Are You Hitting the New 49.5% Tax Bracket? (Hint: You Might Be)
When Congress passed the 2018 Tax Cut and Jobs Act (TCJA) the intent was lower income taxes. On average, that is exactly what happened.
Unfortunately, the intricacies of the law created a (probably unintended) “danger zone” income bracket where the marginal tax rate can be nearly 50%. What that means is for every $1.00 earned in this income range, almost 50 cents goes to pay income taxes.
The new tax law handed C corporations (Think Caterpillar, Ford, and Walmart) a massive 40% tax rate cut. The top corporate income tax rate fell from 35% to 21%. The idea was to help American multi-national companies compete more effectively in the global arena.
However, a large swath of American privately-held companies are not C corporations. According to Brookings, only 5% of American companies are C corporations and the other 95% are organized as S corporations, partnerships and proprietorships.
These entities that make up the 95% are known as “pass-throughs”. That is because the businesses themselves do not pay income tax, but rather their taxable income is “passed through” to the personal tax returns of the owners.
Personal tax rates were reduced, but not as dramatically as the C corporation tax rate. Since pass-through owners pay tax based on personal tax rates, the new law would have unfairly favored C corporations without some intervention.
To help keep things fair, the new law includes a tax deduction for pass-through owners. The deduction is 20% of their pass-through income. For example, if an S corporation has one owner and $100,000 of taxable income, the owner will only pay tax on $80,000. (Please keep in mind all illustrations in this article are oversimplified and blatantly ignore possible exceptions to the rules).
Here is the big catch: For certain types of service businesses (e.g. consulting, health, accounting, law, financial services, athletics, etc.), the 20% deduction begins to disappear at $157,500 of taxable income for single taxpayers and $315,000 for married filing joint (MFJ) taxpayers.
Why That Matters
Let’s compare two separate taxpayers, Jordan and Sam. Jordan has $315,000 of income from a consulting S corporation. Sam has $415,000 of income from a similar business.
To keep things simple, let’s say for both taxpayers their business income happens to equal their taxable income (before the 20% deduction). Also, they both file married filing joint (MFJ) tax returns.
Jordan is eligible for the 20% deduction, which brings his taxable income down to $252,000 ($315,000 x 80%). Applying the tax tables, his total tax will be $49,059.
Sam owes the same $49,059 on his income up to $315,000. Unfortunately, for every dollar earned above $315,000, Sam begins to lose some of the 20% deduction. By the time he hits $415,000 in income, the 20% deduction is completely phased out.
Since Sam has earned $415,000, he is not eligible for any of the 20% deduction, not even on the first $315,000 of income. Applying the tax tables, his total income tax will be $96,629. Sam earned only $100,000 more than Jordan, but owes $47,570 more income tax. Sam’s effective tax rate on the extra $100,000 is essentially 47.57%!
It gets worse.
The Child Tax Credit
The new tax law generously increased the child tax credit from $1,000 to $2,000 per eligible child. Here again, a phase-out begins at certain income levels. For this credit, the phase-out starts when modified adjusted gross income (MAGI) hits $400,000. At that income level, the child tax credit drops by $50 per $1,000 of income over $400,000.
Imagine Sam and Jordan both have 3 children eligible for the child tax credit. That means Jordan will receive a $6,000 child tax credit against his $49,059 tax bill calculated above. The credit brings his total tax down to $43,059.
Sam will get some of his $6,000 child tax credit, but not all of it. His modified adjusted gross income (MAGI) is $439,000, so he will lose $1,950 (39 x $50) of his $6,000 credit. That brings his child tax credit down to $4,050. He will owe income tax of $92,579 ($96,629 calculated above, minus $4,050).
Sam now owes $49,520 (his $92,579 minus Jordan’s $43,059) more tax than Jordan. That means 49.52% of the extra $100,000 he earned will go to pay income taxes. And that is just the federal tax!
If Sam lives in a state that has a state income tax (most states do), he would have to add his effective state tax rate to the 49.52% federal rate. Very likely, that could bring the overall tax rate to 55% or even higher for the income earned between $315,000 and $415,000.
Please note, as Sam goes beyond the $415,000 threshold, his marginal tax rates will drop back to the tax table rates of 35% or 37%. The extremely high marginal rates apply specifically to the $315,000 to $415,000 income range of business owners with personal-service-based businesses and children.
It doesn’t make sense to avoid earning money to avoid paying tax. However, let’s say you are in Sam’s shoes, except you earn $415,000 this year but only $215,000 next year.
With that fact pattern, total tax paid between the two years would be significantly reduced if both years were at $315,000 (same total 2-year income, just equalized across the years). You might consider arranging your affairs to smooth out the annual taxable income.
- Find out if your pass-through business is subject to the 20% deduction phase out (many businesses such as manufacturing and construction companies, and oddly even engineering firms, are not subject to the phaseout).
- Determine if your income levels could sporadically land in the “danger zone” income range. What I mean by that is one year you’re in the range, and the next year not.
- If the answer to the first two questions is “yes”, then there could be wisdom in looking at planning opportunities to spread income more evenly across years. That is a discussion for you and your tax accountant.
Author’s note: Thank you for reading today. If you have questions or comments feel free to write them in the box below. I’ll try to respond promptly. Otherwise look me up through toptal.com.