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Determining true tax rate can be taxing

Tax credits and complicated phaseouts have made it tougher than ever to figure out the rate at which your next dollar of income will be taxed.

What tax rate will you pay if you cash in a savings bond or get a $100 bonus in your paycheck?

Most people haven't a clue. And even if you think you know, there is a good chance you have it wrong.

A retired couple with $60,000 in income, including $16,000 in Social Security benefits, would pay $504 in taxes on an extra $1,000 an income _ a whopping 50 percent tax rate. But at $61,000, another $1,000 adds only $280 to the tax bill _ back to 28 percent.

Tax credits and complicated phaseouts have made it tougher than ever to figure out your true marginal tax rate _ the rate at which your next dollar of income will be taxed.

This little bit of information is critical for making informed decisions about which investments to buy or sell and whether it is really worthwhile to go back to work or take a second job.

The higher the rate, the less benefit you get from taxable investments such as certificates of deposit and government bond funds _ but the more benefit you get from tax-exempt income and strategies designed to defer income. Keeping a careful eye on your tax rate pays off if you are selling stocks, redeeming savings bonds or taking IRA withdrawals. A high tax rate becomes a disincentive to work if you can get by without the money.

The problem is that the tax rates found in tax tables may be quite different from the effective tax rates people pay on any additional income. In published tax tables, tax rates go up like a neat set of stairs as your income rises _ 15 percent, 28 percent, 31 percent, 36 percent, 39.6 percent. But in real life _ after you take into account how the tax code actually works _ marginal tax rates form a jagged city skyline whose outline varies with personal circumstances.

The tax tables tell you, for example, that in 1999, a married couple will pay tax at a 28 percent rate on taxable income (after deductions and exemptions) between $43,350 and $104,050. Officially, that's the 28 percent tax bracket. But a couple in that bracket might actually have an effective marginal tax rate of 36 percent because deductions and credits are lost as income rises. Marginal rates can be less than zero (for certain recipients of the earned income tax credit) or more than 40 percent.

How do these odd variations come about? Politics, says Kevin Hassett, an economist at the American Enterprise Institute for Public Policy Research in Washington.

"Bill Clinton wants to give a speech saying, "I want to give a credit to everybody who goes to college,'

" Hassett said. "It's a great speech, and we all want to give hope to people, but to actually do that we'd have to raise the taxes on everybody else."

The solution: Reduce the cost by limiting eligibility for the benefit.

For example, the only families that can qualify for a full $1,500 Hope scholarship credit are those with adjusted gross incomes of less than $40,000 for singles or $80,000 for married couples. The partial credit stops at incomes of $50,000 (single) and $100,000 (joint). Upper-income families, who are the most likely to send their children to college, don't get the credit at all.

That means that when the income of the college student's parents creeps above $80,000, the effective marginal tax rate jumps because additional income is not only taxed as usual, but also results in the loss of a credit that otherwise would apply.

Other phaseouts based on income were created to help low-income taxpayers. For example, Social Security benefits are tax-free for the low-income elderly, but up to 85 percent taxable for those with higher incomes.

The chart on page 8H was prepared for the Times by the American Enterprise Institute to show the quirky way marginal tax rates bob up and down for two couples in different circumstances. Both examples use 1998 tax figures and assume the couples take the standard deduction.

For the retired couple, the calculations assume that both are 65 or older and collecting a combined $16,000 in Social Security benefits, about average for a couple. The other income is assumed to be taxable interest and dividends.

When the couple's income, including Social Security, crosses $40,000, the Social Security benefits become up to 50 percent taxable. That causes the effective marginal tax rate _ the rate on the next dollar earned _ to jump from 15 percent to 23 percent. At $52,000, benefits become 85 percent taxable, pushing the marginal tax rate to nearly 28 percent.

The spike up to a 50 percent marginal rate that you see at $60,000 is the result of a double whammy: More Social Security benefits are being taxed at the same time the couple is moving into the 28 percent bracket.

At that level, retirees who knew their income with pinpoint accuracy probably would recoil from cashing in a savings bond when half a $1,000 gain would go straight to the IRS.

And the example charted here does not show some other ways tax rates can soar for Social Security beneficiaries.

Although long-term capital gains are supposed to be taxed at 10 percent or 20 percent, depending on the tax bracket, middle-income Social Security recipients end up paying a higher effective rate if the extra income makes their Social Security benefits taxable.

The formula for taxation of Social Security benefits is a big puzzle to many recipients. However, most of them have no trouble understanding the economic impact of another part of the law: the loss of Social Security benefits for workers under 70 who exceed the earnings limit.

For example, workers between 65 and 69 lose $1 in benefits for each $3 in earnings above $15,500 in 1999. That's a 33 percent tax. In the 28 percent tax bracket, the effective marginal rate on an extra dollar of earnings will total 61 percent. And that's not even counting Social Security taxes, which are not considered in either example in the chart.

The working couple used as an example has two children, one of whom is under 17 and eligible for the child credit, which was $400 in 1998 and jumps to $500 this year. The example assumes that one of the children is a college freshman or sophomore eligible for a $1,500 Hope scholarship credit and that one of the parents spent $500 on tuition for a college course, earning a $100 Lifetime Learning credit. The couple also was credited with $4,000 in individual retirement account contributions and $1,000 in student loan interest.

The first big bump in the effective tax rate occurs as the couple loses eligibility for the earned income tax credit. With two children, the couple might have qualified for a maximum credit of $3,756 in 1998. The credit begins declining when income passes $12,300 and is eliminated entirely at $30,095.

The next painful boost in the effective marginal tax rate comes at about $50,000 in income, when the couple begins to lose the IRA deduction. The deduction is eliminated at $60,000. Between $60,000 and $75,000, the deduction for student loan interest is phased out. At $80,000 to $100,000, the Hope and Lifetime Learning credits fade away. The child tax credit starts to slip away at $110,000, and at $186,800, personal exemptions begin to disappear.

This example is based on the standard deduction, but itemizers face an additional bump in taxes. Up to 80 percent of itemized deductions is disallowed at income levels above $124,500.

"That's the biggest one that upper-income people don't understand, particularly as it relates to their charitable contributions," Clearwater financial planner Raymond Ferrara said.

If a couple is right at the $124,500 threshold, taking a $40,000 capital gain would cost them $1,200 of their itemized deductions. The formula is 3 percent of the amount over the threshold, up to 80 percent of the deductions.

The variety of phaseouts is part of what makes the tax code so complicated for even financial professionals to understand and apply.

"You can make some good guesses and there's some excellent software out there to help you, but in the final analysis, because of the interaction of the various tax laws, you don't know the bottom line until you've done the taxes," said Ferrara, who heads ProVise Management Group.

The best that many people can do is to analyze the previous year's tax return. However, the results of that analysis stay true only as long as the situation stays the same.

People who buy tax preparation software such as TurboTax may find it handy long after tax time to run "what if" scenarios, even though the numbers will be slightly off. (Not only are the brackets, exemptions and standard deductions adjusted for inflation each year, but many of the phaseout ranges also change.)

Keep in mind, though, that the marginal tax rate is not the same as the overall tax rate on income, which is lower. The overall rate is easy enough to determine: Simply divide your tax by your gross income before deductions.

For those hoping Congress will come to their relief, the bad news is that the trend is toward more complication rather than less.

"My feeling is that it's going to get worse," said Mark Luscombe, principal analyst for tax information publisher CCH Inc. in Riverwoods, Ill. "The Republicans want tax cuts and the Democrats want to skew them toward the perceived most needy people. The result of that process is you get a phaseout, which creates this bubble effect."