It's amazing the number of times when I asked someone what their tax rate is and they don't have an idea.
For you as a taxpayer it’s a number you should know or have at least an approximate idea since its your tax dollars that you are sending to the government instead of keeping in your pocket to grow your wealth.
As discussed in past articles your taxable income is somewhat within your control if you put some effort into it so you should know what your tax rate is to plan ahead, and when possible even control the amount of tax you pay both now and in the future.
Just to clarify a little bit, there are tax brackets, and then there are tax rates. There are multiple tax brackets and those change over time as new tax laws are passed.
It’s said that tax laws are written in pencil since they do change and there are some significant changes coming in just a few years as the lower tax rates passed under President Trump are due to expire unless the government takes action to keep them where they are. What will happen we have no idea but that doesn’t mean you can’t plan.
Tax brackets are ranges of income and those have rates assigned to them and as your income goes up the rates go up.
As your income increases you cross into higher tax brackets from the lowest to the highest depending on your level of income. You might cross over more than one tax bracket depending on your income.
Your income starts off at the lowest bracket and smallest rate and as your income goes up you cross into the next higher tax bracket. As your income continues to increase into the next tax bracket, and so forth, your effective rate is essentially that blended rate across the tax brackets.
Another way to think about it is that the tax bracket that you are in is what would be the tax effect of the next dollar of income or the tax benefit of another dollar of deduction you might find.
So let's just say you're in the 22% tax bracket and you've just earned $100 more dollars of income so that new $100 will be taxed at $22.
Your effective tax rate across your entire tax return is probably less than 22% in this case. You might have an effective rate of say 18% as part of your income is taxed at a lower rate and the upper end of your income is taxed at your tax bracket rate.
But both rates are important because there are financial planning decisions that can have tax consequences that could be worth thousands of dollars of tax or avoidable tax if you don't take into account the tax bracket you're in.
Let's just say that you are $5,000 from the top of the tax bracket that you're in, and somebody advises you or you hear on a podcast or you read an article or even your financial advisor who has never asked you for your tax return suggests that maybe you do a $10,000 Roth conversion.
If you're only $5,000 from the next higher tax bracket, doing a $10,000 Roth conversion just pushed you into a higher tax bracket. Is that really what you want to do?
Or, maybe you have a need of additional income and the only source of that income is your pre-tax accounts so pulling that $10,000 of unplanned cash draw pushes you into that next higher bracket because you didn’t know how close you were to that bracket and if you are below age 59 ½ you might even get a penalty on top of that. Do you still do that?
Maybe the answer is yes. Maybe the answer is no. But at least if you know where your tax rate is, you made an informed decision rather than get a surprise tax bill on April 15th when you file your tax return.
Another thing that we see commonly is talk about federal rates. But if you're in a state that has a state income tax, you really have to consider the combined effect. So while you may be in a 22% tax bracket for federal tax you might be in a five to eight percent state tax bracket so make sure you consider both the federal and state taxes in your tax planning decisions.
And then for those of you that are self-employed and you're filing on Schedule C you know that on top of all of those taxes, you've got another self-employment tax rate of 15.3%.
So that's why if you're a Schedule C filer and you've got a successful business, it is very possible that you're up into a 40% effective tax rate because you have to factor in both federal and state income tax and self employment tax on top of that.
So that's why knowing your tax rate, your effective tax rate and knowing your tax bracket are very important when it comes time to financial planning and tax planning.
It also is very important because if you're a business owner there comes a certain point in time that maybe possibly you can choose a different structure for your LLC and actually lower your tax bill. That was a recent newsletter article so go back through those or check out www.vwshi.com/blog for past articles.
We’ve helped quite a few small business owners with lowering their self-employment tax bill. Even if you only lower it by a few thousand dollars, that effect gets multiplied by every year you are in business and can add up to significant tax savings and that’s more money in your pocket to grow your wealth.
So again, if your tax preparer is not doing tax planning, and your financial planner is not asking to see your tax returns but giving you advice without knowing the tax consequences, you owe it to yourself to at least consider asking a tax planner for some advice and possibly lower your lifetime tax bill.
The information in this and other articles is intended to be educational in nature only. Not tax, legal or investment guidance for you specifically. Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.