More income is generally a very good thing, but some of the impact of a higher income can be blunted by a higher tax rate. Fortunately, there are sensible steps you can take to make sure you’re taking full advantage of that new money.
We asked Brian McCann, a financial advisor from San Jose, California, for some tips on maximizing income and minimizing taxes.
How should taxes guide decisions around adding income to a household?
It’s important to think about the after-tax impact of your earnings. Adding more salary to the family budget could be a great idea, but it could also boost you into the next income tax bracket, resulting in a higher marginal tax rate and decreasing the overall impact of the extra salary.
For example, if your family has an income of $155,000 and lives in California, then every extra dollar that you earn will be taxed at your marginal rate of 28% for federal and 9.3% for California state taxes, for a total of 37.3% in taxes. (In 2016, for married couples filing jointly, income from $75,300 to $151,900 is taxed at 25% for federal.) Also, earned income is subject to Social Security and Medicare taxes, which combine for an additional 7.65%.
However, your tax-time deductions will probably be enough to take your adjusted gross income below $151,900, so you won’t actually pay 28% federal tax on any of those dollars.
Now, if one spouse earns $155,000 and the other spouse is considering taking a job for $45,000, you would be looking at a family income of $200,000. Here it may make sense for both spouses to max out their 401(k) contributions of $18,000 per year. Even though it leaves one spouse bringing home only $27,000 before tax, those $36,000 tax-deferred dollars would bring the family income down to $164,000 — dramatically lowering the amount on which you may be taxed at the 28% federal rate.
I frequently see people get this one wrong. Lower-paid spouses often do not max out their 401(k) contributions because they feel it would reduce their take-home pay by too much.
Of course, paying slightly more in taxes isn’t the only factor to consider when deciding whether to bring an additional income into the home. You should also ask yourself if the job will affect the future earning potential of the spouse. If starting or continuing at a job will leave the spouse in a position to earn much more five or 10 years down the road, it may well be worth the effort despite the taxes incurred.
Are there any other personal finance decisions that can affect your taxable income?
Here are some common considerations:
- Rental income. Many people want to build passive income streams in order to replace their current income in retirement. But rental income is fully taxable. If you invest in a rental property that generates significant income and you are in a high tax bracket, you will reduce your after-tax return. It may be more appropriate to invest in assets where gains can be deferred, such as stocks, so that current income is limited.
- Asset location. Some investment assets, such as bonds or REITs (real estate investment trusts), may generate fully taxable income. Holding these types of assets in tax-exempt or tax-deferred accounts may be beneficial to avoid paying current-year tax rates on the income.
- Business ownership. Many common expenses are deductible from your income taxes if you have a business. Running a small business can be a great way to generate extra income and receive substantial tax benefits.
What else should people keep in mind about tax brackets?
It is always very useful to understand your family’s tax bracket, so that you know how much more income could be earned at your current tax rate before jumping up to the next marginal rate. It’s also a good idea to explore whether you can shift income from one year to the next — for example, opting to take a work bonus in the new year rather than in December — in order to balance out earnings across multiple years and avoid too big a tax hit.