What tax rate to use?

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kyounge1956
Posts: 6
Joined: Sat Sep 06, 2008 5:49 am

What tax rate to use?

Post by kyounge1956 » Sat Oct 01, 2011 4:37 am

I volunteered to demo a retirement calculator for an employee group, and I'm planning on showing frp, but I'm confused about what tax rate to use. The way I have figured out my own budget is to estimate the gross income I will need after retirement to pay all my expenses including taxes. I estimated my post-retirement taxes by using my projected pension on form 1040 instead of my real salary, and income tax comes out to about 11% of my post-retirement gross income. Should I use 11%, instead of the default of 20%, for income tax rate? As an aside, why was 20% selected as the default? In view of my results using the actual 1040 form, it seems on the high side, but maybe that's because there is no state income tax here in WA.

As a possible workaround, I tried putting in my estimated gross income need, but using a tax rate of zero. However, I noticed in the detailed results that taxes are still being deducted from the portfolio withdrawal. That puzzled me until I guessed the amount being deducted was the penalty for taking premature distributions from a tax-deferred account. If some of the people at the demo know neither their actual expenses nor what percentage of the total they would pay in income tax, can they use an estimate of their needed gross income (e.g. the much-used 80% of your current salary) and a tax rate of zero to get a ballpark estimate of where they stand?

jimr
Posts: 518
Joined: Thu Feb 28, 2008 6:48 pm

Re: What tax rate to use?

Post by jimr » Sat Oct 01, 2011 8:32 am

What you've done with estimating the income tax rate sounds reasonable. It's always a pretty rough guess, but the more work you do on the estimate, the better it should be. The default at 20% was a rough guess that included state income tax.

Also, keep in mind that the other tax rate - the investment tax rate is also important to estimate correctly. This is the tax paid on investment gains each year. You could use the same rate for both income and investments if you'd rather not break it out. They are separated because for many people, the investment tax rate is different from the rate of taxes on ordinary income.

Finally, if you had both tax rates set to 0, then any taxes shown in the detailed output table probably would have been due to early withdrawal penalties.

Jim

kyounge1956
Posts: 6
Joined: Sat Sep 06, 2008 5:49 am

Re: What tax rate to use?

Post by kyounge1956 » Sat Oct 01, 2011 3:01 pm

jimr wrote:What you've done with estimating the income tax rate sounds reasonable. It's always a pretty rough guess, but the more work you do on the estimate, the better it should be. The default at 20% was a rough guess that included state income tax.
Thanks for the quick answer. Just to make sure I have this straight, for my own scenarios, I should use the calculated value of 11%? I will play with the tax rate a little and see how much changing the rate affects the results.
Also, keep in mind that the other tax rate - the investment tax rate is also important to estimate correctly. This is the tax paid on investment gains each year. You could use the same rate for both income and investments if you'd rather not break it out. They are separated because for many people, the investment tax rate is different from the rate of taxes on ordinary income.
All my retirement money is in either tax-deferred or Roth account, so I often forget to consider taxable investments. I think for the demo I will just leave that at the default value. If there are no taxable savings, that setting won't make any difference anyway, will it?
Finally, if you had both tax rates set to 0, then any taxes shown in the detailed output table probably would have been due to early withdrawal penalties.

Jim
I know that's what they were, because I changed the minimum age for retirement distributions to 55, and they went away. :)

As government employees saving in a 457b plan, we can take non-penalized distributions at age 55 under certain conditions. Or someone retiring younger than age 59-1/2 could roll over some money from the 457 account into an IRA, take a 72t distribution, and avoid the penalty that way.

jimr
Posts: 518
Joined: Thu Feb 28, 2008 6:48 pm

Re: What tax rate to use?

Post by jimr » Sun Oct 02, 2011 12:13 am

kyounge1956 wrote:Just to make sure I have this straight, for my own scenarios, I should use the calculated value of 11%? I will play with the tax rate a little and see how much changing the rate affects the results.
Great idea to try different tax rates to see how much it matters. It sounds like you put enough work into your estimate that it should be better than mine, which was just a wild guess.
If there are no taxable savings, that setting won't make any difference anyway, will it?
Correct. The investment tax rate only applies to the taxable investment portfolio, so if there aren't any taxable investments, the rate won't matter.

Good luck with your presentation!

Jim

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