Federal Income Tax Rates for Retirement Planning

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Most of the income you earn is taxed, but not always at the same rate. Learning how federal income tax rates work is critical to estimating your tax burden today and planning for retirement tomorrow. This guide to taxes can help you understand how taxes are applied to you so that you can craft a successful retirement strategy.

Basics of Federal Income Tax Brackets

When interpreting tax rates, the most important thing to remember is that the U.S. has a progressive tax system consisting of several tax brackets. Each of the tax rates applies only to the amount of taxable income (income after your standard or itemized deductions and exemptions are applied) that falls in the respective single or married range for that bracket. This means that high-income individuals generally pay more in taxes as a percentage of their taxable income than low earners.

For example, if you are a single filer with an income of $84,400, and you take a standard deduction of $12,400, your taxable income is $72,000. But the full $72,000 is not taxed at the same rate. Instead, a different tax rate is applied to different portions of the amount according to seven different tax brackets based on income and filing status and ranging from 10% to 37%. Although the 37% tax bracket may seem high, you need only look at marginal tax rates from 1900 to the present to determine that the top tax rate today is far lower than it was a century ago.

How Federal Taxes Work for Singles

If your taxable income is $72,000 and you are single, here is how your tax is calculated according to 2020 tax brackets:

  • The first $9,875 is taxed at 10%, so you pay $987.50 on that amount.
  • The next $30,250 is taxed at 12%, so you pay $3,630 on that portion.
  • And the last $31,875 is taxed at 22%, so you pay $7,012.50.
  • You owe a total of $11,630 in taxes.

In this situation, your margin rate—or your highest tax bracket—is 22%, but notice that only $31,875 of your income is taxed at that rate. Your effective rate (taxes paid divided by taxable income) is about 16.2%.

How Federal Taxes Work for Couples

If you are filing jointly with a spouse and have the same taxable income of $72,000, here is how the federal income tax is calculated for 2020:

  • The first $19,750 is taxed at 10%, so you pay $1,975 on that amount.
  • That leaves $52,250 of taxable income, which is taxed at 12%, so you pay $6,270 on that portion.
  • You owe a total of $8,245 in taxes.

In this situation, you would be at the 12% marginal rate, but only $52,250 of your income is taxed at that rate. Your effective tax rate would be about 11.5%.

The 2020 tax brackets are only slightly different from 2019. Each year, the breakpoints between the rates are adjusted based on an inflation factor.

Capital Gains Tax Rates

If you hold investments in a taxable account you plan to draw from in retirement, selling an investment in that account triggers what is known as a capital gain. Capital gains amount to the difference between the sale price and purchase price of the investment and are treated as taxable income in the year you incur them.

Short-term capital gains on investments held for a year or less are taxed at ordinary income tax rates. The good news: Long-term capitals on investments held for over one year are taxed at lower rates. You'll pay either 0%, 15%, or 20% tax rate on long-term capital gains depending on your income and filing status.

  • A 0% tax rate applies to long-term capital gains and qualified dividends on a taxable income of no more than $40,000 for single filers or $80,000 for married couples.
  • A 15% tax rate is imposed on gains for singles with an income of no more than $441,450 or couples with an income of no more than $496,600.
  • A 20% tax rate only applies to taxpayers with an income above $441,450 (single) or $496,600 (married).

For example, assume that a married couple has $50,000 of taxable income. They could realize another $30,000 in long-term capital gains and pay no tax on the gain.

Realizing a capital gain in years where you pay no tax on the gain is one of the few ways to earn tax-free investment income.

Taxes for High Earners

There are some special tax rules that only apply to certain economically advantaged taxpayers.

Alternative Minimum Tax (AMT) recaptures tax from high earners. This tax is imposed on wealthier taxpayers who are eligible for various tax benefits to ensure that they still pay a minimum amount in tax. In parallel to your regular tax calculation, you calculate AMT by reducing your taxable income by certain exclusions and the AMT exemption amount and then multiplying that figure by AMT tax rates and subtracting foreign tax credits. If the calculated tax is higher, you'll pay it. For single filers in 2020, the AMT exemption is $72,900 but phases out at an income of $518,400; the exemption is $113,400 for married couples and phases out at $1,036,800.

Additional Medicare tax applies to high earned incomes. This is a tax that works just like current payroll taxes (FICA taxes). It is a 0.9% tax on earned income in excess of $200,000 for singles or $250,000 for married couples

Additional Medicare tax applies to high investment incomes. This tax is sometimes referred to as Net Investment Income Tax (NIIT). It is a 3.8% tax that applies to investment income if your adjusted gross income is in excess of $200,000 for singles and $250,000 for married couples.

Using Tax Rates Before Retirement

In the years before you retire, contributing pre-tax dollars to a tax-deferred retirement account such as a traditional IRA or a 401(k) minimizes your taxable income and thereby lowers your tax bill in the contribution year. This is particularly beneficial if you are in a higher tax bracket now and expect to be in a lower tax bracket when you start withdrawals in retirement.

For example, assume that a single filer with a taxable income of $72,000 decides to contribute $2,000 to a traditional IRA. The $2,000 saves them taxes at the 22% rate, reducing their tax bill by $440 in total.

Suppose this person loses their job in the same year and expects a taxable income of only $25,000 for the year. The benefit of contributing to a traditional IRA starts to diminish because the tax-deductible contribution of $2,000 would only save them tax at the 12% rate, reducing their tax bill by only $240. In this scenario, contributing with post-tax dollars to a ​Roth IRA may make more sense.​

As you earn less, it may not make sense to continue making tax-deductible contributions. 

If your income varies each year (such as those working on commission), consider using your expected tax bracket in retirement to determine which type of account to fund each year. This decision should also be revisited if you are easing into retirement. While you are doing your tax planning, you should also see if you have investment income that could be repositioned to reduce your overall annual tax bill.

Using Tax Rates During Retirement

Tax planning gets more complex when it's time to withdraw your retirement income. Each withdrawal you take from a tax-deferred retirement account counts as taxable income that is taxed at ordinary income tax rates.

In addition, once you turn 70.5, you are required to take withdrawals. To make things more complex, all your combined sources of income affect how much of your Social Security income will be taxed. Getting help from a financial planner before you start withdrawals can save you money in the long run.