When an extra dollar of income can cause problems

How could your effective tax rate exceed 100%?

In a previous message, I explained that you (almost) never don’t want to make more income from a tax perspective.

That’s true in normal circumstances; however, my colleague and fellow Floridian Adam Markowitz called me out on Twitter with some cases where the absolute version of that statement isn’t always true.

In other words, there are some edge cases where your effective tax rate could exceed 100%.

The most common example I’ve seen while working as a tax advisor has been the advance Premium Tax Credit (APTC) cliff. This occurs when the following happens:

1. A taxpayer signs up for Marketplace health insurance.
2. She uses the APTC to reduce her monthly premium payment. Because the APTC is tied to income (the lower the estimated income, the more APTC you get, and the lower your monthly premium payment), some people will report they expect much lower income than they actually do. This maximizes APTC and minimizes monthly premium payments.
3. But her income actually exceeds the 400% of poverty level threshold, even by one dollar, which disqualifies her from any APTC. On her tax return, the entire amount of APTC applied toward her premium payments is now due back. (We call this a cliff because just one dollar sends you over the threshold, just like how one step would send you falling off a cliff.)

I’ve seen clients owe back thousands of dollars in APTC repayment on the tax return due to barely exceeding the threshold.

But this example shows the way higher marginal tax rates often occur: not through taxing more of your income away, but by reducing or eliminating a benefit that is delivered via a tax credit or adjustment.

Tying government benefits—e.g., TANF, SNAP, CHIP, and Housing Choice Vouchers—to income often creates cliffs, where an extra dollar of income can cause, not a gradual tapering off, but rather a total loss of benefits.

But the point is that, for taxpayers who are not facing these cliffs at relatively lower incomes, there are edge cases that would require an extra bit of planning and perhaps some adjustments.

With some proper planning in place, you can avoid or mitigate the effect of these situations.

So again, in general, it’s rare that you should ever want to turn down income to avoid a higher tax bracket.