An important part of retirement planning is estimating your future tax rate. This helps determine how much income you’ll be able to draw from your 401(k) or IRA, among other considerations. Most financial planners assume tax rates will go up in the future. But while that may be true it doesn’t necessarily mean the amount of tax you pay will rise too.
Why might tax rates rise? The main reason is the soaring U.S. budget deficit and rapidly growing entitlement costs of an aging population. Sooner or later the bills must be paid; it makes sense to figure that higher tax rates will be part of the solution.
For wealthy clients, most planners start with an assumption that the federal government will take at least 35% of income, and add the state’s bite on top of that. For middle-income clients, the common assumption is 25% plus whatever the state takes. But Financial Planning columnist Bob Veres notes that this way of thinking leads to “a very sloppy estimate.” For planning purposes, it’s much more useful to work with your effective tax rate—what you actually pay relative to income from all sources.
This takes into account that a couple’s first $17,400 is taxed at only 10% and the next $53,300 is taxed at just a 15% rate, and so on. A couple only experiences the top marginal rate of 35% on dollars earned past $388,350. Veres writes:
“Beyond that, clients have all the exemptions and deductible expenses, some portion of their total receipts are taxed at (lower) dividend or capital gains rates, muni bond payments are not taxed by the federal government at all (unless you are in the AMT), losses are harvested out of the investment portfolio, and many advisory clients have a host of other lines filled out on their tax forms that blunt Uncle Sam’s fingers in your client’s wallet.”
This is especially true of the wealthy. But through things like mortgage and charitable deductions, and our progressive tax scale, many people’s effective tax rate is considerably lower than the top marginal rate they pay.
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So, how do you calculate your effective tax rate for retirement planning purposes? Take total income from all sources, including interest, capital gains and dividends (Form 1040), and add to this any other amounts received but not required to be reported to the IRS. Now look at the total income taxes paid that year. Divide the taxes paid by total income and you’ll have your effective tax rate, which for most people is well below the 35% or more that many build into their planning.
For example, Veres says, one client with total income of $500,000 was shocked to learn that his effective tax rate was just 22%. Now, that’s the number he starts with when figuring how much income he’ll collect in retirement.