Using marginal income tax rates may be a flawed approach

By Steve Savant

Ash Brokerage Corporation

Co-written by Steve Savant and Ken Davis, CLU, ChFC, CFP, CPA

Tax rates are useful in evaluating proposed financial transactions. But before we consider the best way to do that, lets define what we mean by "tax rates" as used in this article:

Marginal income tax rate: The amount of tax paid on an additional dollar of income. The marginal income tax rate is taken from the highest tax bracket a taxpayer would be required to use to compute their income taxes before the proposed transaction is made.

Effective income tax rate: The average rate at which income is taxed. An effective tax rate is calculated by dividing total tax expense by taxable income. The authors’ opinion is that the effective income tax rate is not a useful metric for evaluating the purchase of a financial asset.

Effective marginal income tax rate: This is a hybrid of the prior two calculations. We take the taxes caused by the marginal income tax rate and add any additional taxes the transaction creates to come up with the total taxes caused by the transaction. This sum is then divided by the total taxable income to derive the effective marginal income tax rate.

An example of using only the marginal income tax rate: Weigh the net after tax results of purchasing taxable bonds versus municipal bonds. Consider a taxable bond paying 5 percent with the same duration and quality rating as a municipal bond paying 3.75 percent. Which is the best choice for federal income tax purposes?

Well, if your marginal income tax bracket is less than 25 percent, then the taxable bond is the best bet. We derive that by subtracting 25 percent of the interest rate to arrive at 3.75 percent. If it was 20 percent, the after-tax interest rate would be 4 percent and therefore greater than the municipal bond net after tax interest rate.

In this example 25 percent is the “crossover” point where higher tax rates would cause the municipal bonds to be the superior choice.

However, the transaction may trigger other parts of the income tax law that increase the overall tax impact. If you’re buying a municipal bond that will provide “so-called” tax-free income, then you may also be required to include a portion, or all, of your Social Security income in taxable income. Municipal bond income is included in provisional income. This is the amount that determines if your Social Security income is taxable. Thus, additional tax rules like this may cause the marginal effective income tax rate to be substantially higher than the marginal income tax rate.
But wait, there is more! What if you buy a piece of raw land with no current taxable income? You purchase the land and five years later you sell it for a very nice profit of $10,000. This is classified as a long-term capital gain (LTCG). Let’s say your marginal LTCG rate is only 15 percent and creates $1,500 in additional taxes. You may very well be patting yourself on the back for deferring taxes and then getting a low tax rate. But are there other correlated tax consequences you’ve missed?

Take a look at the form 1040 federal income tax return. Your LTCG will be reported on Schedule D. Assuming this is the only capital gain or loss you have, that amount flows to page one. It then travels down to the bottom line on page one. That is called adjusted gross income (AGI). And now an unexpected tax effect may kick in. This is subtle but important. The capital gain income has been included at 100 percent, or $10,000 in our example, not 15 percent or $1,500.

How can that be? The tax rate is applied to the LTCG, but the full amount of the capital gain travels through the tax return and impacts the AGI. The higher AGI may affect the taxation of things like the inclusion of Social Security income, alternative minimum tax calculations and many other deductions, credits and exemptions that may be phased out at higher AGI levels. All of these favorable tax items are limited if the AGI is too high. And to add to the confusion, they all have different formulas for limitation.

Now back to your land deal. We make $10,000 in LTCG. That causes $8,500 in additional Social Security income, in our example, to be included in our tax return. At a marginal income tax bracket of 25 percent, that increases our taxes on the capital gain by $2,125 (.25 times $8,500). That is a net effective percentage income tax rate of over 21 percent on our $10,000 gain. This is then added to our 15 percent capital gains tax. So, instead of paying only 15 percent on the capital gain, we end up paying a total of $3,700 or a 37 percent effective tax rate.

And who knows, the increase in AGI or modified adjusted gross income (MAGI) may cause other tax issues to arise as well. The only good way of evaluating the tax impact of a transaction is to use a tax projection software package to look at the before and after tax cost on new income. The software considers all the various tax law elements to find the end result on a before and after basis. It is virtually impossible to give a quick, off-the-cuff estimate of taxes on a proposed transaction.

Now that you see the problem, how can we help our clients? Take a look at the article, “How can line 20(b) help you sell more annuities?" located on the ProducersWEB site. This article demonstrates how a combination annuity strategy can reduce adjusted gross income and thereby reduce or eliminate some of the alternative tax impacts on additional income.

And of course the seasoned insurance professional will also realize that there are many other tax strategies employing both life insurance and annuities that can favorably impact the clients’ taxes. Deferral is king right now. It provides the richest variety of opportunities we have to help our clients build their wealth.