What’s your marginal tax rate?
It’s an important question. The answer will determine whether it makes sense to buy municipal bonds, whether to put money into a Roth or Traditional IRA, and even whether to convert a Traditional IRA into a Roth. Let’s face it: almost everything we do has tax consequences. The government puts its finger into almost every financial pie – they’re our partner in almost every financial decision we make.
But they’re a passive partner. It’s perfectly reasonable to take steps to reduce our tax burden. Judge Learned Hand noted in 1947 – when marginal tax rates were a lot higher – that taxes are enforced exactions, not voluntary contributions. Nobody owes any public duty to pay more taxes than the law demands. There’s nothing wrong with arranging your finances to minimize your tax burden.
So, to understand how significant a partner they are, it’s important to calculate what happens on the margin – to the last dollar you earn. That’s where the tax brackets come in. The US has seven tax brackets, ranging from 10% up to almost 40%. We have a progressive income tax, where those who make more are taxed more highly. Where we fall on their scale will largely determine our marginal tax rate.
Most folks fall somewhere between 25% and 33%. Married and single taxpayers have different break-points. For single taxpayers, the 25% rate begins at $38,000 of taxable income; for married couples, it’s at twice that level. The 35% bracket begins at $417 thousand for both married and single folks.
How do you calculate your taxable income? That’s pretty simple. Project your income – wages, interest, capital gains. Subtract your deductions or the standard deduction. Subtract your exemptions – $4,050 per dependent. The result is your taxable income. There are other factors that can impact your marginal tax bracket, like phase-outs, the Alternative Minimum Tax, exclusions, and so on. But for most folks, their tax bracket will be their marginal tax rate.
Once you know your marginal tax rate, you can start to make plans. For example, if you expect your tax rate to be higher when you retire, you should probably contribute to a Roth retirement account. Pay the taxes at a lower rate. Conversely, if you will be in a lower bracket down the line, reduce your taxes now. Also, structure your portfolio to minimize taxes. If you need to own bonds – to reduce your portfolio’s risk, or for some other reason – and you have a substantial retirement account, it’s best to own taxable bonds in the tax-sheltered account like an IRA, rather than tax-exempt bonds in a taxable account. Taxable bonds pay a higher interest rate, and that income compounds over time to give you a higher payout at the end. And even though it feels satisfying to have tax-exempt income, in some circumstances tax-exempt income can count against you in other calculations. It’s better for income – inside an IRA or 401(k) – never to show up on your tax forms at all.
One of the most common investment mistakes is to ignore taxes in our investment decisions. Knowing our marginal tax rate is a good first step to improving after-tax returns. Because government is our partner in our financial decisions. And it’s not what we make that matters in reaching our goals. It’s what we keep.
Douglas R. Tengdin, CFA