70% marginal tax rate !?!

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curmudgeon
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70% marginal tax rate !?!

Post by curmudgeon »

OK, I exaggerate. It's only 69.05% Still hard to stomach working for 31 cents on the dollar.

The tax code has so many pitfalls and snares for the unwary that I never trust the concept of tax brackets to truly show the impact of additional earnings or deductions. Instead, I take my tax software (turbotax in this case) and generate dummy tax returns for potential income scenarios in the coming year; putting in a guesstimate of the values, and then bumping up various categories by $1000 to see the marginal impacts. Doing a projection for 2017 (using 2016 turbotax) was unnerving.

The baseline scenario is that I expect to retire in another few weeks (after filling up 401K for this year). My boss would really like me to stretch this out by another month or two. As part of my retirement plans, I want to reduce my concentrated position in silicon valley real estate, by selling a rental property which will generate about $400K in long-term capital gains and depreciation recapture. Plug this into turbotax, along with the various deductions for taxes, mortgage etc, and going from $30K to $31K of earned income, I find that I'm at 50.6% marginal fed income tax and 9.9% CA. On top of that I would have 7.65% FICA and .9% CA disability tax. Now, this tax rate doesn't stretch on indefinitely, after about $75K of earned income the marginal rate drops back down to around 55%, and later on it is even lower, but that is a good sized chunk of very poor net earnings for additional work.

I had a hard time believing the numbers, so I had to dig a while to understand how this came to be. It is a nasty combination of ACA, AMT, Pease/PEP, and bracket displacement. The earned income displaces LTCG/qualified dividends out of the 0% bracket and into 15/20%+ACA zone, while at the same time being taxed itself at AMT+phaseouts. Then add CA and payroll taxes, and 69% is gone from every additional dollar I earn.

Not being a very happy camper about this, I have to put my livesoft hat on and think of alternatives. One option is to do a 1031 exchange from the rental property - but while that would solve the immediate tax problem, it would just shuffle around the real estate concentration, not really solve it. Another option (with some off-topic complications) would be to sell our primary residence, downsize move to the rental. We pocket ~$500K tax free gains, reduce our RE exposure, pay zero income tax (though 8.5% payroll tax), snag about $8K of ACA subsidies instead of paying COBRA, and maybe even get some "savers credit" as well for doing some IRA or Roth contributions. I think I can actually get a negative effective tax rate for the year. The taxes on the rental property are deferred, not eliminated, but there are ways to ease that impact over time.
Novine
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Re: 70% marginal tax rate !?!

Post by Novine »

"The earned income displaces LTCG/qualified dividends out of the 0% bracket and into 15/20%+ACA zone, while at the same time being taxed itself at AMT+phaseouts. Then add CA and payroll taxes, and 69% is gone from every additional dollar I earn. "

Can you show the breakdown of the various taxes on the earned income piece?
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curmudgeon
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Re: 70% marginal tax rate !?!

Post by curmudgeon »

Novine wrote:"The earned income displaces LTCG/qualified dividends out of the 0% bracket and into 15/20%+ACA zone, while at the same time being taxed itself at AMT+phaseouts. Then add CA and payroll taxes, and 69% is gone from every additional dollar I earn. "

Can you show the breakdown of the various taxes on the earned income piece?
I think the really ugly stuff is happening down in the schedule D calculations. I will have to spend some time with them to tease it all out. Long term capital gains (and qualified dividends) is taxed at 0% for the first $75K of income (MFJ), and 15% for $75K to $467K (plus 3.8% ACA tax over $250K). If you have earned income, it displaces the 0% zone for your cap gains, but the tax rate on the earned income is based on the total income after the cap gains. It's a bit like the high marginal zone that comes where social security starts going from untaxed to taxed. So $10K of additional earned income is itself taxed at 31.4%, but it also causes $10K of the cap gains to go from 0% to 18.8% at the same time. Net effect is 50.5% marginal federal income tax, plus 9.9% marginal state tax and 8.6% marginal payroll tax.
Tanelorn
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Re: 70% marginal tax rate !?!

Post by Tanelorn »

Dang. I've seen some high marginal tax scenarios (around 60%), but you've got them beat by a fair bit. Sorry for your situation and best of luck planning around it. It seems like the government really doesn't want you to work, or at least that you should sell your home instead of your investment property? :confused
inbox788
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Re: 70% marginal tax rate !?!

Post by inbox788 »

curmudgeon wrote:Net effect is 50.5% marginal federal income tax, plus 9.9% marginal state tax and 8.6% marginal payroll tax.
Have you looked at purchasing power with taxable goods? How much income do you need to buy a $100 item? I just realized that sales tax is paid for with after tax dollars!?! Is $300 enough? About $150 fed tax, $30 state, $27 payroll only leaves $93. Not even enough for the item. Need about $350 if these numbers are correct.
itstoomuch
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Re: 70% marginal tax rate !?!

Post by itstoomuch »

Take loans on primary and rentals. Essentially you are selling the RE to yourself.
Take loan money and invest some in GLWB annuity (low cost but with the LI), bonds, and equity.
You will be taking a discount hit but not the capital gains tax hit. ?

Sell but you finance the purchase (hold the loan and take payments). ?

I may be wrong :oops: .
Rev012718; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax TBT%. Early SS. FundRatio (FR) >1.1 67/70yo
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Ethelred
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Re: 70% marginal tax rate !?!

Post by Ethelred »

Ouch!

Our marginal rate is pretty heavy because we're at the worst point for AMT, but we have the luxury that Texas has no state income tax. Our property tax and sales tax are relatively low because we choose to live in a house that's still nice, but far cheaper than what we could afford if we wanted to.

One thing to consider would be to take significantly more income or cap gains in 2017 to get into the AMT sweet spot. Where that would leave your state income tax, though, I don't know.
niceguy7376
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Re: 70% marginal tax rate !?!

Post by niceguy7376 »

so what are the different incomes and cap gains u r looking at?
income from job of 30 to 31k
ltcg of 400k?
rental property gains and depr capture of another 400k?
what else?
btenny
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Re: 70% marginal tax rate !?!

Post by btenny »

You might look into installment sales for the rental property. It can reduce your income tax bill a lot and give you enough money to diversify and use other places. It also beats moving back into your rental house. See below.

https://www.google.com/webhp?sourceid=c ... eal+estate


Good Luck.
mouses
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Re: 70% marginal tax rate !?!

Post by mouses »

curmudgeon wrote: As part of my retirement plans, I want to reduce my concentrated position in silicon valley real estate, by selling a rental property which will generate about $400K in long-term capital gains and depreciation recapture. Plug this into turbotax, along with the various deductions for taxes, mortgage etc, and going from $30K to $31K of earned income, I find that I'm at 50.6% marginal fed income tax and 9.9% CA. On top of that I would have 7.65% FICA and .9% CA disability tax. Now, this tax rate doesn't stretch on indefinitely, after about $75K of earned income the marginal rate drops back down to around 55%, and later on it is even lower, but that is a good sized chunk of very poor net earnings for additional work.
I didn't attempt to follow all this, as you're in an area of taxes I have little experience with, but off the top of the head comments:

Your FICA and CA disability tax only come out of your small month or two earned income this year. Also, why are you talking about $75K of earned income when yours will be $30-31K. No one is forcing you to work that extra month or two.

A little looking on the web says the capital gains tax on selling rental property is 20% with some handwaving about depreciation.

I am not sure your number crunching is correct.

A marginal tax rate is an income tax rate. You are loading up the cart with FICA, disability, I'm surprised you didn't put sales tax and property tax in there Maybe I missed those.
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Epsilon Delta
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Re: 70% marginal tax rate !?!

Post by Epsilon Delta »

It would be interesting to know how wide the 70% marginal band is. Have you tried adding $2,000, $3,000, $10,000 ... of wages?

It doesn't help with your particular situation but it may put things into perspective. There are plenty of cliffs in the tax code that have well over 100% marginal rates for small increments of income. (If you're using the tax tables every 5,000th penny gets taxed at something like 75,000% :twisted: )
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grabiner
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Re: 70% marginal tax rate !?!

Post by grabiner »

curmudgeon wrote:I had a hard time believing the numbers, so I had to dig a while to understand how this came to be. It is a nasty combination of ACA, AMT, Pease/PEP, and bracket displacement. The earned income displaces LTCG/qualified dividends out of the 0% bracket and into 15/20%+ACA zone, while at the same time being taxed itself at AMT+phaseouts.
You can't be subject to both AMT and Pease/PEP; AMT has a different phase-out for personal exemptions.

If your qualified dividends and long-term gains use up the entire 25%-35% brackets, and you are subject to AMT, then $1 of earned income is taxed at 26% under AMT, and it pushes $1 of long-term gains into the 20% tax rate, for an overall tax rate of 46% plus 3.8% ACA surtax, which is 49.8%.
Then add CA and payroll taxes, and 69% is gone from every additional dollar I earn.
I wouldn't count federal payroll tax as a negative, since you will get the money back in increased Social Security benefits; this is close to break-even. Still, this gives a tax rate of 49.8% federal plus 0.9% CA disability plus 9.9% CA regular tax, a net of 60.6%.
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Novine
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Re: 70% marginal tax rate !?!

Post by Novine »

Perhaps this is semantics but I don't think it's accurate to claim that the earned income is being taxed at 70%. If the marginal rate is the combination of both the rate on earned income and on long-term gains, how does the percentage get allocated to the earned income? Absent the long-term gains, the percentages would be much lower.
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curmudgeon
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Re: 70% marginal tax rate !?!

Post by curmudgeon »

A few more thoughts. It's actually pretty easy to see this using a somewhat simpler scenario using one of the tax calculators without getting into all the details of depreciation recapture and such. The TaxAct calculator is pretty easy to use.
https://www.taxact.com/tools/tax-calculator.asp

A couple, filing jointly, starting with $30K of wage income, $10K of (qualified) dividend income, $400K of long-term cap gains, $20K of taxes paid, $10K of mortgage interest. Fed tax comes out at $58,625. Then bump up the wage income to $100K. The tax is $95, 537. The fed income tax is $36,912 more for $70K more of earned income, or 52.7%. Add CA and payroll taxes, and you are at 71.1% of everything you earn from working a few more months.

Getting back benefits from the SS tax is a nice theory, though my understanding is that the courts have held that you are not actually guaranteed any benefit in return for your SS taxes. And in my case, I already have 35 max years, so even under the current benefit model, the return on my additional SS tax is essentially zero. I could consider the state disability tax as offering a real benefit, though that fund has been raided by the legislature to the point that the potential benefit bears little relationship to the tax I pay.

I have considered doing an installment sale to spread out the capital gains hit. There are several serious problems with this, however. It would seriously mess with the marketability of selling a SFR around here because of the complications it creates for the buyer. If 90% of the potential buyers are scared off by the installment sale, I will seriously lose on the sale price. California requires that the buyer do a withholding on every payment and send it to the state! And I presumably end up with my money tied up in a 30-year note or sales contract. It would be very hard for a typical buyer to spread payments over 5 years, for example.

Bottom line, I don't intend to work for 30 cents on the dollar, so I will either quit sooner than I had planned, or use one of the other options to reduce the tax hit. It's by no means a disaster, and I have benefited significantly from my RE exposure, but it is just unfortunate to hit such a strong disincentive to work this year.
Tanelorn
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Re: 70% marginal tax rate !?!

Post by Tanelorn »

Is there a way for you to negotiate with your boss to be paid differently? Like in an extra employer contribution to your 401k or to be paid on next year's payroll instead of this year?
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curmudgeon
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Re: 70% marginal tax rate !?!

Post by curmudgeon »

Tanelorn wrote:Is there a way for you to negotiate with your boss to be paid differently? Like in an extra employer contribution to your 401k or to be paid on next year's payroll instead of this year?
The work side is an inflexible megacorp. Not much to be done there. I'm maxing the 401K and HSA, but that is about all I can do to reduce the impact there.

I can put off the sale of the rental house until next year, but I'd really like to de-risk and deleverage for retirement. Concentration and (mild) leverage have paid off pretty well for me, but there comes a time to step back.

Doing a sale of our primary residence this year is ideal from a tax perspective, but the timing is awkward for personal reasons. I still think I will either do that or the 1031 exchange. I don't actually mind paying taxes to a degree, but the hit for doing the straightforward path is just too much.
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Cyclesafe
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Re: 70% marginal tax rate !?!

Post by Cyclesafe »

I feel your pain.

I did the $1000 incremental thing with Turbo Tax for my situation when I was in a position to take a much lower paying position in 2004 at age 50. I decided that on the actual margin, it wasn't worth it for me to work especially when also considering commuting time and general wear-and-tear.

Without actually running the numbers, I would still be a wage slave - albeit employed of course.
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VaR
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Re: 70% marginal tax rate !?!

Post by VaR »

1. What's the effect of funding a Donor Advised Fund this year?
2. Your situation is a bit odd in that you are choosing to realize 400k in capital gains in a year where you are only taking 30k in earned income. What would your marginal rate be if you upped your earned income to $100k?
3. Why not just choose to keep the rental property "forever" and treat is an income in perpetuity? I don't hear anyone talk about rents going down in the bay area. Or does your retirement plan depend on tapping the equity for expenses in retirement?
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curmudgeon
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Re: 70% marginal tax rate !?!

Post by curmudgeon »

VaR wrote:1. What's the effect of funding a Donor Advised Fund this year?
2. Your situation is a bit odd in that you are choosing to realize 400k in capital gains in a year where you are only taking 30k in earned income. What would your marginal rate be if you upped your earned income to $100k?
3. Why not just choose to keep the rental property "forever" and treat is an income in perpetuity? I don't hear anyone talk about rents going down in the bay area. Or does your retirement plan depend on tapping the equity for expenses in retirement?
1) DAF is fairly effective in this high marginal zone. It would be about 58% marginal reduction in taxes, though that drops to about 33% once you have matched all the earned income. But I put quite a large chunk in the DAF already...

2) The big cap gain and small earned income is the key to the high marginal rate. Once you get above about $125K earned income, the marginal rate drops significantly. Additional cap gains also have a lower marginal rate, but it is better yet to push them off to a fully retired year. The challenge here is that a bay area house is just a big block of gains to hit at once.

3) The rental house has had a total return of around 15% per year over the 8 years I have owned it, but much of that has been in the form of appreciation. On a straight income basis, it is not nearly so attractive, and cash flow is further limited by the mortgage. Tapping the equity is important to bridging the gap until we draw SS in 12 years. We do have other investments we could draw on, but that would make us even more overweight in silicon valley. I have been through three "busts" in the bay area where property values and rents have dropped significantly; it is not a perpetual motion machine and I don't want more than 50% of my net worth tied up in RE here for the long run.
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curmudgeon
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Re: 70% marginal tax rate !?!

Post by curmudgeon »

While it may not have seemed actionable, writing the original post, and bouncing ideas off the forum has really been helpful in making me think out the various options and tradeoffs of this tax situation. It has helped my wife and I clarify our priorities; we may end up going down the most tax-efficient path not so much because of the tax impact but because of how it fits our retirement priorities. Sometimes an anonymous internet forum is an ideal space (and I really appreciate the moderators here who help deter the political rants that are easy to get into with taxes).

Several years ago, I looked at what would be the tax consequences of selling the rental house, in a typical employed year. The tax bill when stacked on top of a full-year income was pretty high. This made me think - "put it off until retirement when you don't have other income", where the tax hit would be substantially less. As it got closer, I refined this to add just working long enough to fill up the 401K space in the last year, which would have little tax consequences. Since charitable donations were actually more tax effective in a normal employment year than a year with only the capital gains (even though the total income will be higher), I loaded up the DAF last year.

Now I have this request to work a bit longer, and the tax effects are dizzying. As I have been working through more analysis, given the big cap gains as a baseline, about the first $25K of taxable earned income has a marginal federal rate of only 19% (with payroll and state it makes 37%). I can live with that. But as you go beyond the $25K earnings, the marginal federal rate zooms up to 52% (or 70% if you add in the others), which is what got me steaming. But as poster VaR reminded me, charitable donations interact differently with this high marginal rate, and I see that they become very valuable to the extent the earned income is in that rate.

The net of this is: We may well sell our primary residence and move to the rental, but do it less as a tax strategy and more as a way of positioning for the style of retirement we would like to be in for the next few years (and the personal negatives aren't so negative after all). But if we do sell the rental, having earned income up to $25K this year isn't too much additional tax pain, and if I go beyond that, it can be largely offset by putting an equivalent amount into our DAF.
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tfb
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Re: 70% marginal tax rate !?!

Post by tfb »

curmudgeon wrote:Several years ago, I looked at what would be the tax consequences of selling the rental house, in a typical employed year. The tax bill when stacked on top of a full-year income was pretty high. This made me think - "put it off until retirement when you don't have other income", where the tax hit would be substantially less.
curmudgeon wrote:But as you go beyond the $25K earnings, the marginal federal rate zooms up to 52% (or 70% if you add in the others), which is what got me steaming.
When you have more earnings, you are back to the "stacked on top of a full-year income" situation. It shouldn't be a surprise that your taxes will be high. You can see the taxes as exceptionally high marginal tax rate on your employment earnings or you can see them as just normal tax rate on employment earnings plus paying the full freight on your capital gains. Regular working folks are in that situation all the time. They pay normal tax rate on their employment earnings, and they pay tax on 100% of their capital gains.
Harry Sit, taking a break from the forums.
pangea33
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Re: 70% marginal tax rate !?!

Post by pangea33 »

curmudgeon wrote: Another option (with some off-topic complications) would be to sell our primary residence, downsize move to the rental. We pocket ~$500K tax free gains...
If you don't purchase another primary residence with that money, I believe you will have to pay capital gains. Since you're talking about moving into a home that you already own, I believe you're mistaken on that money being tax free.
Novine
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Re: 70% marginal tax rate !?!

Post by Novine »

"If you don't purchase another primary residence with that money, I believe you will have to pay capital gains."

Why do you believe that?
missingdonut
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Re: 70% marginal tax rate !?!

Post by missingdonut »

pangea33 wrote:If you don't purchase another primary residence with that money, I believe you will have to pay capital gains. Since you're talking about moving into a home that you already own, I believe you're mistaken on that money being tax free.
Those rules changed in 1997.
3PKWzh9
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Re: 70% marginal tax rate !?!

Post by 3PKWzh9 »

Even megacorps have deferred compensation plans that they should be willing to give you access to. There's no law saying that an employer must pay you right now for work performed right now. Insist on a deferred compensation plan and have your labor earnings dribbled out over the first five years of your retirement.

And, not to get political, but let me simply add that you are Not Paying Your Fair Share (TM) and must be made to pay more than 70% of your labor in taxes. The State does not have enough! More! More!
pangea33
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Re: 70% marginal tax rate !?!

Post by pangea33 »

missingdonut wrote:
pangea33 wrote:If you don't purchase another primary residence with that money, I believe you will have to pay capital gains. Since you're talking about moving into a home that you already own, I believe you're mistaken on that money being tax free.
Those rules changed in 1997.
For crying out loud. How old am I? I clearly need to brush up on the portions of tax law that don't currently apply to my situation.
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