NO INCOME IS TAXED ALONE

Fellow tax blogger Trish McIntire, of OUR TAXING TIMES, recently gave us an excellent post titled “No Income is Taxed Alone”.

Trish was talking about withholding – and the problem that arises when there are multiple sources of income or couples who both work.

As Trish points out in her post –

“Withholding is based on that particular income source; paycheck, IRA distribution or other income.”

If a spouse fills out a Form W-4 with her employer claiming “Married – 1” the withholding will be based on the often false assumption that the wages from which the tax is being withheld is the only source of taxable income. 

If the other spouse does not work, and the couple does not have substantial other income, the withholding should be sufficient to cover the tax cost of the wage income.

But what happens if the other spouse also works, and makes more money, and/or one or both of the spouses is collecting Social Security or Railroad Retirement, and/or is self-employed, and/or the couple has a substantial capital gain or substantial interest and dividend income?  Then the “Married – 1” withholding on the wages will be nowhere near enough to cover the tax cost of that particular source of income, and the couple could end up with a huge balance due to Uncle Sam and their resident state.

But if the couple also has substantial itemized deductions – state income and real estate taxes, mortgage interest, charitable contributions, etc – the balance due will be less.

You must take all sources of income, and all deductions, into consideration when deciding what to claim on a federal and state W-4 (while the federal W-2 usually also covers state income tax withholding - you can often file a separate federal W-2 and state W-4).

As a general rule I advise my two-income couples to have the spouse with the smaller wage income claim “Married, but withheld at the higher Single rate – 0”.

Just what is the tax cost of a particular source of income?  You might think it is your marginal tax rate.  If you are in the 25% tax bracket you would expect that $10,000 of additional income would cost $2,500 in federal income tax.  Or $1,500 if the income is qualified dividends or long-term capital gains. 

But this is very often not necessarily the case.  Why?  Because additional taxable income will increase your Adjusted Gross Income (AGI), and many tax deductions and credits are reduced or totally eliminated based on one’s Adjusted Gross Income or a “Modified” Adjusted Gross Income (MAGI).

Here are just some of the tax items that are affected by AGI or MAGI –

 

·      losses from rental real estate activities,

·      traditional IRA contributions,

·      the ability to contribute to a ROTH IRA

·      student loan interest,

·      qualified tuition and fees,

·      medical and dental expenses,

·      casualty and theft losses,

·      miscellaneous deductions,

·      the Credit for Child and Dependent Care Expenses,

·      the American Opportunity and Lifetime Learning credits,

·      the Retirement Savings Contributions Credit, and

·      the Child Tax Credit

And additional taxable income could increase the amount of Social Security or Railroad Retirement benefits that are taxed.  An additional $1,000 could increase your taxable income by as much as $1,850!

And additional taxable income will increase Alternative Minimum Taxable Income, which could in turn reduce the exemption allowed under the dreaded AMT.  $1,000 in additional income could add $1,250 to income subject to the dreaded AMT.

Even though we are told that the maximum tax on qualified dividends and long-term capital gains is 0%, 15%, or 20%, under both the regular tax and the dreaded AMT, the actual tax cost of additional qualified dividends and long-term capital gains, under both the regular tax and the dreaded AMT, could be much more than 0%, 15%, or 20%. 

We certainly know that investment income could be subject to the 3.8% Net Investment Income Tax (NIIT).  SInce qualified dividends and long-term capital gain are included in investment income, additional qualified dividends and long-term capital gains could be taxed at 18.8% or 23.8%.

So not only is no income taxed alone, but no income is taxed separately, or in a vacuum. 

This is just more proof of the complexity of the US Tax Code.  And of the need for careful year-round tax planning with the help of a tax professional.

TTFN