Author Topic: Jumping a tax bracket -- tips to reduce tax liability?  (Read 7480 times)

lisahi

  • Stubble
  • **
  • Posts: 225
Jumping a tax bracket -- tips to reduce tax liability?
« on: May 03, 2014, 01:55:09 PM »
I work for the Federal Government and am set to receive a promotion at the end of July. For those familiar with the General Schedule, I'm moving from a GS-13, Step 2 to a GS-14, Step 1. I'm still in the "Rest of the United States" locality, so receive a 14.16% pay bump from the standard pay rate. (For those unfamiliar with the GS system, every Federal employee under this system receives some bump, depending on city). I will move from $85,396 per year to $97,657 per year. So I'll be bumped from the 25% tax bracket to the 28% tax bracket.  I don't know whether I'll be assessed at the 28% rate in the 2014 tax year or in the 2015 tax year given that I'll have spent more than half of 2014 at the lower salary.  (I'm an attorney, and forgot all my math).  I think it's more likely I'll be assessed starting 2015.

I understand there are various ways to reduce your tax liability.  I could set up an FSA (not an HSA; I can't set up that with the health plan I'm on), which uses pre-tax money and that has a max of $3300.  The problem is that I am unlikely to use the majority of that money for medical needs and under an FSA I lose what I don't use.

Right now I contribute to a Roth TSP account (like a Roth 401K), so I'm currently paying taxes on the money I'm saving.  I'm wondering whether I should switch back to the traditional TSP account, which would use pre-tax money and therefore reduce the amount of my taxable salary.  From what I've read, whether you use a Roth or a traditional investment account depends on whether you expect to be at a higher tax bracket when you take the money out after retirement.  The problem is... I have no idea.  It would depend on how I choose to receive my TSP after retirement, correct (i.e., how much I have taken out per year)?  I will receive about 1/3 of my income as a pension under FERS, as well as Social Security (at some point).

If I max out my TSP ($17,500) and that is subtracted from my taxable income, that would get me under the lower limit for the 28% tax rate. But is it worth it to switch to a traditional TSP from a Roth and pay the taxes later?

I'm just having a problem seeing into the future and what I should be thinking about now

chasesfish

  • Magnum Stache
  • ******
  • Posts: 3749
  • Age: 39
  • Location: South Carolina
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #1 on: May 03, 2014, 02:02:28 PM »
Just one clarifying question/statement before I dig too deep in this:

You're "jump" is only in the marginal income that you earn over and above the 25% bracket.  This doesn't retroactively make all of your income taxable at the higher rate.

However, there are plenty of deductions/credits that phase out at certain income levels, which is why what appears like six simple rates becomes so complicated most people have to pay a CPA or use software.

lisahi

  • Stubble
  • **
  • Posts: 225
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #2 on: May 03, 2014, 02:14:05 PM »
Ok, I admit -- this isn't my area. I'm mostly a labor lawyer. lol.

So, alright, the rule for me right now, assuming I'm taxed on my full salary, is I will pay $5081.25 plus 25% of any amount in excess of $36,900. So, I pay $5081.25 + .25(48496) = $17,205.25.

Assuming my entire income is taxable after the promotion, I pay $18,193.75 plus 28% of any amount in excess of $89,350.  So I pay $18,193.75 + .28(8307) = $20,519.71.

If I max out my TSP under a traditional investment account, my taxable income after the promotion will be $80,157 and my tax liability will be $5081.25 + .25(43257) = $15,895.50.  Of course, I have to pay taxes on that $17,500 at some point.

ETA: I already had my student loan interest deduction phased out. I used to be able to get it, but now that's completely phased out and will continue to be so regardless of what I do. I'm not sure what other credits/deductions will be phased out. My taxes are fairly simple -- I'm single, no kids. I take a mortgage interest deduction, which would not change (except for the lower amount of interest paid each year as I pay off the principal).
« Last Edit: May 03, 2014, 02:19:35 PM by lisahi »

dragoncar

  • Walrus Stache
  • *******
  • Posts: 9633
  • Registered member
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #3 on: May 03, 2014, 02:21:24 PM »
Just one clarifying question/statement before I dig too deep in this:

You're "jump" is only in the marginal income that you earn over and above the 25% bracket.  This doesn't retroactively make all of your income taxable at the higher rate.

However, there are plenty of deductions/credits that phase out at certain income levels, which is why what appears like six simple rates becomes so complicated most people have to pay a CPA or use software.

Yeah, whenever I see someone freaking out about going into the next tax bracket, I assume they don't understand tax brackets.  They should mostly be happy about getting more money!

lisahi

  • Stubble
  • **
  • Posts: 225
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #4 on: May 03, 2014, 02:24:25 PM »
Just one clarifying question/statement before I dig too deep in this:

You're "jump" is only in the marginal income that you earn over and above the 25% bracket.  This doesn't retroactively make all of your income taxable at the higher rate.

However, there are plenty of deductions/credits that phase out at certain income levels, which is why what appears like six simple rates becomes so complicated most people have to pay a CPA or use software.

Yeah, whenever I see someone freaking out about going into the next tax bracket, I assume they don't understand tax brackets.  They should mostly be happy about getting more money!

Well, I'm not really freaking out. I'm not struggling to make ends meet and of course am happy for the promotion. I do know that I don't get taxed at 25 or 28 percent of my whole income. That doesn't make any difference as to what my taxable income is, though. If I jump a tax bracket, I get taxed more and I pay more relative to what my income is. My question was about weighing what is good for me now with what will be good for me later (i.e., paying taxes now vs. paying taxes later).

bikebum

  • Pencil Stache
  • ****
  • Posts: 562
  • Location: Nor Cal
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #5 on: May 03, 2014, 02:28:01 PM »
I'm not familiar with TSP. But for IRA's, there are other things you may want to consider when deciding between Roth and Traditional. One example is the Roth allows you to withdraw contributions (not earnings) without the 10% penalty at any age. A google search should give you what you need if you decide to look more into it.

zolotiyeruki

  • Magnum Stache
  • ******
  • Posts: 4291
  • Location: State: Denial
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #6 on: May 03, 2014, 02:32:26 PM »
Lisahi, here are a couple things you may have overlooked:
1) Deductions - the standard deduction will drop your taxable income by something in the region of $12k, and each exemption (you, spouse, children) will drop it by another $3900 or so (depending on the amounts for next year).  If you itemize, you could drop your taxable income even more.
2) I don't know if your TSP affects your allowable IRA contributions.  If it doesn't, you can contribute $5500/year for yourself, and if you're married, another $5500 for your spouse.  That will also decrease your taxable income further (and boost your stache).

On the Roth vs Traditional IRA question, here is the rule of thumb (as I understand it):  If you expect that the effective tax rate you will pay in retirement will be higher than it is today, then you want a Roth IRA.  If you expect to pay a lower effective tax rate in retirement, then you want a traditional IRA.  Assuming that tax rates stay the same, the rule can be rephrased thus:  If you expect a higher income in retirement than you have now, the Roth is better.  If you expect a lower income, then a traditional IRA is better.

Of course, the mustachian approach would be "well, duh, max out both!"

lisahi

  • Stubble
  • **
  • Posts: 225
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #7 on: May 03, 2014, 02:39:40 PM »
Thanks zolotiyeruki -- I had completely forgotten about the standard deduction, which I guess means I don't have to think about this for awhile.

dragoncar

  • Walrus Stache
  • *******
  • Posts: 9633
  • Registered member
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #8 on: May 03, 2014, 03:01:38 PM »
Just one clarifying question/statement before I dig too deep in this:

You're "jump" is only in the marginal income that you earn over and above the 25% bracket.  This doesn't retroactively make all of your income taxable at the higher rate.

However, there are plenty of deductions/credits that phase out at certain income levels, which is why what appears like six simple rates becomes so complicated most people have to pay a CPA or use software.

Yeah, whenever I see someone freaking out about going into the next tax bracket, I assume they don't understand tax brackets.  They should mostly be happy about getting more money!

Well, I'm not really freaking out. I'm not struggling to make ends meet and of course am happy for the promotion. I do know that I don't get taxed at 25 or 28 percent of my whole income. That doesn't make any difference as to what my taxable income is, though. If I jump a tax bracket, I get taxed more and I pay more relative to what my income is. My question was about weighing what is good for me now with what will be good for me later (i.e., paying taxes now vs. paying taxes later).

I see that, but then tax bracket shouldn't really be the first thing in the title.  It's a very minor detail.  We have a number of threads discussing pre and post tax retirement options.

Rebecca Stapler

  • Pencil Stache
  • ****
  • Posts: 907
    • Stapler Confessions
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #9 on: May 03, 2014, 03:03:37 PM »
Thanks zolotiyeruki -- I had completely forgotten about the standard deduction, which I guess means I don't have to think about this for awhile.

Wait wait ... if you're deducting your mortgage interest, then you're itemizing deductions and you can't take the standard deduction.

DollarBill

  • Pencil Stache
  • ****
  • Posts: 901
  • Age: 46
  • Location: Austin TX
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #10 on: May 03, 2014, 04:16:04 PM »
To take an example, suppose your taxable income (after deductions and exemptions) is exactly $100,000 in 2012 and your status is Married filing jointly; then your tax would be calculated like this:

( $ 17,400   minus    0 )   x .10 :       $   1,740.00
( 70,700   minus    17,400 )   x .15 : 7,995.00
( 100,000   minus    70,700 )   x .25 : 7,325.00
     Total:    $ 17,060.00

This puts you in the 25% tax bracket, since that's the highest rate applied to any of your income; but as a percentage of the whole $100,000, your tax is about 17%.

http://www.moneychimp.com/features/tax_brackets.htm

sol

  • Walrus Stache
  • *******
  • Posts: 8457
  • Age: 44
  • Location: Pacific Northwest
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #11 on: May 03, 2014, 05:06:02 PM »
I'm a federal employee too and I've looked at the Roth TSP in some detail.  Unless you're active duty military or intend to work until you're 70, like some federal judges, the Roth TSP is not your best choice.  Switch to the deductible regular TSP and you'll save thousands per year.

The Happy Philosopher

  • Bristles
  • ***
  • Posts: 342
    • thehappyphilosopher
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #12 on: May 03, 2014, 06:15:59 PM »
As a rule of thumb I would use a Roth in the 10 or 15% bracket and switch to tradition at 25 and up. To get an idea of your marginal federal rate use turbotax taxcaster or some other online tool, just enter your deductions, estimated income, etc.  I think most people here feel they will be efficient enough with their money in retirement to stay in the 15% bracket so it makes no sence to pay 25% tax and withdrawal it at 15 or even 10.  Obviously if you think you will be in a higher bracket in retirement use a Roth. Roths do have some addition estate planning advantages and are more flexible.

lisahi

  • Stubble
  • **
  • Posts: 225
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #13 on: May 03, 2014, 06:23:50 PM »
Thanks all. As I said, this isn't my area. Ask me about equal employment laws and collective bargaining agreements and I'm great. Ask me about taxes and... well, I'm learning.

ljp555

  • 5 O'Clock Shadow
  • *
  • Posts: 32
  • Location: San Jose, CA
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #14 on: May 03, 2014, 07:56:53 PM »
I'd recommend switching to traditional TSP if your marginal rate is 25%, even more true at 28%. TSP is essentially a 401K for federal employees.

TomTX

  • Magnum Stache
  • ******
  • Posts: 4564
  • Location: Texas
Re: Jumping a tax bracket -- tips to reduce tax liability?
« Reply #15 on: May 03, 2014, 08:01:43 PM »
In addition to maxing the TSP, you should also be able to put $5,500/year into an IRA. More if you are over 50.