The first thing to understand about tax rates is how they work. Above you are seeing the 2013 tax rates.
The tax rate applies to your taxable income that falls in the respective single or married range. For example, if your taxable income is $89,000 and you are single, here is how the tax is calculated:
How Tax is Calculated Using 2013 Tax Rates
- The first $8,925 is taxed at 10%, so you pay $893
- The next $27,325 is taxed at 15% so you pay $4,099
- The next $51,600 is taxed at 25% so you pay $12,900
- And the last $1,150 is taxed at 28% so you pay $322
- Total taxes owed would be $18,214
You would be at the 28% marginal rate, but notice only $1,150 of your income is taxed at that rate.
Understanding how tax rates work is important to building a successful retirement plan.
2013 Tax Rates Are Good News for Those in the 10% & 15% Tax Brackets
The good news for those with taxable incomes under about $36,000 for singles and $72,000 for married couples is that the 0% tax rate on long term capital gains and qualified dividends was made permanent.
This means qualified dividends paid by stocks and mutual funds (not all dividends are qualified for this lower tax rate) and long term capital gains (this means you owned the investment for at least twelve months, and realized a gain when you sold it) may fall into a zero percent tax rate for you, and thus you will truly be earning tax free money! There are not very many opportunities to do this other than by using a ROTH IRA.
The other good news for those in the lower tax brackets is a permanent fix for AMT (Alternative Minimum Tax). AMT is a parallel tax calculation that uses a different set of rules. If you owe more under the AMT rules than under the regular tax rules, you have to pay the higher amount. Under the AMT rules, you calculate your taxable income but then get to reduce it by an exemption amount. For singles that exemption amount is $51,900; for marrieds it is $80,750.
New 2013 Tax Rules Includes Bad News For High Earners
Many rules changed for high income earners. Let’s take a look at some of them.
- Medicare Surtax on Earned Income
This is a tax that works just like current payroll taxes (FICA taxes). It is a .9% tax on earned income that applies to earned income in excess of $200,000 for singles and $250,000 for marrieds.
- Medicare Surtax on Investment Income
This is a 3.8% tax that applies to investment income if your adjusted gross income is in excess of $200,000 for singles and $250,000 for marrieds. I provide details on how it works and what types of investment income it applies to in Medicare 3.8% Tax – What is It and How Will it Apply to You.
- Phaseouts Reinstated
In addition to the new taxes above, the phaseout of itemized deductions and personal exemptions has resurfaced. This was a rule that has been around before and with 2013 tax changes it was reinstated. Here's how it works: you may start losing some of your deductions and exemptions if you are single with adjusted gross income (AGI) of $250,000 a year or a married couple filing jointly with AGI of $300,000 or more. You’ll lose 2% of your personal exemptions for each $2,500 beyond the threshold limit, and 3% of your itemized deduction to the extent your AGI exceeds the threshold.
- AMT for High Earners
The alternative minimum tax is most likely to affect singles with incomes of about $200,000 - $350,000 and married couples with incomes in the $250,000 to $475,000 range. (You may be more likely to have to pay AMT tax if you have a large family with many dependents that you claim, pay high state taxes, high property taxes or have large miscellaneous itemized deductions.)
Using 2013 Tax Rates While Still Saving
In our example at the top of this article, let’s assume the person was not making any contributions to a retirement plan. Suppose they started contributing $2,000 to a traditional IRA or company 401k plan. The first $1,150 saves them taxes at the 28% rate; so in this example it reduces their tax bill by $322. The next $850 saves them taxes at the 25% rate, so it will save them $213. Their $2,000 deductible IRA contribution reduced their tax bill by $535.
Now suppose this person lost their job part way through the year, and expected their taxable income for the year was going to be about $25,000. Maybe they still have money in savings they could move to an IRA, but does it make as much sense now? That same IRA contribution would only save them tax at the 15% rate so it would reduce their tax bill by $300. Perhaps a ROTH IRA would make more sense.
When viewed over the long run, which type of account to fund should in large part be dependent on what tax rate you are at today, and what tax rate you expect to be at during retirement. It takes a multi-year tax projection to figure this out and plan appropriately.
In addition to managing the types of accounts you contribute to based on tax rates, you may have investment income that could be repositioned to reduce your overall annual tax bill while maintaining your appropriate asset allocation. I discuss this in Rearrange Investments to Reduce Taxable Income.
Using Tax Rates While Planning Your Retirement Income
Tax planning gets more complex when you begin planning for retirement income. Learn how to apply the rates above in 2013 Tax Planning Moves - By Income and Age.
At the time I wrote this the IRS had not officially released 2013 tax rates, but many reputable organizations have imputed the numbers which should turn out to be accurate. All the following sources were used for this article:
- Tax Foundation.org 2013 Tax Brackets
- Oblivious Investor Tax Bracket Changes
- Michael Kitces, January 2013 The Kitces Report
- ISOs: AMT by myStockOptions.com