Your Marginal Tax Brackets

When I tell people about the 46.25% and 55.5% tax brackets, their responses are almost always the same. I don’t make anywhere near that amount of money. It is logical to believe that high rates like that are only for those making at least six figure incomes. The reality is that those rates can start at gross incomes of $55,000 or less. Understanding these marginal tax rates is essential for the proper planning of your retirement and that is what these pages are all about.

There are three ways to look at taxes:

  • Your overall tax rate is your total taxes over your total income, $5,163 / $63,000 = 8.19%.
  • Your Federal Tax Bracket is how much the IRS is charging you for each dollar that your "taxable income" increases, 25%
  • Your Marginal Tax Rate is how much additional tax is due for each new dollar of income. Taxable income can come from multiple sources at the same time.

Your marginal tax rate is by far the most important number, it is the amount of tax you will have to pay on the next dollar you earn or withdraw plus any additional taxes due on your various deferred income sources. Using the income level just mentioned, $30,000 SS benefit plus $33,000 from your IRA and Pension, the Marginal Rate on the next dollar of earnings will be 46.25%. If your benefit is only $20,000, the 46.25% marginal rate starts at a gross income of only $55,000.

Tax brackets while working

We are talking about retirement, so let’s assume you are over 65 and single. Your standard deduction will be $7,850 plus a $4,050 exemption so your 10% federal bracket will start at $11,900.

1935

When Social Security started in 1935 the Treasury Department made a series of rulings that declared that your SS benefits would be tax free income. If we assume that your benefits are $30,000 for the purpose of this example, your 10% bracket would now start at $41,900 and your tax brackets would be the same size and rise at the same rate as if you were not receiving benefits.

1983 and 1993

The dotted green line represents the deferred taxation of your benefits created by the 1983 and 1993 amendments to Social Security. The 1983 amendment created a basis for deferred taxability as one half of your benefit plus your other taxable income. As your income rises above the basis of $25,000 if you are single or $32,000 if you are married, each additional dollar of income causes 50 cents of your benefits to become taxable income. The 1993 amendment declared a second set of basis points at $34,000 and $44,000 for 85 cent taxability until 85% of your benefit has been taxed. This parallel increase in taxable income, the actual income plus the previously untaxed SS benefits, causes the standard federal brackets, the dotted red lines, to occur faster.

Marginal Tax Rates

The blue marginal tax rate line in this graph is extremely important for you to understand when planning for and living in retirement, so let’s discuss it in detail. Excuse the term, but we are all aware of the books, so the rest of this page could be called:

Marginal Tax Rates for Dummies

The blue line starts at 15%, not 10% like the solid red line. The dotted red line at this point shows the 10% federal tax bracket but the dotted green line is also present indicating the 50% taxability of your Social Security benefits. Since both dotted lines are present, you are paying 10% of the dollar increase in your income plus 10% of the 50 cents of your SS benefit that became taxable income because of the same dollar increase in your income. 10% of the dollar is 10 cents and 10% of the 50 cents is 5 cents for a total tax increase of 15 cents when your actual income only increased one dollar. 15 cents is 15% of one dollar and that is the basic definition of a “Marginal Tax Rate”, the percentage taken from your next dollar of taxable income.

The big “Tax Hump” happens when an additional dollar is earned at the 25% federal bracket while your benefits are becoming taxable at the 85% level. 25% of $1.85 is 46.25 cents or a marginal tax rate of 46.25%.

In the last graph, when your social security benefit is $30,000 The Hump starts at about a gross income of only $63,000. At the $20,000 benefit level The Hump starts at only $55,000 of gross income.

This Tax Hump does not happen to the rich, those with six figure incomes, they are "Over The Hump" and just think of taxes as if 15% of their Social Security benefits as tax free income.

Understanding marginal tax rates and ways to avoid The Hump is the primary purpose of these pages.

Parallel Taxation

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