Income Tax 101 for Investment and Tax Planning

With this article, I hope to equip the reader with a basic understanding of the individual income tax calculation and the use of a taxpayer’s marginal tax rate or tax bracket in investment and income tax planning.

The tax brackets, also called marginal tax rates, can be used to calculate the tax cost of additional income or the tax benefit of additional adjustments to income or additional itemized deductions. This article does not incorporate state income tax rates into the discussion, your tax professional should add the state tax rate when considering the tax cost or benefit of a recommendation. The U.S. Income tax calculation breaks down as follows:

  1. Report all items of income subject to tax to arrive at gross income
  2. Report all adjustments to gross income to arrive at the taxpayer’s adjusted gross income
  3. Report all itemized deductions and determine if itemized deductions are greater than the standard deduction, and
  4. Subtract the greater of itemized deductions or the standard deduction from adjusted gross income resulting in taxable income

Once taxable income is calculated, it is time to calculate the income tax. The calculation is a confusing one because there is a tax rate applicable to capital gain income and a different tax rate applicable to ordinary income. Most taxpayers have both capital gain income and ordinary income included in their taxable income. Generally speaking, capital gain rates apply to 1) income resulting from the sale of securities that have been held for at least one year, 2) income resulting from the sale of certain depreciable property, e.g. a rental house and 3) qualified dividends. Ordinary income tax rates apply to pretty much all the other types of income, e.g. W-2 wages, income from business operations, interest, short term capital gain, retirement plan distributions and taxable social security.

Tax rates for ordinary income beginning with the 2018 tax year and continuing through 2025 will be broken down into seven tax brackets for individuals. The percentage rates will be:

  • 10%
  • 12%
  • 22%
  • 24%
  • 32%
  • 35%
  • 37%

The rate will apply to the different income levels depending on filing status.

Capital gain rates for 2018 and beyond have not changed; however, the breakpoints for the rates have changed. The 15% breakpoint applies to adjusted net capital gain in excess of:

  • $80,800 for joint returns and surviving spouses (half this amount for married taxpayers filing separately),
  • $54,100 for heads of household, and
  • $40,400 for other unmarried individuals.

The 20% breakpoint applies to adjusted net capital gain in excess of:

  • $501,600 for joint returns and surviving spouses (half this amount for married taxpayers filing separately),
  • $473,750 for heads of household, and $445,850 for any other individual (other than an estate or trust).

A single taxpayer with taxable income consisting entirely of ordinary income in excess of $86,375 or a married filing jointly taxpayer with taxable income consisting entirely of ordinary income in excess of $172,750 has a marginal tax rate of 24% for U.S. income tax purposes. This means that a dollar increase in itemized deductions or adjustments to gross income produces 24 cents in U.S. income tax savings. An additional item of ordinary income would have a tax cost of 24 cents if the taxpayer has a 24% marginal tax rate.

A taxpayer in the 15% bracket for long-term capital gain income will pay 15 cents on one dollar of long term capital gain income. If the taxpayer’s advisor sells a stock and produces one dollar of capital loss to offset one dollar of capital gain the tax savings will be 15 cents. A taxpayer might have capital losses remaining after offsetting their capital gains, in which case he or she is allowed to take up $3,000 of capital losses against ordinary income ($1,500 for a single taxpayer.) Assuming a 24% rate, the result would be a tax savings of $720 for a married filing separately taxpayer.

There are numerous investment and tax planning decisions that are made using the taxpayer’s marginal income tax rate and or capital gain rate as a key variable. Consider the following:

  • Tax benefit or cost of the timing of retirement plan contributions and distributions
  • The decision to make a Roth or a traditional IRA contribution
  • The decision to harvest capital loses to offset capital gains
  • The decision to make a large contribution to a donor advised fund, and
  • The tax benefits of mortgage interest on a principal residence

Your advisor and tax professional have the tools and expertise to calculate the costs and benefits for the planning decisions listed above. In many situations, there are other taxes to consider such as the 3.8 % net investment income tax.

It is imperative to arrange for a tax projection given the complexity of the tax calculation in order to have reliable information regarding the tax cost or benefit of a decision. Consider the almost certain likelihood that tax rates are likely to change during the course of one’s lifetime. A reasonable estimation of projected future rates is an important factor in the development of a long-term investment plan.

We are happy to discuss Parsec tax planning and compliance services. If you are interested, please contact your advisor who will be happy to arrange for a meeting or provide additional information regarding tax services.

Brad Burlingham, CPA
Director of Tax Services


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