Tax planning can provide extraordinary benefits when we use it to avoid the two situations that we will focus on today: tax cliffs and surtaxes.
For example, through tax planning one can turn $1 (one!!!) of income reduction into $6,659 of additional cash in one’s pocket.
How? Because it avoids a tax cliff.
What is a tax cliff?
A tax cliff is when a small increase in income results in a disproportionate increase in taxes.
As we discussed several times before in CBP, our income tax system is progressive. As income grows, it jumps from one tax bracket to another, and the additional income in the next tax bracket gets taxed at a higher rate than the income in the lower tax bracket.
For example, for a single US person with $85,525 in US taxable income, the last dollar is taxed at 22%. If that person earns an additional dollar, that next dollar will be taxed at 24%, not 22%, because 24% is the tax rate that applies to the next tax bracket.
Most taxpayers assume that increases in income are taxed at higher rates at the graduated progression, as in the example in the prior paragraph, but that is not always the case. Sometimes, an additional dollar of income can be taxed at a marginal rate that exceeds 100%. Even multiples of 100%. When this happens, the affected taxpayer, although having higher income, ends up with less after-tax income than a taxpayer with lower income.
This type of situation does not make intuitive sense. Something seems wrong, doesn’t it?
Why do tax cliffs happen?
Tax cliffs happen because certain deductions and credits are lost completely once income meets certain thresholds. When deductions or credits are fully lost at once, instead of being phased out over an income range, the extra dollar of additional income can cost the taxpayer hundreds or thousands of dollars of lost credits.
Let’s see some examples of tax cliffs.
A very extreme example of a tax cliff is found in the Earned Income Tax Credit (EITC). The EITC provides support to lower income families, especially those with children. In 2020 the maximum credit for a family with 3 children is $6,660. One of the requirements to qualify for the EITC is not to have investment income over $3,650/year.
A family with three children who owns a rental property that generates $3,650 in annual rental profit receives $6,660 in EITC. If instead the rental property generates $3,651 in profit, the family receives no EITC at all. The extra dollar of rental income costs this family to lose $6,660 in EITC.
Thus, in two families with identical wages, the one with $3,650 in rental profit will have $6,659 more cash in their pocket after paying their taxes than a family with $3,651 of rental profit. What is the marginal tax rate of that additional dollar of rental income?
This seems a little harsh.
Other examples of tax cliffs include:
- Tuition deduction: an extra dollar of income above the deduction threshold can cost the taxpayer a loss of $2,000 in tax deductions for eligible tuition expenses.
- Premium Tax Credit: this is a credit that subsidizes the cost of health care premiums under the Affordable Care Act. If a family income’s is below or at 400% of the federal poverty line, they qualify for the credit. One extra dollar of income will cost them the entire subsidy.
- Social Security Taxation: 50% of a single individual’s social security income is taxable if their income is up to 34,000, but 85% of it is taxed if the income is above that threshold. One extra dollar of income can cause the taxpayer to have to report $11,900 in additional taxable income, resulting in thousands of dollars in extra taxes.
Most of the time, credits and deductions are not completely lost to that one extra dollar. Instead, they are phased out over an income range. Phaseout ranges ease the pain of the loss of the credit or deduction, by reducing the benefit little by little, instead of all at once.
Examples of credits and deductions with phaseout ranges out include:
- Child Tax Credit
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Student Loan Interest Deduction
- American Opportunity Credit
- Deductible IRA contributions for active participants in employer retirement plans
This report by the Tax Policy Center provides additional information to anyone interested in learning more about the impact of tax cliffs and tax credit phaseouts.
Now let’s address the other situation that can cause tax rates to spike with the change of a dollar: Surtaxes.
A surtax is an additional tax on an item of income that has already been taxed. Sounds lovely!
Two common, and almost equally disliked surtaxes, are the Net Investment Income Tax and the Additional Medicare Tax.
The Net Investment Income Tax (NIIT) is a 3.8% tax that applies to certain net investment income of individuals, estates and trusts, when the income is above the statutory threshold amounts. That threshold is $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly (marriage penalty!) and $125,000 if they are married filing separately.
The Additional Medicare Tax is a 0.9% tax that applies to wages, compensation and self-employment income above the same thresholds that apply to the NIIT.
US expats dislike the NIIT because it is an income tax that cannot be offset by foreign tax credits. It is a form of double taxation. We will discuss this issue in more detail when we cover foreign tax credits in the coming weeks.
US expats working overseas in a country with a Totalization Agreement with the USA are not subject to the Additional Medicare Tax, even if their income is above the threshold.
A Totalization Agreement is tax treaty for Social Security Taxes. The Additional Medicare Tax is a social security tax. We will cover this issue in more detail when we discuss tax treaties in the coming months.
US resident taxpayers, i.e., taxpayers living in the USA, are subject to both the NIIT and Additional Medicare Tax without execptions, when their income is above the relevant thresholds.
Can anything be done to avoid or mitigate the impact of tax cliffs and surtaxes?
Yes, of course. Tax planning!
A helpful tax planning technique that can be used to help mitigate the impact of tax cliffs and surtaxes is managing income and deductions to keep income below the desired threshold. For example:
- Postponing income: if you are a business owner close to signing a contract with a new client and it’s December, you may be able to postpone the engagement until January to delay the income until the following year.
- Accelerating deductions: making purchases of office supplies or other business expense, in December instead of in January, or the reverse, depending on the situation, can help you keep your business income within the desired levels.
- Making deductible retirement account contributions: for example, making a $6,000 IRA contribution or maxing out a 401K contribution to lower income below the 400% of poverty line threshold can avoid having to repay Premium Tax Credits, which can be significant.
- Reducing your tenant’s rent if you receive the EITC: sometimes, as in our first example today, reducing monthly rent by one dollar can help you qualify for the EITC.
- Managing the timing of tuition payments: if given a choice of paying tuition in one year or the next, choose making the payment in the year in which your income qualifies you for one of the education credits.
- If you are retired and have retirement accounts that are taxed differently, such as IRAs, Roth IRAs or brokerage accounts, be strategic about from where you withdraw your money to cover retirement living expenses. Strategic cash withdrawal strategies can result in thousands upon thousands of dollars in tax savings.
By helping you avoid tax cliffs and surtaxes, good tax planning can provide a a high rate of return. Advisors refer to the value added by tax planning as tax alpha.
A dollar in the right place in right year, can give you thousands of dollars of extra cash in your pocket. And that’s not bad.
Our key tax insight of the week, #11, is:
“Understanding tax cliffs and surtaxes, and using tax planning techniques to avoid them, puts extra cash in your pocket”
See you next week,
Un abrazo y buena onda,