Question on income tax rate?

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Question on income tax rate?

Post by Guest »

Hello,

I'd like to know if the income tax rate in the planner should be for federal or state taxes and if it should be an effective rate or a marginal rate?

Thanks

jimr
Posts: 634
Joined: Thu Feb 28, 2008 6:48 pm

Re: Question on income tax rate?

Post by jimr »

Hello,

For the income tax rate, use your average combined federal/state tax rate.

Obviously, when comparing plans, this calculation won't be very precise because changes in income amounts at the margins can disproportionally affect the average tax rate . In addition, future tax rates are anyone's guess.

Some find it helpful to experiment with different rates and see how tax changes affect their plan.

Jim

rchow
Posts: 10
Joined: Thu Jun 11, 2015 7:16 pm

Re: Question on income tax rate?

Post by rchow »

So on the income tax rate inside FRP, I'm assuming that this is the effective tax when we put in a % in the income tax rate field?

Thanks,

RC

jimr
Posts: 634
Joined: Thu Feb 28, 2008 6:48 pm

Re: Question on income tax rate?

Post by jimr »

Yes. That's correct.

rchow
Posts: 10
Joined: Thu Jun 11, 2015 7:16 pm

Re: Question on income tax rate?

Post by rchow »

Hi Jim,

I setup a scenario where there is only an income of $70K a year coming in with no taxes, no expenses, no inflation, no other investment account, and 0% return with 0% std dev of returns. As expected, in the detailed view, it shows an after-tax income of 70K a year for as many years as this income comes in. However, when I apply a 35% tax to this income of $70K, it now shows an after-tax income of $61,425 for as many years as the $70K gross comes in. This only represents a tax of about 12% versus 35% - can you please advise if FRP is calculating this correctly or whether I may have missed something?

Thanks and Kind Regards,

RC

rchow
Posts: 10
Joined: Thu Jun 11, 2015 7:16 pm

Re: Question on income tax rate?

Post by rchow »

Hi Jim - nevermind, I was able to answer my own question. Thanks!

rpatrickjr
Posts: 1
Joined: Thu Mar 08, 2018 6:37 pm

Re: Question on income tax rate?

Post by rpatrickjr »

When you say "For the income tax rate, use your average combined federal/state tax rate", an example would be helpful. I would think you would sum the federal and state percents as in:

If Frate=Federal Tax/Federal Taxable income and Srate=State Tax/State Taxable income then
use Frate+Srate.

I think you're suggesting something else. Can you clarify?

jimr
Posts: 634
Joined: Thu Feb 28, 2008 6:48 pm

Re: Question on income tax rate?

Post by jimr »

The main point of my comment is to use your expected AVERAGE tax rate rather than a marginal rate.

I didn't intend to get into the complexity of how to combine the rates to account for different types of income being taxable or not at the state level. You could try to adjust for that sort of thing if it'd make a huge difference, but given that the entire tax problem is getting reduced down into two average tax rates, it's probably not worth going too far with that. FRP is only designed to model your retirement and the key with any model is to simplify as much as possible, while still holding onto enough detail that the model captures reality well enough to be useful.


Also, this is another good example of where sensitivity can help. If you're worried about the reliability of your tax estimate, try doubling the rate (or halving it) to see how much it impacts things. If the difference in the success rate is significant, try a 50% increase rather than doubling it and see how much that matters.

For most people a few percent difference in tax rate either way probably won't matter much, but every case is different so you have to test it out for yourself.

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