What Will Your Tax Rate Be In Retirement?

Our 50-year-old hypothetical very early retiree is able to retire early despite putting no thought into tax diversification of investment accounts. So, all withdrawals will incur a 10% early withdrawal penalty.

Filing as a single filer narrows the tax brackets. Living in a high-tax state increases this individual’s tax burden further.

Let’s dive into the numbers.

First, we’ll calculate their federal income tax.

Add a 10% penalty on the entire $85,000 for the early withdrawal. Total tax increases to $19,968. The effective tax rate is 23.5%. This would be your total tax burden in a no-income-tax state.

Because this hypothetical retiree lives in a high-tax state, we’ll add another 4.95% tax to the entire $85,000. State income tax would be $4,207.50.

Total federal plus state tax is $26,492.50. The total effective tax rate is 28.4%.

So it is possible to actually pay a 25% effective tax rate or more as a retiree generating $85,000 of retirement income.  But you really have to try.

Single, Retiree, All Investments Tax-Deferred

Next, we’ll keep all assumptions identical with the exception of assuming a 60-year-old retiree. This would eliminate the 10% early withdrawal penalty.

Federal and state income taxes would be the same, totaling $15,675.50 tax on $85,000 of income for an effective federal plus state tax rate of 18.4%. In a no-income-tax state, your effective rate would be 13.5%.

Simply not taking the early withdrawal penalty gets us well below the assumed 25% effective tax rate.

Married, Early Retiree, All Investments Tax-Deferred

For the next scenario, let’s assume that the $85,000 will support a couple of 60-year-olds who file their taxes married filing jointly, with all else equal to the previous scenario.

This changes the federal income tax calculation as you can see in the table.

In a no-income-tax state, this would be your total tax burden. Utah’s “high” state taxes remain the same, bringing the total taxes due to $10,888.50, for an effective tax rate of 12.8% on $85,000 in this scenario.

Notice the difference in taxes between someone married filing jointly compared to a single person. By widening the federal tax brackets applied to the same amount of income, you lower your federal marginal tax rate from 22% to 12% and your effective rate by almost 6% compared to a single filer, all else equal.

Even with no tax diversification and living in a high-tax state, we’re now at about 50% of our emailer’s assumed 25% effective tax rate. In a no-tax state, the 25% assumption overstates our actual effective tax rate by a factor of three.

Single, Early Retiree, All Investments Taxable

For our next scenario, we’ll again assume a single, early retiree, living in a high-tax state. The difference in this scenario is that they planned for early retirement and saved aggressively in taxable accounts.

How much tax you pay on taxable accounts depends on your specific situation. Taxable accounts consist of cost basis, the amount of money you contributed to the account, plus capital gains, assuming your investments have increased in value since you purchased them.

Capital gains can be short-term gains or long-term gains. Short-term gains occurred in the past year. They are taxed as regular income.

Long-term gains occurred over periods greater than a year. They receive favorable tax treatment.

For our scenarios, we’ll consider that the account is highly appreciated with only a 20% cost basis and 80% long-term capital gains.

In this scenario, you have $68,000 of taxable income. Federal capital gains are taxed as follows for someone filing taxes as an individual:

***UPDATE: An astute reader, Jeff, pointed out in the comments that I forgot to apply the standard deduction in this scenario. The post has been updated to correct this error.***

At the state level, all taxable income is taxed at the same rate in Utah. Because 20% of the account is non-taxable cost basis, we apply the flat 4.95% to the $68,000 capital gain, for $3,366 of state tax.

This brings our total tax bill to $5,564 on an $85,000 retirement withdrawal, for an effective federal plus state tax rate of 6.5%.

Married, Early Retiree, All Investments Taxable

As with income tax rates, capital gains tax rates widen for married couples filing their taxes jointly.

In 2022, long-term capital gains are taxed at a rate of 0% up to $80,801 of taxable income.  In our scenario, $17,000 of their withdrawal is non-taxable cost basis, and the other $68,000 falls into the 0% tax bracket, leaving them with a federal income tax bill of $0 and an effective federal tax rate of 0%.

At the state level, we would have $3,366 of tax for an effective total tax rate of 3.96% on our $85,000 retirement withdrawal.

At this point, let’s take note of the difference between the proposed effective tax rate of 25% and our calculated effective tax rates. It widens so much that the original assumptions are not valid.

In reality, someone in this situation could:

• Substantially increase retirement spending.
• Convert tax-deferred investments to Roth at favorable rates and/or harvest capital gains on taxable accounts at a rate of 0% to further raise their cost basis, reducing their future tax burden.
• Simply take what they need to generate the desired $64,000 of retirement income and pay even fewer taxes than shown above.

Answer quick MicroSurveys for cash. Designed with convenience and timeliness in mind, 70% of surveys are answered on a mobile device in just a few minutes.

Physicians, Pharmacists, and other healthcare professionals are invited to join Incrowd today!

Single or Married Retiree, All Investments in Roth Accounts

If you use only Roth IRA accounts to generate retirement income, you will pay no tax in retirement at the federal or state level. Your effective tax rate would be zero.

Before you get too excited about this, remember that these accounts are not tax-free accounts. They are tax-free after having already paid income tax in the year the money was earned and the contribution to the account was made. The money then grows tax-free and it can be taken from the accounts tax-free in retirement.

Depending on the rates you would have paid when working and the rates you will pay in retirement, that may or may not be a good deal for you.

Calculating Effective Tax Rates: Traditional Retirement Scenarios

These simplified scenarios demonstrate how different sources of retirement income are taxed. Keep in mind that we save for retirement over the course of decades.

Over that time our circumstances and strategies change. As a result, many of us end up with a mix of tax-deferred, Roth, and taxable accounts that we can use to meet our retirement spending needs. Most of us will also receive Social Security retirement benefits at some point.

Let’s create a few more scenarios to see what happens to our effective tax rates when we combine these sources of income.

Mixing Taxable, Tax-Deferred, and Roth Accounts

Let’s assume that a retiree has amassed substantial taxable, tax-deferred, and Roth accounts. For this scenario, let’s suppose the retiree is in their early 60’s.

They have full access to all of these accounts without penalty. They are not yet receiving Social Security benefits or required to take required minimum distributions from tax-deferred retirement accounts.

We’ve established that a married couple will pay fewer taxes than an individual, all other things equal. So let’s focus on the higher tax situation of individuals.

Let’s again make no attempt at tax optimization. We’ll simply take $28,333, a third of our $85,000 withdrawal, from each account.

Withdrawals from tax-deferred accounts are taxable at regular income tax rates.

Withdrawals from Roth accounts are tax-free.

The gains from taxable accounts are subject to taxes. We’ll stick with the assumption that 80% of the account is long-term capital gains. So the taxable portion of the withdrawal is $22,667

With a total taxable income of $51,000 ($28,333 withdrawal from tax-deferred account + $22,667 of long-term capital gains), $10,600 of the long-term capital gains are taxable at a rate of 15%. This is $1,590 of long-term capital gains tax.

The total federal income tax is $3,230 on $85,000 of retirement withdrawals from a tax diversified portfolio, an effective federal income tax rate of 3.8%.

In our high-tax state, an additional $2,525 state income tax is owed. That is an effective state tax rate of 2.9%.

The total federal plus state tax owed is $5,755 for an effective federal plus state income tax rate of 6.7%.

Married couples, in this scenario, would pay a total of $243 federal income tax on the tax-deferred income. All long-term capital gains are tax-free. State taxes would be the same.

Mixing Tax-Deferred and Social Security Income

For a final scenario, we’ll look at the tax burden of someone who is creating retirement income from a mix of Social Security and tax-deferred investments. We’ll assume half, $42,500 from each source.

It should now be apparent from prior examples that the ability to generate some income with Roth or taxable accounts will lower the tax burden.

We’ll first look at a single tax filer in an attempt to give the least favorable tax scenario.

The amount of Social Security benefit that is taxable is dependent on the size of your Social Security Benefit and other taxable income.

My scenario will be a little off (overestimating taxes due) for 2022 calculations. I used Worksheet 1 from IRS Publication 915 to determine the amount of Social Security Benefits that are taxable. I used the 2021 IRS Form 1040 to determine taxable income for the calculations. The 2022 forms were not yet available at the time I was working on this blog post, so I used the 2021 forms.

Single Filer, 50% Tax-Deferred, 50% Social Security

For a single filer, the taxable amount of the $42,500 Social Security benefit in this scenario would be $36,125. After subtracting the standard deduction of $12,950, this leaves taxable income of $65,675.

Utah uses the federal formula to determine your taxable social security benefits. The taxable benefits are taxed at 4.95%. So the state tax in this scenario is $3,892.

The total federal plus state income tax on $85,000 would be $13,958. The federal plus state effective tax rate for a single filer in this high tax state would be 16.4%.

Married Filers, 50% Tax-Deferred, 50% Social Security

For a married filer, the taxable amount of the $42,500 Social Security benefit in this scenario would be $26,463. After subtracting the standard deduction of $25,900, this leaves taxable income of $43,063.