Marginal and Effective Tax Rates and Their Importance in Tax Planning

By Kenneth H. Bridges, CPA, PFS     August 2011

When discussing tax planning with our clients, we often use the terms “marginal tax rate” and “effective tax rate”.  Marginal tax rate generally refers to the rate of tax to be incurred on the next dollar of income (or the value of the next incremental dollar of deduction), whereas effective rate generally refers to the amount of your overall tax as a percentage of your overall income.  While different, both are important to understand for optimal tax planning.

Range of rates – The highest marginal Federal income tax rate is currently 35%, the highest state income tax rate is 11% (Hawaii and Oregon), and self-employment tax or FICA can be as high as 15.3%.  Accordingly, in the right (or shall we say “wrong”) situation your marginal tax rate could be higher than 60%.

Planning at the margin – Marginal tax rates are what we tend to focus most on in tax planning, since that is where the real permanent tax savings can be derived.   Most people don’t really understand the concept of marginal tax rate.  The general thought is that the higher your income the higher your marginal rate.  While that is sometimes true, it is not always the case.  For example, if in the year of sale of your business you have $10,000,000 of long-term capital gain and $500,000 of ordinary income, you might automatically assume that you would be in the 35% Federal marginal rate bracket.  However, if you also have $1,000,000 of charitable donations in that year, then your marginal Federal rate is actually only 15% (since the charitable donations would first offset the ordinary income and then the long-term capital gain).

AMT – Clients tend to think it is a terrible thing when they are in the alternative minimum tax (AMT) posture.  While it does mean that you are losing the Federal benefit of certain deductions (e.g. real estate taxes and state income taxes), it also means that you are paying tax at a maximum Federal rate of 28% (versus the highest rate of 35%), because the AMT caps out at 28%; and it may mean you are paying tax at a maximum Federal rate of 15% (the maximum AMT rate on long-term capital gain and qualified dividends).

Phase-outs – Many exemptions, exclusions, deductions and credits are subject to being phased out, based on your income level.  These “silent tax increases” can have a significant impact on your marginal tax rate as your income moves through the phase-out range.

Deferral/acceleration strategies and rate arbitrage – In an era of very low short-term interest rates, we do not get too excited about short-term deferral strategies. Long-term deferral strategies like 1031 exchanges or the continuing year after year deferral from adoption of cash method are another story.  True permanent tax savings, however, tend to come when you can get rate arbitrage (e.g. take a deduction in a high marginal rate year and the related income in a low marginal rate year). Qualified retirement plans are one way to work this.  For example, you make retirement plan contributions in high marginal rate years and take the related distribution or do a Roth conversion in low rate years.

Avoid negative rate arbitrage – You should avoid deferring income from a low marginal rate year into a high marginal rate year.  Sometimes when we pick up a new client we find that (due to lack of proactive advice) they have had years in which they felt good about having paid little or no tax, but in reality they wasted itemized deductions, exemptions, and low rate brackets that could have been used to capture income at a zero or low tax cost.  Or they took losses that produced a benefit of maybe 20 cents on the dollar which will effectively be recaptured in a later year at 40 cents on the dollar.   This type of cost is not readily apparent, until you analyze your tax situation over many years.

Impact of state income tax – State income taxes on individuals can range from 0% in states like Florida up to 11% in states like Hawaii and Oregon.  It is important to factor that into your tax planning; especially if you may be contemplating a move to or from a high tax state.  Accelerating the recognition of income into a year in which you are a resident of Florida (a no tax state) ahead of your relocation to California (a high tax state) could result in a significant permanent tax savings.

Impact of self-employment tax or FICA – Self-employment tax or FICA is 15.3% of the first $106,800 of “earned income” for the year, and 2.9% thereafter.  For W-2 employees, the employer pays ½ of this amount.  This tax is in addition to the income tax, so the marginal tax impact on earned income can be quite substantial.  Knowing where you are relative to the hurdle (i.e. over or under the $106,800) is important in your planning.  Itemized deductions and exemptions do not reduce the income subject to self-employment tax, so your effective tax rate (as defined relative to taxable income) can appear quite dramatic if you are paying self-employment tax.

NOL considerations – Net operating losses (NOLs) can generally be carried back 2 years or forward 20 years.  Unless you make an election with your return for the year of the loss to waive the carryback period, you have, by default, made an irrevocable election to carry the loss back. Accordingly, it is important before filing your return for the year of the loss to carefully analyze the effective tax benefit of carrying the loss back (as a percentage of the loss) versus the probable effective benefit of electing to carry the loss forward instead.  Doing this sort of analysis before the end of the loss year, can guide you as to whether you should accelerate deductions into the loss year (e.g. where the loss has a very substantial effective tax benefit in the carryback year).

Cash flow considerations – There are times when, even though accelerating income into a low-rate bracket year makes the most sense from a long-term perspective, the client may not be in a position cash-flow wise to incur the incremental tax.  Similarly, there are times when a client’s need to maximize a tax refund for cash flow purposes may dictate accelerating deductions, even though a greater percentage benefit might be derived in some future year.

A multi-year, long-term process – Tax planning is a multi-year, long-term process.  We feel really good about the job we have done for a client when we can analyze their situation over many years and see that, in spite of generating tremendous wealth over that period of time, they have incurred a very low effective tax cost.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.