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I’ve long promoted using free retirement calculators, easily available on the web, to get a better handle on your retirement trajectory. These tools give you a sense for how much you need to save to retire, providing much-needed perspective and motivation.

I’ve also advocated for ignoring the hideously complex U.S. tax code whenever possible in your planning. Sometimes you can boil that tax code down to a simple “effective” tax rate. Further detail would just be intimidating and distracting for many prospective retirees early in the process. For example, I’ve shown that our taxes in early retirement are a relatively small expense, far less than we spend on either housing, health care, groceries, or recreation.

But, when it comes time for the major financial decisions, like leaving a career, or choosing an investment strategy in retirement, you can’t afford to ignore taxes. You need to get those details right, if you want a realistic picture of your financial status. Without accurate projections of your tax obligations, you run the risk of making serious financial mistakes with your retirement assets. Guessing at your retirement taxes using simplistic effective tax rates just isn’t good enough….

Effective Tax Rates

Let’s begin with a quick review of the terminology: Your effective tax rate is the total amount you pay in taxes, divided by your gross income. So, if you earned $100,000 for the year and paid $15,000 in taxes, your effective tax rate would be 15%. Your marginal rate is the amount you pay on each additional dollar of income you earn. So, if you pick up a job on the side, and bring in $10,000, but have to pay $2,500 of that to the government, your marginal rate would be 25%. Marginal rates are sometimes, but not always, equivalent to your tax bracket. Thanks to complex tax rules, such as those governing the taxation of Social Security benefits in retirement, your marginal rate can differ from your tax bracket. Marginal rates can reach values as high as 46% for single, middle-income taxpayers in certain scenarios!

Let’s use a simple scenario to explore just how important accurate tax rates are to your retirement planning. We’ll start with a middle-aged couple, nearing retirement: Both are 55 and plan to retire at 60. He makes $100K now and will collect $24K annually in Social Security starting at age 70. She makes $60K now and will collect $12K in Social Security starting at age 62. They currently have $300K in taxable savings and $500K in tax-deferred retirement savings. Their annual expenses are $72K. We assume an inflation rate of 3%, and nominal returns on their investment portfolio, a mixture of stocks and bonds, of 6%.

Before I give you the answers, take a guess: What do you suppose their effective tax rate is while working? How about after they retire? Do you think it changes much while they are retired, or is it constant? This is a simple scenario, so surely the tax rates will be simple, right? Over the decades of retirement, this couple has the same expenses each year and just two income changes: her Social Security starting at 62, and his at 70. Maybe their tax rates will change when they stop work, but then they shouldn’t fluctuate much, right?

The Numbers

Sadly, the reality is much more complicated than that. The root of the problem is that, while this couple’s situation might be simple, the tax environment that they inhabit — that we all inhabit — is anything but.

Here are the answers, computed with a high-fidelity retirement calculator that automatically performs detailed tax calculations with all the relevant tax provisions: In the last year that they are working, this couple’s effective tax rate is 23.8% (including payroll taxes). The next year, the first they are retired, when they turn 60, their effective rate drops to 0%. That’s right. They pay no taxes for 10 years in retirement. Then he turns 70 and they begin collecting more Social Security and taking Required Minimum Distributions (RMDs) from the tax-deferred account. At this point their effective rate jumps up to 8.1%. From there it rises to 9.0%, and stays at that rate for the rest of their retirement….

So, how does their retirement turn out? Using the high-fidelity calculator, I can tell you with some certainty that this example couple will make it to age 100 with about $22K left over in today’s dollars. They are secure, but not by much.

And what if this was your retirement scenario? What if you were using one of the majority of retirement calculators that takes an effective tax rate instead of performing detailed tax calculations? What would you input for that effective tax rate to get the most accurate results?

If you input 23.8%, the rate while they were working, the couple’s ending net worth will be negative $282K. Not only is this answer wrong by a huge factor, but it tells the couple that they cannot retire, when they really could!

If you input 0%, the couple’s rate immediately after retiring, their ending net worth will be about $676K, more than 30 times the correct answer. That’s wildly optimistic.

If you input 9.0% for the effective rate, the rate later in retirement, their ending net worth will be about $305K, almost 14 times the correct answer. Still very wrong.

OK, how about using an average of all the effective rates? Surely that will get us close. That average, as computed by the high-fidelity retirement calculator, is 8.6%. But, plugging that average effective rate into your low-fidelity calculator, you get an ending net worth of $321K, still very far from the correct answer.

Turns out that a simplistic numerical average is inadequate to capture the tax code. That’s because many tax provisions are not linear or proportional: they incorporate numerous thresholds and marginal rates that create “cliffs” or “chasms” in the math.

Detailed Tax Calculations

Choosing accurate tax rates is not just an abstract exercise. There are important retirement scenarios that require knowing your exact rates in order to make an optimal decision. For example, understanding when to do a Roth conversion. You could attempt to compute your tax rate at different stages of retirement using commercial tax software. But that process is laborious and error-prone. To ensure accuracy, you would need to input the proper inflation-adjustments to your income and the various tax thresholds, for every year of your future retirement.

The best way to get accurate tax predictions for retirement, is to use software designed for it. Stuart Matthews of Pralana Consulting, author of the PRC/Gold retirement calculator, is a leading expert on this topic. PRC/Gold is one of the very few retirement calculators able to perform detailed tax calculations. (During some recent research I had occasion to verify PRC/Gold’s output against a dozen or so critical retirement tax provisions, and found it uncannily accurate.)

Matthews has done extensive testing on the impact of taxation on retirement outcomes. He says that “Absolute precision in specification of your tax rate is not crucial; however, just making a rough estimate will probably result in substantial errors.” We’ve already seen examples of those errors above, with ending retirement results off many-fold.

In one of his own tests, Matthews found that each 1% error in effective tax rate results in an 8% error in the final savings balance. It doesn’t take complicated math to realize that if you guess wrong at your effective tax rate in retirement, missing it by only a few percentage points, you could misjudge your ending net worth by hundreds of thousands of dollars. The consequences of that could be working much longer than necessary, or running out of money in your later years.

High Fidelity

Predicting your financial future is difficult, at best. Lower fidelity retirement calculators using effective tax rates can be useful tools during the accumulation stage, to know if you’re saving roughly enough, and to evaluate alternative saving scenarios. But when it comes time to make major financial decisions, like leaving a career, or managing investments in retirement, you owe it to yourself to use more accurate tools.

Low-fidelity calculators cannot produce accurate results, unless you supply an accurate effective tax rate. How will you do that? As we’ve seen, effective tax rates are difficult to guess. In our example of an ordinary retirement, we’ve seen effective rates vary between zero and 23.8%. And, because they change over the course of retirement, you would actually have to guess at multiple effective rates, and somehow average them correctly, to get the right answer.

By the time you manage to compute realistic effective tax rates to use with a low-fidelity calculator, if you ever do, you will have already done the work of a higher-fidelity tool. You might as well choose and use a high-fidelity retirement calculator in the first place. Or, if you don’t want to do the work yourself, hire a skilled and impartial financial planner who can.