The first thing to understand about tax rates is how they work. In the chart above are the 2014 tax rates.
The applicable tax rate applies only to the amount of taxable income that falls in the respective single or married range. For example, if your taxable income is $91,000 and you are single, here is how the tax is calculated:
How Your Tax Bracket Works
- The first $9,075 is taxed at 10%, so you pay $907 on that amount
- The next $27,824 is taxed at 15% so you pay $4,174 on that portion
- The next $52,449 is taxed at 25% so you pay $13,112
- And the last $1,650 is taxed at 28% so you pay $462
- Total taxes owed would be $18,655
In this situation you would be at the 28% marginal rate, but notice only $1,650 of your income is taxed at that rate.
Understanding how tax rates work is important to building a successful retirement plan.
2014 Capital Gains Tax Rates - Zero Percent!
Many people are unaware that there is now a 0% tax rate that applies to long term capital gains and qualified dividends for those that fall in the 15% or lower tax bracket. That means for those with taxable income under about $36,900 for singles and $73,800 for marrieds they can use smart tax planning to pay very little tax on their investment gains.
This type of smart planning would involve intentionally harvesting capital gains at the zero percent tax rate. In this way the gains don't build up and you do not have a large embedded tax liability on down the road. There are not very many ways to truly earn tax-free money so I think a strategy that helps you manage capital gains is worth the effort.
AMT(Alternative Minimum Tax) 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 $52,800; for marrieds it is $82,100.
2014 Tax Rules for High Income Earners
Let’s take a look at some of the tax rules that now apply to those with higher incomes.
- 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 $254,200 a year or a married couple filing jointly with AGI of $305,050 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 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 $1,650 saves them taxes at the 28% rate; so in this example it reduces their tax bill by $462. The next $350 saves them taxes at the 25% rate, so it will save them $87. Their $2,000 deductible IRA contribution reduced their tax bill by $550.
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.
It is smart to use your expected tax bracket to determine which type of account to fund each year. Those who have have income that varies a lot each year (like a real estate agent, or other sales person) can realize a lot of benefit by doing this consistently. You can find out how much you can contribute to which types of accounts in 2014 Retirement Plan Limits.
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. Each withdrawal you take from a traditional IRA is taxable income, and once you turn 70 1/2 you are required to take withdrawals. To make things more complex, all your combined sources of income affect how much of your Social Security income will be taxed. Learn more about the taxation of your retirement income in Taxes in Retirement.