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Marginal tax rates require strategic planning


Some higher income earners approached the April 15 deadline for filing 1997 federal income tax returns with a new – and unpleasant – awareness of their “marginal tax rate.” Those who wrote a larger tax payment check than they expected are likely to remember that lesson in planning their 1998 tax profile.

A strategic approach is to calculate whether one`s marginal tax rate projected for 1998 will increase or decrease compared with the next tax year. That will help the taxpayer decide whether to accelerate or defer income and deductions.

Through calculations based on each individual`s income, the marginal tax rate is the tax rate paid on the next dollar of taxable income. The marginal tax rate is the income tax rate plus the tax increase resulting from the limitation on itemized deductions – 3% of adjusted gross income (AGI) over $121,200 – and the calculation of the phase-out of personal exemptions at the rate of 2% per each $2,500 or a fraction thereof by which AGI exceeds $121,200 for single filers and $181,800 for married joint filers, based on 1997 amounts.

For 1997, the 39.6% federal tax bracket for married couples filing jointly began at $271,050 of taxable income. The phase-out of the deduction for personal exemptions ended at a taxable income of $304,300. Therefore, these specific marginal rates listed above only apply for this range.

These rates will also be increased by the state tax rate net of the federal tax benefit of deducting state income taxes. When state taxes are included many taxpayers may be boosted over the 50% level in total marginal tax rates.

Normally, the shrewdest tax planning is to receive income in the year you are in the lowest tax bracket and to take deductions in the year you are in the highest tax bracket. This year, however, that might not be the best strategy.

To qualify for many of the new tax breaks created by the Taxpayer Relief Act of 1997, your income cannot exceed certain limits. For example, only taxpayers with AGI of $100,000 or less are permitted to roll over traditional IRAs to the new Roth IRA.

Of course, tax planning is integral to one`s overall financial planning and usually requires assistance by legal and accounting counselors and specialists in estates and trusts, investments and insurance.

Here are three example strategies that combine tax benefits with other long-range financial planning objectives:

Qualified retirement plans

Taxes can be reduced and future returns can be enhanced by contributing the maximum amount of money possible to your employer`s plan or to your individual plan. Under certain circumstances, the money contributed comprises a deduction from taxable income and returns will not be taxed until withdrawals are made.

The leverage provided by tax-deferred growth is one of the most powerful financial tools available. Individual retirement accounts (IRAs) should be maintained even if a person does not qualify to deduct the contribution because of participation in an employer`s qualified plan. The benefit of tax-deferred growth still applies.

Tax-free municipal bonds

Because of the public value of investments in infrastructure and beneficial facilities, municipal bonds are the most favored investment by the tax laws. Municipal bond earnings are usually free of federal taxes and, in some cases, free of state and local taxes in their states of issue.

Watch out for private activity tax-free bonds issues after Aug. 7, 1986, where the interest income is subject to alternative minimum tax. While municipal bonds typically pay lower interest rates than U.S. Treasury bonds (where income is exempt from state and local but not federal taxes) and corporate bonds (where income is fully taxable), the “tax equivalent yield” can be considerable.

If you are in the 36% tax bracket, your tax equivalent yield on a 6% municipal bond would be 9.38% (subtract your tax percentage of .36 from 1.00 = .64, then divide into the interest rate, in this case 6.0) The tax equivalent yield will be even higher when you add your state income tax rate to your federal rate for your total effective tax rate.

That rate is useful for planning purposes, but will actually be reduced somewhat by the benefit of itemizing state income taxes on your federal return.


Many annuity products receive favorable tax treatment and allow flexibility to select a structure that best serves your needs. Certain annuities allow their owner to invest in a wide variety of investment portfolios that can include stocks, bonds or other securities. Annuities represent a tax-advantaged opportunity for those retired investors who have any of their Social Security benefits taxed. Withdrawals taken from an annuity prior to age 59 1/2 may result in certain penalties and taxes. Assistance should be obtained from your accountant and an annuities specialist.

With the help of income sheltering strategies such as these, taxpayers may be able to keep from worrying about marginal tax rates in the future.

J. Harmon Bays is a financial advisor with Legg Mason Wood Walker, a diversified securities brokerage and financial services firm that is a member of the New York Stock Exchange.


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