- Your taxes depend on how much income you have and tax laws.
- You pay taxes at different rates.
- Marginal rates can help you make decisions, while an effective rate helps you understand the big picture.
You’ve probably heard that you should make decisions based on your tax bracket today and your expected tax bracket after retirement.
That’s especially true with things like retirement contributions. For example, should you contribute to Roth accounts and pay taxes up front, or is it better to use pre-tax accounts during your working years.
To make an informed decision, you need to understand your tax situation.
So, what will your tax bracket be in retirement? It primarily depends on two factors:
- Your income level: The more income you have, the higher your tax bracket.
- Tax laws: We know what the rules are today, but things could change in the future
Continue reading below, or get similar information from this video.
It’s also important to understand exactly how income gets taxed. Do you pay at a single rate, or is it more complicated than that? In many cases, you pay at several different rates, which can be confusing. Still, it’s critical to know what those numbers are, and it’s also possible to boil everything down to a single rate.
We’ll cover the details below, including which type of tax is best to use in your planning, but it’s important to get familiar with two concepts;
- Marginal tax rate: The rate at which each additional dollar of income is taxed.
- Effective tax rate: The overall rate that you pay on all of your income.
Why Does It Matter?
Tax rates are critical for retirement planning. Depending on how you save money (and withdraw it later), you might end up with more or less to spend each month.
Consider the examples below, where you have $100 in income from work. What should you do with the money?
Assuming you want to save the funds for your future, you could put the money in a pre-tax account or a Roth account (or both, but let’s keep it simple).
The after-tax value—the amount you actually get to spend—can be different. Add some zeroes, and the amounts can start to matter.
Start by assuming you’re in a higher tax bracket today than you’ll have in retirement.
25% Rate Today and 10% Rate in Retirement
|Money doubles (X years)
|Tax at withdrawal
Next, assume your tax bracket is lower today.
10% Rate Today and 25% Rate in Retirement
|Money doubles (X years)
|Tax at withdrawal
As you can see, your tax situation—which can change over time—is important.
What Determines Your Tax Bracket in Retirement?
While you can’t predict the future, you need to make some educated guesses. By understanding how much you might pay in taxes, you’re better prepared to evaluate your retirement readiness. So, it’s critical to estimate what taxes will cost given your income, assets, and goals for retirement spending.
Your income is a primary driver of tax brackets. In general, the higher your income, the higher your tax bracket. You might hear the term “progressive” tax system, which refers to how rates rise progressively with your income.
Income in retirement comes from several different sources, including:
- Social Security
- Interest in taxable bank accounts
- Dividends and capital gains in taxable accounts
- Withdrawals from retirement accounts
- And more
Keep in mind that a dollar of income from a given source doesn’t necessarily translate to an additional dollar of income at your marginal tax rate. Some of those income sources get taxed differently and have unexpected consequences.
Managing your income might be a new concept. You may have more control over your income during retirement than you ever had during your working years, which opens the door to various tax planning strategies. But sometimes, there’s little you can do, depending on the nature of your income.
As just one example, you might have an opportunity to manage your income after you stop working. Perhaps there will be several years before you begin Social Security income or before RMDs begin. During that time, you can either keep your income low, or you might choose to take additional income through Roth conversions or pre-tax account withdrawals.
- You might choose to keep your income low in an effort to minimize healthcare costs.
- You might choose to take extra income to reduce your income in the future.
There are a variety of other strategies available for managing your income in retirement. For instance, you might be able to dial your income higher or lower, depending on which accounts you spend from first.
Keep in mind that tax rules are rarely simple. For instance, the nature of your income can affect your taxes.
Types of Income
You might not pay tax on any of your Social Security income, or up to 85% of your benefits might be taxable. It depends on everything else happening on your tax return. And some investment income might get favorable tax treatment. Long-term capital gains and qualified dividends, for example, can behave in surprising ways when you calculate taxes.
Plus, you might face costs above and beyond income tax and capital gains taxes. Depending on your income, you might have to pay more for Medicare premiums, for example. Those IRMAA costs are not technically taxes, but they are tax-like, and you might call them “phantom” taxes. You can also run into Net Investment Income Tax (NIIT), which is an additional amount due on certain types of income if you have a high income.
By making some assumptions about how much income you’ll have (and the makeup of that income), you can estimate how much tax you’ll pay each year in retirement.
Keep in mind that tax planning tools don’t always make it easy to estimate these costs. A DIY tax planning package often helps with income tax, but it probably won’t look at the impact of IRMAA. For a robust estimate, you may need to use financial planning tools or a combination of tools.
You can make educated guesses about tax brackets in retirement with the information we have today. You might assume that if your income stays roughly the same (even after adjusting for inflation), your tax rates might be similar in the future.
But remember that tax rules can and do change. The question is whether or not things might change enough to make a meaningful difference.
Unfortunately, there’s no way to know.
Still, it’s wise to understand how sensitive your retirement plan is to tax law changes. If paying a few extra percent each year would ruin your plan, that’s essential information. It tells you that you may need to reevaluate things or explore strategies to reduce your risk in the future.
Currently, income tax rates are relatively low, whether you look at historic rates or taxes in other nations. While rates might remain more or less the same, things could change. Only time will tell.
Be cautious about trying to predict the future with too much confidence, as it’s extremely difficult. Nobody knows if income tax rates will rise, fall, or stay the same. If they do change, the differences might be minimal or dramatic. You might even see fundamental changes in the tax system (or not…). For example, things could shift toward consumption taxes instead of income taxes, making some tax planning efforts backfire.
As you evaluate your plan, run some what-if scenarios to understand the impact of a higher-rate regime. If you have significant assets in pre-tax retirement accounts or you spot other potential issues, consider options for changing the makeup of your assets.
This might bring up questions about rule changes. For example, will Roth withdrawals remain completely taxable, or could lawmakers change the rules? While anything is possible, making qualified Roth withdrawals taxable seems less likely than some people imagine. But if you’re concerned about it, model your retirement income with taxable Roth withdrawals to see how things look. The more you know, the better.
Ultimately, facing high tax brackets in retirement might be a nice problem to have. It won’t always make sense to contribute to Roth or do Roth conversions, and there might not be much you can do. But you can at least look at various strategies and rule them out if they’re not right for you.
Marginal vs. Effective Tax Rates
During your working years, you might not have paid much attention to tax rates. But as you prepare to use your life savings for income, it’s important to refine your understanding of tax rates.
Knowing the difference between effective and marginal tax rates is an essential skill for any retiree.
Marginal Tax Bracket
A marginal tax bracket is a rate you pay on income at specific income levels.
People often think about taxes in terms of their marginal tax bracket. They say “I’m in the 22% bracket,” for example.
Unfortunately, most people assume that they pay taxes on all of their income at the marginal rate. That’s generally not the case. Instead, you typically pay taxes at several different rates, with higher rates applying to higher levels of income.
For instance, consider the following fictional example of a tax system:
- 0% on the first $10,000 of income
- 10% on additional income up to $20,000
- 20% on additional income up to $30,000
- 30% on all subsequent income
If you have $31,000 of income, you might say “I’m in the 30% tax bracket.” While that’s accurate, many people assume they pay 30% on every dollar of income, which is incorrect. Your tax bill is not 30% times $31,000 (or $9,300).
Instead, it would be:
|Portion of income
|$10,001 to $20,000
|$20,001 to $30,000
Even though you’re “in the 30% tax bracket,” you only pay 30% on $999 of income.
The actual tax due is significantly less than a flat 30% applied to all of your income. This example is an oversimplification. However, the concept is similar to how a progressive tax system, like the U.S. tax system, works.
Effective Tax Rate
An effective tax rate is a single number telling you how much tax you pay on all of your income. To calculate an effective tax rate, divide the taxes due by your total income. Depending on how you define income, you might include every dollar you receive, or you might calculate your effective rate using only your taxable income.
The example above illustrates how effective tax rates work. You’ve seen how different tax rates might apply to different segments of your income, and you can add up all of the pieces to arrive at your final tax bill.
That total number is often interesting. In our example, you pay $3,299.40 on your $31,000 of income.
Steps to calculate the effective tax rate in this example:
- Total tax due (expressed in dollars): $3,299.40
- Total income $31,000
- $3,299.40 divided by $31,000 equals 0.106
- Convert 0.106 to a percentage: 10.6%
In this case, 10.6% is your effective tax rate. That might be lower than you thought, especially if you only focus on your highest marginal tax rate. There’s a big difference between 30% and 10.6%, and that information might be useful as you make decisions.
Marginal or Effective Tax Rate: Which Is Better?
Both types of tax rates are important. Marginal tax brackets are especially helpful when making decisions such as whether or not to take additional income in a given year. With a high marginal rate, it makes more sense to minimize income. Effective tax rates can be helpful for understanding the big picture.
With your effective tax rate, you can evaluate how much tax you pay on all of your income. This may help you understand the overall efficiency of your finances, and in many cases, people find that rate to be surprisingly low. While it’s never fun to pay taxes, you might feel better if your effective rate is on the low side.
How Can You Manage Your Taxes in Retirement?
Your accounts influence your tax rate for retirement withdrawals. When drawing from pre-tax accounts, you typically increase your income, which can lead to higher tax rates. Drawing from Roth accounts can provide tax-free income.
Roth withdrawals enable you to avoid taking income in the highest tax brackets. But you need Roth funds available, and getting money into those accounts requires paying taxes when you contribute. So, the idea is to add funds to Roth accounts when you’re in relatively low brackets and withdraw when you need to minimize income.
You might be required by law to draw from pre-tax accounts (taking RMDs, for example). So, you don’t have full control over when and how you take income.
That said, you can do some planning for a relatively low effective tax rate on retirement income. For example, you might draw down pre-tax accounts when you have low income years. For example, a Social Security bridge strategy involves delaying Social Security as you spend other assets, and this can work out well. You might also do Roth conversions during low income years to take advantage of low tax brackets.
What Is a “Good” Tax Rate for Retirement?
Your tax rate will depend on your assets and income, and you might not have much control over the rates you pay on retirement income. Generally, the lower the rate, the better. Many retirees have effective tax rates in the single digits or low double digits.
It might make sense to pay taxes at higher rates (sometimes), or you might have significant assets that make those low rates unattainable—even with strategic Roth conversions and other strategies. Ultimately, a high rate could be a nice problem to have.
What Is the Average Retirement Tax Rate?
On average, U.S. households pay roughly 6% in federal and state income taxes. However, many people pay less, and your tax burden depends on where you get income. The top 5% of households (by income) pay 16.4% because much of their income comes from pre-tax savings in IRAs and 401(k) accounts. Pension income is also typically taxable. But the lowest four quintiles get the majority of income from Social Security or similar sources. As a result, they might pay 1.9% or less in taxes.
The top quintile was defined by households with Social Security benefits of at least $50,900 and and financial assets of at least $441,400 based on a study from the Center for Retirement Research at Boston College. At that level, the study projected a tax rate of roughly 11%, but households with more would pay higher rates.