Episode Transcript
Brenton: [00:00:00] While earning a high income is definitely the goal for many people, the consequence of doing so on your tax return can greatly affect the rest of your finances. In this episode, we talk about some of the ways those finances can be impacted by the tax return and how a knowledge of these areas can improve the overall financial health of your household. Let's get started.
Brenton: Hello. My name is Brenton Harrison of New Money, New Problems and your host for the New Money, New Problems podcast. I hope you've enjoyed the last few episodes as we've given you some of the foundational elements of taxes, such as adjusted gross income tax deductions and tax credits. And I wanted to take things a step further [00:01:00] and cover other areas of your finances that can be impacted by having a high income on your tax return. So in this episode, we're gonna cover five areas that high income earners are greatly impacted, not just on the tax return, but as a result in the rest of their finances.
Number one is the net investment income and additional Medicare taxes. We've talked about different accounts called qualified and non-qualified accounts. Qualified accounts are things like your 401k or your 403b and these are tax deferred, meaning that they cover the taxes that you owe either when you put the money in or take it out. But the transactions that you make from year to year and the growth of those funds are not taxed. non-qualified accounts are the reverse.
There are less restrictions when it comes to things like when and how much you can contribute. But in exchange, things like capital gains, when you sell an investment for a profit, dividends that are issued by certain stocks and mutual funds, all of those [00:02:00] things are taxable and they are a type of income called investment income.
Well, the net investment income tax is a tax on investment income for those, with a Modified Adjusted Gross Income above certain levels. In the 2023 tax year for couples who are married and following their taxes together, it is $250,000 of modified, adjusted, gross income. For those who are married, but following their taxes separately from their partner, it is literally half, $125,000. And if you are single or head of household then it is $200,000. And to clarify, you are only paying that additional 3.8% investment income tax on what comes above those thresholds.
Conversely, the partner to net investment income tax, the additional Medicare tax, is a much lower rate, It's 0.9%, but it is applied to all income above those M AGI levels. So while net investment income tax is a higher rate, you only [00:03:00] have to pay it on investment income, but the lower rate of 0.9% for the Medicare tax is potentially applied to a much larger chunk of your income. And when coupled together, you have to consider that many of the people paying this tax as high income earners could be living in areas where they not only pay these taxes. They also pay federal and some cases, state, and in other cases, city taxes as well.
The cumulative impact of all these taxes can have a larger impact as your income increase.
The second area where the taxes of high income earners can have an impact on the rest of their finances has to do with the ability to contribute to and, or deduct the contributions made to certain retirement accounts.
And we're also gonna break this up into two parts, starting with your ability to contribute to a Roth IRA. We've talked about contributions to pretax retirement accounts, where the money that you put into that account is a tax deduction that reduces the income on which [00:04:00] you are taxed. If you have a hundred thousand dollars income and you put $5,000 into a pre-tax account, the income on which you pay taxes will be reduced by that same 5,000. But conversely, when you take those funds out in retirement, you pay taxes on that income. You pay taxes on that withdrawal as if you earned it. Now a Roth is the opposite. You put money in that has already been taxed in exchange for not worrying about it when withdrawn in retirement. And many people at the beginning or middle stages of their career when they hopefully are make. And many people in the early stages of their career, when they hope they are making as little as they'll make or paying as low a taxes as they'll pay, will put money into the Roth that has already been taxed because the hope is that when they withdraw it in retirement, they would be avoiding taxes on what would be a higher percentage as a result of how well they've done. However, when it comes to your ability to contribute, it is often dictated by the level of your [00:05:00] Modified, Adjusted, Gross Income. And depending on how high that falls, you either could be able to contribute you could be able to contribute a reduced amount, or you could be prohibited from contributing to these accounts.
If you're following along with this on screen, you'll see that the contribution limit for an IRA or a Roth IRA in 2023 is $6,500. But you'll also see towards the bottom of the screen, a Roth IRA phase out range for people who are single or head of household, it is 138,000 to 153,000 for people who are filing their taxes, Married, Filing joint, it's 218,000 to 228,000. And we covered in the previous episode, if you file your taxes, Married, Filing Separately, they greatly reduce your ability to contribute to Roth IRAs.
What you see here for the phase out range is $0 to $10,000. So, what do these phase out ranges mean? Well, if your Modified, Adjusted Gross Income falls above [00:06:00] the range, you flat out cannot participate. So if you are single and you have a modified, adjusted, gross income of $160,000, you can't put a dime into a Roth IRA.
If it falls below the range, you can participate and you can contribute up to the $6,500 But let's say that it falls within the phaseout range. So we have a single prepare who has a Modified, Adjusted, Gross Income of in this example, $141,000.
Now, if you look at the phase out range from 138,000 to 153,000, in our example, the person with $141,000 will fall exactly 20% of the way into that phase out range. What this means is that instead of them being able to contribute the full $6,500 towards their account, They can participate, but they will have the amount they can contribute reduced by that same 20%.
So instead of contributing, what is technically a $6,500 [00:07:00] max, they would be limited to a maximum contribution in their scenario of $5,200 because of that phase out range.
So that's part a, when it comes to IRAs with Roth IRAs, the phase out range determines whether you can cannot, or how much you can contribute to a Roth IRA.
Part B however, pertains to pre-tax IRAs and not whether you can contribute, but whether you can deduct that contribution.
The reason we recapped the premise of pretax retirement accounts is so that you can understand that one of the most valuable features of putting your money into a pre-tax account is that tax deduction. Because if you don't get the tax deduction, you are setting yourself up for double taxation. You would tax the money when it goes in and you would have to pay income taxes on the money you withdrew. So the benefit of contributing to this account is greatly reduced if you reduce or eliminate the deduction itself.
So on screen you see a phrase that says [00:08:00] IRA deduction, phase out for active participants. In 2023 for a person who is single or head of household, it's 73,000 to 83,000. For a couple Married Filing Jointly 116,000 to 136,000. It is the same greatly reduced phase out for people Married, Filing Separately of zero to 10,000.
And we'll cover what you see for this last area on screen that says spousal IRA in just a second, but let's start with the deduction phase out for an active participant. If I have a retirement account available to me at my job and I'm eligible to contribute, it doesn't matter if I choose to do so or not. I'm considered an active participant. And the IRS wants to incentivize participation in these workforce plans. And one of the ways they do so is to limit or eliminate the deduction that high income earners can take when they instead choose to put their funds into individual retirement accounts, rather than their workforce plan. Looking at these phase out limits, it's [00:09:00] not whether or not they can contribute. They can still put up to the $6,500 limit into that pre-tax IRA. But if you earn above these phase out ranges, you cannot deduct a single dollar of that contribution. And if you are in the phase out range, the amount of the deduction you can take is reduced by how much of your Modified Adjusted Gross Income is in that phase out range.
So now that we've covered these areas, what is a spousal IRA? Well in typical years, if you were a person who was single and you wanted to put money into an individual retirement even if the contribution limit is in this case, $6,500, you cannot contribute to an IRA more than 100% of what you earned.
So if you earned $0 in the tax year, even though many people can contribute up to 6,500, you can't contribute at all. When you are married, however you can open what's called a spousal IRA, where even if you did not earn an income, you [00:10:00] can use your spouse's income to justify your ability to participate.
So if I stayed at home, but my spouse earned a hundred thousand dollars, I can now open a spousal IRA and I can contribute the full 6,500 to my account. However, the ability to deduct that contribution is also restricted based on the income that my household earns and whether or not my spouse is an active participant at their employer . If you have a spousal IRA and the modified adjusted gross income of your family falls between 218 to $228,000, you can still contribute the full amount to that spousal IRA. But the amount that you can deduct will be dictated by how far you fall into that phase out range if your spouse is an active participant in an employer plan .
And if you earn above the 228,000, you can contribute but you cannot deduct a single dollar of that contribution.
So those are the first two areas that we'll cover. And after the break, we'll bring [00:11:00] things on home with three, four, and five.
[00:12:00]
Brenton: Number three is all about education credits. We've talked about the fact that deductions reduce the amount of income that you pay taxes on, credits actually reduce the taxes that you owe dollar for dollar. So they are very valuable and there are a number of tax credits that are associated with either your higher education pursuits or those of your children. One of those would be the lifetime learning credit. Another would be the American opportunity tax credit. And there are phase out ranges for how much of these credits that you can use based on your adjusted gross income.
For single tax filings, it is 80 to $90,000 for both credits. For Married Filing Jointly. It's 160,000 to 180,000. And both of these are credits that we covered in the previous episode are not allowed to be taken for people who are Married, Filing Separately.[00:13:00] Now there is also for people who have already gone through their schooling and incur loans to do so, deductions that are available for the amount of interest that you pay while repaying your student loan debt. And these deductions are also subject to phase out limits. For single tax followers, It's 75,000 to 90,000. For Married Filing Jointly it's 155,000 to 185,000. And this deduction is yet another deduction that cannot be taken by those who are Married, Filing Separately.
Number four is about tax credits for your children. The child tax credit is one for those who have dependents, regardless of whether you're paying for their care. If you simply have a tax dependent, that's under a certain age, you can file that tax credit.
We also covered the child and dependent care credit, which is a credit that's available to those who incur childcare costs so that they can work. Now, you cannot have a stay-at-home spouse, unless there's certain things like they're disabled or they're a student, but if you or you and your spouse incur [00:14:00] childcare costs so that you can work, you are eligible for the child and dependent care credit.
For the child tax credit in 2023 if you're single head of household or file your taxes, Married, Filing Separately, your ability to claim this credit starts to phase out once your Modified Adjusted Gross Income goes above 200,000. If you're Married, Filing Jointly, it starts to phase out. Once you have exceeded 400,000 of Modified, Adjusted, Gross Income.
And for the child independent care credit, there are phase out ranges to this as well. However, the tax filing status of Married, Filing Separately is disallowed from participating in this tax credit completely.
And lastly, alternative minimum tax. We're not gonna spend a lot of time on this because for one, there's not many people to whom is applicable. You have to earn a significantly high amount of income in 2023 for a person who's single or head of household, that threshold is 578,000 $150. If it's Married Filing Jointly it's over a million. But the premise of alternative minimum tax [00:15:00] is that there is a parallel tax code that the IRS applies to all of our tax returns. And what they do for high income earners is they look at where they would've paid more taxes: the traditional tax code to which we all must adhere and then also the alternative minimum tax. And if they find for these high income earners that they would have paid more on the alternative minimum tax, that is the code that they apply. It's designed to make sure there is at least a minimum burden that these high income and likely wealthy people must pay. But because of those high incomes, it's unlikely that this applies to the overwhelming majority of the people in this country. But if you do have income above those ranges, The alternative minimum task can lead to some significant adjustments and alterations in your tax filing strategy. And if you are above these ranges, not only is there no scenario in which I think you should be filing your own, you would likely need a number of other professionals in your corner to help you navigate how your finances are [00:16:00] changed by that high income.
That's it I hope that this was illuminating and gave you some insights into the power of understanding your tax return and how all of these different tools that we've discussed can help improve the rest of your finances. If you like this episode, or you have topics that you want us to cover in the future, join our email list and send us a message with what you want And it may be the next episode you hear on the New Money, New Problems podcast. See you soon.
