Our tax system
Our income tax system seems straightforward at first glance. Individuals are taxed according to their income, with rates increasing as income goes up. So, the more you make, the higher percentage of tax you’re expected to pay. These increasing rates are often referred to as “tax brackets.” The top rate that applies to you, or your tax bracket, is usually considered your marginal tax rate. It’s the rate you will pay on an additional dollar of income.
For 2009, the ordinary income tax brackets range from 10 percent to 35 percent. (See chart 1 for the full schedule.) Ordinary income includes things such as salary and bonuses, self-employment and business income, interest, retirement plan distributions and more.
Looking beyond the tax brackets
Unfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may be much different than the actual rate in your tax bracket. For one, not everything is ordinary income. Different types of income are taxed in different ways. (Read more on on investment income.) But more importantly, hidden taxes that kick in at higher income levels when you reach the top tax brackets can drive your marginal tax rate higher.
Many tax credits and deductions phase out as your income increases, meaning an extra dollar of income actually increases your tax liability more than the top tax rate. Two of the most costly phaseouts apply to your personal exemptions and itemized deductions.
In 2009, the personal exemption of $3,650 that taxpayers receive for themselves, their spouses and their dependents phases out by $24.33 for every $2,500 (or fraction thereof) of adjusted gross income (AGI) above a designated high-income threshold. This threshold in 2009 is:
- $166,800 for single filers,
- $250,200 for joint filers,
- $208,500 for heads of household, and
- $125,100 for married couples filing separately.
In 2009, each personal exemption can be reduced to no lower than $2,433.
The phaseout for itemized deductions operates a little differently. Some deductions — such as medical expenses, investment interest, casualty losses and certain contributions to disaster relief — are not included in the phaseout. But many of the most popular and valuable deductions — such as mortgage interest and employee business expenses — are affected. In 2009, the affected deductions are reduced by an amount equal to one percent of any AGI that exceeds $166,800 ($83,400 for married couples filing separately) up to a maximum reduction of 26.67 percent.
The effects of the phaseouts of both itemized deductions and personal exemptions have been shrinking gradually thanks to a 2001 tax bill. In 2010, both are scheduled to disappear completely for one year. But in 2011, they are scheduled to come back at triple their 2009 rates. If that occurs, beginning in 2011 your personal exemptions can be eliminated completely and the applicable itemized deductions can be reduced by up to 80 percent.
It’s worth noting that both of these phaseouts are tied to AGI, as are nearly all of the tax-benefit phaseouts in the code that apply to individuals. That’s why above-the-line deductions are so valuable. They reduce AGI. Most other deductions and credits only reduce taxable income or tax, itself, without affecting AGI. (See Tax planning opportunity 3 for information on taking full advantage of above-the-line deductions.)
Phaseouts of tax benefits aren’t the only things you need to worry about. Many high-income taxpayers could also face the alternative minimum tax (see more on the AMT), and anyone with earned income will have to pay employment taxes.
Employment taxes take a bite
Employment taxes are made up of Social Security and Medicare taxes and apply to earned income. Social Security taxes are capped, but you must pay Medicare tax on all of your earned income. (See chart 2 for the current employment tax rates and Social Security tax ceiling.)
If you are employed and your earned income consists of salaries and bonus, your employer will withhold your share of these taxes and pay them directly to the government. If you are self-employed, you must pay both the employee and the employer portions of employment tax, though you can take an above-the-line deduction for 50 percent of the total tax. There are also special employment tax considerations if you’re a business owner who works in the business. (See Tax planning opportunity 9.)
Taxes are due year round
Although you don’t file your return until after the end of the year, it’s important to remember that you must pay tax throughout the year with estimated tax payments or withholding. You will be penalized if you haven’t paid enough.
If your AGI was over $150,000 in 2008, you can generally avoid penalties by paying at least 90 percent of your 2009 tax liability or 110 percent of your 2008 liability through withholding and estimated taxes (taxpayers under $150,000 need only pay 100 percent of 2008 liability). Additionally, the stimulus bill enacted in February 2009 allows certain taxpayers with a 2008 AGI of under $500,000, and at least half their income from a small business, to prepay an amount equal to just 90 percent of their 2008 liability.
If your income is often irregular due to bonuses, investments or seasonal income, consider the annualized income installment method. This method allows you to estimate the tax due based on income, gains, losses and deductions through each estimated tax period. If you’ve found you’ve underpaid, try and have the shortfall withheld from your salary or bonus. (See Tax planning opportunity 1.)
You also want to avoid early withdrawals from taxadvantaged retirement plans, such as 401(k) accounts and individual retirement accounts (IRAs). Distributions generally must be made after reaching the age of 59½ to avoid penalties. Distributions from these plans are treated as ordinary income, and you’ll pay an extra 10-percent penalty on any premature withdrawals. This can raise your effective federal tax rate to as high as 45 percent on the income.
