Ah, spring is here. I’ve told this story before but figured the time was right to tell it again. I worked with a CPA years ago. He once told me spring was his favorite time of year. Now, this is when I lived in Michigan and I figured he loved spring because the long winters were over. Nope. He loved spring because “everything turns the color of money.” With spring brings the end of tax season. Well, not really, but at least the main tax deadline most of us individuals worry about.
Enough of that background. Let’s talk taxes. Actually, this will be the start of a few articles on taxes. You know one of my mantras – It’s not what you make. It’s what you keep. I learned this years ago from a tax expert in my world, however, I extend it to also apply to the fees you pay to your advisor and also investment fees. But the focus in this series will be on taxes. And please know you have more control of your taxes than you think.
A big portion of my practice is centered around taxes and being tax smart. This does not mean doing anything illegal or even questionable. It simply means taking advantage of opportunities to not tip Uncle Sam and we do this through a variety of ways to reduce taxes.
This time of year I am asking all my clients to send me their completed tax returns. I do not do taxes. Heck, I don’t even do my own. However, I get into the returns to make sure everything is in order and more importantly to do planning for the current and even future years. And now is the time to be looking at taxes. Waiting until the end of the year is what most of my peers do. That is way too late. Paying attention to taxes has to happen throughout the year.
With all of that background, let’s talk about a couple of simple tax and income-related concepts that everyone has heard, but maybe you are not completely sure what they mean. It involves tax rates.
First, you have your Marginal Tax Rate. This is where a lot of people focus their energy, but it is only part of the picture. The marginal tax rate is the additional tax paid for every additional dollar you earned as income. Basically, it is the top end of your tax rate. Let’s say you are married and have taxable income of $340,100. Well, for every dollar you earn over this amount those new/additional dollars will be taxed at 32% for each one. Dollars below that income level are taxed at lower rates. The point is your entire income of $340,100 is not taxed at 32%. Marginal tax rate is an important number, but not the entire picture.
Let’s now talk about Effective Tax Rate. This is what most of us focus on, especially CPAs. It is also referred to as the Average Tax Rate. Calculating this is rather simple. You just take you’re the total amount you paid in taxes and divide it by your taxable income. If you paid $75,000 in taxes and made $350,000 of income your effective or average tax rate is 21.4%. I just want to point out your average tax rate here is much smaller than your marginal rate. Again, the marginal rate in this example is 32% on every dollar above the $340,100. So, for the roughly $10,000 of income above $340,000 you paid taxes of $3,200.
Now, I want to explain how I take these tax rates a step further. I look at Effective and Average Tax Rates as two different calculations. It is an approach I use just to understand the whole tax picture a bit more.
When I look at average tax rates I am taking the total tax paid and dividing it by your taxable income before any deductions. This is better known as your Adjusted Gross Income (AGI). I also look at the effective tax rate I take deductions into consideration. Here I simply look at your total tax paid and divide it by taxable income once deductions are added in. Again, this is more in line with what CPAs look at and what you should focus on. However, it is important to know the average tax rate (before deductions) too.
The one thing I want you to take away from this article is that marginal rate is the rate on the next dollar earned and effective tax rate is the rate on your overall tax picture.
This seems like a good place to stop. Next time we will talk about qualified vs nonqualified dividends and also the sunsetting tax rates. I know taxes are not exciting. However, they are critically important to understand and use to your benefit to improve your wealth picture. Especially as our tax rates are rising due to the sunsetting tax cuts of 2017. Because remember – It’s not what you make. It’s what you keep!
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.