How tax rates are applied - Additional Inputs section

A retirement planning tool is only as good as its assumptions and inputs. Share your thoughts or ask questions about the internals of the simulation, built in planner assumptions, or planner inputs.
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FRPJunkie
Posts: 23
Joined: Wed Feb 24, 2016 8:17 am

How tax rates are applied - Additional Inputs section

Post by FRPJunkie » Mon Aug 05, 2019 10:51 am

I'm confused by how tax rates are applied, the order, and the nomenclature with respect to a pension.

On the main planner page, under Income Tax Rate, I have entered 15%. I assume that this rate is applied to any entries that are added on the Additional Inputs section that are considered Income (such as a pension). On the main planner page, under Annual Retirement Income, I have left this blank. Inflation is entered at 2%.

On the Additional Inputs page, I have added an entry as follows:
Cashflow Type: Pension
Start Year (Age 61)
End Year (End of Plan)
Annual Amount ($48,960)
Taxable Percent ($100%)--which I assume means that the entire amount is subject to tax; this may be incorrect
COLA type (track then no COLA)
COLA percent (blank)

Now, on the output screen, the first year the pension is in effect, the amount shown in the after tax income column is $38,189. I have no idea how this number has been calculated as $48,960 x .85 = $41, 616.

The subsequent entries (later years) are:
$37,425 (Age 62)
$36,677 (Age 63)
$35,943 etc

So these are clearly only reduced by 2% inflation.

Can you tell me where I've gone wrong here?

jimr
Posts: 512
Joined: Thu Feb 28, 2008 6:48 pm

Re: How tax rates are applied - Additional Inputs section

Post by jimr » Mon Aug 05, 2019 11:14 am

From what you describe, it sounds like your understanding of how this should work is correct and what you're seeing is confusing to me too.

Unfortunately, I'm not able to reproduce the result you're seeing based on what you've described. I started with a new plan, changed the tax rates and inflation rates as you have, then entered a single additional inputs "Pension" cash flow as you've specified and ran the planner.

The "after tax income" value I'm seeing in the detailed view table for the first year of of pension is $41,616 as you correctly calculated.

So my guess is that there has to be something else going on to cause that amount to be different from what we're expecting.

One thing I experimented with was changing the "Income Tax Rate" input on the main screen and I found that if I set the income tax rate to 22% I could exactly match the "after tax income" number sequence that you reported (starting with $38189 at age 61).

I'm not sure if my experiment is at all relevant, but could there possibly be an entry in the top additional inputs table that's overriding the income tax rate that you've entered on the main input window?

Jim

FRPJunkie
Posts: 23
Joined: Wed Feb 24, 2016 8:17 am

Re: How tax rates are applied - Additional Inputs section

Post by FRPJunkie » Mon Aug 05, 2019 11:20 am

jimr wrote:
Mon Aug 05, 2019 11:14 am
From what you describe, it sounds like your understanding of how this should work is correct and what you're seeing is confusing to me too.

Unfortunately, I'm not able to reproduce the result you're seeing based on what you've described. I started with a new plan, changed the tax rates and inflation rates as you have, then entered a single additional inputs "Pension" cash flow as you've specified and ran the planner.

The "after tax income" value I'm seeing in the detailed view table for the first year of of pension is $41,616 as you correctly calculated.

So my guess is that there has to be something else going on to cause that amount to be different from what we're expecting.

One thing I experimented with was changing the "Income Tax Rate" input on the main screen and I found that if I set the income tax rate to 22% I could exactly match the "after tax income" number sequence that you reported (starting with $38189 at age 61).

I'm not sure if my experiment is at all relevant, but could there possibly be an entry in the top additional inputs table that's overriding the income tax rate that you've entered on the main input window?

Jim
Bingo! That was it. It was pulling a 22% rate from an entry in that section.

But just so I am clear: the 15% income tax rate on the main planner page is simply applied across the board to income sources (unless overridden by entries in the addl inputs section? (i.e. there's no progressive taxation function, so one should just try to estimate an average rate?)

What, then, is the purpose of the "taxable %" field ? Is this only for income sources like SS that can only be taxed up to a particular percentage?

jimr
Posts: 512
Joined: Thu Feb 28, 2008 6:48 pm

Re: How tax rates are applied - Additional Inputs section

Post by jimr » Mon Aug 05, 2019 11:31 am

I'm glad you found it.

The "Income Tax Rate" should be your effective or average tax rate and not your marginal rate. Giving you an average tax rate input that can be varied from year to year in additional inputs (upper table) basically hands the problem of estimating taxes over to you. The planner's tax model is intentionally low precision because otherwise the complexity would get out of hand very fast and also it wouldn't work across multiple states and countries.

The "taxable percent" is designed to handle income sources that are only partly taxed like some social security benefits. It also can offer extra control for cases when you'd like to dial down the amount of taxes that will be paid on a specific income source. For example, if for some reason a pension is subject to federal taxes but not state taxes, you could adjust to taxable percent on the pension down below 100% to accommodate the lower expected tax rate without having to reduce the overall income tax rate that's applied to everything else.

FRPJunkie
Posts: 23
Joined: Wed Feb 24, 2016 8:17 am

Re: How tax rates are applied - Additional Inputs section

Post by FRPJunkie » Mon Aug 05, 2019 11:33 am

All makes sense! Thanks for the speedy reply!

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