Do you have a working understanding of basic income tax rates?

[Roland Slugg]

On December 15, 2016, you met for lunch with a client for whom you had just done simple tax planning. After the meal you review with him a print-out of his projected income and taxes, which was all based on information he had recently furnished you, and which he believes is very close to actual. The client is a 61-yo single man with no dependents, and his 2016 income is expected to be as follows:

* Interest income ... $1,500
* Dividends, 100% qualified ... $15,000
* Long-term capital gain ... $8,000
* Rental income ... $30,000
* He does not itemize.
* His 2016 estimated tax was set up on a “safe” basis at $3,680 ... four installments of $920 ... which have (or will) all be paid on time.

Before coming to this meeting you entered all the above in your tax program, and it shows tax of $3,688 and a projected balance due of $8.

For purposes of this exercise, I invite all interested viewers to enter the above information in your own tax prep program, using a fictitious “dummy” taxpayer, and making sure that you, too, see that the 2016 tax is projected to be $3,688 and the tax due to be $8. When you get to this point, turn away from the computer and pretend you are now at lunch with this client. You don’t have your computer or tax prep program with you at lunch.

Your client now informs you that he is considering taking $10,000 from his IRA before year’s end, and asks you how much more his 2016 federal income tax will be if he does that. You know he has no basis in his IRA, so any distributions will be fully taxable.

With the print-out of his projected 2016 income in front of you, you can see that his projected taxable income is just over $44,000, of which $23,000 represents qualified dividends (QD) and LTCG. A quick visit to IRS.gov on your phone to consult the tax rate schedule reminds you that the 15% tax rate for single taxpayers ends at $37,650, and the 25% tax rate on ordinary income starts above that level. You also realize that when you reduce his taxable income by the total of his QD and LTCG, only about $21,000 is subject to the tax rates on his ordinary income.

Your client has asked you, “How much more will my federal income tax be if I withdraw $10,000 from my IRA this year?” What do you tell him?

I urge you to answer this question based on your working knowledge and understanding of how the taxes on ordinary income and “tax favored” income ... ie QD and LTCG ... interact. Can you give your client an accurate reply to his question right on the spot? I also recommend that you NOT read anyone else's replies before you come up with your own answer, as that will defeat the purpose of this exercise. The correct answer may surprise some readers here.

[Rapid Robert]

Can you give your client an accurate reply to his question right on the spot?

No, nor would I try. If it was easy enough to do in your head (which is what I assume you mean by "right on the spot"), we wouldn't need the Qualified Dividends and Capital Gain Tax Worksheet (QDCGTWS).

But I'm pretty sure you're getting at the fact the cap gains rates are "stacked" separately from ordinary income, and my guess is the $10K extra taxable income will not be taxed at more than 15%.

Higher end tax software will actually provide a worksheet showing exactly how the total tax is reconciled to the different tax rates when coming up with the final tax calculation. As a professional, I invest in using professional tools, and that is what I would bring to bear in service of this client.

[kathyc2]

30% 15% marginal rate from the 10K, plus 15% from pushing 10K more from 0 ltcg rate to 15% rate.

The next part of the question should be what other questions should you ask him to recommend if he take the additional 10K or not?

[DonB]

Without looking, I will guess 32.5% of the $10,000 will go to tax. I have made mistakes in the past disregarding the taxation of QD and LTCG on such advise.

[kathyc2]

Questions such as this are related to a bigger issue. Are you a computer operator, tax preparer or tax advisor?

Computer operator enters the information in software and expects it to be correct. My software has saved me from mistakes many times. There have also been times when it produces results different that what I expect. That is when someone that is more than a computer operator will look into what caused the difference. Was it because a box was not checked to produce the correct results?

Tax preparers have a good understanding of how taxes work and can take the documents provided by clients to produce an accurate return.

Tax advisors take it a step further. Their understanding is such that they can make recommendations to reduce tax liability. If someone has an HSA and is not fully funding but paying medical expenses outside of HSA, do you explain to them the difference if they were to run all expenses through HSA? If someone is close to benefitting from RSC do you look at how making a prior year IRA contribution can have a large percentage tax saving? If the Sch A deductions are close to standard to you explain how shifting between years will benefit them by taking standard /itemized every other year?

Everyone can move up the levels if they are willing to put in the time and effort. A good exercise for computer operators is during the off season to take source documents from a prepared return and start from scratch to prepare the return without software. If the manual return is different than the computer one, look at what the differences are and develop an understanding of where you need further knowledge.

To move from a preparer to an advisor, again in the off season look at returns you have prepared. Do you see anything on them that if client would have done something different the tax liability would have changed?

[Rapid Robert]

I have made mistakes in the past [regarding] the taxation of QD and LTCG on such advise.

So have I. That is why, in my previous reply, I was careful not to actually answer the exact question posed. It's always possible to come up with a scenario where there is a completely unexpected "phantom" marginal tax rate, due to phase-outs and limitations and whatnot.

I think it's much better to tell a client you don't know the answer but will get back to them, than to take a guess and have to retract it. Imagine calling the client the next day and trying to tell him you made a mistake, and he says, "oh, I already went ahead and made the IRA withdrawal this morning!"

[Rapid Robert]

Questions such as this are related to a bigger issue. Are you a computer operator, tax preparer or tax advisor?

Or a financial advisor? Or a risk management consultant?

I think in the end it's usually true that the tax tail should not wag the dog. Many times I've thoroughly explained to a client what the tax consequences of certain actions are, and they go ahead and take the tax hit anyway for reasons of cash flow, or questions about whether deferring to the income or tax to a future year might not even be worse, because with these decisions there is often risk involved. This applies to both high income and low income clients.

[TAXNJ]

Well stated and it should be reposted every quarter!

To the points presented, two that stand out are:

...... Are you a computer operator, tax preparer or tax advisor? .....

Everyone can move up the levels if they are willing to put in the time and effort.......

Most important " if they are willing to put in the time and effort"

[Bonnie]

Always the unexpected, so I rely on software but also am always searching for the why. Had a new client this year and wife and 5 other siblings had inherited some property and then sold it a couple years later with capital gains. Initially they kept questioning me about what % they would pay. Someone had told them all siblings would pay the same and I tried to explain that's not so depending on other income and what tax bracket each sibling was in. After looking over other income for my client I told them quite possible there would be no capital gains tax (which there wasn't), but they owed 2550 which was for the excess premium tax credit repayment because she had insurance through the marketplace. I was not expecting this. I ended up doing 4 of the 6 returns for the siblings and all 4 were so different with the exact same amount of capital gain. Interesting experience

[kathyc2]

Absolutely nothing wrong with using software to speed things up or to serve as a double check on math and knowledge. I think we have all seen prior year returns from new clients where it was obvious software was relied on in place of common sense.

My point was if someone doesn't have a good understanding of what the answer should look like, how would they know to check if it was correct or not? IMO it comes from a feel developed over time as to what the answer should be, but if someone doesn't understand the math behind the return, I don't know how they can develop the "feel".

It's the same concept as using a calculator. Most of us don't consciously do math in our head, but instinctively know if the result on the calculator is wrong.

Quickbooks and similar programs will produce the correct results if the information is entered correctly. I would guess we have all had clients that enter transactions willy nilly in QB and the result is not even close to what it should be. Same concept with tax software.

I think the following is my favorite example of relying too much on technology. Last summer an investment advisor was trying to sell my client a financial product. They gave him a nice amortization printout, which he in turn brought to me for my opinion. I tried to replicate the schedule in Excel so I could put in different parameters, but could not get the numbers to match the schedule. I called the investment advisor and asked him to walk me through how they got from year 1 to year 2 numbers. He said he didn't know, but if they put the numbers in the computer they get the printout. Yikes!

[taxea]

I would not even attempt to answer. It is a waste of my time to manually figure all this out when I can get it done much quicker using my program. Is he preparer shopping? Is there a possibility that he would qualify for EIC?

[RitaB]

No and No

I would not even attempt to answer. It is a waste of my time to manually figure all this out when I can get it done much quicker using my program. Is he preparer shopping? Is there a possibility that he would qualify for EIC?

In the original post, we are told that it's an existing client and that his investment income is well over the limit for EIC. And that there actually is no earned income at all.

I thought it was a good post, and I've been guilty of forgetting that even though a LTCG may be taxed at X%, it could also increase taxable SS benefits, and oops, I told you wrong...

[Gretel]

I thought it was a good post, and I've been guilty of forgetting that even though a LTCG may be taxed at X%, it could also increase taxable SS benefits, and oops, I told you wrong...

I agree, first thing I did was looking if SS benefits are involved. That in itself could bump the taxable income into the 25% tax bracket and increase capital gains taxability. While I would not want to give a client a hard number not being close to my computer, I would try to explain the general taxable effect of the additional distribution.

The original post ask about "a working understanding of tax rates", and yes, I feel that is important to understand how capital gains are effected.

Where are you, Roland? Would you give the client a hard number?

[Roland Slugg]

The answer to the client's Q, as kathyc2 correctly posted in her first reply, is that the additional tax on the $10,000 IRA distribution the client asked about would, indeed be $3,000. That's 30% of the $10,000 even though there is no 30% tax bracket, per se, on either ordinary income or on LTCGs or QDs. kathyc2 also correctly explained the reason for this "contra-intuitive" result.

LTCG and QD income is "stacked" on top of ordinary income, so if a taxpayer's taxable income excluding his LTCG/QDs is below the start of the 25% tax bracket, then some or all of his LTCG/QDs will be taxed at 0%. I'm sure almost everyone who visits this forum knows this. But if the taxpayer's ordinary income is then increased, that increase will, in turn, cause an equal portion of the same taxpayer's LTCG/QDs to become taxed at 15% instead of 0%. The 15% ordinary income tax on the additional $10,000 IRA distribution, PLUS 15% tax on the client's LTCG/QD income that is no longer in the 0% bracket comes to $3,000 altogether ... 30%.

A 30% increase is not always the case. It can be less. The income in the OP was carefully chosen to demonstrate this phenomenon is its simplest form. However, if the client's ordinary income had been less, so that his taxable income including his LTCG/QDs was still below the top of the 15% tax bracket, then additional ordinary income would push only a portion of his LTCG/QDs out of the 0% bracket and into the 15% bracket on tax-favored income. For example, suppose the client's taxable income was, say, $35,650. That's $2,000 below the top of the 15% regular tax bracket. Now an additional $10,000 of ordinary income will push only $8,000 of his LTCG/QDs out of the 0% bracket, resulting in an additional tax of $2,700 ... $1,500 tax on the extra $10,000 of ordinary income, plus $1,200 tax on the $8,000 of LTCG/QD that gets "pushed" out of the 0% bracket and into the 15% bracket on that category of income.

Look at yet a slightly different scenario: Assume the same client's taxable income was, say, $57,650, of which $23,000 is LTCG/QDs, the same as before. Now what will be the effect of an additional $10,000 of ordinary income? The answer is $2,650, and it consists of three elements: (1) $3,000 of the additional $10,000 gets taxed at 15%, (2) $7,000 of that additional $10,000 gets taxed at 25%, because when his ordinary taxable income crossed the $37,650 level, he entered the 25% tax bracket, and (3) $3,000 of his LTCG/QDs that had been in the 0% bracket get pushed out of that bracket and into the 15% bracket. Adding it all up, and you get $2,650 ($3,000 x 15%, plus $7,000 x 25%, plus $3,000 x 15%).

You would think a person's tax would get higher as his income increased, especially when he crosses from the 15% tax bracket into the 25% tax bracket, and, of course, the tax itself does. However, as you can see from these examples his tax rate actually decreases in the three sets of assumptions used here after first jumping to 30%. It then decreases to 27% and to 26½%. If you consider a fourth assumption, one where the taxpayer's income was already in the 25% tax bracket even without his LTCG/QDs, then the tax on an additional $10,000 of ordinary income would be just the 25% alone, or $2,500. The tax on his LTCG/QDs would be unaffected.

The fact pattern presented in the OP is a fairly common one that probably fits many of your clients. It certainly fits several of mine. The point of this exercise was to demonstrate that it is useful to have a working understanding of the interplay between the tax rates on ordinary income and LTCG/QDs when the 0% tax bracket on LTCG/QDs is in play. In almost all cases before-the-fact tax planning is far more valuable to our clients than is after-the-fact tax return preparation.

There is a corollary to the above: If ordinary income goes down, it can, within certain income ranges, cause a taxpayer's tax to go down at that same 30% rate. Using the same facts as in the OP, if the client's rental income turns out to be $1,000 less, his tax will decrease by $300 ... 30%. Finally, it is good to understand that whereas additional ordinary income can also cause the tax on LTCG/QDs to increase, the opposite of that is not the case. An increase in LTCG/QDs will not increase the tax on ordinary income.

At lunch that day I explained that the $10,000 would cost him $3,000 in tax and asked if he had any other options for raising the $10,000 he needed. He happened to have a stock he was willing to sell some of, so he did that instead. The proceeds were $10,000 and the LTCG on its sale was about $6,000, resulting in additional tax of only $900.

[Rapid Robert]

" the additional tax on the $10,000 IRA distribution the client asked about would, indeed be $3,000"

That is not what you asked originally. You asked, "How much more will my federal tax be?" The answer to that question, indeed, is $3K.

I correctly answered (first!) a slightly different question, that the tax on the additional $10K would be no more than 15%. You are now incorrectly stating that the tax on the $10K IRA distribution is $3,000, unless you are going to make the absurd argument that this $10K IRA distribution is subject to both ordinary plus LTCG rates simultaneously. Next thing you know, someone will be saying that for a taxpayer who is otherwise eligible for, let's say, a $2,500 EIC, that if one extra dollar of investment income puts them over the threshold for EIC eligibility, then the tax on that one dollar was $2,500. In fact I think I know some people who make that absurd argument too. ;-)

You did state correctly, "The 15% ordinary income tax on the additional $10,000 IRA distribution, PLUS 15% tax on the client's LTCG/QD income"

It is true that some other income already in the picture is now going to be taxed at a different rate, but that is not the same as the tax on the $10K of marginal ordinary income.

Before you say I am just nitpicking, let me remind you it was YOU who asked, "do you have a working understanding of basic income tax rates?" :-)