Tax Strategies for Retirement Income

To help a client meet their goals , financial advisors need to know how taxes could impact the client's retirement income strategy. Marginal tax rates, effective tax rates, and effective marginal tax rates all play a role in determining how much of your client's retirement income will stay in their pocket and how much will need to be paid in taxes. Learn more about different tax rates in this month's FinPlan Friday conversation with Joe.

February 2022 FinPlan Friday

FinPlan Fridays

In our video blog series, FinPlan Fridays, Covisum® Founder and President Joe Elsasser, CFP®, offers his take on the issues financial advisors see every day. Joe is a practicing financial planner with a unique perspective on industry challenges. Join us on the first Friday of every month for FinPlan Fridays and get helpful tips to grow your financial planning practice. 


I'm Joe Elsasser, CFP®, Founder and President of Covisum®, and I'm also a practicing financial advisor. Welcome to another FinPlan Friday. Today we're going to talk about the difference between marginal tax rates, effective tax rates, and effective marginal tax rates — three concepts used differently in financial planning.

Marginal Tax Rate

You may have also referred to a marginal tax rate as a tax bracket. Tax brackets are what most people talk about and think about taxes. The more income you have on your return, you're going to be taxed at a progressively higher rate. And that rate is your tax bracket. Now, conceptually, it would be nice if we could all know that our income is going to fall into a 10%, 12%, or a 22% tax rate, but ultimately if you take your total taxes and you divide that by your total gross income, you're seldom going to come out with a rate that even really resembles any of the bracket rates.

Effective Tax Rate

And that brings us to our second concept, the concept of the effective tax rate. In addition to this bracket system, we also have various deductions. People get a standard deduction or itemize on a Schedule A. The effective tax rate is the total taxes you pay divided by the household's total gross income. Think about it as the blended rate after accounting for the standard deduction and the fact that some income falls into a 10% rate, some into a 12% rate, and some may even fall into a 22% or higher percentage rate. When you blend all those tax rates, you'll often find that the total taxes you pay are dramatically less than your tax bracket.

Effective tax rates are applicable when we're thinking over a lifetime. Your total lifetime assets minus your total lifetime taxes give you a lifetime effective tax rate. And that lifetime effective tax rate is applicable when thinking about, "How much of my money do I have?" and "How much of it is a loan from Uncle Sam?" In other words, if I've saved primarily in 401(k)s and IRAs, I have a silent partner—Uncle Sam. The unpaid taxes will be due when I withdraw the funds from those accounts. When you think about an effective tax rate, it's crucial to think about that over a lifetime because it tells you how much of your money is your own. 

Effective Marginal Tax Rate

The question for the effective marginal tax rate is, "what happens on the next dollar that I withdraw from a certain account or the next dollar of capital gain that I harvest?" Of course, we have tax brackets for ordinary income and a tax for capital gains. Still, you'll run into situations where the rate you pay on your next dollar of withdrawal differs from any of the brackets. Let's look at an example.

Let's say that I'm right on the edge of the 12% heading into the 22% tax bracket. I take an extra dollar out of my IRA, but let's also say that I have some capital gains falling into a 0% tax bracket. When I take that extra dollar out of my IRA, I'm pushing not only a dollar at 12% onto my return, but I'm also moving a dollar of capital gains out of a 0% capital gains bracket and into a 15% capital gains bracket. The only thing I did was take an extra dollar out of my IRA. Technically I would fall into a 12% tax bracket. Still, I'm going to pay 27% in federal income tax on that withdrawal because the combination of paying my 12% on my IRA withdrawal, plus pushing a dollar of capital gains that would've come at a 0% rate into a 15% rate means I pay 27 cents in tax.

The right way to think about taxes is this effective marginal rate when making financial planning decisions. How much do I lose to Uncle Sam on my following action on the next dollar I take from an IRA or the next dollar of capital gains I harvest?

Calculate your client's effective marginal tax rate easily with Tax Clarity®.

 Three Different Tax Concepts:

  1. Marginal Tax Rate — Your bracket rate. It's the most straightforward tax rate to talk about, but it's the least valuable.
  2. Effective Tax Rate — How much of your money do you own, and how much of it belongs to Uncle Sam. It's instrumental when thinking about the lifetime of the client.
  3. Effective Marginal Rate — The vast majority of financial planning decisions should be made.

Tax Clarity

Our Tax Clarity software helps you quickly calculate your client's effective marginal tax rate and identify dangerous points where just one additional dollar of income can push your clients into much higher effective marginal tax rates. 

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