Your Marginal Tax Rate Could Be Much Higher Than You Think

1. Qualified Dividends and Capital Gains: These are taxed at preferential rates (0%, 15%, or 20%), depending on your taxable income. However, as your income increases, it can push dividends and capital gains into higher tax brackets. This creates a “cliff effect” where earning an additional dollar in ordinary income increases the tax rate applied to your capital gains or dividends.
2. Phaseouts and Credits: Certain tax benefits, like the Child Tax Credit or eligibility for specific deductions, phase out as your income rises. This effectively increases your marginal tax rate because the value of these benefits decreases with higher income.
3. Net Investment Income Tax (NIIT): If your modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for joint filers, an additional 3.8% tax applies to investment income.
4. Interaction with Medicare Premiums: Higher income can increase your Medicare Part B and Part D premiums due to Income-Related Monthly Adjustment Amounts (IRMAA), effectively adding another layer of marginal cost to each additional dollar earned.
5. Loss of ACA Subsidies: If you rely on subsidies under the Affordable Care Act (ACA) for health insurance, a Roth conversion that increases your income could reduce or eliminate your subsidy. This can effectively add tens of percentage points to your marginal tax rate, making the true cost of a conversion much higher.

The Impact on Roth Conversions

Roth conversions involve transferring funds from a traditional IRA to a Roth IRA. While you pay taxes on the amount converted, future growth and withdrawals are tax-free. The potential benefits include avoiding required minimum distributions (RMDs) and locking in lower tax rates today. However, accurately assessing whether a Roth conversion makes sense requires understanding your true marginal tax rate.

Key Considerations for Roth Conversions:

1. Hidden Marginal Costs:
   • A conversion increases your taxable income, which could push dividends and capital gains into higher tax brackets.
   • It might trigger phaseouts of credits or deductions, amplifying your marginal rate.
   • You could cross the MAGI threshold for the NIIT or higher Medicare premiums.
   • It could result in the loss of ACA subsidies, significantly increasing your marginal tax rate.
2. Estimating Tax Bracket Crossover Points:
   • Use tax software or consult a financial advisor to model scenarios. Include all income sources, deductions, and potential phaseouts to see how a conversion affects your overall tax liability.
3. Timing:
   • If you’re in a lower tax bracket this year due to reduced income (e.g., during early retirement), a Roth conversion may make sense despite these additional complexities.
   • Conversely, large conversions in high-income years could result in disproportionately high taxes.

A Specific Example: How your marginal tax rate could skyrocket due to a Roth conversion.

Consider a married couple filing jointly with a taxable income of $100,000, placing them in the 12% federal tax bracket for ordinary income using the standard deduction. They also receive $30,000 in qualified dividend income that they for the most part pay no federal tax on as most would fall into the 0% tax bracket for qualified dividends.

Suppose they decide to convert $20,000 from a traditional IRA to a Roth IRA. This $20,000 increases their taxable income to $120,000. As a result:

1. The additional income pushes part of their qualified dividend income into the 15% tax bracket for dividends, because their total income now exceeds the 0% bracket threshold for capital gains and dividends (which is $94,050 for 2024).
2. This means they pay 15% on some or all of the $30,000 in dividends, in addition to paying 12% on the Roth conversion amount itself.
3. The effective marginal rate on the $20,000 Roth conversion becomes a sum of the 12% on the ordinary income and 15% on the shifted dividends, resulting in an effective marginal rate of 27% (12% + 15%).
4. If the couple relies on ACA subsidies, the increased income could reduce their subsidy. Under the ACA, health insurance premiums are capped at 8.5% of income. Losing the subsidy might increase their premium costs by $1,700 (8.5% of $20,000). This effectively adds another 8.5% to their marginal tax rate, pushing the true marginal rate to 35.5% (27% + 8.5%).

This example highlights how a Roth conversion can trigger unexpected tax consequences, effectively increasing the couple’s marginal rate significantly. There is a tool available to help estimate the tax owed under different scenarios and specifically analyze the impact of incremental income or IRA distributions. The tool is available by following this link.

Practical Steps to Determine Your True Marginal Tax Rate

1. Map Out All Income Streams:
   • Include salary, dividends, capital gains, Social Security (if applicable), and any other income sources.
2. Simulate Tax Scenarios:
   • Tools like TurboTax, the Tax Estimator that I developed as I was planning for my Roth conversion or professional tax planning software can show the effects of incremental income changes. Look for thresholds where phaseouts, NIIT, or IRMAA apply.
3. Consider the Big Picture:
   • Weigh the benefits of Roth conversions against the immediate tax cost.
   • Factor in future tax changes, such as expiring provisions from the Tax Cuts and Jobs Act in 2026, which will raise rates for most brackets.
4. Consult a Professional:
   • A tax advisor or financial planner can provide personalized advice based on your situation. They can help identify opportunities to optimize conversions over multiple years.

Conclusion

Your true marginal tax rate is often much higher than what’s implied by your federal tax bracket, particularly if you have dividend or capital gains income. Understanding these nuances is crucial when evaluating tax strategies like Roth conversions. By carefully modeling your income, anticipating tax interactions, and seeking professional advice, you can make more informed decisions that maximize your financial outcomes.