Federal Income Tax Rates for Retirement Planning

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Most income you earn is taxed, but it's not always taxed 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 tax brackets for retirees so you can craft a successful retirement strategy.

Basics of Federal Income Tax Brackets

The U.S. uses a progressive tax system that consists of several tax brackets. Each of the brackets is associated with a span of income that's taxed at that percentage. The brackets apply only to the amount of taxable income that remains after you subtract your standard deduction or itemized deductions and any exemptions you're entitled to claim.

High-income individuals pay more in taxes as a percentage of their taxable incomes than low-income earners.

Your taxable income would be $72,000 if you're a single filer with an income of $84,400, and if you take the 2020 standard deduction of $12,400. But the full $72,000 isn't taxed at the same rate. A different tax rate is applied to different portions of that amount according to seven different tax brackets that are based on filing status.

Tax brackets range from 10% to 37% as of 2020. The 37% tax bracket might seem high, but it only applies to the highest earners.

How Federal Taxes Work for Single Filers

Your 2020 tax would be calculated like this if your taxable income is $72,000 and you're single:

  • 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.

Your marginal rate—your highest tax bracket—is 22%, but only $31,875 of your income is taxed at that rate. Your effective tax rate, which is your taxes paid divided by your taxable income, works out to about 16.2%.

How Federal Taxes Work for Couples

This is how your federal income tax would be calculated in 2020 if you're filing jointly with a spouse and have the same taxable income of $72,000.

  • 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.

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

NOTE: The breakpoints between these rates are adjusted annually based on inflation, but the adjustment typically isn't more than a few hundred dollars, if that. The first $19,900 would be taxed at 10% in 2021.

Capital Gains Tax Rates

Selling an investment held within a retirement account can trigger a capital gains tax if the difference between the sale price and the purchase price of the investment is positive—you realized a profit. Capital gains are treated as taxable income in the year you incur them, and they're sometimes subject to their own tax rates.

Short-term capital gains on investments held for a year or less are taxed at ordinary income tax rates along with your other income. But long-term capital gains on investments you've held for more than one year are taxed at lower rates. You'll pay either a 0%, 15%, or 20% tax rate on long-term capital gains, depending on your income and filing status.

  • The 0% tax rate applies to long-term capital gains of no more than $40,000 for single filers, or $80,000 for married couples.
  • The 15% tax rate is imposed on capital gains for singles with incomes from $40,001 to $441,450, or couples with incomes from $80,001 to no more than $496,600.
  • The 20% tax rate applies only to single taxpayers with incomes above $441,450, or $496,600 for married taxpayers.

A married couple with $50,000 in taxable income could realize $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 a few ways to earn tax-free investment income.

Taxes for High Earners

Some special tax rules apply only to financially-advantaged taxpayers.

Alternative Minimum Tax

The Alternative Minimum Tax (AMT) recaptures tax from high earners. It's imposed on taxpayers who earn sufficient income to take advantage of multiple tax breaks, whittling their taxable incomes down to a point where they pay very little in taxes. The AMT ensures that they still pay a minimum amount in tax.

You can calculate your AMT by reducing your taxable income by certain exclusions and the AMT exemption amount, then multiplying the result by AMT tax rates and subtracting foreign tax credits. You'll have to pay the AMT calculated tax if it's higher. The AMT exemption is $72,900 for single filers in 2020. It's $113,400 for married couples.

Additional Medicare Tax

The Additional Medicare Tax also applies to high earned incomes. This tax works like FICA taxes—Medicare and Social Security. It's a flat 0.9% on earned income in excess of $200,000 for singles, $250,000 for married couples who file joint returns, and $125,000 for married taxpayers who file separate returns.

Net Investment Income Tax

As the name suggests, the Net Investment Income Tax (NIIT) applies to investment incomes rather than wages or earned income. It's a 3.8% tax that comes due on the investment portion of your income if your AGI is in excess of $200,000 and you're single, or $250,000 for married couples who file joint returns. Married filing separately taxpayers are limited to a threshold of $125,000.

Using Tax Rates Before Retirement

Contributing pre-tax dollars to a tax-deferred retirement account, such as a traditional IRA or a 401(k), in the years before you retire, minimizes your taxable income in the years before you retire. It would reduce your taxable income in the year you make the contribution. This is particularly beneficial if you're in a high tax bracket now and expect to be in a lower bracket when you start taking withdrawals in retirement.

NOTE: If a single filer with a taxable income of $72,000 contributes $2,000 to a traditional IRA, that $2,000 would save them taxes at the 22% rate, reducing their tax bill by $440 in total.

The benefit of contributing to a traditional IRA starts to diminish if you expect a taxable income of only $25,000 for the year because the tax-deductible contribution of $2,000 would only save you tax at the 12% rate, reducing their tax bill by just $240. Contributing with post-tax dollars to a ​Roth IRA might make more sense in this scenario.​

It might not make sense to continue making tax-deductible contributions if you find yourself earning less. 

Consider using your expected tax bracket in retirement to determine which type of account to fund each year if your income varies, such as if you work on a commission basis. This decision should also be revisited if you're easing into retirement. Determine 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 complicated when the time comes to start withdrawing your retirement income. Each withdrawal you take from a tax-deferred retirement account counts as taxable income that's taxed at ordinary income tax rates in the year you make the withdrawal.

You're required to take withdrawals when you reach the age of 70½ unless you attained your 70th birthday on July 1, 2019 or later. Required distributions don't occur until age 72 in this case.

All your combined sources of income will additionally affect how much of your Social Security income is taxable when you begin collecting benefits. Getting help from a financial planner before you start withdrawals can save you money in the long run.