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Understand the Tax Implications of Financial Decisions
The Internal Revenue Code is a very complex and often confusing set of rules. Individuals sometimes let tax issues cloud their decision-making. Here are three areas where some simple reminders can help you make wiser financial decisions:
The income tax rate structure
Our marginal tax rate structure generally means that income at lower levels is taxed at lower rates than income at higher levels. There are complex rules about how to calculate taxable income, taking into account deductions and exemptions. The 2001 tax law started to bring rates down and the 2003 tax law change accelerated that reduction. The tax rates start at 10% and go up to 37%. Below are tax tables for 2018.
2018 Taxes on capital gains and dividends compared to regular taxes
Long term capital gains and qualifying dividends receive favorable tax treatment, based on taxable income levels.
2018 Medicare Surtaxes
As part of the health care reform enacted in 2010, additional Medicare surtaxes began in 2013 for high income wage earners and high income investors. The surtaxes apply when a single taxpayer's Modified Adjusted Gross Income (MAGI) exceeds a threshold of $200,000 or joint return filers when their MAGI exceed $250,000.
Taxable vs. tax free bonds
Those in higher tax brackets often benefit from tax-exempt interest income. To see if you should consider tax-exempt bonds, compare the after-tax yield of a taxable bond to the yield of a tax-exempt bond. To calculate the after tax yield of a taxable bond you can use the following formula:
For example, here is the equation to calculate the after tax yield of a taxable bond with a yield of 6% for someone in the 32% marginal tax bracket.
Or you can use the following table:
The tax brackets are those in effect in 2018.
Remember, to get a true comparison it is critical that the taxable and tax exempt bonds have similar maturity dates and similar quality ratings.
According to the chart, a tax-exempt bond yielding 4.0% has an equivalent after-tax yield of 5.9% for someone in the 32% tax bracket. For that person, a taxable bond yielding more than 5.9% will produce a better after tax return.
Taking time to understand how the tax laws apply to your financial situation will enable you to make more informed decisions. You should always consult your tax advisor to determine how the rules apply to your situation and remember that state income taxes must be considered.