### Executive Summary

Effective financial planning for clients often has tax-related consequences, which in turn requires a good understanding of not only the tax laws themselves, but also the client's tax rates. Unfortunately, though, significant confusion abounds regarding what tax rates should be used when analyzing various problems. Is it the client's tax bracket? Or a marginal tax rate? Or an effective tax rate? When should each be used? The key is that in the end, marginal tax rates should be used to compare strategies, and effective tax rates should be used to compare people.

Accordingly, if you want to know who commits a larger portion of their total income to their tax obligations, use an effective tax rate. But if you want to know whether to do that Roth conversion/IRA withdrawal/annuity investment/sale for a capital gain or loss/etc., the marginal tax rate is what should be used. In point of fact, this actually means that the marginal tax rate is really the only rate that should be used for financial planning scenarios!

The caveat, however, is that in practice determining a client's marginal tax rate requires more than just looking at his/her tax bracket... so be certainly to calculate the marginal tax rate correctly, too!

## Calculating Marginal Tax Rates

What is a marginal tax rate? A marginal tax rate is the tax rate that will apply to the next *marginal *- or incremental - amount of income (or deductions). It is calculated by dividing the amount of additional taxes that will be due based on some decision (e.g., to take an IRA withdrawal) by the amount of income involved.

. If a retired client is in the 28% tax bracket next year, then taking an IRA withdrawal for another $1,000 of income next year will incur another $280 of taxes (due to the 28% tax bracket). If the client is in the 33% tax bracket this year, then the IRA withdrawal this year will result in a tax liability of $330, given the 33% tax bracket. Accordingly, the client is subject to a 28% marginal tax rate next year ($280 of taxes divided by $1,000 of income) and a 33% marginal tax rate this year (which means the client might decide that, at the margin, it's better to take that $1,000 IRA withdrawal next year).Example 1Notably, these tax consequences have no relationship to all the

otherincome that the client already has, which may have filled the lower 10%, 15%, and 25% tax brackets; the point is that, at the margin, that last transaction for a $1,000 IRA withdrawal will be taxed at 28% or 33%, and accordingly the client can choose which is preferable.

In the example above, the determination of the marginal tax rate was fairly simple: it was the client's tax bracket. However, as noted earlier, a true analysis of the marginal tax rate should measure the *total *increase in taxes due as income increases, not just the client's tax *bracket*. The difference is that under the tax system, changes in income can indirectly affect other tax deductions and credits, which means the actual change in taxes due (and thus the true marginal tax rate) may be more or less than just what the tax bracket happens to be.

. Assume a married couple has a total of $150,000 of income and deductions include $5,000 of state income taxes, $10,000 of mortgage interest, and $13,000 of investment management fees. Since the latter fall into the category of "miscellaneous itemized deductions" that are only deductible to the extent they exceed 2% of AGI ($150,000), the client loses the first 2% x $150,000 = $3,000 of the deduction, and can only claim the remaining $10,000 of the investment management fees.Example 2In this scenario, total deductions would be $5,000 (state income taxes) + $10,000 (mortgage interest) + $10,000 (deductible portion of investment management fees) = $25,000 of total deductions. Net taxable income would be $150,000 - $25,000 = $125,000, which would put the couple in the 25% tax bracket. If this couple had another $1,000 of income, however, the marginal tax rate would not simply be the 25% tax bracket. After all, if income rose to $151,000, then the threshold for miscellaneous itemized deductions would rise to $3,020, which means total deductions would decline to $24,980.

Accordingly, the client's taxable income would actually come out to be $151,000 - $24,980 = $126,020, an increase of $1,020, which at a 25% tax bracket results in a total tax increase of $255. The end result: a $1,000 increase in income actually leads to a $255 increase in taxes, which means the marginal impact of the income was not 25%, but 25.5% due to the impact additional income had on the phaseout of deductions.

(Editor's Note: To simplify, this example excluded personal exemptions, which would have been an additional deduction available to these clients, although it would not change the results of the marginal tax rate calculations. This example also ignores Alternative Minimum Tax exposure, which would be analyzed similarly but could produce a different marginal tax rate.)

Due to phaseout effects like miscellaneous itemized deduction thresholds, in many situations a client's marginal tax rate may be different than the client's tax *bracket*. Deductions impacted by income phaseouts, such as medical expense deductions, miscellaneous itemized deductions, and the AMT exemption (for those subject to the Alternative Minimum Tax), can all cause the marginal tax rate that applies to income to vary from just the tax bracket alone. Nonetheless, if the goal is to assess the impact, at the margin, of a decision to defer or accelerate income, understanding the *total *marginal impact is crucial.

Notably, a similar result can happen if a client crosses a threshold from one tax bracket to another.

. Assume a couple has $80,000 of total income, and deductions include $4,000 of state income taxes and $11,000 of mortgage interest, for total deductions of $15,000 (again ignoring personal exemptions for simplicity). The client's net taxable income is $80,000 - $15,000 = $65,000, which places them in the 15% tax bracket.Example 3If the couple earned another $20,000 of income, total income would rise to $100,000, and taxable income after deductions would be $85,000. As a result, the couple would actually cross from the 15% tax bracket to the 25% tax bracket.

However, the couple's marginal tax rate for $20,000 of income is not 15%, nor 25%, but a blended rate. Since the upper threshold for the 15% tax bracket is $70,700 (in 2012), the first $5,700 of the additional income would be taxed at 15%, and the remaining $14,300 would be taxed at 25%, for a total tax increase of $855 + $3,575 = $4,430. This would represent a marginal tax rate of $4,430 (total additional taxes) / $20,000 (total additional income) = 22.15%.

Notably, this means the marginal tax rate of a strategy may depend on the amount of income involved. If this couple had only added $2,000 of income, the tax bracket would have remained 15%, and the marginal tax rate would have been 15%. Because the income increase was $20,000, though, and that resulted in crossing into another tax bracket, the marginal tax rate was 22.15%, which represents a blend of the two brackets across which the income landed.

By contrast, an effective tax rate is arguably much simpler to calculate.

## The Formula To Calculate An Effective Tax Rate

How do you calculate an effective tax rate? The formula for an effective tax rate is simply the individual's total taxes paid, divided by total income. It represents a measure of the total tax burden that the client bears on *all *his/her income.

. Assume a couple has $200,000 of total income, and $30,000 of total deductions. The client's taxable income is $170,000. Using the 2012 tax tables, the client's total tax liability would be $35,379, with income falling across the 10%, 15%, 25%, and 28% tax brackets. The client's effective rate would be $35,379 (total taxes) / $200,000 (total income) = ~17.7%, which means that 17.7% of the client's total income was consumed by his/her tax liability.Example 4

Notably, in practice the calculation of effective tax rates varies slightly, depending on what is used as a measure of "total" income. In some cases, the effective tax rate might divide the tax liability by total *gross *income. In other scenarios, practitioners may prefer to use Adjusted Gross Income (AGI), which allows for so-called above-the-line deductions that include many *losses*; as opposed to just tax deductions which reduce a liability, *losses *(from business losses to capital losses and more) arguably should be included to get a more accurate representation of an effective tax liability. Although notably, not all above-the-line deductions are losses; some are simply deductions, such as the one for 401(k) contributions.

In all scenarios, the fundamental principle is the same: to determine the portion of total income that was allocated to the client's tax liabilities. The complication, though, is that there is some subjectivity to determining what will be characterized as "income" in the first place. For instance, in the recent presidential election, Governor Romney earned approximately $20 million in 2011, but contributed nearly $4 million to charities, raising the question of whether his effective tax liability should be calculated based on his $20 million of gross income, or the $16 million net given that he donated a portion of the income away before he ever used it (especially since the taxes themselves *are* calculated based on a net income of $16 million due to the charitable tax deduction).

## When (And When Not) To Use Marginal vs Effective Tax Rates

So when is it proper to use marginal tax rates, and when should effective tax rates be used?

Effective tax rates are used to measure a person's total tax obligation relative to his/her income; accordingly, it is a useful tool to compare the relative tax obligations *amongst *several people. For example, in the recent tax reform debates during the election, there was discussion about the effective tax rate of Governor Romney, or Warren Buffett (and his secretary); the effective tax rate was a measure of the portion of various peoples' incomes that are consumed by their tax obligations, to evaluate which of those people have a greater or lesser *relative *tax burden. Notably, though, the measure is still a *relative *measure; even if Warren Buffett's effective tax rate is lower than his secretary, his total tax liability - the total amount of taxes he actually pays - is still far larger, as his tax obligations are measured in the millions, many times the amount of his secretary's that are measured in the thousands. Nonetheless, the fundamental usefulness of effective tax rates is to compare *across people* and the portion of each person's income that is consumed by taxes. Effective tax rates can also be useful to simply understand the portion of an individual's overall income that is consumed by taxes - for instance, in determining an 'average' tax rate to apply during retirement.

Marginal tax rates, on the other hand, are used to measure how a person's tax obligation will change based on some change in *strategy*; unlike an effective tax rate, which is properly used to compare person A to person B, the marginal tax rate is used to compare *strategy/scenario *A to *strategy/scenario *B for a particular person/couple. The marginal tax rate is used in this manner because it is, by definition, meant to measure *at the margin* the impact of making a certain change or implementing a certain strategy, by evaluating the tax obligation in scenario A, and scenario B, and the relative difference between the two.

This makes marginal tax rates especially useful in evaluating income deferral or acceleration strategies, from Roth conversions or contributing to an IRA to using a tax-deferred annuity to deciding whether to harvest capital gains or capital losses. Similarly, it makes effective tax rates quite useless; after all, as seen in *example 4*, knowing that a client *already *owes $35,379 on the first $200,000 of income signals *nothing* about what the tax consequences will be on the *next *$1,000 of Roth conversion/IRA withdrawal/annuity investment/sale for a capital gain or loss/etc., which instead depends on how income, deductions, exemptions, credits, etc., will be impacted by that next $1,000 of income.

By analogy, if I want to know the height impact of wearing shoes with thicker soles, the proper answer is to measure my height with and without the shoes and calculate the difference. If I go from 6 feet to 6' 1", then the marginal impact of the shoes is 1 inch. But notably, this is equally true no matter how tall I happen to be; the marginal height impact of the shoes is the same, regardless of whether they are worn by someone 5' tall or 6' fall. In this context, being 6 feet tall is like an effective tax rate - it represents where you stand now. Adding 1 inch of height is like a marginal tax rate - it represents how much the situation will change as I go from no-shoes to wearing the shoes.

So remember - in the end, marginal tax rates measure the incremental tax consequences between *strategies *(scenario A vs scenario B), while effective tax rates measure the relative tax obligations of different *people* (person A vs person B) or simply a person's *total *tax obligation relative to income (e.g., to understand how much of their income they keep over time). Notably, this means that while effective tax rates are useful for making evaluations of tax policy amongst the population, or understanding a tax burden over time, ** marginal tax rate is the right one to use for evaluating strategies and making financial planning decisions**, which by definition are about determining whether scenario/plan A is better than scenario/plan B. In any event, though, be certain the marginal tax rate is calculated properly!

*(This article was included in the Carnival of Wealth on Control Your Cash, the Carnival of Retirement on Making Sense of Cents, the Carnival of Financial Planning on Good Financial Cents, the Carnival of Investing #15 on Investeem, and also the Carnival of Personal Finance on NerdWallet.) *

Tammy Prouty says

Love it! Thanks Michael, more of this basic stuff needs to be taught to us. That’s why we use our financial planning software to run tax projections, but it is still good to be able to calculate manually and conceptually have it in our minds.

Luciano,Neville says

The excessive fat is the layer that covers your actual weeds so as to make your method look fat.

This is to make certain that all your efforts will be

paid off.It has even been said that a handful of consumers didn’t even workout whereas on it and lost weight.

Knox says

Thanks Michael for the clear conceptual breakdown.

I very much appreciate it!

James M. Matthews says

Great breakdown Michael. This is something that is pretty fundamental in tax-planning yet is widely misused and misunderstood, in my experience. Now we just need to get our friends in congress to understand these concepts and maybe we’ll make some progress towards a less complex tax system.

Dan Mathews says

Dear Michael:

I don’t think I have ever seen an article that addresses the proper use of these rates, so thank you for crafting it for the planning community.

We prepare quarterly balance sheets for clients that show a Pre-Tax Net Worth and an After-Tax Net Worth, after deferred taxes. The deferred taxes are mostly broken down into Ordinary (Traditional IRAs, annuities, etc…) and Capital Gains (unrealized gains in taxable accounts, real estate, etc). My questions are should we use an effecive or marginal rate (using caps for LTCGs) to calculate these deferred taxes? Also, since a Balance Sheet is essentially a “snapshot in time” should the rates be based on a client’s current situation, or their projected situation in retirement when they are more likely to realize the deferred income?

Thanks!

Dan

Gary Smith says

Thanks, Michael, for helping to clarify the concepts of marginal, bracket, and effective rates. When the advisory community has absorbed the current lesson, perhaps you’d like to write about marginal rates as a broader concept. Specifically, as I view the subject, a marginal tax rate is the incremental tax caused by an increment of income. As there are several taxes that may apply, and a few types of income that can vary, there is actually a two-dimensional set of marginal rates. The taxes include federal income tax, state income tax, Social Security tax, and Medicare tax. Types of income include ordinary (as generated by an IRA withdrawal), long-term capital gains (generated by sale of a security), and employment income. Furthermore, people often have *combinations* of taxes in mind, like federal and state income tax, or all of the above taxes, when they complain about the high percentage of investment income or wages that government takes. Imprecise thinking about marginal rates can lead to incorrect planning decisions in some cases, so your education efforts are important.

KyleMEaton says

When is a dollar not taxed as a dollar? When you were in the 15% marginal bracket and decide to pull an additional dollar out of retirement account or earn a little “extra” retirement income. It can set off a nuclear chain reaction of sorts. The ordinary income can cause $.85 of the next $1 of Social Security to become taxable and at the same time also make another $1 of 0% capital gains or qualified dividend income taxed at 15%. Tell this to a client who is trying to earn some mad money in retirement. Has anybody here even attempted to explain to a client why the marginal tax rate is now +60% on that dollar. When the train left the station, they were just in the 15% marginal bracket? Or better yet why they need to withhold 50% on that IRA RMD?

Donald A. Cole says

Brianlinnekens