Taxes and the Big Picture
Let’s talk about some fact and fiction.
There’s a myth floating around out there that if you barely break into the next tax bracket, you’ll be taxed to the point that you would have less money than if you stayed in a lower bracket by making less income.
This is ridiculous. Until the tax rate is 100 percent, it will never be bad to make more money.
The truth is, tax rates are marginal and progressive, not regressive. Moving up a tax bracket doesn’t give you a blanket tax rate that applies to all your income. The new rate only applies to the income you make within that bracket.
Let’s say the top federal tax bracket starts at $469,000. That top bracket is almost 40 percent, and the state tax rate is 5 percent. That puts a wealthy taxpayer at nearly 50 percent in taxes. However, just because he’s broken into that top bracket doesn’t mean the top bracket’s tax rate extends all the way down through all his earnings. All dollars under the top bracket are taxed at their respective tax brackets, not at 39.6 percent. Any money made in addition to the $469,000 will be taxed at the top bracket’s rate.
Though a higher-income taxpayer pays more in taxes than a lower-income taxpayer, the higher-income taxpayer still enjoys the same rates on the same levels of income. Money earned up to the higher threshold is taxed at the lower threshold.
If you are $1 into a higher tax bracket, only that $1 will be taxed at that higher bracket’s rate. The idea that someone can advance to a higher tax bracket only to end up with less money is a myth.
In addition, many taxpayers often believe they are taxed at a higher rate than they actually are. They assume they are in a 50 percent tax bracket when they are making substantially less than the top rate, especially taking into consideration deductions, credits and items that offset their income.
Marginal vs. Effective Tax Rates
There are marginal tax rates and effective tax rates. The marginal tax rate is the highest tax bracket that applies to your last dollar of income. The effective tax rate is the average of all taxes paid divided by your total income.
Yes, someone making $2 million is in the 50 percent tax bracket—this is their marginal tax rate, which includes payroll tax, federal income tax, state income tax, net investment tax, etc. Their effective tax bill may actually be closer to $600,000, or 30 percent due to deductions, credits and other items that affect their overall tax bill.
Obviously, there is a substantial difference between the marginal tax rate and the effective tax rate. The effective tax bracket is hardly relevant in tax discussions other than as a barometer of total tax to total income. In figuring effective tax, it’s crucial to track all taxes paid, not just federal tax.
Tax Refund vs. Total Tax Paid
Too often, taxpayers are overconcerned with their tax refund—the amount of money they receive at the end of the year—instead of the amount they pay throughout the year. The refund is simply the difference between taxes paid and taxes owed. The real concern should be the actual amount of total taxes paid. And many advisors are so concerned with federal taxes that they overlook many other areas rife with savings opportunities.
It’s not your CPA’s or your tax advisor’s fault. A few things are working against these advisors that people don’t usually realize. First, their purpose is not to give proactive tax advice. They work in a highly regulated environment, and they face innumerable penalties and general professional embarrassment if they happen to give any advice that runs afoul of the IRS.
As mentioned in the last blog entry, most people pay their CPAs to do the bare minimum to get them through tax season. They simply aren’t paid enough to thoroughly gather information and develop a strategy. They simply don’t have the full story, and most of the decisions have already been made before the CPA has a chance to chime in. The client loses out on the tremendous value of the synergies that result in a multifaceted, holistic, and proactive plan.
That’s why Addicus believes in having a full picture of all the information and taking a confident approach to structuring transactions and managing ongoing businesses and other things that can, and generally do, have substantial positive tax effects. Addicus is engaged from the beginning to coordinate with advisors and collaborate to conceive a plan tailored to the client’s individual needs.
At the end of the day, the client is left with a simpler, more efficient, and truly effective plan that caters directly to their individual needs, concerns, and desires.