marginal vs effective tax rate

Marginal vs Effective Tax Rate in Retirement

Knowing the difference between your marginal vs effective tax rate is an important element of tax planning. When you understand your tax rate, you’ll be able to incorporate that into an integrated retirement withdrawal plan.

The ability to properly manage your tax bill can save you thousands of dollars. It can also dramatically improve your retirement by allowing you to keep more of your money. Keeping more of your money is just as valuable as earning more because you’ll be able to reach the same level of after-tax income with a smaller withdrawal. This lowers the strain on your savings.

In this article we will discuss the difference between marginal vs effect tax rates, and look at an example of how you can use that information to reduce your taxes in retirement.

Income Tax

First, some groundwork. You may already understand how the basic income tax structure works but we will review it here in case you don’t. If you already understand how the progressive income tax system works you can skip ahead.

Federal income tax is progressive. What this means is that you pay a higher rate of income tax on larger amounts of taxable income. For 2019, the rates below apply:

RateSingle, Taxable Income Over:Married Filing Jointly, Taxable Income Over:
10%$0$0
12%$9,700$19,400
22%$39,475$78,950
24%$84,200$168,400
32%$160,725$321,450
35%$204,100$408,200
37%$510,300$612,350

Lets go through this with an example. If you can follow the example and understand how it works you can do the same for your own situation.

Suppose you are a single taxpayer with $100,000 in taxable income.

For a single taxpayer, you owe 10% on the first $9,700 of taxable income. of course, that comes out to a $970 tax bill.

However, on the first dollar that you make over $9,700 you’ll owe $0.12 in income tax. You’ll owe $0.12 on every dollar you make over $9,700 up until $39,475. The difference between $39,475 and $9,700 is $29,775. Twelve cents out of every one of those dollars adds up to $3,573 which is the amount of income tax you’d owe for that portion of your taxable income.

$39,475 - $9,700 = $29,775 x .12 = $3,573 income tax

From there, you’ll owe $0.22 on every dollar you make between $39,475 (starting with the 39,476th dollar) and $84,200. That comes out to $44,725 that is taxed at 22%. Your tax bill for that portion of your income is $9,840.

Next, the amount of your taxable income between $84,200 and $100,00 is taxed at 24%. That difference is $15,800 and 24% of it is $3,792.

Effective Tax Rate

Your effective tax rate is the total dollar amount of your tax liability as a percentage of your taxable income. In other words, it’s the average tax rate that you pay on all of your taxable income.

In this example, your total tax bill is $970 + $3,573 + $9,840 + $3,792 = $18,175.

You paid $17,205 on $100,000 in taxable income. Your effective or average tax rate is 18.175%

Marginal Tax Rate

With an understanding of how a progressive income tax system works, let’s think about that next dollar you earn or withdraw from your retirement account. Suppose your taxable income goes up by $1 to $100,001.

How is that last $1 taxed? You are in that 24% bracket so that last dollar will lose $0.24 to income tax.

That is your marginal rate.

Your marginal tax rate is the tax rate you’ll pay on the next dollar of taxable income. It’s also the amount you would save by reducing taxable income by a single dollar.

Reducing Your Tax Rate

Reducing your taxable income may not sound good at first, but we don’t necessarily have to reduce your actual income to do that. Not all dollars are taxable, and as you have seen not all dollars are taxed at the same rate.

With proactive planning you can lower your tax bill in meaningful ways. By understanding how your withdrawals are taxed, you can maximize your withdrawals when you are in a lower marginal tax bracket.

The value of this is relative, meaning wherever you are in the income tax schedule you can increase your after-tax value by getting your taxable income into the next lowest bracket. The general concept is to keep that marginal rate as low as possible for you. Maybe you are in the 37% bracket. If you can reduce your taxable income into the 35% bracket then you are better off.

That point is likely obvious but I wanted to make it so that you don’t get distracted with some hypothetical ideal target tax rate. Lower is better, and the lowest possible bracket achievable will vary from couple to couple or person to person. If you can reduce your marginal tax rate from 32% to 24%, for example… great!

If, despite your best efforts, you are unable to reduce your marginal tax rate below 37%, then congrats! That means you are unable to reduce your taxable income below $510,300. You’re probably doing ok and there are worse problems to have.

Again, the point here is that you are trying to reduce your tax rate to a level that is reasonable for you.

Multi-Year Tax Planning

Most often we tend to think of tax planning as lowering our tax bill each year. Usually, we wait until it’s time to file our taxes for the year. We talk to our tax preparer, give them all the information, and then they give us a recommendation of things we can do to lower the current year’s taxable income by taking advantage of deductions, credits, or by making charitable gifts. For example, maybe you make that last minute IRA contribution.

That helps, but it’s a very short-hand way of planning. Especially when it comes to retirement withdrawals, there are strategies you can employ over a multi-year period that may not look like they make much sense when looking at it one year at a time.

Why is that? Because sometimes it makes sense to drive up taxable income in one year so that you can reduce it in another.

For example, consider that over the course of your career you have accumulated savings in several different accounts. Not at all unlikely considering most people will switch jobs several times over their life. Some of those accounts may be taxable, tax-deferred, or Roth.

If you simply look at how to reduce your current year’s tax bill you would probably withdraw from the taxable account or Roth. However, that would mean at some point you would take your entire withdrawal from the tax-deferred account. When that happens you would put yourself in your highest possible marginal bracket. Instead, consider blending those withdrawals from each account to keep your average effective rate as low as possible over your entire retirement.

Smoothing Your Tax Rate

When you plan distributions over several years you can smooth out your tax rate and keep as may dollars taxed in lower brackets as possible. As a simple example, consider that you have a Roth IRA and a traditional tax-deferred IRA. Dollars are withdrawn tax-free from Roth IRAs, and are of course taxed when you withdraw them from the tax-deferred account.

Suppose you want to take that $100,000 withdrawal we talked about earlier.

If you only consider your taxes one year at a time you’d take it all from the Roth account because you’d have no tax liability on that $100,000 withdrawal.

However, you’d also delay the time that that a full $100,000 withdrawal is taxed when you are only left with your traditional account and have to take the whole amount from there.

Instead, take part of the withdrawal from each account. If you take $50,000 from each account, you’d never even reach that 24% bracket. You wouldn’t even fill up the 22% bracket.

You tax bill on the $50,000 withdrawal is:

First $9,700$970
12% of the amount between $9,700 and $39,475$3,573
22% of the amount over $39,475$2,316
Total Tax Bill:$6,859

The other $50,000 that you withdraw from your Roth has a tax bill of $0. Your total tax bill is $6,859. Notice that your tax bill dropped my more than half, even though your taxable income was only cut in half. That’s the effect of avoiding that highest marginal tax bracket.

Spend More or Reduce Withdrawals

In the first example you withdrew $100,000 and paid income tax of $18,175. That means you are left with $81,826.

In the second example you still withdrew $100,000 it was just split between two accounts. Your tax bill was $6,859 leaving you with $93,141 in after-tax spending ability.

That’s a difference of $11,316. You could enjoy a higher standard of living since your after-tax, net withdrawal went up. That’s enough for an awesome vacation every year!

You could also reduce the amount you take from your Roth by $11,316. That gives you the same amount of after-tax value as you would have by taking the whole distribution from the traditional account. If you take a $50,000 withdrawal from your tax-deferred account and pay $6,859 in income tax you are left with $43,141. To get up to that same $81,826 in spendable cash you would only need to withdraw $38,685 from the Roth.

If you opt to reduce withdrawals then you are increasing the chance that your money lasts throughout retirement, and is a good bump to safety.

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