The White House recently introduced what it billed the “biggest
tax cut” in U.S. history. While a presidential tax proposal is not likely to
get passed without significant changes, the fact that Republicans dominate both
chambers of Congress suggests 2017 may well be a year in which significant tax
reform is engineered.1
One thing should be perfectly clear: The U.S. tax code is highly
complicated.2 There may not be anyone who understands it all off the
top of their head. CPAs and tax professionals must conduct thorough due
diligence to tailor strategies and complete returns for taxpayers with complex
situations.
Because of this, we recommend our clients who require tax advice
work directly with an experienced and qualified tax professional. However, we
also believe financial and tax professionals should not work in a vacuum, and
therefore are more than happy to work in concert with our clients’ tax advisors
to help align their financial strategy with their tax situation.
This is particularly important when it comes to retirement
planning, because you want to save as much as possible before you retire, which
may include tax-deferred financial vehicles such as a 401(k) or IRA, but you
don’t want to get hit with a big tax bill on untaxed earnings once you’re in
retirement.3 This is a delicate balance that requires experience and
collaboration from both a financial professional and a tax professional.
One tax issue each of us deals with is the federal income tax
rate. Our annual earnings determine which federal tax bracket we land in, but that tax bracket isn’t the tax rate applied to our entire income.
Instead, we pay every tax rate on income blocks up to our individual bracket. Like
many things about filing taxes, this can be highly confusing for many people.
It may be easier to understand this through a hypothetical example.
Let’s say Joe, who is single, had $92,000 of taxable income in 2016, which
landed him in the 28 percent tax bracket. This is how his total tax is
calculated:4
·
He pays 10%
on the first $9,275 (tax of $927.50)
·
He pays 15%
on the next $28,375 (tax of $4,256.25)
·
He pays 25%
on the next $53,500 (tax of $13,375)
·
He pays 28%
on the final $850 (tax of $238)
o
Total tax
bill of $18,796.75
As you can see, Joe doesn’t pay 28 percent on the full amount of
his taxable income; his taxable amount progresses through each income bracket
and their respective tax rates until it reaches his total taxable income for
the year. Therefore, a person who falls in the highest tax bracket is only
paying that higher tax rate on a portion of his or her income.
This is an important distinction to remember as the U.S. works
toward tax reform. On one hand, reducing the number of tax rates from seven to
three (Trump’s proposal: 10 percent, 25 percent, 35 percent)5 looks
to simplify tax filings, but for many people, this could mean paying a higher
tax rate on larger blocks of income. Let’s take the hypothetical example of Joe
again, using the same income brackets (to date, no tax rate income brackets
have been proposed). Here’s how Joe’s scenario might break down:
·
He pays 10% on
the first $9,275 (tax of $927.50)
·
He pays 25%
on the next $81,875 (tax of $20,468.75)
·
He pays 35%
on the final $850 (tax of $297.50)
o
Total tax
bill of $21,693.75
This example simply illustrates how a progressive income tax
works. Obviously, it doesn’t take into consideration credits and deductions,
which vary substantially among taxpayers. Nor does it include payroll taxes.6
Federal income brackets and their respective tax rates are the
most fundamental issues Americans are subject to when filing taxes. But as you
can see, there’s nothing straightforward about them. This is worth remembering
as tax reforms continue to be proposed and debated moving forward: Nothing
concerning taxes is simple, and there are usually layers that impact us that
the average layperson isn’t likely to see.
Content prepared by Kara Stefan Communications
1 Fox News. April 26, 2017. “Mnuchin vows
‘biggest tax cut’ in US history, confirms plan to slash business rate.” http://www.foxnews.com/politics/2017/04/26/mnuchin-vows-biggest-tax-cut-in-us-history-confirms-plan-to-slash-corporate-rate.html.
Accessed May 5, 2017.
2 Vanessa Williamson. The Atlantic. April 18,
2017. “How the Tax-Filing Process Confuses Americans about Tax Policy.” https://www.theatlantic.com/business/archive/2017/04/paying-taxes-confusion-policy-1040/523287/.
Accessed May 5, 2017.
3 Fidelity. March 1, 2017. “How to invest tax
efficiently.” https://www.fidelity.com/viewpoints/investing-ideas/tax-strategy.
Accessed May 5, 2017.
4 Tina Orem. Nerd Wallet. Sept. 8, 2016. “2016
Federal Income Tax Brackets.” https://www.nerdwallet.com/blog/taxes/federal-income-tax-brackets/.
Accessed May 5, 2017.
5 Martha C. White. NBC News. May 2, 2017. “Even
Families Making $100K Won’t Be Better Off Under New Tax Plan.” http://www.nbcnews.com/business/taxes/even-families-making-100k-won-t-be-better-under-new-n753941.
Accessed May 5, 2017.
6 NPR. 2017. “On Tax Day, an Economist
Outlines How the Payroll Tax Works.” http://nhpr.org/post/tax-day-economist-outlines-how-payroll-tax-works#stream/0.
Accessed May 5, 2017.
These
hypothetical examples are for illustrative purposes only. This information is
not intended to provide tax advice. Be sure to speak with qualified
professionals about your unique situation.
We are an
independent firm helping individuals create retirement strategies using a
variety of insurance and investment products to custom suit their needs and
objectives. This material is intended to provide general information to help
you understand basic financial planning strategies and should not be construed
as financial advice. All investments are subject to risk including the
potential loss of principal. No investment strategy can guarantee a profit or
protect against loss in periods of declining values.
The
information contained in this material is believed to be reliable, but accuracy
and completeness cannot be guaranteed; it is not intended to be used as the
sole basis for financial decisions. If you are unable to access any of the news
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