Tax rates visualized, and basics of income tax management

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Tax rates visualized, and basics of income tax management

Postby dailybagel » Sun Dec 30, 2012 9:28 am

One of the key parameters we ask people to supply when asking portfolio questions is their marginal tax rate.

I am an unmarried young person who has just started my first "real job," and accordingly have been diving deep into income taxes. Here is what I've learned -- I've tried to summarize things that would be important/applicable to an ordinary person, or at least an ordinary Boglehead who doesn't know much about taxes.

EDIT: If I've made any mistakes, or if you have other "basic" tax strategies, please reply! I did not include information about capital gains management (loss/gain harvesting), since I feel that is well covered on the forums.

The figures below show the marginal tax rates and average tax rates for an unmarried person, under 65 years of age, with no dependents, as a function of adjusted gross income (AGI). They were prepared after a quick review of the 2012 IRS form 1040 and a tax table for 2012.

As a reminder, AGI = W-2 wages + (other income) - (trad. IRA deduction) - (student loan interest deduction),
where (other income) consists, generally speaking, of interest earned; alimony received; non-qualified dividends; capital gains distributions; rent received; taxable social security benefits; IRA and pension distributions; unemployment compensation; etc. Note that traditional 401(k) contributions reduce W-2 wages.

The following assumptions and calculation methods were used:
a. The taxpayer is unmarried, younger than age 65, and not blind.
b. The taxpayer has no dependents and takes a standard deduction, so that
taxable income is AGI less standard deduction less one exemption amount.
c. The calculations do not consider any "phaseouts," since those would affect AGI directly.

In my mind, the biggest takeaway from these figures and is this:
It makes a big difference to keep AGI below $45,100, and therefore in the 15% tax bracket. There is a smaller marginal rate increase at $95,400, from 25% to 28%.

In addition, the average tax rate (taxes paid divided by gross income) for most individuals in the United States is between 5 and 20%, assuming that AGI is approximately equal to gross income for many Americans.

Finally, a person can minimize their taxes by reducing their AGI and their taxable income, as discussed below.
A. Given a certain amount of gross income, minimizing AGI can save some serious money, especially in upper tax brackets. For a person who is not self employed, the way to do this is to reduce W-2 income, or increase the deductions on Form 1040.
    a. Contribute to a traditional 401(k), 403(b), TSP, or similar plan. Up to $17,000.
    b. Contribute to a traditional IRA. Up to $5000.
    c. Use a Flexible Spending Account (FSA) for healthcare expenses or childcare. Up to $2,500 for medical expenses, $5,000 for dependent care.
    e. Use a Health Savings Account if you have a high-deductible healthcare plan. Up to $3100.
    f. Use a pre-tax spending account for commuting expenses (requires employer cooperation). Up to $1500.

B. Along with minimizing AGI, it's desireable to reduce taxable income as far as possible with itemized deductions, if the sum of these exceeds the standard deduction ($5950 for a single person). These include:
    i. Unreimbursed medical and dental expenses, in excess of 7.5% of AGI.
    ii. Interest paid on home mortgages and investments.
    iii. Taxes paid to state and local governments.
    iii. Charitable gifts.
    iv. Work-related expenses in excess of 2% of AGI.

I. Focused income range
Image
Last edited by dailybagel on Sun Dec 30, 2012 10:15 am, edited 1 time in total.
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Re: Tax rates visualized, and basics of income tax managemen

Postby livesoft » Sun Dec 30, 2012 9:45 am

It's great that you are working to understand this for yourself. I have a few comments.

I wonder if the average federal income tax rate paid by individuals is really as high as you mentioned, since so many folks do not have to pay income taxes, but maybe my perception is skewed since I usually use families and not individuals as examples.

Yesterday I showed how a family making $100,000 actually could pay no income taxes and get $500 back from the government. Are there any things like that for individuals?
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Tax rates visualized, and basics of income tax managemen

Postby Sidney » Sun Dec 30, 2012 9:47 am

Tables are interesting data but to really know your true marginal rate you have to do a return. With various interactions and phase-ins and outs, the tables are not always telling you what you need to know to make decisions.
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Re: Tax rates visualized, and basics of income tax managemen

Postby Bob's not my name » Sun Dec 30, 2012 9:50 am

dailybagel wrote:c. The calculations do not consider any "phaseouts," since those would affect AGI directly.
Not sure what this means. Phaseouts don't affect AGI. AGI affects phaseouts. To obtain an accurate graph you need to take credits into account, and make your y-axes both go negative. Credits and their phaseouts increase marginal rates and decrease average rates; both effects can be significant -- in fact, in many instances they dominate nominal marginal rate effects and average tax rate, so in a way you're graphing the unimportant part of the tax code.

Oh, and at the upper end of your graph you're in AMT territory, where the marginal rate is 32.5% ... or maybe not so upper end, since there still isn't a 2012 AMT patch.

Good luck with your 2013 graph :D
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Re: Tax rates visualized, and basics of income tax managemen

Postby Bob's not my name » Sun Dec 30, 2012 10:07 am

By the way, I prepare the tax returns of a single person who lies at the bottom right hand corner of your graph.
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Re: Tax rates visualized, and basics of income tax managemen

Postby dailybagel » Sun Dec 30, 2012 10:13 am

By popular demand, here is the same graph covering a larger income range, and showing more "break points."

As not-Bob has pointed out, this graph may be less realistic, as upper-income taxpayers may have itemized deductions that exceed the standard deduction. Furthermore these plots do not consider the AMT.

II. Extended Income Range
Image
Last edited by dailybagel on Sun Dec 30, 2012 10:16 am, edited 1 time in total.
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Re: Tax rates visualized, and basics of income tax managemen

Postby dailybagel » Sun Dec 30, 2012 10:15 am

Bob's not my name wrote:
dailybagel wrote:c. The calculations do not consider any "phaseouts," since those would affect AGI directly.
Not sure what this means. Phaseouts don't affect AGI. AGI affects phaseouts. To obtain an accurate graph you need to take credits into account, and make your y-axes both go negative. Credits and their phaseouts increase marginal rates and decrease average rates; both effects can be significant -- in fact, in many instances they dominate nominal marginal rate effects and average tax rate, so in a way you're graphing the unimportant part of the tax code.


This is a fair point, thank you very much. What I was thinking of was the IRA deductability phaseout, which changes form 1040 line 32, and thereby changes AGI. I'm sure there are other phaseouts for deductions that could make an individual's marginal rate higher.
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Re: Tax rates visualized, and basics of income tax managemen

Postby livesoft » Sun Dec 30, 2012 10:19 am

There are tax statistics available which show filing status, AGI, taxes paid, etc. It would be interesting to see if reality matches what you have graphed. My perception is that the average tax rate (red lines) are really about half of what you have shown.

Here's a link to 2008 data: http://www.irs.gov/pub/irs-soi/08inreturnsbul.pdf and lots more:
http://www.irs.gov/uac/SOI-Tax-Stats-In ... Statistics
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Tax rates visualized, and basics of income tax managemen

Postby dailybagel » Sun Dec 30, 2012 10:26 am

livesoft wrote:There are tax statistics available which show filing status, AGI, taxes paid, etc. It would be interesting to see if reality matches what you have graphed. My perception is that the average tax rate (red lines) are really about half of what you have shown.

Here's a link to 2008 data: http://www.irs.gov/pub/irs-soi/08inreturnsbul.pdf and lots more:
http://www.irs.gov/uac/SOI-Tax-Stats-In ... Statistics


I haven't had a chance to look at the links you showed, but I think I should have been more precise about my supposition.

I should have said, Among those individuals who file an income tax return (i.e. among tax units who are unmarried), I would bet the average tax rate is between 5 and 20%. I am assuming that since the average savings rate is pretty low, probably less than 5% for these tax units, that AGI is approximately equal to gross income.

If the above statistic includes, for example, retired persons whose only income is social security, and who pay very low or no income taxes, then they would shift the average.
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Re: Tax rates visualized, and basics of income tax managemen

Postby Default User BR » Sun Dec 30, 2012 12:53 pm

dailybagel wrote:The figures below show the marginal tax rates and average tax rates for an unmarried person, under 65 years of age, with no dependents, as a function of adjusted gross income (AGI).

Why? It's taxable income that determines the tax paid and the marginal bracket. AGI is only the starting point for computing taxable income.


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Re: Tax rates visualized, and basics of income tax managemen

Postby Browser » Sun Dec 30, 2012 1:08 pm

Marginal rates are in flux- for example, the 10% bracket will go away and the marginal rates are all increased if the Bush tax cuts are allowed to expire. Stay tuned...
If we have data, let’s look at data. If all we have are opinions, let’s go with mine. – Jim Barksdale
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Re: Tax rates visualized, and basics of income tax managemen

Postby Bob's not my name » Sun Dec 30, 2012 4:39 pm

Default User BR wrote:
dailybagel wrote:The figures below show the marginal tax rates and average tax rates for an unmarried person, under 65 years of age, with no dependents, as a function of adjusted gross income (AGI).
Why? It's taxable income that determines the tax paid and the marginal bracket.
Per above, AGI often has a larger direct impact on marginal rate than taxable income (aka AGI indirect impact). And I think dailybagel was pretty clear that he wanted to correlate taxes to AGI, with AGI being a closer approximation of gross income than is taxable income, at least over the lower income ranges. The public is constantly flummoxed by the press's willful conflation of the three, so I think correlating average tax rate to AGI is useful. Furthermore, using AGI allows the model to be extended to included credit phaseouts, though that hasn't been done here.
Browser wrote:Marginal rates are in flux- for example, the 10% bracket will go away and the marginal rates are all increased if the Bush tax cuts are allowed to expire. Stay tuned...
Not everybody's marginal rate will go up. The core middle class will still be in the 15% bracket. A family in the child tax credit phaseout would see its marginal rate change from 30% to 30.5%, almost flat. A widowed mother in the AOTC phaseout could see her marginal rate drop from 100% to 28%. A family in the AMT might also see no change in marginal rate. Wealthy elderly people in nursing care will still be in the 0% bracket. It's not a fiscal cliff, it's a fiscal bluff.
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Re: Tax rates visualized, and basics of income tax managemen

Postby Browser » Sun Dec 30, 2012 5:02 pm

Not everybody's marginal rate will go up. The core middle class will still be in the 15% bracket. A family in the child tax credit phaseout would see its marginal rate change from 30% to 30.5%, almost flat. A widowed mother in the AOTC phaseout could see her marginal rate drop from 100% to 28%. A family in the AMT might also see no change in marginal rate. Wealthy elderly people in nursing care will still be in the 0% bracket. It's not a fiscal cliff, it's a fiscal bluff.

You didn't think this through. Since the 10% marginal rate goes away, the effective tax rate for all taxpayers in the current 10% and higher brackets goes up. For single taxpayers, the first $8,700 is now taxed at 10% and for married taxpayers it is the first $17,400. That means that a single taxpayer would have $435 added to his tax bill and joint taxpayers would have $870 added. Actually, married couples filing jointly would have a higher tax increase than this because the standard deduction for married couples will fall, no longer double what it is for single filers; and the ceiling of the 15% bracket for married couples will fall, no longer double what it is for single filers
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Re: Tax rates visualized, and basics of income tax managemen

Postby Bob's not my name » Sun Dec 30, 2012 5:13 pm

So you're conflating marginal rate with average rate, just like the press?
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Re: Tax rates visualized, and basics of income tax managemen

Postby Sidney » Sun Dec 30, 2012 5:34 pm

Bob's not my name wrote:So you're conflating marginal rate with average rate, just like the press?
and neither should be conflated with the brackets.
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Re: Tax rates visualized, and basics of income tax managemen

Postby jebmke » Sun Dec 30, 2012 5:36 pm

Sidney wrote:
Bob's not my name wrote:So you're conflating marginal rate with average rate, just like the press?
and neither should be conflated with the brackets.

very true. My state brackets progress like most ... in a progressive increase topping out at ~ 8%. But depending on your other inputs on the return the marginal rate can exceed 100% at the state level.
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Re: Tax rates visualized, and basics of income tax managemen

Postby dailybagel » Tue Jan 01, 2013 11:21 am

Default User BR wrote:Why? It's taxable income that determines the tax paid and the marginal bracket. AGI is only the starting point for computing taxable income.
Brian


Yes, graphing that would involve fewer assumptions, but would basically be graphing the tax tables.

I wanted to create something a little more informative, to help answer the question: "With my gross income, what is my marginal tax rate, and can I reach a lower marginal rate by making 401(k) or similar contributions?" of course, this question should be qualified, "...given that I am single with no dependents and taking the standard deduction."
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