Congress is placing greater reliance on Stealth Taxes to raise revenue, as I’ve warned taxpayers for years. That makes the tax code more confusing and causes taxpayers to fall into expensive traps.
One onerous effect of a Stealth Tax is that, while the taxpayer stays in the same bracket in the in the tax rate tables, the taxpayer’s marginal tax rate increases.
The marginal tax rate is the tax rate on the last dollar of income earned. In the tax rate tables, the highest marginal tax rate is 37%.
But Stealth Taxes increase the tax bill by reducing tax breaks or adding other taxes. As the taxpayer’s income rises to trigger or increase Stealth Taxes, the total tax bill rises independent of the rate in the tax rate tables.
Stealth Taxes have been in the tax code for decades, and several were added in the One Big Beautiful Bill Act.
One example from the OBBB is the limit on the deduction for state and local taxes.
The OBBB raised the limit on SALT deductions from $10,000 to $40,000. But the limit is reduced for taxpayers with higher incomes, beginning with modified adjusted gross income above $500,000.
A recent analysis from attorney Bruce Brumberg published in “Steve Leimberg’s Income Tax Planning Newsletter” found that the real top marginal tax rate for a married couple with $500,000 of MAGI and at least $40,000 in state and local taxes eligible or the SALT deduction is 32%.
But as income rises, the SALT deduction is reduced so the real marginal tax rate increases. The marginal tax rate for the couple peaks at 45.5% when MAGI is $550,000. When MAGI is above $550,000, the marginal tax rate declines, but never below 35%.
The same analysis can be done with the other Stealth Taxes, such as the inclusion of Social Security benefits in gross income, the Medicare premium surtax (or IRMAA), the 3.8% net investment income tax, the new senior tax deduction, the new limits on charitable contribution deductions, and the limit on total itemized expense deductions.
Those Stealth Taxes are triggered at much lower income levels than the SALT deduction.
When planning transactions, taxpayers need to be aware of where they stand in their current income tax bracket. Most people don’t want to be pushed into a higher income tax bracket.
But taxpayers also need to know where they stand in the brackets for each of the Stealth Taxes. Taking additional taxable income for the year could increase Stealth Taxes even if it doesn’t push the taxpayer into the next higher income tax bracket.
It’s important to know those numbers when considering a conversion of a traditional IRA to a Roth IRA.
It’s also an important consideration when deciding the source of additional cash flow. Some years you might want to take fully taxable income from a traditional IRA. Other years, a tax-free distribution from a Roth IRA or health savings account might be advisable. Or it might be beneficial to take long-term capital gains in a taxable account.
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