Archives for September 2024

Admin note: I have the annual Bogleheads Conference coming up this week, followed immediately by some vacation travel and then a finger surgery which will require a couple days of not-very-productive recovery. So there will be a temporary publishing hiatus here, with the next article appearing October 21.

If you have read about retirement tax planning, you have likely read about how people’s tax rate in retirement is often much higher than they’d expected. You may have even heard it referred to as a “tax torpedo.”*

The idea, broadly speaking, is that there are assorted provisions in our tax code that result in situations where, as your income goes up, not only does your tax go up in keeping with your tax bracket, it also causes something else to happen (e.g., some other tax kicks in) — which leads to your actual marginal tax rate being much higher than just your tax bracket.

In some cases we can see marginal tax rates in retirement exceeding 50%, especially when we include state income tax.

That sure sounds scary, doesn’t it? Sounds like it could be a major risk to your financial security in retirement.

But here’s the key point: those high tax rates are marginal tax rates. And at the levels of income in question, the effective tax rate is usually still very low.

Just to back up a step and make sure everybody is clear on definitions:

• Your marginal tax rate is the tax rate you would pay on an additional amount of income. (For example if your income went up by $100 and your tax bill went up by $30, your marginal tax rate for that $100 of income was 30%.)
• Your effective tax rate is the total amount of income tax you pay, divided by your total amount of income.

Let’s run through a few simple examples of relatively common retirement income profiles. You’ll see what I mean about high marginal tax rates and not-that-scary effective tax rates.

For all examples we’re assuming it’s 2024, using current tax law. We’re looking only at federal taxes. And for all examples we’re assuming a married couple filing jointly, both age 65 or older. (The exact same concepts apply to people filing as “single.” I’m simply keeping the filing status the same from one example to another in order to make it easier to compare.)

The tax calculations were done using Holistiplan.

Example 1:

• $40,000 of ordinary income (e.g., any combination of taxable interest or taxable distributions from a traditional IRA)
• $10,000 qualified dividends/long-term capital gains
• $40,000 Social Security benefits

Their marginal tax rate for additional ordinary income is 22.2% (12% bracket, but each dollar of income is also causing $0.85 of Social Security to become taxable at a 12% rate). But they have $90,000 of income, and their total federal income tax is just $3,832. That’s an effective tax rate of just 4.3%.

Example 2:

• $80,000 of ordinary income (e.g., any combination of taxable interest or taxable distributions from a traditional IRA)
• $10,000 qualified dividends/long-term capital gains
• $44,000 Social Security benefits

Their marginal tax rate for additional ordinary income is 27% (higher than just their tax bracket, because each additional dollar of ordinary income is causing a dollar of QD/LTCG income to get pushed from the 0% tax rate range into the 15% tax rate range). But they have $134,000 of income, and their total federal income tax is $9,906. That’s an effective tax rate of just 7.4%.

Example 3:

• $60,000 of ordinary income (e.g., any combination of taxable interest or taxable distributions from a traditional IRA)
• $10,000 qualified dividends/long-term capital gains
• $80,000 of Social Security benefits

Their marginal tax rate for additional ordinary income is 49.9% (!!!). This is because each additional dollar of income is causing $0.85 of Social Security to become taxable at a 22% rate, while also pushing a dollar of QD/LTCG income into the 15% rate range. And yet, on $150,000 of income, their total tax is $11,175. An effective tax rate of 7.5%.

Example 4:

• $250,000 of ordinary income (in this case, assuming taxable distributions from a traditional IRA)
• $40,000 qualified dividends/long-term capital gains
• $70,000 Social Security benefits

Their marginal tax rate for additional ordinary income is 24%. That’s because, in this case, we’re past the “weird” stuff that’s relevant in the examples above. That is, 85% of their Social Security is already included in their gross income, so that effect is no longer a concern for additional income. And all of their capital gains are already being taxed at the 15% rate. So they’re just in the regular 24% bracket. They have $360,000 of total income, and their total federal income tax is $60,133. That’s an effective tax rate of 16.7%. Definitely higher than in the previous examples, but that’s what you’d expect with a much higher level of income.

For tax planning (especially with respect to retirement accounts), we generally care about marginal tax rates. Marginal tax rates are what matter when we’re trying to figure out things like:

• Whether to contribute to Roth or tax-deferred accounts while still in our earning years.
• Whether to spend from Roth or tax-deferred accounts in our retirement years.
• Whether to do a Roth conversion in any given year.

For those decisions, we exclusively care about marginal tax rates. We don’t want to consider effective tax rates at all. And that’s why you hear so much about these high marginal tax rates in retirement. They are an important factor in many decisions we have to make.

But for budgeting, we care about effective tax rates. If we want to know whether taxes pose a risk to your financial security in retirement, we care about your effective tax rate in retirement. That is, how much total tax are you paying? Is it likely to be so much that it puts you at risk of depleting your savings?

*I really dislike the term “tax torpedo,” because it gives the impression that it’s a big danger to people, when, for the reasons discussed above, it tends not to be. Still, it’s the term that has become popular, so I’m acquiescing here.