Does a higher effective tax rate mean less tax efficiency comparing one year to another? If so, what are potential causes of less efficiency?
Obviously a higher taxable income in 2021 (vs 2020) would most likely result in more taxes. However does that increase in taxable income mean the effective rate will increase? Assume the 2021 taxable income increases but no other significant changes in taxable activities. Both 2021 and 2020 marginal tax brackets are 22%. If the 2021 effective tax rate is 15.75% and the 2020 effective tax rate is 13.50% would that indicate that 2021 is less tax efficient vs 2020?
In this example the 2021 effective rate is over 2% higher which seems like itâs telling us that there is something less tax efficient in 2021 vs. 2020.
If that is an indication of less tax efficiency then what are some possible causes? For example, maybe the higher income in 2021 pushed the long term capital gains rate up into a higher bracket vs. 2020? Or a larger impact from the alternative minimum tax in 2021 due to the higher taxable income?
Obviously a higher taxable income in 2021 (vs 2020) would most likely result in more taxes. However does that increase in taxable income mean the effective rate will increase?
Well, since the next dollar of income is taxed at the marginal rate, and the effective rate accounts for all of the lower rates, include any deductions that are counted at 0%, then yes, in general, with more taxable income, the effective rate will be higher. That said - there are different marginal rates for capital gains/qualified dividends vs. ordinary income. So if more of the income in 2021 is taxed at capital gains rates, then the effective rate in 2020 might be higher than the 2021 effective rate.
In this example the 2021 effective rate is over 2% higher which seems like itâs telling us that there is something less tax efficient in 2021 vs. 2020.
I think that given all of the changes to tax law because of COVID, including, but not limited to, credits that were not previously available, trying to compare 2020 to 2021 for âtax efficiencyâ (or even 2020 or 2021 to 2019) is probably somewhat pointless.
If that is an indication of less tax efficiency then what are some possible causes? For example, maybe the higher income in 2021 pushed the long term capital gains rate up into a higher bracket vs. 2020? Or a larger impact from the alternative minimum tax in 2021 due to the higher taxable income?
Yes, those are possibilities. Plus anything that was changed because of COVID changes to tax law. I would suggest doing a line-by-line comparison to see whatâs different between the two returns if you want to understand what your particular differences are.
Donât forget about IRMMA which imposes additional costs Today for what $$$ you made two years ago. Notice I said âcostsâ, but payments to the gubbermint are Taxes regardless of what they are labeled.
Yes, those are possibilities. Plus anything that was changed because of COVID changes to tax law. I would suggest doing a line-by-line comparison to see whatâs different between the two returns if you want to understand what your particular differences are.
Expanding on ajâs advice, if you really want to see the change in efficiency, I would take your 2021 numbers and run them through the 2020 tax program, and take your 2020 numbers and run them through the 2021 program. You can then compare the 2020 tax program results to see how the efficiency changed due to income changes from 2020 to 2021. You can also compare the 2021 tax program results to see the efficiency change. I wouldnât expect to see the same results from the two software programs due to the effect of income-based tax provisions.