Posts Tagged ‘Taxes

12
Mar
12

Taxes going up! Taxes staying the same! Taxes going down!

Welcome! from our blüg’s tax research dawghouse based in a sunny spot here in the Milky Way.  Last week, we posted that taxes are more than likely to decrease in retirement.  And, a Grumpy, wisely gave us some push back.  Each and every one of us can toss about conjecture when it comes to future tax rates.  Personally, we like to look at our tea leaves every day to get a reading on future tax rates.

Regardless of who’s kool-aid you’re drinking, prudent retirement planning will require some sort of tax rate assumption.  So, what assumption do we use?  Well, let’s take a look at what you would have paid from 1913 all the way up to 2011 to have some sort of historical foundation to base our guess on.

First off, we should give credit, where credit is due.  The Tax Foundation did some of the heavy lifting for us.  And you can download the same data which we built our tool around here.  We also did some high level research into the Tax Foundation’s data and found it to be accurate to a degree suitable for understanding trends in Federal income taxation.  Furthermore, if you are into minutiae like we are, you should see why the Tax Foundation’s numbers will differ slightly from the IRS’.

Second, we should clear up a common misconception about how American’s are taxed.  The U.S. has a progressive tax system, meaning the more you make, the more you pay.  And more often than not, at a higher tax rate.  If an individual(s) is in the 25% tax bracket, that does not mean you multiply their income by 25%.  All American’s pay the same amount of tax on their first $10,000 (or insert whatever number you like) regardless of what their marginal tax bracket is, so on and so forth.  If this is unknown to you, please see this Wikipedia article, which even includes a sample calculation under the obvious heading.  Now that we all know our marginal tax rate is the amount of tax we pay on our next dollar, not our entire ordinary income, we can proceed.

But why is knowing our marginal tax rate helpful?  For those working stiffs like ourselves, it helps one to determine if the effort of making more income is worth the after tax payout.  It can also help in making decisions such as how much money you should convert to a Roth IRA.  These two reasons are by no means exhaustive.  Let’s pop some incomes into our handy tool and see what poops out the other end.  For this article, we are using $50k, $100k and $200k in 2011 dollars (so, your 2011 $50k spending power was the same in 1913) and a Married Filing Jointly status.

We learn a couple of things from this chart.  First, as stated previously, the more money you make, the higher your marginal tax rate.  And historically, we learn two things: 1) The tax structure changed dramatically in 1941.  We are not history buffs, but there was a war around that time.  We just merely wish to point out this change associated with major events, not to discuss every reason why this change came about (and knowing why is applicable, but a different conversation).  We would not suggest using any tax rate before 1941 for tax planning purposes.  And 2) the late 80’s early 90’s had a “rate bubble,” where higher incomes actually had a marginal tax rate less than some lower incomes.

It is also interesting to note, that for a family making $50k, the marginal tax rate has not changed for the last 25 years!  And the highest it’s ever been is 29% in 1945 and 28% in 1981.  A couple’s effective (or total dollar paid) peaked in 1945 when they had to pay $12,077 (2011 dollars) in taxes for an effective tax rate of 24%.  Oddly enough, the marginal tax rate dropped in 1954 to 22% and held there for 10 years, but less tax was paid in 1981 (marginal tax rate of 28%).

While there is an effective rate localized maximum in 1981, it is interesting that it is less than the 35 year period of 1942 to 1976.  And in fact, a couple has paid approximately 20% to 30% less in taxes the last 35 years than they would have the 35 years prior!

What about those couples making $100k and $200k?  Well, here is a chart with their marginal and effective tax rates.

The conclusion we draw from this chart is, the lower your income, the less variability for effective tax rates.  Also, as you are less likely to have significant tax increases, you also are less likely to have significant tax decreases (we all knew that already, this is just the history to prove it).

If we were to look at even higher incomes, the variability would be even higher!  So, this is another reason to keep your expenses low, you are less likely to experience large variations in your income tax.

So, what to use for your retirement tax rate assumption?  The real risk is a significant change during retirement, not during the accumulation phase.  Most people will be able to react, tack on a few years of saving to account for changes during the accumulation phase.  We suggest entering your income into our tool below to see what you would have paid historically.  And make sure there is enough wiggle room in your plan to cover the highest tax rate since 1941, plus a few percentage points (more if you are a “high” earner).  And if you often sport a tin foil hat, perhaps a few more.  There is some point where enough is enough and you’ll have to accept some risk, unless you want to work into the grave.  We’ll go over how to build in wiggle room in another post (psst…it doesn’t always mean accumulating more).

What we don’t account for

Tax deductions.  We input no tax deductions.  So an interesting exercise would be to compare your annual effective tax rate in these years and see how much you are reducing your taxes through deductions.  If you have dependents or large deductions (e.g. mortgage interest), we would caution you from extrapolating straight into retirement, as those will (HOPEFULLY!!) go away.  State income tax is something we didn’t look at either.  Doing 40 something states didn’t seem like too much fun.  And, there are other ways the gubmint can tax individuals.  Social Security is a prime example and one which is not included in our tool.  Long term capital gains and dividends are not covered and in our opinion, deserve their own post.  Also, some years, for REALLY high income earners, there is a max effective rate that we did not put into our tool (sorry uber rich!).

Our tool can be downloaded here.  Just remember, it was created by us and is therefore our property.  If you use the tool for any calculations or to generate any charts which will be published, we would appreciate a little linky love.  And as always, we are human dawgs, so we can make mistakes.  Please let us know of any errors or improvements that can be made.

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