Author Topic: Nasty Tax Cliffs  (Read 18399 times)

Gone Fishing

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Nasty Tax Cliffs
« on: October 31, 2014, 02:11:36 PM »
Another thread got me thinking about tax cliffs, or when $1 more in income costs you hundreds or even thousands in additional taxes. I thought it might be nice to list them in one convienient thread.

Here are a few to get started:

If you are on a ACA subsidized plan, going over the 400% of the poverty level income for your household completely wipes out your subsidy.

Moving from the 15% tax bracket to the 25% tax bracket can result in going from 0% tax to 15% tax on all of your qualified dividends and capital gains for the period.

Also, please let me know if I am looking at this incorrectly...

 

beltim

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Re: Nasty Tax Cliffs
« Reply #1 on: October 31, 2014, 02:55:35 PM »
Moving from the 15% tax bracket to the 25% tax bracket can result in going from 0% tax to 15% tax on all of your qualified dividends and capital gains for the period.

I don't think this is quite accurate.  If you're in the 15% tax bracket, you don't have unlimited room for tax-free qualified dividends and capital gains.  Any dividends or capital gains in excess of the 15% tax bracket are taxed as if they're in the 25% tax bracket (i.e. at 15%).  So there shouldn't be a tax cliff there.

beltim

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Re: Nasty Tax Cliffs
« Reply #2 on: October 31, 2014, 03:19:58 PM »
Moving from the 15% tax bracket to the 25% tax bracket can result in going from 0% tax to 15% tax on all of your qualified dividends and capital gains for the period.

I don't think this is quite accurate.  If you're in the 15% tax bracket, you don't have unlimited room for tax-free qualified dividends and capital gains.  Any dividends or capital gains in excess of the 15% tax bracket are taxed as if they're in the 25% tax bracket (i.e. at 15%).  So there shouldn't be a tax cliff there.

If you are in the 15% tax bracket, your dividends/cap gains are taxed at 0%.  If you jump up to the 25% tax bracket (just one dollar into it), then ALL of your dividends/cap gains are taxed at 15%.

If you want to see this in action, play around with the TurboTax TaxCaster.  Put in the following information:

Married: Yes
Filing Jointly: Yes
Age: 50/50

Click on Other Income.  Put $92,500 in Qualified Dividends.  Notice you owe $0 in taxes on the right-hand side.  Now change that to $92,501.  Cliff!  Now you owe $9,989 because you made one dollar too much.  That's one hell of a tax on that dollar.

This is why, if you're not going to look at the actual tax forms, sometimes it's worth spending money on software.  You, and the free online software, are incorrect.  I put that info into Turbotax 2013 (made by Intuit) and the results:
$92500 Qualified Dividends, Tax = $0
$92600 Qualified Dividends, Tax = $15

beltim

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Re: Nasty Tax Cliffs
« Reply #3 on: October 31, 2014, 03:38:50 PM »
Thanks for the correction.  Strange that Intuit would provide two tools that give different information.  I remember reading about this several months ago, didn't quite understand what they were saying, then I used Intuit's TaxCaster to understand (or what I thought was understanding).  I should have just went to the IRS publication instead of relying on Intuit.

No problem!  Nice find on the link.  I generally find that the IRS gives pretty good guidance on most situations, especially when you read the examples.

Gone Fishing

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Re: Nasty Tax Cliffs
« Reply #4 on: October 31, 2014, 03:42:33 PM »
Moving from the 15% tax bracket to the 25% tax bracket can result in going from 0% tax to 15% tax on all of your qualified dividends and capital gains for the period.

I don't think this is quite accurate.  If you're in the 15% tax bracket, you don't have unlimited room for tax-free qualified dividends and capital gains.  Any dividends or capital gains in excess of the 15% tax bracket are taxed as if they're in the 25% tax bracket (i.e. at 15%).  So there shouldn't be a tax cliff there.

If you are in the 15% tax bracket, your dividends/cap gains are taxed at 0%.  If you jump up to the 25% tax bracket (just one dollar into it), then ALL of your dividends/cap gains are taxed at 15%.

If you want to see this in action, play around with the TurboTax TaxCaster.  Put in the following information:

Married: Yes
Filing Jointly: Yes
Age: 50/50

Click on Other Income.  Put $92,500 in Qualified Dividends.  Notice you owe $0 in taxes on the right-hand side.  Now change that to $92,501.  Cliff!  Now you owe $9,989 because you made one dollar too much.  That's one hell of a tax on that dollar.

This is why, if you're not going to look at the actual tax forms, sometimes it's worth spending money on software.  You, and the free online software, are incorrect.  I put that info into Turbotax 2013 (made by Intuit) and the results:
$92500 Qualified Dividends, Tax = $0
$92600 Qualified Dividends, Tax = $15

Thank you for running the software.  Is there any way at all to create a long term cap gains/qualified dividend cliff with a mix of wages and investment income?

beltim

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Re: Nasty Tax Cliffs
« Reply #5 on: October 31, 2014, 03:50:02 PM »
Thank you for running the software.  Is there any way at all to create a long term cap gains/qualified dividend cliff with a mix of wages and investment income?

You're welcome.  I'm not aware of any tax cliffs with long term cap gains or qualified dividends, other than those that occur regardless of income source (like your ACA tax credit, for example). 

marty998

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Re: Nasty Tax Cliffs
« Reply #6 on: October 31, 2014, 04:08:57 PM »
What the hell? You guys can earn $92,500 in dividends tax free?

No wonder the "working class" is fucked. Capital is king

Sid Hoffman

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Re: Nasty Tax Cliffs
« Reply #7 on: October 31, 2014, 04:15:55 PM »
What the hell? You guys can earn $92,500 in dividends tax free?

No wonder the "working class" is fucked. Capital is king

Generally speaking, the only people making a living off dividends alone are people who have worked their butt off for a lot of years and invested that money into the economy in the form of buying dividend paying stocks.  Statistically, old age retirees are the most common group who hold large amounts of dividend paying stocks without other major income coming in.  Retirees are not a group where it's nice to chase after them with more taxes.  Mustachians, or young-age retirees, are a statistically insignificant anomaly to be honest.  I don't think there's any huge exploit going on.  Besides, the TRULY wealthy will be booking a lot more than $92,500 a year in income, thus they pay the higher taxes than people making less than $92,500.

hexdexorex

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Re: Nasty Tax Cliffs
« Reply #8 on: October 31, 2014, 04:31:17 PM »
They have already been taxed on the corporate level. That is unless corporations find the loopholes to get around that...

I don't think the answer should be to tax capital different because capital can move anywhere in the world. The key is to never let capital accumulate in one place to such extremes. I would say increase the inheritance tax so legacy wealth doesn't exist..but again they can move to another country : (

VirginiaBob

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Re: Nasty Tax Cliffs
« Reply #9 on: October 31, 2014, 04:42:28 PM »
Can't think too many cliffs, but in another thread we were discussing switching from Roth to Traditional IRA to increase the earned income credit by about $2500. 

Cheddar Stacker

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Re: Nasty Tax Cliffs
« Reply #10 on: October 31, 2014, 06:57:57 PM »
Thank you for running the software.  Is there any way at all to create a long term cap gains/qualified dividend cliff with a mix of wages and investment income?

You're welcome.  I'm not aware of any tax cliffs with long term cap gains or qualified dividends, other than those that occur regardless of income source (like your ACA tax credit, for example).

Good correction beltim. If the dividends put you over it's gradual, not a cliff. Often misunderstood concept.

Gone Fishing

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Re: Nasty Tax Cliffs
« Reply #11 on: October 31, 2014, 07:11:36 PM »
Thank you for running the software.  Is there any way at all to create a long term cap gains/qualified dividend cliff with a mix of wages and investment income?

You're welcome.  I'm not aware of any tax cliffs with long term cap gains or qualified dividends, other than those that occur regardless of income source (like your ACA tax credit, for example).

Good correction beltim. If the dividends put you over it's gradual, not a cliff. Often misunderstood concept.

Thanks guys! One of my goals is to have a real solid understanding of taxes at the personal level before I pull the FIRE trigger.  I leaned something new today. 

Gone Fishing

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Re: Nasty Tax Cliffs
« Reply #12 on: October 31, 2014, 07:13:02 PM »
How about with SS income, any cliffs there?

teen persuasion

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Re: Nasty Tax Cliffs
« Reply #13 on: October 31, 2014, 07:41:17 PM »
If your investment income is $1 over $3300, you become ineligible for the EITC, a loss of up to $6044.  My state matches EITC at 30%, so another possible $1813 loss.

kpd905

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Re: Nasty Tax Cliffs
« Reply #14 on: October 31, 2014, 08:13:33 PM »
How about with SS income, any cliffs there?

I was researching this a bit while planning my dad's retirement, and it is a headache.  My dad is still 10 years out, so I'm just going to mostly ignore this for now.

This is from SSA.gov:

No one pays federal income tax on more than 85 percent of his or her Social Security benefits based on Internal Revenue Service (IRS) rules. If you:

file a federal tax return as an "individual" and your combined income* is
between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
more than $34,000, up to 85 percent of your benefits may be taxable.

file a joint return, and you and your spouse have a combined income* that is
between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits
more than $44,000, up to 85 percent of your benefits may be taxable.

are married and file a separate tax return, you probably will pay taxes on your benefits.

*Note:

Your adjusted gross income
+ Nontaxable interest
+ of your Social Security benefits
= Your "combined income"
« Last Edit: October 31, 2014, 08:16:53 PM by kpd905 »

VirginiaBob

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Re: Nasty Tax Cliffs
« Reply #15 on: October 31, 2014, 08:17:04 PM »
If your investment income is $1 over $3300, you become ineligible for the EITC, a loss of up to $6044.  My state matches EITC at 30%, so another possible $1813 loss.

For this investment income, is it just withdrawals?  I mean, it is ok if your Ira account grows as long as you don't withdraw, right?  If so, maybe some benefit to alternating withdrawal years.  for example, withdraw enough for 2 years in 2014, put in an regular  interest earning account that earns 3,299.99 or less interest for 2015, but withdraw nothing from IRA in 2015.   I may be reading this wrong, but a possible strategy to get the EITC every other year after retired.

brooklynguy

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Re: Nasty Tax Cliffs
« Reply #16 on: October 31, 2014, 08:35:02 PM »
Both the ACA tax credits and the Earned Income Tax Credit also have tax cliffs in the opposite direction, where $1 less in income can cost you thousands in additional taxes (or lost profits, since both of these tax credits are refundable even if you owe no taxes).

If your income falls just below the minimum required amount (which will vary depending on whether your state expanded Medicaid), you will miss out on potentially thousands of dollars in ACA tax credits.  If you are in a state with a Medicaid coverage gap, you are shit out of luck and have to purchase private insurance at full cost (if you want insurance).  Even if you are in a state without a Medicaid coverage gap, you can end up in a situation where you purchase insurance expecting it to be subsidized by ACA tax credits, but then your income turns out to be a little less than anticipated, which means you won't be eligible for the tax credits for the entire year (and you can't go back in time to enroll in Medicaid instead of purchasing private insurance).

Similarly, for the EITC, you won't qualify if your earned income falls below the the minimum required amount.

VirginiaBob

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Re: Nasty Tax Cliffs
« Reply #17 on: October 31, 2014, 08:45:08 PM »
Can't think too many cliffs, but in another thread we were discussing switching from Roth to Traditional IRA to increase the earned income credit by about $2500.

On further review, you may get a higher EITC, but you might also be cutting out your child tax credit, making this almost a wash.  Child tax credit only applies to taxes paid, although the alternative child tax credit may come into play.  So by reducing your income to get a higher EITC, you may be reducing your tax liability down to zero, which will eliminate your child tax credit.

forummm

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Re: Nasty Tax Cliffs
« Reply #18 on: October 31, 2014, 08:57:29 PM »
If you are on a ACA subsidized plan, going over the 400% of the poverty level income for your household completely wipes out your subsidy.

This can be a cliff, but doesn't have to be. At 400% FPL, the premium tax credit is only the difference between the 2nd lowest cost silver plan in your area and 9% of your household income (i.e. capping your expense for health insurance at 9% of your income). In many cases (say if you're not that close to 65) your premium will be less than 9% of your household income, so you won't actually be getting any tax credit anyway.

GardenFun

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Re: Nasty Tax Cliffs
« Reply #19 on: October 31, 2014, 08:59:13 PM »
Can't think too many cliffs, but in another thread we were discussing switching from Roth to Traditional IRA to increase the earned income credit by about $2500.

On further review, you may get a higher EITC, but you might also be cutting out your child tax credit, making this almost a wash.  Child tax credit only applies to taxes paid, although the alternative child tax credit may come into play.  So by reducing your income to get a higher EITC, you may be reducing your tax liability down to zero, which will eliminate your child tax credit.

Until this thread, I thought the child tax credit went away above the set maximums.  Now I know it is a phase-out.  Nice to know that earning an extra $1 won't completely wipe out a $2K tax credit. 

Joel

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Re: Nasty Tax Cliffs
« Reply #20 on: November 01, 2014, 10:39:04 AM »
Thank you for running the software.  Is there any way at all to create a long term cap gains/qualified dividend cliff with a mix of wages and investment income?

You're welcome.  I'm not aware of any tax cliffs with long term cap gains or qualified dividends, other than those that occur regardless of income source (like your ACA tax credit, for example).

Good correction beltim. If the dividends put you over it's gradual, not a cliff. Often misunderstood concept.

Glad this got pointed out. Related to this situation, if someone is straddling the 15% and 25% tax brackets, and has a significant enough chunk of qualified dividends or long term capital gains, you can actually be at a 30% marginal tax rate. Meaning one more ordinary income dollar earned results in 15% taxes on that dollar, while also pushing one of your qualified dollars from0% to 15%, resulting in the 30% marginal rate. As I straddle this area, I pay close attention to my traditions vs. roth contributions throughout the year to make sure it's close enough to make the exact traditional IRA contribution to not have a 30% marginal rate.

teen persuasion

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Re: Nasty Tax Cliffs
« Reply #21 on: November 01, 2014, 09:35:22 PM »
If your investment income is $1 over $3300, you become ineligible for the EITC, a loss of up to $6044.  My state matches EITC at 30%, so another possible $1813 loss.

For this investment income, is it just withdrawals?  I mean, it is ok if your Ira account grows as long as you don't withdraw, right?  If so, maybe some benefit to alternating withdrawal years.  for example, withdraw enough for 2 years in 2014, put in an regular  interest earning account that earns 3,299.99 or less interest for 2015, but withdraw nothing from IRA in 2015.   I may be reading this wrong, but a possible strategy to get the EITC every other year after retired.

Investment income is line 8a, 8b, 9a, and 13 (but only gains, can't use losses to lower it).  So this is only taxable accounts, not IRA withdrawals.

Also, you need EARNED income to be eligible for the earned income credit.  IRA withdrawals won't count.  So if you are FIRE you would need at least some sidegig earnings.
« Last Edit: November 01, 2014, 09:40:04 PM by teen persuasion »

teen persuasion

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Re: Nasty Tax Cliffs
« Reply #22 on: November 01, 2014, 09:56:46 PM »
Can't think too many cliffs, but in another thread we were discussing switching from Roth to Traditional IRA to increase the earned income credit by about $2500.

On further review, you may get a higher EITC, but you might also be cutting out your child tax credit, making this almost a wash.  Child tax credit only applies to taxes paid, although the alternative child tax credit may come into play.  So by reducing your income to get a higher EITC, you may be reducing your tax liability down to zero, which will eliminate your child tax credit.

We have had zero fed taxable income after 401k deductions, and you are right that you can't take the CTC, but the additional CTC does kick in, in full.  That is, we get $2k for two kids under 17.  However, we can't get the retirement savers credit, since it is not refundable.

For our income situation, tIRA contributions won't increase EITC, because they don't reduce our line 7 wages, only our AGI.  The EITC tests BOTH line 7 and line 38, and gives you the LOWER credit, which is usually from the higher income (unless your income is really low and you are on the uphill side of the curve, not in the phaseout downhill).  For us, with three kids left on our taxes, phaseout begins at $23k-ish.  We'd have to be below $13400 to be on the uphill side.  At that income level, I'd be converting tIRAs to Roths instead.

MDM

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Re: Nasty Tax Cliffs
« Reply #23 on: November 01, 2014, 10:33:33 PM »
Seems a good group of tax-wise people following this thread.

If anyone would like to check the spreadsheet referenced in http://forum.mrmoneymustache.com/ask-a-mustachian/how-to-write-a-'case-study'-topic/msg274228/#msg274228 for accuracy (tax or otherwise), that would be great. 

As mentioned in the above post, the purpose of the spreadsheet is to help people compose a case study.  There is no intent to include all possible tax situations - TurboTax, Excel1040.com, etc. are welcome to that space.  But it would be good to know that what is covered is correct. 

If there are any blatant errors, please PM me.  Or post them for all to see: won't be the first nor last spreadsheet error I'll ever make.  Improvement requests will also be seriously considered, and several have already been implemented.  Of course, "this is not a commercial product" also means some things will forever be out of scope.  Thanks.

mlipps

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Re: Nasty Tax Cliffs
« Reply #24 on: November 01, 2014, 11:25:32 PM »
Can't think too many cliffs, but in another thread we were discussing switching from Roth to Traditional IRA to increase the earned income credit by about $2500.

On further review, you may get a higher EITC, but you might also be cutting out your child tax credit, making this almost a wash.  Child tax credit only applies to taxes paid, although the alternative child tax credit may come into play.  So by reducing your income to get a higher EITC, you may be reducing your tax liability down to zero, which will eliminate your child tax credit.

We have had zero fed taxable income after 401k deductions, and you are right that you can't take the CTC, but the additional CTC does kick in, in full.  That is, we get $2k for two kids under 17.  However, we can't get the retirement savers credit, since it is not refundable.

For our income situation, tIRA contributions won't increase EITC, because they don't reduce our line 7 wages, only our AGI.  The EITC tests BOTH line 7 and line 38, and gives you the LOWER credit, which is usually from the higher income (unless your income is really low and you are on the uphill side of the curve, not in the phaseout downhill).  For us, with three kids left on our taxes, phaseout begins at $23k-ish.  We'd have to be below $13400 to be on the uphill side.  At that income level, I'd be converting tIRAs to Roths instead.

Exactly what I came here to say!

And there's no cliff on the EITC as someone said earlier, it phases in as your income increases, then phases out after a certain point.

DoubleDown

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Re: Nasty Tax Cliffs
« Reply #25 on: November 03, 2014, 10:12:12 AM »
A few years ago I unwittingly discovered a huge marriage penalty in the form of passive rental income/expenses. Deductions start getting phased out at $100k MAGI, and are completely wiped out at $150k MAGI. It turns out those limits are the same whether you're married or single, so I was completely f*ed when I got married and our combined MAGI got pushed over $150k (yeah yeah, MMMs and Louis CK's White People Problems).

That little change cost me an extra $15k in taxes every year after I got married, even though our respective incomes and all other circumstances were unchanged. It's also annoying that the tax code makes no provision for where the real estate is, as though a house in Topeka, KS has the same value, rents, and expenses as, say, NYC.

brooklynguy

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Re: Nasty Tax Cliffs
« Reply #26 on: November 03, 2014, 01:33:31 PM »
A few years ago I unwittingly discovered a huge marriage penalty in the form of passive rental income/expenses. Deductions start getting phased out at $100k MAGI, and are completely wiped out at $150k MAGI. It turns out those limits are the same whether you're married or single, so I was completely f*ed when I got married and our combined MAGI got pushed over $150k (yeah yeah, MMMs and Louis CK's White People Problems).

That little change cost me an extra $15k in taxes every year after I got married, even though our respective incomes and all other circumstances were unchanged. It's also annoying that the tax code makes no provision for where the real estate is, as though a house in Topeka, KS has the same value, rents, and expenses as, say, NYC.

Doubledown, just to clarify, you are talking about the exception to the passive activity rules that allows you to deduct up to $25k of passive losses against ordinary income, right?

If so, I didn't follow your last point about different real estate markets -- why should you get to deduct more of your losses in one market versus another?  Presumably in more expensive markets you will collect higher rent but also have higher depreciation and other expenses.

minimustache1985

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Re: Nasty Tax Cliffs
« Reply #27 on: November 03, 2014, 02:50:11 PM »
If you make enough to get hit with the Alternative Minimum Tax.  Losing the state and property tax deductions can be a massive hit.  One more reason to max out the 401(k)!

dragoncar

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Re: Nasty Tax Cliffs
« Reply #28 on: November 03, 2014, 03:17:48 PM »
If you make enough to get hit with the Alternative Minimum Tax.  Losing the state and property tax deductions can be a massive hit.  One more reason to max out the 401(k)!

This has a phase-out too, though

Cheddar Stacker

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Re: Nasty Tax Cliffs
« Reply #29 on: November 04, 2014, 07:44:06 AM »
A few years ago I unwittingly discovered a huge marriage penalty in the form of passive rental income/expenses. Deductions start getting phased out at $100k MAGI, and are completely wiped out at $150k MAGI. It turns out those limits are the same whether you're married or single, so I was completely f*ed when I got married and our combined MAGI got pushed over $150k (yeah yeah, MMMs and Louis CK's White People Problems).

That little change cost me an extra $15k in taxes every year after I got married, even though our respective incomes and all other circumstances were unchanged. It's also annoying that the tax code makes no provision for where the real estate is, as though a house in Topeka, KS has the same value, rents, and expenses as, say, NYC.

Doubledown, just to clarify, you are talking about the exception to the passive activity rules that allows you to deduct up to $25k of passive losses against ordinary income, right?

If so, I didn't follow your last point about different real estate markets -- why should you get to deduct more of your losses in one market versus another?  Presumably in more expensive markets you will collect higher rent but also have higher depreciation and other expenses.

One of the great benefits to living in a lower cost of living area is the tax code ignores it. As an example, the standard deduction of ~$6K per person doesn't care if you live in NYC or Omaha. In relation to this, and possibly what DD meant, is that this $150K limit is the same for everyone from the hot shot banker in NYC to the farmer in Omaha.

Also DD, while you can't deduct the passive rental losses they don't disappear, they carry forward and can either offset passive income or will be fully deductible when you sell the rental property. So it's not a total loss, but it is a pain in the ass in the meantime.

DoubleDown

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Re: Nasty Tax Cliffs
« Reply #30 on: November 04, 2014, 11:52:45 AM »
A few years ago I unwittingly discovered a huge marriage penalty in the form of passive rental income/expenses. Deductions start getting phased out at $100k MAGI, and are completely wiped out at $150k MAGI. It turns out those limits are the same whether you're married or single, so I was completely f*ed when I got married and our combined MAGI got pushed over $150k (yeah yeah, MMMs and Louis CK's White People Problems).

That little change cost me an extra $15k in taxes every year after I got married, even though our respective incomes and all other circumstances were unchanged. It's also annoying that the tax code makes no provision for where the real estate is, as though a house in Topeka, KS has the same value, rents, and expenses as, say, NYC.

Doubledown, just to clarify, you are talking about the exception to the passive activity rules that allows you to deduct up to $25k of passive losses against ordinary income, right?

If so, I didn't follow your last point about different real estate markets -- why should you get to deduct more of your losses in one market versus another?  Presumably in more expensive markets you will collect higher rent but also have higher depreciation and other expenses.

One of the great benefits to living in a lower cost of living area is the tax code ignores it. As an example, the standard deduction of ~$6K per person doesn't care if you live in NYC or Omaha. In relation to this, and possibly what DD meant, is that this $150K limit is the same for everyone from the hot shot banker in NYC to the farmer in Omaha.

Also DD, while you can't deduct the passive rental losses they don't disappear, they carry forward and can either offset passive income or will be fully deductible when you sell the rental property. So it's not a total loss, but it is a pain in the ass in the meantime.

Yes, what CheddarStacker said!

Allen

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Re: Nasty Tax Cliffs
« Reply #31 on: November 04, 2014, 02:30:16 PM »
So, if your expenses were irrelevant and you can live forever off savings that are earning non-taxable or zero interest, what is the 'best' income to make to maximize things?

MDM

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Re: Nasty Tax Cliffs
« Reply #32 on: June 30, 2015, 01:38:53 PM »
Another thread got me thinking about tax cliffs, or when $1 more in income costs you hundreds or even thousands in additional taxes.
The Saver's Credit.  The largest cliffs are at $18K for single and $36K for MFJ.

devan 11

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Re: Nasty Tax Cliffs
« Reply #33 on: July 01, 2015, 07:23:13 AM »
  The tax trap for traditional IRA's that hits at required minimum distribution age of 70.5 years old is one that will hit us, depending on market growth over the years it takes for us to get that age. When IRA's became available, later when Roth's became available, when 401k's became available and when Roth 401k's became available, we maxed out each and all that we could.  We took an "Extreme Early Retirement" type path because we barely made enough money to pull it off.  Now, we are FI in a few days, but future projections predict that we will hit be hit by high taxes when we get old enough to RMD.

  Starting next year, we will convert what we can from traditional IRA's to Roth IRA's and that will help, but I never expected to reach the point that yearly IRA growth would overtake the place where we could reasonably convert.

Axecleaver

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Re: Nasty Tax Cliffs
« Reply #34 on: July 01, 2015, 10:15:10 AM »
Not a strict cliff, but the exemption and deduction phase-outs, and AMT around $309k AGI MFJ are pretty brutal, especially for people in a high tax state. Marginal rates in excess of 50%.

dragoncar

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Re: Nasty Tax Cliffs
« Reply #35 on: July 01, 2015, 12:12:40 PM »
Not a strict cliff, but the exemption and deduction phase-outs, and AMT around $309k AGI MFJ are pretty brutal, especially for people in a high tax state. Marginal rates in excess of 50%.

Don't the phase outs amount to like 3% higher marginal rate?

Axecleaver

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Re: Nasty Tax Cliffs
« Reply #36 on: July 02, 2015, 11:25:28 AM »
It depends on what deductions you have; more deductions mean a higher marginal rate. We pay really high property tax, school taxes, and a state income tax around 7.6%. So, big Schedule A deductions normally. When the phase outs kick in, you lose the personal exemption in pieces, and then a portion of your deductions disappear. In my case, my marginal rate was 56%.

dragoncar

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Re: Nasty Tax Cliffs
« Reply #37 on: July 02, 2015, 12:55:47 PM »
It depends on what deductions you have; more deductions mean a higher marginal rate. We pay really high property tax, school taxes, and a state income tax around 7.6%. So, big Schedule A deductions normally. When the phase outs kick in, you lose the personal exemption in pieces, and then a portion of your deductions disappear. In my case, my marginal rate was 56%.

Ok, I assume you know what you are talking about but help me understand.

Lets say I'm a married filer making $309,900 AGI in California.  I've got a million dollar house with an 800k mortgage at 4%.  I pay 1% in property taxes.  So mortgage interest is $32,000, property tax is $10,000, and California taxes (after those deductions) are $20,040.  So my federal deduction is $62,040, making my Federal taxable income $247,860, for a Federal tax bill of $57,698.  By the way, my marginal Federal rate here is around 30%, and total marginal rate of 40.6%.

Now lets say I earn an extra $1000.  Now I've got phase outs!  California taxes (after full deductions) are $20,133.  So my federal deduction is $62,133, minus 3% of $1000, for a final deduction of $62,103.  My Federal taxable income $248,797, for a Federal tax bill of $58,008.

I made an extra $1000, and paid an extra $310 in taxes, making my marginal rate 31%.  My marginal rate went up by only 1%.  Even including my state marginal rate, SSI and Medicare, my marginal rate is 41.6%. 

Now this excludes the personal exemption and standard deduction for simplicity.  But the analysis is very similar for personal exemption phaseout -- two personal exemptions are normally equivalent to $8,000 deduction.  Before the phaseout, an $8,000 exemption saves me $8,000*(marginal rate=40.6%), or $3,248.  But say I'm $2,500 over the phase-out, the exemption is reduced by 2%, saving me only $8,000*0.98*(marginal rate=40.6%), or $3183.  So the phaseout causes me to pay an extra $65 in taxes on an extra $2,500 in income -- increasing my marginal rate by 2.6%. 

Since the deduction phaseout increases my marginal rate by 1%, and the exemption phaseout increases my marginal rate by 2.6%, both together will increase my marginal rate by 3.6%.  Thus, my total marginal rate will increase from 40.6% to 44.2%. 

I fail to see how a 56% marginal rate is possible, but I'd love to see an example.



MDM

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Re: Nasty Tax Cliffs
« Reply #38 on: July 02, 2015, 01:38:45 PM »
By the way, my marginal Federal rate here is around 30% ... Thus, my total marginal rate will increase from 40.6% to 44.2%. 

I fail to see how a 56% marginal rate is possible, but I'd love to see an example.
With taxable incomes above $464,850 the marginal Federal rate is 39.6%.  Adding 9.6% to 44.2% gets one to 53.8%.  Not quite 56%, but close enough that 56% seems plausible given other circumstances.

dragoncar

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Re: Nasty Tax Cliffs
« Reply #39 on: July 02, 2015, 02:39:38 PM »
By the way, my marginal Federal rate here is around 30% ... Thus, my total marginal rate will increase from 40.6% to 44.2%. 

I fail to see how a 56% marginal rate is possible, but I'd love to see an example.
With taxable incomes above $464,850 the marginal Federal rate is 39.6%.  Adding 9.6% to 44.2% gets one to 53.8%.  Not quite 56%, but close enough that 56% seems plausible given other circumstances.

The 30% is a 33% marginal rate, minus state tax deductions.  So it's really 44.2%+6.6%=50.8%

Don't forget, the marginal rate due to Pease drops after $435k (because the personal exemption is totally gone at that point).  Eventually, most people will also hit the 80% cap on deduction phase-out.  So once you are in the truly top bracket of 39.6% Federal + 12.3% CA + 2.35 medicare = 54.25% , there's no "bonus rate" to get you up to 56%.  It may be possible but it's an extreme corner case (millions in income + hundreds of thousands of deductions, plus some kind of local taxes like NYC, self-employment, plus you are terrible at tax management)
« Last Edit: July 02, 2015, 02:42:29 PM by dragoncar »

Jeremy

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Re: Nasty Tax Cliffs
« Reply #40 on: July 02, 2015, 11:14:53 PM »
How about with SS income, any cliffs there?

There is a Social Security Tax Torpedo

It phases in, but for people on the edge of income bands it can result in high phantom marginal rates
(see marginal rate charts in this post: http://www.gocurrycracker.com/social-security-tax-torpedo/)

Axecleaver

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Re: Nasty Tax Cliffs
« Reply #41 on: July 03, 2015, 10:19:27 AM »
Quote
I fail to see how a 56% marginal rate is possible, but I'd love to see an example.

You're right, I played around with this a bit and when I dug into it, I came up with a 51.85% marginal rate. Here's how I got there.

339k total income
247k AGI

The AMT tax rate is normally 28% and is assessed on the disallowed deductions- state tax, real estate and school taxes in my case. But, because we're in the phase-out stage, the rate increases from 28 to 35% on the disallowed deductions until the phase outs are exhausted, at which point the marginal rate drops back to 28%. For an explanation of this see http://www.amtadvisor.com/AMT_Exemption.html, or check out the calculation on line 29 of Form 6251. I filled out two 6251's with a difference of $1000 in income, and this resulted in an increase of $65 in the AMT. So, net is 6.5% to the marginal rate at this point in the phase-outs. This form is complicated but the key seems to be in the line 29 calculation.

The exemption loss is 2.6% (you showed a good example there, thanks!)

33% federal bracket
6.85% NYS tax bracket.
2.9% Medicare tax on self employment (see 1040 SSE - why is this shown as 2.35% in some calcs?).
6.5% AMT
2.6% exemption loss
---
51.85% marginal rate


MDM

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TomTX

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Re: Nasty Tax Cliffs
« Reply #43 on: July 03, 2015, 08:17:37 PM »
Another thread got me thinking about tax cliffs, or when $1 more in income costs you hundreds or even thousands in additional taxes.
The Saver's Credit.  The largest cliffs are at $18K for single and $36K for MFJ.

As an example of the smallest cliff: a single can earn $30,000, put $2,000 in an IRA and get a $200 credit. Earn $30,001, put $2,000 in an IRA and get $0. Yep, earning $1 means you really have a loss of $199.

Should have put another $1 in a tIRA instead of the ROTH ;)

johnny847

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Re: Nasty Tax Cliffs
« Reply #44 on: July 03, 2015, 08:43:56 PM »
Another thread got me thinking about tax cliffs, or when $1 more in income costs you hundreds or even thousands in additional taxes.
The Saver's Credit.  The largest cliffs are at $18K for single and $36K for MFJ.

As an example of the smallest cliff: a single can earn $30,000, put $2,000 in an IRA and get a $200 credit. Earn $30,001, put $2,000 in an IRA and get $0. Yep, earning $1 means you really have a loss of $199.

Should have put another $1 in a tIRA instead of the ROTH ;)


This hypothetical person can recharacterize $1 of the Roth contribution to a traditional contribution and get the credit back.

TomTX

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Re: Nasty Tax Cliffs
« Reply #45 on: July 03, 2015, 08:59:59 PM »
Another thread got me thinking about tax cliffs, or when $1 more in income costs you hundreds or even thousands in additional taxes.
The Saver's Credit.  The largest cliffs are at $18K for single and $36K for MFJ.

As an example of the smallest cliff: a single can earn $30,000, put $2,000 in an IRA and get a $200 credit. Earn $30,001, put $2,000 in an IRA and get $0. Yep, earning $1 means you really have a loss of $199.

Should have put another $1 in a tIRA instead of the ROTH ;)


This hypothetical person can recharacterize $1 of the Roth contribution to a traditional contribution and get the credit back.

Yep, and they actually could have an extra 6 months to do so.

frugledoc

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Re: Nasty Tax Cliffs
« Reply #46 on: July 04, 2015, 03:18:34 AM »
In UK earnings between 100 - 120 k are taxed at 62%

dragoncar

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Re: Nasty Tax Cliffs
« Reply #47 on: July 05, 2015, 03:58:55 PM »
Quote
I fail to see how a 56% marginal rate is possible, but I'd love to see an example.

You're right, I played around with this a bit and when I dug into it, I came up with a 51.85% marginal rate. Here's how I got there.

339k total income
247k AGI

The AMT tax rate is normally 28% and is assessed on the disallowed deductions- state tax, real estate and school taxes in my case. But, because we're in the phase-out stage, the rate increases from 28 to 35% on the disallowed deductions until the phase outs are exhausted, at which point the marginal rate drops back to 28%. For an explanation of this see http://www.amtadvisor.com/AMT_Exemption.html, or check out the calculation on line 29 of Form 6251. I filled out two 6251's with a difference of $1000 in income, and this resulted in an increase of $65 in the AMT. So, net is 6.5% to the marginal rate at this point in the phase-outs. This form is complicated but the key seems to be in the line 29 calculation.

The exemption loss is 2.6% (you showed a good example there, thanks!)

33% federal bracket
6.85% NYS tax bracket.
2.9% Medicare tax on self employment (see 1040 SSE - why is this shown as 2.35% in some calcs?).
6.5% AMT
2.6% exemption loss
---
51.85% marginal rate

Thanks, that's totally plausible.  But I still wouldn't call that a "cliff"... I found a good graph here:



http://taxfoundation.org/blog/there-are-more-marginal-income-tax-rates-advertised

Obviously it can't account for different deduction amounts.  And I couldn't find one that shoes total effective rate by income, which is really what we mean when we (I?) say "cliff" -- i.e., one extra dollar earned has >100% marginal tax rate.
« Last Edit: July 05, 2015, 04:00:32 PM by dragoncar »

foobar

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Re: Nasty Tax Cliffs
« Reply #48 on: July 08, 2015, 06:55:36 PM »
Quote
I fail to see how a 56% marginal rate is possible, but I'd love to see an example.

You're right, I played around with this a bit and when I dug into it, I came up with a 51.85% marginal rate. Here's how I got there.

339k total income
247k AGI

The AMT tax rate is normally 28% and is assessed on the disallowed deductions- state tax, real estate and school taxes in my case. But, because we're in the phase-out stage, the rate increases from 28 to 35% on the disallowed deductions until the phase outs are exhausted, at which point the marginal rate drops back to 28%. For an explanation of this see http://www.amtadvisor.com/AMT_Exemption.html, or check out the calculation on line 29 of Form 6251. I filled out two 6251's with a difference of $1000 in income, and this resulted in an increase of $65 in the AMT. So, net is 6.5% to the marginal rate at this point in the phase-outs. This form is complicated but the key seems to be in the line 29 calculation.

The exemption loss is 2.6% (you showed a good example there, thanks!)

33% federal bracket
6.85% NYS tax bracket.
2.9% Medicare tax on self employment (see 1040 SSE - why is this shown as 2.35% in some calcs?).
6.5% AMT
2.6% exemption loss
---
51.85% marginal rate

Medicare tax is 1.45% on both the business owner and employer. 2.9% for self employed (note you get a deduction for half of those taxes). There is an additional .9% medicare tax on income over 200k (250 married). 1.45+.9= 2.35.

I think CA prohibits city income taxes but a combo of 39.6%, 13.3, 3.8, and some 4% city tax would be scary:)

Medicare tax is 1.45%. 2x 1.45 is 2.9. You get to write off half as a business expense. The 2.35

MDM

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Re: Nasty Tax Cliffs
« Reply #49 on: October 08, 2015, 07:33:17 PM »
Quote
I fail to see how a 56% marginal rate is possible, but I'd love to see an example.

As Jeremy alluded (and discussed in more detail in his blog link):
There is a Social Security Tax Torpedo
It phases in, but for people on the edge of income bands it can result in high phantom marginal rates
(see marginal rate charts in this post: http://www.gocurrycracker.com/social-security-tax-torpedo/)
Social Security taxation can enforce extremely high marginal rates on relatively low incomes.  E.g., for your typical single 64 year old West Virginian getting $2K/mo in SS and withdrawing $3K/mo from a tIRA, the real marginal rate on another $100/yr IRA withdrawal is 57%: (25% federal + 6% state) * ($1.85 taxable per $1 increased ordinary income) = 31% * 1.85 = 57%

Granted, the fraction of all people who meet those requirements is small, but it's an example.  ;)