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What is your effective tax rate? What will your tax rate be in retirement?

These are fundamental questions for financial planning. They help determine:

A closer look at tax rates

  • Whether you should use tax-deferred or Roth savings accounts during your accumulation period.
  • If you should convert from tax-deferred to Roth accounts early in retirement, and if so, how much you should convert in a given year.
  • How much money you need in order to retire securely.

Conventional wisdom around these topics assumes that most people:

  • Have a good idea what their current effective and marginal tax rates are.
  • Can predict with reasonable accuracy what their future tax rates will be. 

I would argue that many people have little idea how much tax they currently pay. Even fewer can predict the future with reasonable accuracy.

For example, I recently received an email from a reader. He writes in part, “So at a 25% effective tax rate (an) $85k (withdrawal) supports (only) $64k in annual (retirement) spending.” 

My initial gut reaction was a 25% effective tax rate on $85,000 of retirement income is grossly overestimated, maybe even impossible. So I decided to run some numbers.

My goals were to:

  1. Confirm whether or not my instincts were correct.
  2. Help you determine a realistic assumption for your effective tax rate in retirement.

Let’s dive into some numbers….

Variables That Impact Your Tax Rate

There is no single “right” answer as to what your tax rate will be in retirement. Several factors impact your tax rate.

Higher Income, Higher Income Tax Rates

The first factor that impacts your tax rate is how much income you make during your working years. In retirement, this shifts to how much taxable income you need to generate to meet your spending needs.

In general, the higher your income when working the higher your income tax rate. The more taxable income you need to generate to meet your spending needs in retirement, the more tax you will generally pay.

For the sake of this example, let’s stick with this reader’s suggestion of $85,000 income. I’ll demonstrate how to calculate the effective tax rate on this retirement withdrawal in a variety of retirement scenarios. You can then do your own calculations based on your spending needs and circumstances.

Single vs. Married Filers

The next thing that determines your tax rate is your marital status. The same amount of income will generally be taxed at lower rates in households married and filing jointly than for single taxpayers. That’s because the same amount of income can be spread across wider tax brackets when married filing jointly. 

We’ll consider both single and married filing jointly households. This may be especially helpful to see for married couples who plan only with the assumption that both spouses will live long lives. Generally, one spouse will die before the other, sometimes much earlier, considerably changing the tax situation.

Related: Adjusting Early Retirement Plans After the Death of a Spouse

State Income Taxes

Another consideration is state income taxes. Each state taxes income differently

Seven states have no state income tax. Eleven states have a flat income tax structure. The remaining states have graduated rates. 

In addition to these different tax structures, states consider different sources of income taxable and may tax different sources at different rates. For example, there is variability between states regarding whether they tax Social Security benefits at all, and if so, how they tax them.

For my scenarios, I’ll use my home state of Utah as an example of a high income tax state. Some other states (California, New York, New Jersey, etc.) have higher marginal tax rates in excess of 10% on high earners. 

I chose Utah for illustrative purposes because it has a simple flat tax rate of 4.95% on almost all sources of income, including Social Security. Thus it is both relatively simple to calculate and representative of a state that is not tax friendly to retirees with low to moderate spending needs.

How Will You Generate Income?

Finally, how you generate retirement income matters. Different forms of income are taxed differently.

During working years, you pay payroll taxes on earned income. They are 7.65% for employees, consisting of Social Security (6.2%) and Medicare (1.45%).

This is the largest tax burden for many Americans during their working years. This is particularly true for the self-employed who are responsible for both the employer and employee halves of this tax, totalling 15.3% of income until income thresholds are exceeded. 

These taxes go away when you are no longer earning income. Confounding payroll taxes with income taxes is likely a contributing factor as to why people vastly overestimate their retirement tax burden.

Since the premise of the email the reader sent me is accounting for the impact of taxes on retirement withdrawals from investment accounts, we’ll assume no earned income and thus the complete elimination of payroll taxes.

For those looking to incorporate some earned income after retirement, I’ve covered that topic separately.

Related: The Amazing Tax Benefits of Semi-Retirement

Investment income tends to be taxed more favorably than earned income. The type of investment accounts you use will determine how much tax you will pay. We’ll explore different scenarios using investments in Roth, taxable, and tax-deferred accounts and Social Security income.

Comparing Retirement Tax Scenarios

I’m going to run through a series of retirement scenarios to demonstrate the range of effective tax rates that are possible on the same amount of income. You can then apply these concepts to your own scenario to help you better estimate your own tax burden in retirement.

We’ll keep the taxable income constant at $85,000 through the examples. That is the amount suggested in the email sent by the reader to produce $64,000 of spending. Note that if my assumptions are correct and the actual tax rate paid is lower than 25%, you wouldn’t need to take such a big withdrawal. In most cases, this would further lower your total taxes paid and your effective tax rate.

I share a lot of numbers in this blog post. If you aren’t clear on how retirement income is taxed, I encourage you to at least explore the scenarios most applicable to your circumstances.

If you just want the results without going through the calculations, scroll ahead to the conclusion and see if your retirement effective income tax rate assumptions are in line with my results. I also provide a no math necessary alternative to estimate your future tax rate with improved accuracy.

Calculating Effective Tax Rates: Early Retirement Scenarios

We’ll start with the worst case tax scenario, then a few more tax friendly scenarios to demonstrate the range of possibilities and assist you with your own tax planning.

Worst Case Scenario: Single, Very Early Retiree, All Investments Tax-Deferred, High Tax State

This is the worst case scenario I could create using the assumptions discussed above. All income is saved in tax-deferred accounts and thus is taxed at ordinary income tax rates.

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.

IncomeTax RateTax Due
12,9500% (Standard Deduction)$0
First 10,27510%$1,027.50
Next 31,50012%$3,780
Next 30,27522%$6,660.50
Total Income = $85,000Effective Federal Income Tax Rate = 13.5%Total Federal Income Tax = $11,468.00

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%. In a no income tax state, this would be your total tax burden.

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.

IncomeTax RateTax Due
$25,9000% (Standard Deduction)$0
First $20,55010%$2,055
Next $38,55012%$4,626
Total Income = $85,000Effective Federal Income Tax Rate = 7.9%Total Federal Income Tax = $6,681.00

In a no income tax state, this would be your total tax burden. Utah’s “high” state taxes remain the same, bringin 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 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:

IncomeTax RateTax Due
$12,9500% (Standard Deduction)$0
$17,000 (Cost Basis)0%$0
First $40,4000%$0
Next $14,65015%$2,198
Total Income = $85,000Effective Federal Income Tax Rate = 2.6%Total Federal Income Tax = $2,198

***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, 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 less taxes than shown above.

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.

Related: Early Retirement Tax Planning 101

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 less 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. 

IncomeTax RateTax Due
$12,9500% (Standard Deduction)$0
First  $10,27510%$1,027.50
Next $5,10812%$612.96
Total Income = $28,333Effective Federal Income Tax Rate = 5.8%Total Federal Income Tax = $1,640.46

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.

IncomeTax RateTax Due
$6,3750% (Non Taxable Portion of SS)$0
$12,9500% (Standard Deduction)$0
First $10,27510%$1,028
Next $31,50012%$3,780
Next $23,90022%$5,258
Total Income = $85,000Effective Federal Income Tax Rate = 11.8%Total Federal Income Tax = $10,066.00

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.

IncomeTax RateTax Due
$16,0370% (Non Taxable Portion of SS)$0
$25,9000% (Standard Deduction)$0
First $20,55010%$2,055
Next $22,51312%$2,702
Total Income = $85,000Effective Federal Income Tax Rate = 5.6%Total Federal Income Tax = $4,757

The taxable benefits are taxed at 4.95%. So the state tax in this scenario is $3,414.

The total federal plus state income tax on $85,000 would be $8,171. The federal plus state effective tax rate for married filers in this high tax state would be 9.6%

What Is A Realistic Effective Income Tax Rate to Assume in Retirement?

Hopefully, these scenarios show that the amount of tax you pay can vary considerably depending on your specific circumstances. 

Technically I was wrong. You could pay an effective tax rate greater than 25% in some years on $85,000 of retirement income. But that would require a combination of unfavorable assumptions and a 10% early withdrawal penalty, which would not persist into traditional retirement age.

Eliminating paying early withdrawal penalties, the worst case scenario we found for a single filer was paying an effective federal plus state tax rate of 18.4%. That’s about ⅓ less than the assumed 25% effective tax rate on an $85,000 retirement withdrawal.

The worst case scenario for a married couple is paying an effective federal plus state tax rate of 12.8%. That’s about 50% of the assumed 25% effective tax rate.

Those are the worst case scenarios! For those living in a state with no or lower income taxes, utilizing the married filing jointly status, and/or possessing diversification between taxable, tax-deferred, and Roth accounts the numbers are even more favorable.

Run your own numbers. You may be pleasantly surprised at how low your taxes can be in retirement.

An Easier Way to Estimate Your Retirement Tax Rate

Understanding how taxes are calculated on different sources of retirement income can be tedious and is not intuitive. Accurately estimating your retirement tax rate becomes more challenging if you are considering retirement locations in different states, which each have different tax structures. But it is worth a little bit of effort to familiarize yourself with these concepts.

However, once you understand the basics, it is much faster and easier to use a quality retirement calculator that computes federal and state taxes. Both the Pralana Gold and NewRetirement PlannerPlus calculators that affiliate with this blog do this. It is one of their most valuable features.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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