Is Your Marginal Tax Rate Being Distorted by Phase Outs?

As your taxable income increases, certain deductions and credits start to phase out and gradually get reduced, often down to zero. There are even new taxes levied on you, including the net investment income tax and additional Medicare tax. As a result, it’s important to understand whether you are approaching or exceeding certain income thresholds to determine whether there are any tax strategies available to you.

Here is a list of tax items that phase out or get reduced as your income increases:

• Child tax credit

• Qualified business income deduction

• Direct Roth contributions

• Deductible IRA contributions

• Dependent care credit

In this article we will discuss how the phase out of these items distorts your marginal tax rate from the rates listed in the tax tables.

What Is A Marginal Tax Rate?

The marginal tax rate is used to compute the tax effect of a change in taxable income. For example, if your federal marginal tax rate is 37% and you increase your taxable income by $100, you’ll pay an additional $37 in income tax. Conversely, if you decrease your taxable income by $100 you’ll pay $37 less in tax. 

How do We Compute Your Marginal Tax Rate?

For most situations, it’s as easy as finding where your taxable income falls on a table like the one below. 

Married filing jointly in 2023

Source: https://www.irs.gov/filing/federal-income-tax-rates-and-brackets

Example of Marginal Tax Rate Distortion

For many physician households, determining the marginal tax rate is not as easy as looking at the tax table. We created the following example of a hypothetical physician household to illustrate this effect.

Filing Status: Married filing jointly

W-2 Income: $350,000

Net 1099 Income: $100,000

Pre-tax Solo 401(k) Contributions: $20,000

Qualified Business Income Deduction

Often referred to as “QBID” or just “QBI”, this is a deduction equal to 20% of the net 1099 income (there’s a little more to the calculation but for the sake of this example we will leave it at that). For certain types of businesses, including healthcare, you can’t deduct QBID once your taxable income gets over a certain amount. There’s a taxable income at which your deduction starts getting reduced and continues to be reduced to $0 as your taxable income increases. Taxable income in this case is computed without regard to QBID, otherwise we would have a circular calculation.

Here are the QBID phase out ranges for single and married households:

Child Tax Credit

This is a credit for each dependent child under age 17 and is worth up to $2,000 per child. The credit is phased out gradually as your adjusted gross income (“AGI”), rather than taxable income, increases.  AGI is your gross income minus certain adjustments like solo 401k contributions, ½ of self-employment tax, and self-employed health insurance deductions.

AGI is different from taxable income because it hasn’t been reduced by QBID (referenced above) or by your standard or itemized deductions.

Here are the child tax credit phase out ranges: 

Examples of Phase Out Bubble and Its Effect On Your Marginal Tax Rate

As shown above, a $20,000 pre-tax solo 401(k) contribution reduced federal taxes by $8,233!

$8,233 / $20,000 = 41% 

According to the tax tables, the taxable income falls in the 32% tax bracket with or without the $20,000 solo 401(k) contribution. The difference between the 41% we calculated and the 32% tax table rate is explained by additional QBI deduction and increased child tax credit.

The takeaway is this - If you’re using marginal tax rates now and expected marginal tax rates in retirement to decide between pre-tax and Roth, you should be aware of these tax rate distortions and factor them into your planning decisions.

How Does Marginal Tax Rate Distortion Impact Your Retirement Plan Choices and Why Do We Care?

Here are two reasons:

1. Tax savings from pre-tax retirement plan contributions

2. Should you favor Roth or pre-tax contributions? Or a mix of both?

Regarding the Roth vs pre-tax, one way to answer this question is to determine your marginal tax rate now and your expected marginal rate in retirement. If your marginal rate now is lower than what you expect in retirement you would favor Roth and if your marginal rate is higher now than what you expect in retirement you would favor pre-tax. Some additional points to consider:

• You should maximize contributions to your workplace retirement accounts such as a 401(k) to take advantage of tax-advantaged growth and potentially reduce your taxable income

• The 2024 contribution limit is $23,000 for pretax and Roth employee contributions made to 401(k), 403(b), and most 457 plans, as well as the federal government's Thrift Savings Plan. Employees who are 50 and older can save an extra $7,500 in catch-up contributions, bringing their employee contribution limit to $30,500

• If you have a retirement plan held with former employers, you should consider consolidating these investments with your current plan

• If cash flow permits, you may want to make after-tax contributions to your 401(k). After-tax contributions can be rolled over upon separation of service or potentially earlier to a Roth

Earned’s Advisors can model Roth vs pre-tax scenarios to determine what strategy may be best for your situation and financial goals. 

This article is provided for educational purposes only and does not constitute specific tax or investment advice. Individuals should seek the opinion of a qualified tax or investment professional prior to taking any action.