Wow, does someone actually pay taxes at a 45,500% rate? Unfortunately, the answer is yes if you happen to land on the edge of a cliff and step over it by having an extra $1 of income.
This rate comes from an actual 2012 tax return that we prepared. You may assume that the taxpayer was some rich fat cat. Actually, no. This taxpayer is married, had an adjusted gross income (AGI) of $34,499, works part time, and the spouse is retired and collecting social security.
Since this taxpayer is eligible they contributed to retirement accounts, which results in a credit due to the contribution and income level. If their income (AGI) falls below $35,000, the credit is 50% of the contribution up to a credit amount of $1,000 for each spouse. Step over that cliff and the credit is 20%.
If the taxpayers get their AGI down to $34,499, their refund would be $2,286. If they had one extra dollar of income, their AGI goes to $35,501 (yes, their AGI goes up $2 if they earned a dollar more because more of their social security becomes taxable) and their refund goes down to $1,831.
So yes, you read that right, one extra dollar increased their tax $455. That’s a 45,500% marginal tax rate.
You may hear politicians clamor for reforming the tax code, or simplifying it, or whatever. We get into problems when policy objectives are inserted into the tax code that politicians feel should not benefit the rich or the middle class, or someone who bought a house on the wrong day. What happens is that the ones hurt the most are the ones in the transitional ranges. A rich person is not affected at all by this retirement credit. They aren’t eligible. It isn’t even on their radar. But someone who is on the borderline faces an absurd marginal tax on their incremental income.
This happens everywhere. The taxation of social security is a prime example. If you earn a lot of money, 85% of your social security is taxed. Earn very little and none of your social security is taxed. Where do these absurd numbers come from? If the government doesn’t want to tax social security, then don’t. If they want to tax it, tax it. From a logical standpoint, half of it should be taxed because everyone has already paid income tax on half of the contribution amounts. I know, it is not really an insurance product, where you are owed what you put in. As the Supreme Court ruled years ago, social security is just a tax and a fully discretionary bribe to old people from the government.
By having a sliding scale to taxing social security, the government is hammering the middle. A single taxpayer who earns around $71,000 including social security, some part time work and required minimum distributions from IRAs, faces an average tax rate of 47% on incremental interest income even though the top tax rate is 43%. Yes, and this taxpayer is in the 25% tax bracket. But as he earns more income, more of his social security gets taxed. 25% becomes 47%.
Meanwhile, the incremental tax rate for the rich stays at 43% (ignoring the limits on itemized deductions). Why? Because extra income doesn’t trigger more social security to be included income.
Welcome to our tax code.
By the way, due to our expert tax advice the client who faced the 45,500% tax rate increased their deductible IRA contribution so they missed the cliff. Many taxpayers won't be so lucky.
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