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Marginal Tax Rates Repost
Old 03-24-2017, 01:28 PM   #1
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Marginal Tax Rates Repost

This is a copy of my original post where the images were not properly displayed.

In my opinion, Marginal Tax Rates are an extremely important concept that many of us need to understand while preparing for and living in retirement.

I am 70 and when I talk to my friends about the 55.5% and 46.25% Federal Tax Brackets almost all of them have the same response, “I don’t make anywhere near that amount of money”! When I tell them that those tax rates start at gross income levels of 50 to 60 thousand dollars, they are shocked and very interested in learning more. So I am bringing to this group the things that I talk to my friends about.

These extreme tax rates are caused by what I like to call the Parallel Taxation of your Parallel Taxation.



Looking at the worse case in this chart, at the top end of the 15% Federal Tax Bracket, when you earn or withdraw $100 of taxable income it causes $85 of your tax deferred Social Security to also become taxable income which causes the combined $185 of your tax deferred Long Term Gains to also become taxable income at the same 15% level. That is a total of a $370 increase in your taxable income at 15%, $55.50, which is 55.5% of the actual $100 increase in your income. A marginal tax rate is the amount of additional tax paid on an additional dollar of income.


I used an Excel spreadsheet to prepare the 3 graphs that I am about to use to illustrate this concept to the members of this forum.



Using the published 2017 federal tax brackets and deductions, this first graph shows the marginal rates paid by a single individual who is getting $30,000 from Social Security, $6,000 from LTCGs, plus other income from taxable sources like TIRA withdrawals or MRDs.

The graph is divided into 4 sections as illustrated by the numbers under the graph.

Due to the deferred taxation of Social Security and LTCGs, for about the first $45,280 of gross income, the retired individual is paying zero taxes while a working individual at the same $45,280 income level with no LTCGs would pay about $4,533 in Federal Tax.

This is where the “Marginal” tax rates start. The parallel sources of the “Marginal” rates are represented by the 3 dotted lines in the graph: Red for your normal tax bracket, plus Green for the taxation of your Social Security Benefits, plus Blue for the taxation of your Long Term Capital Gains. Every dollar of income can cause multiple income sources to be taxed at the same time, in parallel!

During the next $17,720 of your taxable retirement income, the solid red marginal brackets are close to the dashed blue standard brackets, a retired individual is paying about the same in taxes as a working individual during this income range. In this illustration only about $288 of the $4,533 of tax savings is given back to the IRS.

Everything changes drastically at the $63,000 gross income level. The solid red line definitely illustrates why I call the marginal tax rates paid over the next $10,240 “The Hump”. During this income range a working individual is in the 25% bracket and pays $2,560 in federal taxes while the retired individual is in the 55.5% and 46.25% marginal brackets and pays $5,080 in federal taxes giving $2,520 of their tax savings back to the IRS.

Once 85% of your Social Security has been taxed, all of the parallel taxation stops and everyone is back in the 25% Federal Tax Bracket. At this point you can just look back over your shoulder and say that 15% of your Social Security was tax free for a savings of $1,125 and your LTCGs were only taxed at 15% for another savings of $600.

The question to the group is simple, do you want to save $4,533 or $1,725?

As we will see shortly, all of these numbers are totally dependent on the size of your Social Security Benefit and the sources of your other income. You could use a spreadsheet or other tool to give you a nice picture of what happens, but that is not necessary for doing your retirement planning. If your Social Security benefit is above $18,000 The Hump starts at the 25% federal bracket, either as your LTCGs are pushed into that bracket, 55.5%, or when your taxable income reaches that bracket, 46.25%. All you have to do is treat any long term gains or dividends as ordinary taxable income and calculate your tax bracket. If you are close to the 25% bracket, see what you can do to change your income sources from taxable to non-taxable.

The Marriage Penalty

OK, we have seen how this effects a retired individual who is single. There is still a marriage penalty when retired because the taxability of your Social Security benefits starts when half of your benefits plus your other income reaches $25,000 for a single person and only $32,000 for a married couple, not $50,000 as it would be for 2 single individuals.



The gross income scale on the graph represents per-capita income. Note how the married couple, green line, starts paying taxes earlier because their joint taxable income is increasing faster. Their marginal rate starts at 18.5% because they are already in their 85% taxability bracket before their income reaches the 10% federal tax bracket. Since they started paying taxes earlier, they saved less taxes so their Tax Hump is therefore smaller because they have less to give back to the IRS.

The numbers above the graph and the tick marks on the graph illustrate the per capita income levels where The Humps start. The first set of numbers under the graph illustrate what happens when other income is doubled. The married couple is now paying their full Hump tax while the single individual is not. When the per capita gross income levels are pushed to $74,000 everyone is over the hump and is paying close to the same tax rate. A small difference still remains because the over 65 addition to standard deductions is $300 more for a single individual.

Your Social Security level defines The Hump


The red line illustrates how a lower Social Security Benefit gives you less tax deferred income which makes you start paying taxes at a lower gross income level which saves you less taxes which makes your hump smaller because you have less to give back.

This post is aimed at a very specific segment of the retired population. If you have a great pension plan and you are “Over The Hump” it can show you how you got to your after tax retirement income level, but does nothing to help you change it. If your retirement income level is small just about anything you can do could easily be counter productive.

If your retirement income is going to put you at, near, or slightly into “The Hump”, knowing the marginal tax brackets you could be facing can help you to plan for and take steps to avoid paying those ultra high tax rates.
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Old 03-24-2017, 01:33 PM   #2
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You know you can edit your posts I trust? If you edit your original post to include the images and then delete this repost, all the responses in that thread will be preserved too, and you won't dilute the conversation by having started this second thread.
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Old 03-24-2017, 01:37 PM   #3
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My original post no longer allows editing.

It was originally taken down because they wanted me to change my username and is probably locked out for editing by my new username.

The comments were somewhat not on topic because no one could see the images. My fault, not anyone elses!
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Old 03-24-2017, 03:12 PM   #4
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For reference, the original thread is

Marginal Tax Rates – FYI
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Old 03-24-2017, 04:40 PM   #5
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Mod note - tried to copy posts from the first to this thread, but the sequencing doesn't work. Members can copy their posts there and repost here. If any posts were lost in this, my apologies.
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Old 03-24-2017, 05:02 PM   #6
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This is all over my head but all I really care about is that my effective tax rate is 9%-11%.

Not sure why I need to care about my marginal.
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Old 03-24-2017, 05:15 PM   #7
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Quote:
Originally Posted by marko View Post
This is all over my head but all I really care about is that my effective tax rate is 9%-11%.

Not sure why I need to care about my marginal.
It can (or should) make a difference in how you manage your taxable income. If taking $100 more in taxable income (i.e. from a tIRA) forces a bigger amount of your SS to get taxed, or drives some previously tax-free cap gains to be taxed at 15%, then it might be best to get that last $100 from a Roth IRA, or some other source.
In many instances, knowing one's marginal tax rate is more useful than knowing one's effective tax rate, at least when considering strategies for reducing taxes. But when considering mega-questions ("will my savings provide enough income to live on"), effective tax rate is more useful.
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Old 03-24-2017, 05:42 PM   #8
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It can (or should) make a difference in how you manage your taxable income. If taking $100 more in taxable income (i.e. from a tIRA) forces a bigger amount of your SS to get taxed, or drives some previously tax-free cap gains to be taxed at 15%, then it might be best to get that last $100 from a Roth IRA, or some other source.
Good point, but my taxable dividends alone put me way, way over the SS cap anyway. Everyone's MMV but in my case it's just an interesting exercise.
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Old 03-24-2017, 05:51 PM   #9
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I never cared about my effective rate. Only the marginal rate was meaningful to me, because it tells me how much of my raise will go to the government. And since raises often come with promotions and more responsibility, it's especially helpful to know the marginal rate so that you can see clearly how your extra efforts at work will actually result in extra dollars in your pocket.

Paying both federal and California taxes, and being in a fairly high tax bracket, I have very little motivation to earn more dollars. Each additional dollar I earn only leaves me with 50 cents after paying all the taxes. But my average tax rate is probably only around 33%.
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Old 03-24-2017, 05:59 PM   #10
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You seem to be suggesting that there is a situation where $100 of additional income results in $55 in incremental taxes. I think you are wrong. Please provide the before and after details...sources of income for each scenario.
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Old 03-24-2017, 06:15 PM   #11
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I never cared about my effective rate. Only the marginal rate was meaningful to me, because it tells me how much of my raise will go to the government.
Everyone is different but for me my main concern is how much in actual dollars I have to pay.
Regardless of how I get there, I know that I seldom pay more than 10% of my total income to the Fed.

Unless I'm misunderstanding the term 'effective tax rate', a $150K gross income paying $15K in Fed taxes after deductions is a 10% effective rate.
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Old 03-24-2017, 06:32 PM   #12
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You seem to be suggesting that there is a situation where $100 of additional income results in $55 in incremental taxes. I think you are wrong. Please provide the before and after details...sources of income for each scenario.
Well...

Federal tax bracket is 33% for earned income above $233K
California tax bracket is 9.3% above $51K
CA SDI tax of 1%
Social security tax of 6.2% (capped at $128K)
Medicare tax 1.45%

33 + 9.3 + 1 + 6.2 + 1.45 = 50.95%

Granted, Social security is only up to $128K, so maybe that should not be part of the marginal tax if you are earning more than $128K, but all of the others do apply to my marginal bracket.

I'd love for you to prove me wrong, but I'm pretty sure I end up paying at least 44.75% even if I exclude the social security taxes after $128K.
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Old 03-24-2017, 06:44 PM   #13
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OP was referring to federal income tax only, and at a $60-70k level of income. Learn to read.
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Old 03-24-2017, 07:15 PM   #14
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Kitces wrote about this a few years ago, with the example I think you are looking for. I haven't verified it for myself but he presents it more clearly. It has a 46% example, not 55%, so I don't know if that one actually exists or not. Maybe if you throw in LTCGs getting added on.


https://www.kitces.com/blog/the-taxa...rate-increase/


I ran my own rough prediction in tax caster for when I start collecting SS and I'm not seeing it for my numbers. My regular income should be lower, with more income coming from dividends.
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Old 03-24-2017, 07:42 PM   #15
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I can see the 46.25%... essentially 185% of 25% marginal tax bracket.

I'm not seeing anything like that in my situation either.
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Old 03-24-2017, 07:50 PM   #16
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So I am bringing to this group the things that I talk to my friends about.
I doubt any of my friends would make it past the first graph. You obviously did a lot of work putting this together. The two tables under the second graph that shows the impact on taxes when increasing 'Other Income' is all I needed for your point to hit home.
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Old 03-24-2017, 08:36 PM   #17
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General unsolicited comment: without some additional explanation, the first spreadsheet/chart is virtually indecipherable.
Quote:
Originally Posted by Sandy & Shirley View Post
If your retirement income is going to put you at, near, or slightly into “The Hump”, knowing the marginal tax brackets you could be facing can help you to plan for and take steps to avoid paying those ultra high tax rates.
DW and I file MFJ, so the later charts tell me (I think) that when our taxable income is between $116K and $128K we'll be paying high marginal rates. From a practical standpoint, if I had enough savings to allow our safe withdrawals to put us at, say, $130K every year, it would seem that one way to reduce taxes over the years would be to "bunch" withdrawals: go only up to $115K the first year, then go to $145 the next year, etc. It winds up being the same amount of total withdrawals overall, but only 1/2 as much would be subject to these higher marginal rates.
Other than that--if your withdrawals will put you slightly into "the hump," maybe withdraw from Roth's even in the early years of retirement when you hit the first dollar of the "the hump" (contrary to the boilerplate standard advice of spending taxable and tIRA money until they are gone, then spend the Roth money). "The hump" is fairly narrow, and even a moderate amount of Roth money might effectively avoid taxes at these higher rates for many years.
Other observations:
1) Getting taxed at these rates would be a good problem to have for DW and I. I don't expect that will happen.
2) If a retiree has expected withdrawals well above "the hump", then the relatively small window of high marginal rates shouldn't significantly affect their behavior.

Thanks for the post. There's a lot of work here, and I must admit that much of it is wasted on me.
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Old 03-24-2017, 11:21 PM   #18
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Hmmm, what happens when you throw in the loss of ACA credits


I know right now that I owe zero income tax... and can make more money and still owe zero... but, the more money I make the less I get back on ACA credits... so I can see a point where someone could be getting SS early and be on the exchange.... get that 50ish% rate PLUS lose another 10% or so in ACA credits...
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Old 03-25-2017, 03:39 AM   #19
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While these marginal rates are interesting, for many most are irrelevant. Based on current tax law I believe that half of SS is considered as income when figuring if and how much of SS is taxed. When I consider taking SS @ 70 for both of us, even a small RMD will cause 85% of our SS to be taxed. So for us, many of these short lived higher marginal rates are not relevant. SS is over a decade away, so things may change by then.

It is good to know that these exist. But if the "hump" is small enough it may not make a lot of sense to apply much effort.

It would be nice to see have a clear listing of what causes each jump. Some other posts don't include sufficient information to define the situations describe all assumptions.
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Old 03-25-2017, 03:51 AM   #20
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This is all over my head but all I really care about is that my effective tax rate is 9%-11%.

Not sure why I need to care about my marginal.
Depending on your situation, marginal rates can be very important.

If you have a sudden expense during retirement, a home repair, a needed vacation, etc. If you suddenly need an extra $5,000 and your effective tax rate is only 10%, then all you need to withdraw from your IRA is $5,555. The government takes $555 and you get the $5,000 that you need.

When the marginal tax rate on that extra $5,555 is actually 55.5%, your taxes will be an extra $3,083. You withhold the $555 and the following April you owe the government and extra $2,528 in taxes.

If you were in the exact situation as the first graph and you needed an extra $5,000, you could withdraw the $10,240, withhold the $5,080 for the hump taxes and end up with $5,160 to pay your bills. Also, you are now over the hump. You could withdraw another $10,000 at just 25% and put the remaining $7,500 in the bank for next years vacation with a little extra spending money. Just be careful of things like the $85,000 MAGI limit that could raise your Medicare payments.

This is only possible if you realize where your tax hump starts, the start of the 25% bracket, and where it ends, 85% of your SSB has been taxed.



A primary goal in retirement is making sure that you do not run out of money. Giving extra money to the IRS does not help that goal.
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