When a Bit of Extra Income Can Cost You Big Bucks

Q: When does one dollar extra in income have the potential to cost you hundreds of dollars in taxes?

A: When that extra dollar disqualifies you for subsidies or credits, or subjects you to taxes that wouldn't otherwise affect you.

That an incremental dollar in income could be a significant swing factor in their taxes may come as a surprise for investors familiar with how our income tax system works. For the most part, the taxes we pay are set up to increase gradually with our taxable income.

For 2015, for example, an individual taxpayer with taxable income of $37,450 will pay a 10% tax on the first $9,225 ($923) and a 15% tax on the taxable income amounts between $9,226 and $37,450 ($4,234).

Meanwhile, the person with $40,000 in taxable income will pay taxes at the same rates on her first $37,450--10% on the first $9,225 and 15% on the taxable income between $9,226 and $37,450. Because the 25% tax bracket kicks in at $37,451, she'll pay a 25% tax on any taxable income over that threshold--in this case, an additional $638.

Scaling up taxes gradually in this fashion--rather than taxing all of a taxpayer's income at a single rate--keeps people from going through all sorts of machinations just to stay in a lower tax band. Imagine, for example, that the person with $40,000 paid 25% on all of her taxable income, not just on the amount over $37,451. In that case, she'd want to do everything in her power to stay below the $37,450 mark in order to qualify for the 15% tax rate. That creates a perverse incentive that could hurt productivity, while also potentially stymying consumption and savings.

That said, there are a few instances where even one dollar in extra income can have significant ramifications for an individual's taxation. Two of them will tend to have the biggest impact in retirement, while another affects people who are accumulating assets for retirement.

Retirement Savings Contribution Credit The Retirement Savings Contribution Credit provides a clear depiction of how even small changes in income can have a big impact. That's because the income thresholds that determine eligibility for and the size of the credit are jagged. The lowest-income investors--for 2014, that's single filers with adjusted gross incomes of less than $18,000 and married couples filing jointly with incomes of less than $36,000--can take a credit amounting to 50% of their IRA or company retirement plan contributions up to $2,000 (or $4,000 for couples). (They can also take a deduction on their IRA contributions.) Meanwhile, single filers with adjusted gross incomes of more than $30,000 in 2014 and married couples filing jointly with AGIs of more than $60,000 are shut out of the credit entirely.

In this case, even a dollar of additional income can result in less of a credit (or no credit at all) and a higher tax bill. For example, the couple with 2014 adjusted gross income of $59,000 is eligible for a credit equal to 10% of the amount of their IRA/401(k) contributions up to $4,000. (The upper limit on contributions that are eligible for the credit is $2,000 for individuals and $4,000 for married couples.) Say they each contribute $2,000 to their IRAs for 2014. They're eligible for a $400 credit (10% of their $4,000 contribution), as well as the usual deduction that comes along with IRA contributions. Meanwhile, the couple earning $60,001 wouldn't be eligible for the credit at all.

The Workaround: Reducing adjusted gross income is the name of the game for taxpayers on the cusp of eligibility for the tax credit. Making a deductible IRA contribution--rather than Roth--is one way to bring down AGI; those who do so can take advantage of both the credit and the deduction. Contributing to a health-savings account is another way to reduce AGI.

Subsidies Under the Affordable Care Act In a similar vein, subsidies for health-care insurance under the Affordable Care Act are set at four jagged thresholds. Those whose incomes are below 150% of the federal poverty rate are eligible for the largest subsidy; subsidies are available--but reduced--for people with incomes at 200%, 250%, and 400% of the federal poverty rate. Taxpayers whose incomes exceed 400% of federal poverty thresholds don't receive a subsidy at all.

Mike Piper, who has written extensively on this topic for his Oblivious Investor website, urges individuals to watch their incomes in order to qualify for the highest possible subsidy. "There can be cases in which a dollar of income costs you hundreds, even thousands, of dollars in subsidies," he said.

The Workaround: Piper notes that those who are still working have fewer levers to pull to increase their eligibility for, or the level of, their subsidy. But, he said, young retirees (that is, those who aren't yet Medicare-eligible and are buying coverage under the ACA) may have more flexibility to lower their household income to improve their eligibility for a subsidy. Not only can they reduce their absolute level of spending, but they can also pay attention to where they source their portfolio withdrawals--favoring Roth and/or taxable-portfolio withdrawals over tax-deferred distributions. Piper discusses the income thresholds that determine ACA subsidy eligibility here, and this post discusses strategies for maximizing subsidies.

Social Security Taxation Generally speaking, retired individuals who are getting all of their income from Social Security will not be taxed on that amount. But if the Social Security recipient's provisional income--defined as adjusted gross income plus one half of Social Security benefits plus tax-exempt bond interest plus certain other adjustments--exceeds $25,000 for a single taxpayer or $32,000 for married couples filing jointly, then up to one half of her benefit will be taxable. For single filers with provisional income in excess of $34,000 and married couples filing jointly with provisional incomes over $44,000, up to 85% of their benefits will be taxable.

That big bump up--from a Social Security benefit that's 50% taxable to one that's 85% taxable--gives single taxpayers whose provisional income is hovering around $34,000, and married filers with provisional income around $44,000, strong incentive to stay below those thresholds if they possibly can.

The Workaround: The provisional income thresholds for Social Security taxation are fairly low, so Social Security benefits will be 85% taxable for many retirees. Here again, however, retirees with the discretion to favor Roth and taxable-account withdrawals over tax-deferred distributions, which are taxed at their ordinary income tax rates, have some leeway to avoid the so-called tax torpedo. Converting Traditional IRA assets to Roth is a bad idea for those who are trying to avoid the torpedo, in that it jacks up taxable income in the year of the conversion. However, accumulators who suspect they could be subject to the tax torpedo in retirement should consider IRA conversions prior to beginning Social Security benefits. Not only will they be able to enjoy tax-free withdrawals on their eventual distributions, but they'll also reduce the amount of their portfolios that is subject to RMDs. This article delves into the tax torpedo in greater detail.