It always sets my teeth on edge. Reading about some great investment idea or strategy, I'll hit the caveat financial writers insert by rote: "This step might push you into a higher tax bracket, so you'll pay more taxes." Implication: If this idea actually works, you might make money--so maybe you shouldn't do it.
These writers are spreading "bracketphobia"--fear of climbing into a new income bracket and facing a higher marginal tax rate. Their victims are those who, not understanding the income-tax system, take the warnings to heart. Bracketphobia is easily cured with a small dose of knowledge. But its side effects--dumb investments, poor business decisions, and lost income--can be hazardous to your financial health.
VICTIMS. This is one of two periods when bracketphobia is epidemic. Hundreds of thousands of taxpayers had their first experience on Apr. 15, when writing a check to accompany Form 1040. Many tell their accountant: "But I never had to pay taxes before!"--overlooking those regular paycheck exactions. Determined never to "pay taxes" again, they search for ways to reduce the tab, even if it cuts their net worth, too. They might suffer another rash of bracketphobia at yearend when smart investing loses out to the urge to avoid taxes.
Kent Noard, a certified financial planner in San Jose, Calif., sees victims all the time: the landlady who hasn't raised apartment rents for a decade, the investor who loads up on tax-exempt bonds even though other investments would net much more after taxes, the couple who forgo a spouse's income. "Most people don't have any idea how close they are to the next bracket," Noard says. "They just know they don't want to get there."
Why not? Many Americans, it seems, don't understand the concept that underlies tax brackets--the notion of marginal tax rates. When a married couple's 1998 taxable income (after deductions and exemptions) rises from $102,299 to $102,301, they'll go from the 28% bracket to the 31%. But that doesn't mean that they'll pay 31% of all their income. Instead, they'll pay 31% on the single dollar that's in the higher bracket--a 3 cents bite in addition to the tax they would have paid if they hadn't crossed the divide. And since there's no 100% tax rate in the code, "it's almost impossible to conjure up a situation where you come out worse by taking an extra $1 in income," says Thomas Ochsenschlager of accountants Grant Thornton. No, taxes won't "eat it all up."
There's nothing wrong with managing income to minimize taxes. Offsetting capital gains with losses, deferring yearend income if you know you'll face a lower tax rate next year, timing retirement-account withdrawals to coincide with low-tax years--all can be good strategies. But playing tax angles can be risky. Say you have a $20 gain on a stock you bought just over a year ago. You would rather pay a 20% long-term tax rate--for investments held 18 months--than the 28% medium-term rate. But if the stock is peaking, it needs to drop only $2 to wipe out any tax advantage. "Taxes should never override good investment decisions," says Laurence Foster of KPMG Peat Marwick.
Managing taxes is getting harder because Congress is making it tough to even know how high your tax rate is. Since 1983, the code has been cluttered with more than 20 tax breaks available only at certain income levels. Virtually every high-income taxpayer can add a point or more to the statutory tax rate because of the limitation on itemized deductions that kicks in at 1998 adjusted gross income of $124,500. Extra income can also cost you opportunities--such as the ability to fund an individual retirement account. The most punishing of these "phantom" brackets--the phase-out of education tax credits--can add as much as 25 points to a student's tax rate, says Indiana University law professor William Popkin.
But the beleaguered scholars shouldn't be deterred from earning more. Whatever bracketphobes might think, more income up front means more money after taxes. Financial contortions designed to deny Uncle Sam his extra slice of your success will squeeze your own wealth, too.