe

Got it. I can't believe short term capital gains are taxed at the STATE level too!

Now, why do the rates jump from 15% to 32% and from 25% to 42%? The multiples do not seem to work.

Patinator, Now, why do the

Patinator,

Now, why do the rates jump from 15% to 32% and from 25% to 42%? The multiples do not seem to work.

I can't give you a specific answer, but both the IRS and SS have a number of threshold levels at which rates change. I presume that a given level of taxable income in general includes both above and below threshold amounts, and results in somewhat blended rates.

Regards, Don

Don, Generally the

Don,

Generally the observations are valid and point out the quirkiness of the tax code. The percentage of Social security benefit that is taxed changes quickly for broad combinations of SS benefit and other income. An extra dollar of income can result in an additional 85 cents of SS being taxed. So if you are in the 25% tax bracket, you will pay 46 cents of the extra dollar to the IRS – 25 cents on the dollar of income and 21 cents on the additional SS that is taxed (25% of 85 cents).

What numbers did you use for deductions and exemptions? I do not get your exact numbers with my excel functions at www.geocities.com/earlyoutdh. The exact numbers for the marginal tax rates depend on the exemptions and deductions for the particular tax situation being considered. I used $9450 which is the 2005 number for a single taxpayer over 65 taking the the standard deduction who is not blind.

I was a bit confused at first by your terminology. Marginal tax rate usually refers to the rate on the next dollar of income. I understand now that you are using the term "total marginal rate" as the tax rate on the extra $1000 that you are adding in the different scenarios.

Zack, Thanks. What numbers

Zack,

Thanks.

What numbers did you use for deductions and exemptions? I do not get your exact numbers with my excel functions at www.geocities.com/earlyoutdh. The exact numbers for the marginal tax rates depend on the exemptions and deductions for the particular tax situation being considered. I used $9450 which is the 2005 number for a single taxpayer over 65 taking the the standard deduction who is not blind.

I just took the 2005 defaults for single, under 65. My memory is that the total was $8200, but that may or may not be true.

If you see this, please acknowledge with another comment.
If you don't, I'll put something on the Fairmark forum.

Regards, Don

PS This isn't really the whole story as the amount of SS paid will also get reduced directly somehow. Can you precisely express in words the entire interaction between SS and other income, just for single for simplicity?

Don, I don't think there is

Don,

I don't think there is a simple explanation for taxable SS.

For a single individual the first test is whether or not 50% of SS plus other income is over $25000. If so, then some of the SS is taxed. When the total of 50% of SS and other income exceeds $34000, a different algorithm is used to determine how much of the SS is taxable.

A. If the total of 50% of SS plus other income is less than $25000 then none of the SS is taxed.

B. If the total of 50% of SS plus other income is more than $25000, and less then $34000, then the amount of SS that is taxed is the lesser of 1/2 of the amount this total exceeds $25000 or 1/2 of the SS benefit.

C. If the total of 50% of SS plus other income is more than $34000, then the amount of SS that is taxed is the lesser of: 1)85% of the SS benefit, or 2)85% of the amount by which the total exceed $34000 plus the lesser of: a) 50% of SS, or b) 4500. (4500 comes from 1/2 of 34000 - 25000).

Have fun.

Zack, Thanks. It's going to

Zack,

Thanks.

It's going to take a while to untwist my neck, if my head hasn't already become unscrewed completely.

Regards, Don