Reviewed or updated February 1, 2019
How the highest earners made out.
The tax law that took effect last year was favorable to wealthy individuals in various ways. Yet many taxpayers with the highest earnings will see little or no reduction in the effective rate of tax on their income. Some will actually see increases.
The tax rates that apply in most of the seven brackets were reduced. That includes the top rate, which fell from 39.6% to 37%. It may appear that anyone with income in that category would be enjoying the ability to retain an additional 2.6 percentage points. Yet that will be the case only for those who do not pay state income tax.
The same law that lowered our tax rates put a $10,000 cap on the itemized deduction for state and local taxes. Before this cap took effect, this itemized deduction reduced the effective rate of tax for those with the highest incomes. For example, if you paid state income tax at the rate of 5%, each additional $1,000 of earnings would add the state tax on that amount, or $50, to your deduction, so your federal taxable income would go up by $950. At the 39.6% rate that applied under prior law, you would pay $376 in federal tax, so your effective rate was only 37.6%. The new law improves on that rate, but the difference is less than one percentage point.
There are many states with tax rates above 5%, and in some of them, the highest effective rate actually went up with this change in the law. The break-even point is where the state (and local, if applicable) income tax rate is about 6.6%. To fully enjoy the decrease in the top federal rate, a high earner would have to live in one of the states that do not have an income tax.
The highest state income tax rate in California is 13.3%, which produced an effective federal tax rate of 34.3% under prior law. California’s highest earners are facing a federal effective rate that’s 2.7 percentage points higher in 2018 than 2017.
And that’s not all. State income tax usually applies to capital gain. Under prior law, the highest effective federal rate could have been as many as four or even five percentage points below the stated maximum of 20%, because the state tax on capital gain could be deducted against ordinary income that was taxed at 39.6%. The new tax law left capital gain rates unchanged. In states with the highest tax rates, and in New York City, where state and local income taxes combine for a high rate, the $10,000 cap on the state and local tax deduction is causing high earners to pay substantially higher federal taxes on both ordinary income and capital gain.