Financial Wisdom

Understand the Tax Implications of Financial Decisions

The Internal Revenue Code is a very complex and often confusing set of rules. Individuals sometimes let tax issues cloud their decision-making. Here are three areas where some simple reminders can help you make wiser financial decisions:

The income tax rate structure

Our marginal tax rate structure generally means that income at lower levels is taxed at lower rates than income at higher levels. There are complex rules about how to calculate taxable income, taking into account deductions and exemptions. The 2001 tax law started to bring rates down and the 2003 tax law change accelerated that reduction. The tax rates start at 10% and go up to 39.6%. Below are tax tables for 2017.

The Income Tax Rates for 2017

2017 Single Return Rate Schedule

 

2017 Married Filing Jointly Rate Schedule

Taxable income levels

Tax rate

 

Taxable income levels

Tax rate

0 to $9,325

10%

 

0 to $18,650

10%

$9,326 to $37,950

15%

 

$18,651 to $75,900

15%

$37,951 to $91,900

25%

 

$75,901 to $153,100

25%

$91,901 to $191,650

28%

 

$153,101 to $233,350

28%

$191,651 to $416,700

33%

 

$233,351 to $416,700

33%

$416,701 to $418,400

35%

 

$416,701 to $470,700

35%

Over $418,400 39.6%   Over $470,700 39.6%

2017 Taxes on capital gains and dividends compared to regular taxes

For taxpayers in the 10% and 15% brackets, qualifying dividends and long term capital gains (assets held for more than a year) will be taxed at 0%. For those in 25%, 28%, 33% and 35% tax brackets, the tax rate on dividends and long term capital gains is 15%. For those in the top 39.6% bracket, the tax rate is 20%.

2017 Medicare Surtaxes

As part of the health care reform enacted in 2010, additional Medicare surtaxes began in 2013 for high income wage earners and high income investors. The surtaxes apply when a single taxpayer's Modified Adjusted Gross Income (MAGI) exceeds a threshold of $200,000 or joint return filers when their MAGI exceed $250,000.

  • For wage earners, an additional 0.9% Medicare surtax applies to wages (including bonuses and self-employment income) above the threshold amounts.
  • For investors, an additional 3.8% Medicare surtax applies to net investment income (taxable interest, dividends, capital gains, etc.) in excess of the thresholds.

Taxable vs. tax free bonds

Those in higher tax brackets often benefit from tax-exempt interest income. To see if you should consider tax-exempt bonds, compare the after-tax yield of a taxable bond to the yield of a tax-exempt bond. To calculate the after tax yield of a taxable bond you can use the following formula:

For example, here is the equation to calculate the after tax yield of a taxable bond with a yield of 6% for someone in the 35% marginal tax bracket.

AFTER TAX YIELD = 6% - (6% X .35)
                            = 6% - (2.1%)
                            = 3.9%

Or, you can use the following table:

Tax exempt yield
Equivalent taxable yields in these marginal tax brackets
15%
25%
28%
33%
35%
39.6%
3.0%
3.5
4.0 4.2 4.5
4.6
5.0
3.5%
4.1
4.7 4.9 5.3
5.4
5.8
4.0%
4.7
5.3 5.6 6.0
6.2
6.6
4.5%
5.3
6.0 6.3 6.8
6.9
7.5
5.0%
5.9
6.7 6.9 7.5
7.7
8.3
5.5%
6.5
7.3 7.6 8.3
8.5
9.1

The tax brackets are those in effect in 2017.

Remember, to get a true comparison it is critical that the taxable and tax exempt bonds have similar maturity dates and similar quality ratings.

According to the chart, a tax-exempt bond yielding 4.0% has an equivalent after-tax yield of 6.0% for someone in the 33% tax bracket. For that person, a taxable bond yielding more than 6.0% will produce a better after tax return.

Final Words
Taking time to understand how the tax laws apply to your financial situation will enable you to make more informed decisions. You should always consult your tax advisor to determine how the rules apply to your situation and remember that state income taxes must be considered.