Case 8–Retired gotcha

This scenario is of a taxpayer with a variety of income sources, who saved well and planned well for retirement. The taxpayer is also very generous, and therefore itemizes deductions in both 2017 and 2018. Another reason for itemizing could be high medical expenses. In either case, the state and local tax limitation doesn’t come into play in this example. The interesting aspects of this case are:

  1. the loss of the personal exemption increases taxable income, since the taxpayer itemizes in both years, and
  2. the subsequent increase in taxable income also affects the tax preference for qualifying dividends and long-term capital gains.

Total income is $71,576, comprised of $24,840 Social Security (85% taxable), $19,081 in pension and other income, $18,060 in qualified dividends and capital gains, and $9,595 in non-taxable municipal bond interest. Excluding the muni bonds and 15% of Social Security, AGI is $58,255.

Description 2017 2018 Change
AGI 58,255 58,255  
Itemized 15,777 15,777  
Pers. Exempt. 4,050 0 -4,050
Taxable income 38,428 42,478 4,050
Tax 2,662 3,323 661
See below1 2,683 1,961 -722

How could this taxpayer owe 16.32% more in tax on a taxable income increase of 10.54%? Especially when his tax rates dropped by 3% on all but the first $9,525 in taxable income? First, $3,778 of his income is now in the 4th tax bracket (24% in 2018), when his income didn’t leave the 3rd tax bracket last year (25% in 2019). But, but, but, isn’t that also at a lower rate? Yes, but on more taxable income. The bracket shift would have covered the taxable income increase for this taxpayer, except for the other factor–the increase in taxable income reduced the tax preference given for qualifying dividends by $722.

I realize this gets pretty ‘wonky’, and may only be of interest to CPAs and other folks who aren’t much fun at parties. It just shows the inter-relatedness of various aspects of the tax code, and how one change may affect other rules the taxpayers and tax writers might not have anticipated. Is it fair that this taxpayer’s average tax rate as a percentage of AGI went from 4.57% to 5.70?? What’s fair? It likely wasn’t the intention of the tax writers, but it is what it is.

Actually, the most common culprit we see for this type of effect is the phase-in on taxation of Social Security benefits. Depending on other income, Social Security income is anywhere from zero up to 85% subject to tax. This means that, in the income band where Social Security is becoming subject to taxation, each additional dollar of other income may add as much as $1.85 to taxable income. Fair?

1This row represents the tax preference given to qualifying dividends and long-term capital gains (QD-LTCG). Inflation adjustments in 2018 aren’t reflected in our analysis.