If you retire before you are eligible for Medicare at age 65, then you may find yourself buying health insurance through one of the Affordable Care Act health exchanges. Furthermore, if your taxable income falls below 4 times the Federal Poverty Level (FPL), then you will qualify for a subsidy which could pay for a nice chunk of your health insurance premium. For 2016 the FPL is set at $11,770 for singles and $15,930 for couples, so you could be eligible for a tax credit for incomes below $47,080 (single) or $63,720 (couples).
What does this have to do with marginal tax rates? It turns out that the subsidy is a tax credit which gradually decreases as your taxable income increases. For example, if your modified adjusted gross income (MAGI) is between 3 and 4 times the FPL ($47,790 to $63,720 for couples), then your tax credit decreases by 9.56% for every extra dollar earned. And even though it’s a credit and not a tax, the effect of a decreasing credit is mathematically equivalent to a tax because the end result is that you will have 9.56% less money in your pocket for every dollar of increased income. Adding that to the marginal tax rate means that your effective marginal tax rate is higher if you’re in the income range where you receive a health care premium subsidy.
It’s certainly not bad to receive the tax credit because that’s free money. But it’s good to understand how this affects your tax rate so that you can plan on how and when to take income from your portfolio.
Marginal Tax Rates
If you pay your taxes, then you’re probably already well aware of the tax brackets, from 10% all the way up to 39.6% for the highest earners. This article is focused on the 10% and 15% brackets because that’s where the ACA credits occur.
To keep things simple, I’m just going to consider the simple case of a married couple using the standard deduction ($12,600 in 2016) and the the personal exemptions ($4,050 in 2016) which means that the first $20,700 of adjusted gross income is tax free. The same issue applies to single filers, just at a lower income level. Here’s a graph of the marginal tax rates versus income for joint filers in 2016.
If you itemize deductions, this graph will shift to the right by the amount that your deductions exceed the standard deduction ($12,600).
Marginal Effects of Tax Credit Decreases
The IRS publishes a table that is used to calculate how much to reduce your ACA subsidy by comparing your income to the Federal Povery Level (FPL). This table can be found in Table 2 of the instructions for Form 8962 which lists incomes levels from 100% through 400%. For a married couple, the FPL is $15,930, so 100% to 400% of FPL corresponds to incomes between $15,930 and $63,720.
Since the IRS table publishes different values for each FPL percentage point, I have computed the marginal tax effect for every 1% of FPL ($159) between 100% and 400% FPL to come up with the following graph.
Let’s break down this chart by income ranges:
- $15,930 - 21,187 (100-133% FPL) - in the lower range the premium subsidy is reduced by the smallest amount, 2.01%. But many people in this range would be eligible for Medicaid and may choose to not buy insurance and thus may not be affected at all.
- $21,187 (133% FPL) - there is a spike at this income level because there’s
a jump in the subsidy reduction from 2.01% to 3.02%. So as your income increases
from 132% to 133% of FPL, your subsidy goes down by
133*.0302-132*.0201= 136% ($217 more taxes for $159 increase in income).
- $21,187 - 47,790 (133-300% FPL) - in this range the IRS table publishes an
ever increasing subsidy reduction rate which translates to a gradually
increasing marginal tax rate. The jaggedness is due the rounding of the values
in the IRS table. The average effect on marginal tax rate across this range is
(300*.0956-133*.0302)/(300-133)= 14.8%. At it’s peak it approaches 18.5% for incomes right below 300% of FPL.
- $47,740 - 63,720 (300-400% FPL) - this is the top range in which a subsidy is available and the reduction is a constant 9.56% across the entire range.
- $63,720 (400% FPL) - technically there could be a huge spike (cliff) at this income level because when you make $63,720, you lose all remaining premium credits. There could also be no spike if you choose the cheapest health care plan, in which case your premium subsidy may have already been exhausted at this income level. I chose not to show it on the graph because it’s not a constant percentage for all situations but it’s important to be aware of this premium cliff.
To summarize, you will see an increase anywhere from 9.56% to as much as 18.5% in your effective marginal tax rate due to the reduction of the premium tax credit. The average increase across the whole range (133-400%) is 12.8%. Since this occurs in the 10-15% income tax ranges, this is a big jump in marginal tax rates.
Effective Marginal Tax Rate
The next graph simply combines the marginal tax rates with the effects of the reduction in premium subsidies to come up with the effective marginal tax rate. It’s somewhat startling to see that the effective marginal tax rates can be higher than those for people earning over $96,000 (603% FPL).
What we normally think of as the 10% tax bracket is now approximately a 25% tax bracket. The lower end of the 15% tax bracket (below $48,000) has become a 32% tax bracket. And between $48,000 and $64,000 the marginal tax rate is nearly 25%. We finally return to the 15% tax rate above $64,000 but lose the premium subsidy.
Long-term capital gains are are similarly affected. Instead of having zero marginal tax rates up to the 25% bracket, there are now significant marginal effects in the 133-400% FPL range. And in the 250-300% FPL range you would be at a higher marginal rate (> 15%) than people with much higher incomes.
The discovery of this increase in marginal tax rate has colored my views on how and when to take income from my portfolio. It mostly boils down to the concept of delaying my taxable income until age 65 when Medicare kicks in and I no longer am eligible for ACA credits. Alternatively, either Mrs. Moneycle or I could get a job with health benefits, but that requires working.
Here are some things you can do to push income forward.
- Deplete taxable and Roth assets before touching IRA/401k funds
- Perform tax-loss harvesting to capture losses now (taking gains after 65)
- Defer IRA to Roth conversions which produce taxable income
- Move dividend-producing assets like bonds into IRAs
- Delay taking pensions and social security until after age 65
- When buying annuities, add a cost-of-living adjustment (COLA) which gives you less income in the early years and more income later.
- Use delayed income annuities which start at age 65 or beyond
If most of your investable assets are in tax-qualified accounts (IRA/401k), then you may not be able to defer your taxable income as much. In this case I would recommend spreading your Roth and taxable asset withdrawals from now until age 65 so that you can get a little benefit each year. But you might want to consider lumping those same assets over just a few years if it allows you to push your income below 400% FPL and get a tax subsidy for a few years.
Keep in mind, if you are able to push income forward until age 65, you probably want to take as much income as you can between ages 65 and 70 while staying in the 15% tax bracket. This is because at age 70, you will most likely begin taking social security and also be required (at age 70.5) to take required minimum distributions from your IRAs which all adds up to more taxable income.
So the overall strategy is, (1) take as little taxable income as possible while receiving ACA subsidies, (2) take as much taxable income as possible while not receiving ACA subsidies, and (3) make it to age 70 and thank your younger self for planning ahead.