Limit Income to Avoid Taxes?

[twfortune]

Tax question for you:


Would it ever make sense for someone to purposefully limit their pay, in order to avoid paying taxes in a higher bracket?

For example: Let's say a man is self-employed, and will make approximately $250k this year. He has chosen to actually pay himself $24,999 in order to keep him from going into the next bracket, as he believes his take home pay would be significantly less if he paid himself an even 250, instead of dropping down to 249,999.

Let's say another man hears about this, and says "but because we have a graduated tax bracket, won't you only pay the 250k tax rate on $1? . All dollars from $249,999 will be taxed at their lower rates?"

The first man responds and says, "well yes, but it's a BIG difference. Plus things like social security tax are not graduated, so that really messes you up".

What is actually true in this situation?

[Shor]

Both are true, it depends on what the income is at, and what is impacted.

If you are at the edge of the 25% federal tax bracket, and if you make a lot of capital gains, it would probably be really good to get down to the 15% bracket so that long term capital gains and dividends taxes are reduced.

In other cases, you're not considering a tax bracket. For instance, say there is some benefit that is no longer accessible if your income is above a certain level. As soon as your dollars go above that limit, the benefit is gone. Just like above, these are situations where the cutoff is hard set and once you are over the cliff it is gone.

The other side is that the US uses a bracketed tax system so that each additional dollar has a certain marginal tax rate. For this case, each additional dollar is only taxed a certain amount.
If a person makes money, they need to be mindful of all of these things, see how low they can get their taxable income, what tax-advantaged accounts they can divert income toward to get the most benefit, and whether that would be advantageous based on the benefits they gain vs having the money now.

So it is all true, and it is best determined with a comprehensive graph that accounts the cliffs and the tax brackets.

In direct answer to the question you posed though, if a person makes 250k in one year, and then 0 the second year, it would be in his best interest if he could find some way to take those top dollars from year one that are taxed at a very high marginal tax rate, and push them off to year 2 where they would be starting from the bottom of the stack.
Naturally, if he simply made the same or more money the next year and every year after that (inflation-adjusted), he might find out that it was not any better to try to displace the money to a later year, because he could never get his tax bracket to a lower level.

On this forum, if a person is trying to FIRE, they might have some years of low income after RE where they can start claiming that 401k / IRA money at a lowered tax bracket.

[MandalayVA]

My job offers a lot of overtime, but lately I've been avoiding it since Mr. Mandalay's income has decreased and therefore has placed us in a lower tax bracket.  We're getting along fine and I have my weekends back!

[seattlecyclone]

There are very few places in the tax code where an additional dollar of income will result in paying more than $1 of tax. The saver's credit has some cliffs like this, and there are some in the ACA too. Those are the exceptions rather than the rules. The base tax brackets are set up so that you'll always end up with more money if your earn more money.

However as MandalayVA points out, in a higher tax bracket you get to keep less of what you earn. At some point the amount of time you need to trade for an additional post-tax dollar becomes less of a worthwhile trade.

[JJ-]

We are heavily reducing our tax burden this year through maxing DW's 401k even though the fees suck to get our income into the 15% bracket so we can avoid the ~$2250 hit we'd have to pay as cap gains tax if we were in the 25% bracket.

That being said, I wouldn't turn down an easy opportunity to make some money that bumps us back up into the 25% just because I'm afraid of paying 15 or 25% (or more) taxes on those dollars. That'd be the tail wagging the dog.

But, if you don't need the income and enjoy the weekends, don't worry about not taking the OT.