understanding "Income Tax Rate" and "Taxable Percent"

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FRPJunkie
Posts: 38
Joined: Wed Feb 24, 2016 8:17 am

understanding "Income Tax Rate" and "Taxable Percent"

Post by FRPJunkie »

I'm not fully clear on how taxes are calculated in FRP. I understand that FRP does not calculate marginal tax rates, only average. But let's look at a simple example.

Let's say a MFJ couple has a pension of $100,000 and that is their only retirement income. The pension is taxable federally.

If we assume the couple takes the standard deduction of $27,700 and no other deductions.

$100,000
-$27,700 =
$72,800 taxable income

So in this case, would "taxable percent" for the pension in the Additional Inputs windows be entered as 72.8%? If not, then what is this input for? This is also relevant for other addtional inputs like social security. For high earners, 85% of SS is typically taxable. Is that what is entered in this field?

Since this $72,800 is mostly in the 12% bracket, would the Income Tax Rate in the main planner window be entered as 12%?
jimr
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Joined: Thu Feb 28, 2008 6:48 pm

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by jimr »

The taxable percent is the percent of the income that is subject to taxation. The income amount is multiplied by the taxable percent, then the result is multiplied by the tax rate to calculate the taxes due on the income. The taxes due amount is subtracted from the income to determine the net income that can be used to offset expenses.

For many typical retirement income sources, the taxable percent would just be left at 100%. In this case, all of the income is taxed at the income tax rate. However, as you mentioned, there are some situations where only 85% social security income is taxed and the other 15% isn't taxed at all. I'm not an expert but I think some public pension income may be taxed this way as well.

Finally, keep in mind that the income and investment tax rates are intended as average combined tax rates that cover all federal, state and local income taxes. So the amount entered should be a rate that (on average) will be a good estimate of all taxes due, not just federal taxes.
FRPJunkie
Posts: 38
Joined: Wed Feb 24, 2016 8:17 am

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by FRPJunkie »

jimr wrote: Thu Jan 19, 2023 2:06 pm The taxable percent is the percent of the income that is subject to taxation. The income amount is multiplied by the taxable percent, then the result is multiplied by the tax rate to calculate the taxes due on the income. The taxes due amount is subtracted from the income to determine the net income that can be used to offset expenses.

For many typical retirement income sources, the taxable percent would just be left at 100%. In this case, all of the income is taxed at the income tax rate. However, as you mentioned, there are some situations where only 85% social security income is taxed and the other 15% isn't taxed at all. I'm not an expert but I think some public pension income may be taxed this way as well.

Finally, keep in mind that the income and investment tax rates are intended as average combined tax rates that cover all federal, state and local income taxes. So the amount entered should be a rate that (on average) will be a good estimate of all taxes due, not just federal taxes.
Right, I understand. But that does not account for the standard deduction (or other deductions or non-taxable income), in this case $27k (rounded). If we set the taxable percent to 100%, and the income tax rate to...whatever, that will give a false amount of tax due, won't it?

For example if we say that 100% of one's $100k pension is taxable, and the average tax rate is 15%, then the planner would calculate taxes of 15%, or $15k.

However if we subtract 27k (because the standard deduction is not taxable) the actual tax due would be (100k-27k) =73k x .15 = $10,950.
jimr
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Joined: Thu Feb 28, 2008 6:48 pm

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by jimr »

Right, I understand. But that does not account for the standard deduction (or other deductions or non-taxable income), in this case $27k (rounded). If we set the taxable percent to 100%, and the income tax rate to...whatever, that will give a false amount of tax due, won't it?

For example if we say that 100% of one's $100k pension is taxable, and the average tax rate is 15%, then the planner would calculate taxes of 15%, or $15k.

However if we subtract 27k (because the standard deduction is not taxable) the actual tax due would be (100k-27k) =73k x .15 = $10,950.
This is the challenge of working with a model. The goal is to simplify and omit details as much as possible while still achieving a result that's close to reality. The question is always how much simplifying is too much versus not enough.

My approach was to give you the tools to create as precise of a model as you want. Some people say that the future is pretty uncertain and so they'll just throw in a 15% tax rate, forget about the standard deduction, set the taxable percent to 100%, and call it close enough. Others will do extra work to capture the extra details (like the standard deduction) to bring the model as close to reality as possible.

If you decide to go toward very high precision, you have to be extra careful because as the plan gets more complicated, it becomes more likely that errors will creep in. Then you have the worst of both worlds with a very complicated plan that doesn't' actually capture reality very well. So the trick is to find some balance.

It sounds like you understand the way this all works pretty well and at this point have a good idea of ways you could capture that extra detail. I can't tell you how much detail you should include, I will suggest to start with a rough model, see how it does, then as you add more detail and precision, always do a sanity check against your original "rough draft.

So that's a lot of words to try to convey that there's no one right answer.
FRPJunkie
Posts: 38
Joined: Wed Feb 24, 2016 8:17 am

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by FRPJunkie »

jimr wrote: Thu Jan 19, 2023 11:50 pm
Right, I understand. But that does not account for the standard deduction (or other deductions or non-taxable income), in this case $27k (rounded). If we set the taxable percent to 100%, and the income tax rate to...whatever, that will give a false amount of tax due, won't it?

For example if we say that 100% of one's $100k pension is taxable, and the average tax rate is 15%, then the planner would calculate taxes of 15%, or $15k.

However if we subtract 27k (because the standard deduction is not taxable) the actual tax due would be (100k-27k) =73k x .15 = $10,950.
This is the challenge of working with a model. The goal is to simplify and omit details as much as possible while still achieving a result that's close to reality. The question is always how much simplifying is too much versus not enough.

My approach was to give you the tools to create as precise of a model as you want. Some people say that the future is pretty uncertain and so they'll just throw in a 15% tax rate, forget about the standard deduction, set the taxable percent to 100%, and call it close enough. Others will do extra work to capture the extra details (like the standard deduction) to bring the model as close to reality as possible.

If you decide to go toward very high precision, you have to be extra careful because as the plan gets more complicated, it becomes more likely that errors will creep in. Then you have the worst of both worlds with a very complicated plan that doesn't' actually capture reality very well. So the trick is to find some balance.

It sounds like you understand the way this all works pretty well and at this point have a good idea of ways you could capture that extra detail. I can't tell you how much detail you should include, I will suggest to start with a rough model, see how it does, then as you add more detail and precision, always do a sanity check against your original "rough draft.

So that's a lot of words to try to convey that there's no one right answer.
Makes sense. Yes, it's just a model not "real life." I wonder (for a future version?) if a field could be added, say "tax credits" which reduce income dollar-for-dollar (as opposed to deductions).

Since over time the standard deduction adds up to hundreds of thousands of dollars, with resultant tax implications, it might be useful so people aren't thinking their tax burden will be higher than that it will actually be.

Our pension is untaxed at the state level (though it is taxed federally) so that alone is a reduction...
jimr
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Joined: Thu Feb 28, 2008 6:48 pm

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by jimr »

FRPJunkie wrote: Fri Jan 20, 2023 9:15 amOur pension is untaxed at the state level (though it is taxed federally) so that alone is a reduction...
This is a good example of a case where it may make sense to adjust the taxable percent on that income stream to account for the lack of state taxes. If your combined average federal and state rate is 15%, and 3% of that is for state taxes, you could set the taxable percent of this cash flow down to 80% to have this income taxed at 12% rather than 15% (if I did the math right).

You could then adjust the taxable percent down further to account for the standard deduction if you want to try to get even more precise. You just have to keep everything straight in the future if you add other cash flows and also have to remember that things like tax deferred savings withdrawals and RMDs may happen automatically and they get taxed at whatever you have the main income tax rate set at.
Escapevelocity
Posts: 1
Joined: Fri Apr 07, 2023 12:01 pm

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by Escapevelocity »

Is there any place in the detailed view to see the annual taxes paid on taxable investment income as opposed to taxes on the withdrawals? Or is the tax just netted from the taxable investment returns?

How do you suggest modeling portfolio withdrawal order if you are withdrawing annually from BOTH taxable and tax deferred accounts with the objective of maxing out favorable tax bracket (i.e., 12% MFJ).

Thanks in advance!
jimr
Posts: 821
Joined: Thu Feb 28, 2008 6:48 pm

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by jimr »

Is there any place in the detailed view to see the annual taxes paid on taxable investment income as opposed to taxes on the withdrawals? Or is the tax just netted from the taxable investment returns?
The taxes paid on taxable portfolio gains are netted from the returns before they're reinvested into the portfolio. However, there is a "Taxes on Portfolio Growth" column available. To see this column, click on the show more detail radio button, then right-click on any column header and select show all columns. If there are too many columns to make sense of things, you can either hide columns one at a time or just export the whole table to excel to have more flexible display options.
How do you suggest modeling portfolio withdrawal order if you are withdrawing annually from BOTH taxable and tax deferred accounts with the objective of maxing out favorable tax bracket (i.e., 12% MFJ).
That's a tricky one that you'd really have to kludge your way through, since the planner doesn't really support this at all.

One idea might be to use negative savings cashflows from the tax-deferred portfolio to force the withdrawals. The ability to use a negative amount for the savings cash flows is a total kludge that was added after some user requests. Negative savings cash flows short-circuit the simulation's normal withdrawal logic. This means that the planner doesn't verify there's enough in the portfolio to satisfy the withdrawal, doesn't account for taxes due on the withdrawal, and doesn't use the withdrawal to offset spending. The money from the withdrawal just disappears basically. The way people have used this is that they'd only do the negative cash flows from savings in the early years of retirement when they were sure there would be enough in the portfolio to cover the withdrawal. Also, they'd manually net up the withdrawal amount to cover any taxes due on the withdrawal. Then they would reduce their annual expenses by the base withdrawal amount (before it got netted up for taxes due). This approach is not for the faint of heart and comes with the disclaimer that it's really easy to mess up one of the steps and end up in a garbage in garbage out situation.
EMC
Posts: 2
Joined: Fri Dec 15, 2023 4:11 am

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by EMC »

Hello,

From this thread, I learned that FRP doesn't account automatically for any standard deduction.

Would it make sense, then, to use an "effective tax rate" based on gross income instead of taxable income?
In other words, total tax due divided by gross income?

This would also be helpful for the following scenario:

I'm already retired and live overseas. I will not take social security for a few years, and currently receive a tax break such that I pay only U.S. Federal taxes for several years as well. When that ends, the tax rates will be higher in my adopted country. At that time, I will take a credit against U.S. taxes due, and my final tax rate will be that of the foreign country.

I am trying to determine how much taxable IRA distribution to take now, given that my tax rate will increase later on, even if it puts me into a higher U.S. marginal tax bracket now (the future rates will still be higher than my increased U.S. marginal bracket).

But to make this decision with some confidence, I need to compare with estimated future tax rates overseas. I realize trying to predict the future is impossible, but I have to start somewhere!

The problem is that my taxable income overseas is figured differently than in the U.S. So, I cannot simply plug a foreign tax rate into FRP. But if I currently enter a U.S. rate that is based on gross income, then enter a future foreign rate also based on my future estimated U.S. gross income, I hope to compare apples to apples, as it were.

To find out IRA distributions that are most favorable, I will view in FRP the maximum retirement spending allowed given the different rates I try out.
I believe that I know how to work with FRP's Additional Inputs to account for custom distributions: a negative savings entered for tax-deferred accounts, an equivalent positive savings for taxable accounts, and an expense for taxes due on the withdrawal calculated at my top marginal rate. I would also disable automatic RMD distributions in FRP.

So my questions are,
1) in general with FRP, does it make sense to use a tax rate based on gross instead of taxable income? and
2) does the strategy I outlined, using FRP to compare with my estimated future overseas tax burden, make sense?

I should note that my income situation is very simple. Beyond Traditional IRAs, which I plan to exhaust before my overseas tax rate starts, there would be pension, social security and regular, taxable interest income. No capital gains.

Many thanks in advance for your input!
jimr
Posts: 821
Joined: Thu Feb 28, 2008 6:48 pm

Re: understanding "Income Tax Rate" and "Taxable Percent"

Post by jimr »

FRP's tax model is intentionally oversimplified and its goal is to just roughly estimate the impact of taxes on your plan. The tax rates it uses are intended to be average tax rates that are typically calculated by dividing total taxes paid by gross income from taxable sources

The planner does allow you to use a separate average tax rate for investment income (interest and capital gains) versus other income (pensions, working, social security). Keep in mind that the planner figures out taxes on investment income automatically. Unlike in real life, the model taxes all investment gains each year even if the gains are not realized by selling investments. This means that taxable investment portfolio is carried at a 100% cost basis.
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