Monday, October 1, 2012


There has been a lot of BUZZ lately about “effective tax rate” in light of the public release of Mitt Romney’s tax returns.

How should a taxpayer evaluate a tax rate, especially his/her own?

When we speak of “effective tax rate” we generally mean dividing the “total tax” (Line 61 for 2011) number from a Form 1040 by the Adjusted Gross Income (Line 37 for 2011). 

But it that a true picture?  Should the tax figure in the calculation be Line 61 or Line 55?  Line 55 is the federal income, or alternative minimum, tax liability less allowable “non-refundable” tax credits.  Line 61 includes other taxes such as “self-employment tax”, unreported FICA taxes, and the penalty on premature withdrawals from a pension account.  In my opinion you should use Line 55 to determine the true “effective income tax rate”.

And what about refundable credits reported under the “Payments” section of the return, such as refundable portions of the Earned Income Credit, American Opportunity Credit, Homebuyer’s Credit, and Child Tax Credit.  These credits should be deducted from the amount on Line 55 in determining the federal income tax liability that is used in determining “effective income tax rate”.

As we “speak” I am looking at a 2010 tax return from a married couple with one child in high school.  One spouse works full time and one works part time.  The AGI is $134,957, and Line 55 and Line 60 (the appropriate line for 2010) are both $17,999.

Their “effective tax rate” under the normal calculation is 13 1/3%.  But the AGI includes a deduction for a spousal IRA contribution.  Their “Total Income” is $137,407, so should their effective tax rate be 13.1%? 

The full-time spouse contributes to a 401(k), which reduces his gross taxable income.  Should the 401(k) contribution be added back to Line 22, when calculating a true “effective tax rate”?

And what about tax-exempt municipal bond interest reported on Line 8b?  Should this amount be added to either Total Income or Adjusted Gross Income?  With my example the couple had $1,030 in municipal bond interest, so this would minutely effect their effective tax rate calculation.

Because they own a mortgaged home and live in NJ the couple has substantial itemized deductions.  If we look at the tax rate as Line 55 divided by Line 41, AGI less itemized deductions, the rate is 15.86%.  And if we use “Taxable Income” after deducting personal exemptions the result is 17.56%.

They are in the 25% tax bracket (and they are not victims of the dreaded Alternative Minimum Tax), so their “marginal tax rate” is 25%.  If they had $5,000 more of additional income (taxed as ordinary income) they would pay $1,250 more in income.  Every additional $1.00 of “ordinary” income is taxed at 25%, and conversely every additional $1.00 of deductions saves them 25% ($100 more of charitable contributions reduces their liability by $25 – though they would actually be $75 “out of pocket”).

If the couple took a premature withdrawal from a pension plan they would pay 25% in federal income tax on the income, and, unless they qualify for an exemption, an additional 10% in penalty tax.  So the amount of the withdrawal would actually cost 35% in combined federal taxes.  A $10,000 withdrawal would only put $6,500 “in pocket”.

And when determining the actual cost of additional income one must add the appropriate state and local income taxes and, if the additional income is wage income or net earnings from self-employment, applicable payroll taxes (FICA tax withholding or “net” self-employment tax after factoring in the corresponding adjustment to income).

But every additional $1.00 of qualified dividends or long-term capital gains is taxed at 15%.  For lower income taxpayers every additional $1.00 of qualified dividends or long-term capital gains could be taxed at 0%.

Sometimes additional income is effectively taxed at a rate that is substantially more than their “marginal tax rate”.

Because of the way Social Security and Railroad Retirement benefits are taxed, it is possible that every additional $1.00 of income, regardless of the source, is taxed as $1.85.  Such a person who is in the 15% tax bracket will actually pay 27.75% in federal income tax on additional ordinary income, and a person in the 25% bracket will pay 46.25%! 

While qualified dividends and long-term capital gains for such a person in the 15% bracket are separately taxed at a rate of 0%, additional income of this nature for a Social Security recipient could be taxed at 12.75%!  And tax-exempt income reported on Line 8b are included in the calculation of taxable Social Security and Railroad Retirement benefits, so additional income in this category may actually be taxed.   

So you see, as with just about everything else when it comes to taxes, it ain’t simple.


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