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It is a common belief that moving into a higher tax bracket will cause you significant financial hardship. People have given away large sums for a tax deduction or even accepted lower pay believing they are actually saving money by maintaining a lower tax bracket. This post explains why this is incorrect and illustrates what a tax bracket transition really means for you.

The Myth
The basic belief is that tax brackets are retroactive and that all income is subject to your highest tax bracket’s percentage rate. The chart below illustrates the tax amounts a person would be subject to if this logic were applied.

(Click to enlarge)

The Reality
Only the income above the minimum amount for any given tax bracket is subject to that bracket’s rate.

For example:
If you are filing single and made $30,000 in 2008 you would be in the 15% tax bracket. Your first $8,025 would be subject to 10% in taxes. The remainder ($21,975) would be taxed at 15%.

This chart illustrates the actual tax breakdown for each taxable income group:

(Click to enlarge)

This detail view illustrates the different tax brackets as they apply to the income of a person filing single. The red line is a reference to help illustrate the slope of the tax amounts below.

(Click to enlarge)

This final chart illustrates the myth vs reality when one’s income moves from one tax bracket to another. The blue vertical bars indicate the tax brackets. The red zone illustrates the incorrect assumption that your tax rates apply retroactively. The green zone is your true net income.

(Click to enlarge)

Summary
This post should dispel the myth that your current tax bracket applies to 100% of your income. While taxes are complicated by many factors, this basic rule still applies. Don’t let yourself be fooled into believing that you are actually saving money by lowering your tax bracket. You should make tax-deductible donations as you see fit, but don’t think you’re saving any money by doing so.

More information
IRS 2008 tax tables
Chart source data (Google Docs spreadsheet)

Right now is a tedious time to be trading Seattle real estate. While the nation at large is experiencing a deflation in housing values, the Seattle market is stubbornly fluctuating between plateau and boom days.

A large number of properties are going unsold for 90+ days [zillow.com] while others are subject to irrational bidding wars. Part of me wants to sit it all out for another six to twelve months, but my better half insists that we need a house.

And so, we are in the market for a house.

House #1 was an estate sale for a beautiful, large fixer-upper with an entirely unfinished basement and asbestos throughout. Not afraid of building a little sweat equity, we placed a very attractive no-strings-attached offer slightly over the asking price of $350K.

We tried very hard not to get wrapped up, but being the first house we’d made an offer on, it was difficult not to get emotionally invested. It attracted a lot of attention including two offers that ended up beating ours, both with automatic re-bid triggers that pushed the final cost to well over $400,000.

In the end, the most stressful part was waiting for that call from our agent, but we were certainly disappointed when word came that it wasn’t meant to be. Perhaps I shouldn’t have spent all of those hours making a detailed scale Google Sketchup diagram of the entire house.

The buzz was that some of the other bidders had family ties to the house, so I imagine their own emotional attachment added considerably to what they were willing to spend.

Lesson learned: Remember not to lose your head over the first house you fall in love with. Better yet, don’t fall in love with a house if you can avoid it. Best of all, stay away from family affairs if at all possible.

House #2 was FSBO (for sale by owner). While outside of our primary search area, it had a nice location that made it worth considering the extended commute. Not wanting to be consumed in a bidding war like the one we’d just witnessed, I did an extensive amount of number crunching to find the true market value of this house.

Just looking at the raw numbers for the neighborhood, a house of its stats is valued at $315K-$325K. Excluding the outliers on both ends brought the house down a couple thousand, but in real estate it may be best to leave that data in since those are your neighbors, after all.

The killer feature that this house has which few of its neighbors could claim was the wilderness reserve directly across the street. I factored that in at a $20K bonus to the property value. That bonus brought the estimated value right in line with the more contextual housing valuations such as Zillow and an appreciation-adjusted comparison of the houses on the same block that have sold in the past year.

Unfortunately, the house turned out to be FSBSO (for sale by sentimental owner) and they had been given advice by someone that the house was worth $365,000; 75% more per square foot than even the nicest of their close neighbors. Perhaps self-conscious of the high price, they even misrepresented number of bedrooms and square footage.

The owner was quite galled when our agent presented the initial offer of 9% less than the asking price. In fact, this FSBO wrote off the possibility of a counter offer until I called them directly to discuss the situation. Still quite ruffled, they agreed to counter, but only after flat refusing to pay the buyer’s agent’s fee at any price.

The sad part is that this house may have quickly fetched a similarly inflated price a year ago, but I believe that more buyers are getting wise to the fact that they could buy a larger condo near downtown Seattle or a little mansion in the midwest for similar money. 2007 may shape up to be the year of the self-informed house buyer due to the online revolution in market information.

With any luck, this mixed-up market may yet produce a buyer who doesn’t do due diligence and pays full asking price just because they love the house. Then again, this un-motivated seller may still be living there months or years from now when it finally appreciates to the price they want. This person has very little to lose by just waiting until the right buyer comes along.

Lesson learned: Some FSBO sellers don’t want to know what their house home is really worth. They certainly don’t think you’re doing them any favors by butting in with your know-it-all offers. Don’t let yourself think you can convince them otherwise. Don’t let any of that stop you from trying.

Photo credit: Lance McCord

Imagine you were considering your options on a $350,000 traditional home loan. Assuming you have a FICO score of 725 (US average⁽¹⁾), your interest rate might be 6.259% for a 30-year fixed mortgage⁽²⁾. At the end of 30 years, you’ll own your home outright for a total cost of about $776K–that’s $427K in interest⁽³⁾.

By contrast, a 15-year loan will net you a lower interest rate of about 6.011%. Your monthly payments will be a little bit more, but you will own the home in half the time for a total cost of about $532K–only $182K in interest.

Assuming a paltry average annual appreciation rate of 10% (US average since 1980 has been 11.28%⁽⁴⁾), your house would be worth 417% it’s original value after 15 years. That $350K house would sell for about $1.5 million. Assuming you sold it and put the cash towards a bigger home costing $1.85M, taking out a new $350K loan to cover the remainder, you would only pay another $182K in interest in the second 15 years. Sell that house after another 15 years of 10% appreciation and you bank $7.7 million dollars. By comparison, the original house would sell for $6.1M in 30 years.

The net effect of the two fifteen year mortgages is living in a much better home for half the time and only paying a grand total of $364,000 in interest while neting about $1.6M more in value after 30 years. That’s quite a difference! You might be wondering why anybody would opt for a 30 year home loan.

On the other hand, you might have figured out that the 30 year $350K mortgage with its lower payments might be the most you can afford each month; that in order to make that same payment amount on a 15 year loan, you can only borrow $255K⁽⁵⁾.

Well, that stinks. In the Seattle area, that’s 14.5% fewer houses in your price range and 20% less square footage in those you can afford (worse still if you want the same number of rooms)⁽⁶⁾. However, it’s not all bad news. If you’re willing to go the 15/15 route, your second home would be worth $434K in today’s housing dollars⁽⁷⁾, giving you 41% more selection and 22% more space than the 30 year home.

So what’s a buyer to do?

I suggest you start any home buying process by getting a pre-approval for a 15 year loan (higher payments, shorter term). Then, shop the market and see if you can find anything that will fit your needs for the foreseeable future. If you find a house you can call home, snatch it up and start building more equity at a faster pace. If you exhaust the market and can’t find the amount of house you need on your 15-year budget, go back to your loan agent and have them recalculate your pre-approval for a 30 year loan and resume your search.

If must choose the traditional 30 year loan, there is no need to fret. Your needs and budget simply lie in the margin between price ranges of these two loan types. Most of the home buyers out there fall into this range and the seem to be quite happy with it.

If you find you can fill your needs in a 15 year loan, congratulations; you are able to live well within your means and you will eventually reap considerable benefits from your good budgeteering.

References
#1 wikipedia.com – FICO info
#2 myfico.com – FICO/loan rate calculator
#3 moneychimp.com – Compound interest calculator
#4 ofheo.gov – US historical housing appreciation data
#5 equifax.com – Financial calculators
#6 redfin.com – House value mapping
#7 bls.gov – US historical inflation data