APRIL IS NATIONAL FINANCIAL LITERACY MONTH
If you live in the United States you live in a country with a progressive tax system. I call it a system because there is not just one progressive tax, there are many. Understanding how our system works is critical to your financial literacy.
A progressive tax takes a larger share of income from high-income workers than from low-income workers. This results in lower-income workers keeping more of what they earn. A progressive tax system is based upon one’s ability to pay. Therefore, the intent of such a system is to redistribute wealth.
You may or may not like a progressive tax system. However, for purposes of this article, I am stating the facts so you know where your hard earned dollars go. We will not be debating the merits for or against a progressive tax system.
Ordinary Income Tax Rates
Most of us think of ordinary income tax rates when describing a progressive tax system. There are 7 federal income tax brackets in 2017 which are used to tax income at increasing levels of earnings. Those rates are: 10%, 15%, 25%, 28%, 33%, 35%, 39.6%. If you are in the 28% tax bracket it does not mean you pay 28% federal tax on all your income. It means you pay 28% tax on your income above $91,901. Examples of two tax tables, the individual and married filing jointly are included below.
There are, however, many other examples of taxes that follow the concepts of a progressive tax system.
Net Investment Income Tax
The net investment income tax applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above certain amounts. Gross investment income for individuals includes things like interest, dividends, capital gains and rents to name a few. This tax does not, however, apply to gains on the sale of a personal residence, up to the statutory exclusion.
The gross investment income can be reduced by deductions allocated to the income resulting in net investment income. This includes such things as investment advisory fees, brokerage fees, and tax preparation fees.
Individuals will owe net investment income tax if they have net investment income and modified adjusted gross income over $200,000 for singles and $250,000 for married filing jointly.
Planning idea: There are tax planning techniques which might help reduce the net investment income tax. For example, municipal bonds (tax exempt) are not considered taxable income for purposes of the net investment income tax. Therefore, as part of annually re-balancing a portfolio you might consider purchasing municipal bonds. You also might consider tax loss harvesting as an effective way to reduce your net investment income tax.
Capital Gains Tax Rates
Capital gains tax rates vary depending on whether the gains are short-term or long-term. Long-term capital gains are those held for more than one year. Short-term gains are taxed at ordinary income tax rates.
Long-term gains and qualified dividends are not taxed when taxable income falls in the 10% or 15% tax brackets. The tax rate is 15% when taxable income falls in the 25%, 28%, 33% or 35% tax brackets. The tax rate increases to 20% when taxable income falls in the 39.6% tax bracket.
Planning idea: There is a significant difference in income tax rates between those investments held long-term versus those held short-term. Therefore, your investment’s holding period should be closely monitored.
Payroll Taxes: Social Security and Medicare
Up to 50 percent of your Social Security benefits may be subject to income tax.This applies if your modified adjusted gross income plus one-half of your Social Security benefits exceeds $25,000 for an individual filing single and $32,000 if you are married and filing jointly. If your combined income exceeds $34,000 for an individual and $44,000 if married and filing jointly, up to 85 percent of your benefits is taxable.
In 2017, approximately 70% of Medicare beneficiaries will pay $109 per month for Medicare Part B. The other 30% of Medicare participants will pay based upon their level of adjusted gross income, up to $429 a month.
Tax Return Deductions
Our progressive tax system also applies to deductions. The Pease limitation on itemized deductions and the personal exemption phaseout, may effectively increase your tax rate.
The Pease limitation on itemized deductions named after the late Congressman Donald Pease, reduces the value of itemized deductions for high income taxpayers. For every $1 of income over the specified threshold, 3% of that amount will be subtracted from the taxpayer’s itemized deductions.
Therefore, your itemized deductions may be reduced by the lesser of:
- 3% of AGI above the applicable threshold; or
- 80% of the amount of itemized deductions for the tax year.
Pease limitation applies to charitable donations, the home mortgage interest deduction, state and local tax deductions and miscellaneous itemized deductions. They do not apply to medical expenses, investment expenses, gambling losses, and certain theft and casualty losses.
Therefore, you will still be able to deduct 20% of the itemized deductions subject to the Pease limitation and 100% of those not subject to the limitation.
Personal exemptions phaseout reduces the amount of your personal exemption by 2% for each $2,500 by which your adjusted gross income exceeds the threshold amount. Therefore, if your adjusted gross income exceeds the threshold amount by $122,500 your personal exemptions are completely phased out.
Our Progressive Tax System
As illustrated above, our progressive tax system has many components, whether it be ordinary income, capital gains income, social security, medicare or the extent to which itemized deductions or personal exemptions are allowable- just to name a few components of the system. This analysis does not even consider the impact the alternative minimum tax has on our progressive tax system and your tax filing.
We have not debated the pros and cons of a progressive tax system. We have limited ourselves to discussing the impact of the system on your hard earned dollars. However, does it need to be this complicated? Is there a better way?