Why Taxes go Wrong
Often clients find that they owe more taxes than they thought they would. That even happens sometimes when they have consulted me to estimate their taxes, but not as often. There are many reasons, but today I’d like to talk about just one of them–the marginal tax rate.
We hear it talked about all the time. Federal income taxes are progressive: the more you make, the higher your tax rate. This is true, but not the way many think it is.
Everyone pays 10% of their first $9275 (for single people, other statuses are different, just go along with me on this) of income. Then they pay 15% on the next $28,375 of income (the difference between $9275 and the next threshold of $37,650). That 15% only applies to the portion of income that exceeds the 10% threshold. Whatever the thresholds are for the various filing statuses, it works just the same.
Let me repeat. You only pay the higher rate on the amount of income that exceeds the threshold for the previous rate. If the threshold for 15% is $9275 and you make $9275 plus $1, you pay 15% of $1 (that’s $0.15). This is what’s called the marginal tax rate. Often it is described as the tax rate for the next dollar you earn. Although it also applies to unearned income.
Confused yet? Let’s clear the air.
The reason I bring this up is that many people get more income than they think they do, and they also think they have had taxes withheld to pay the tax on that income.
Why would there be more income than is apparent? Here are some reasons:
- Hidden income–for example social security income is taxable on a sliding scale based on other income
- Bad records–if assets such as stocks are sold, improper basis records may make more taxable
- Bad profit calculations–the sale of assets requires the add back of depreciation from prior periods
Why would there be confusion on withholding? Here are some issues:
- Most retirement companies will only withhold 10% or 20% of the withdrawal. Even if the taxpayer is at the 10% rate, the 10% penalty for early withdrawal has to be considered.
- Many people forget the marginal tax rate issue. If you income is already $40,000, then adding the withdrawal amount may push some or all of the withdrawal into the next tax rate, plus the 10% penalty.
- And even without retirement withdrawals, additional taxable social security may not have any corresponding withholding.
And business owners must pay 15% self-employment tax, in addition to their income tax.
This is not intended to be a tutorial on tax planning. It is intended to be a reminder on how important tax planning is. Usually, the reason people that have consulted with me about their tax bill still pay unexpected taxes is that they did something else after they talked to me.
And, of course this says nothing about state taxes that may be involved.
Unless you simply have a W2, taxes in the US are complicated. The complications are those of details, knowing what’s what, and keeping track of it. But the one fact that cannot be ignored is that the details need to be known before the action is taken. You can’t expect even a professional tax preparer to fix mistakes you make out of ignorance, unless you act before the fact, and usually before the end of the year in question.
After you read this do the following two things:
- Set a date in June or July to review your income up until that point.
- On that date, actually do the review.
Include everything–pay from work, withdrawals from retirement, side business, everything. Then use your copy of TurboTax, or consult a tax professional, and calculate the expected tax and see where you are.
Keep this appointment whether you do it yourself or hire someone to do it. Just do it.
If you want some accountability, email me your date. I’ll send you an email then to ask how it went. No pressure, so sales pitch, just a reminder.
It will be time well spent.