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Marginal Tax Rates—Beware

14439217_sButch and Teresa, each age 58, recently stumbled into early retirement. Teresa never worked outside the home, and Butch was laid off from his position at a chemical company. They, like many boomers, found themselves at the doorstep of retirement, without a great deal of retirement planning and absolutely no thought whatsoever about tax planning for their retirement years. This all changed when Teresa observed that her brokerage account was simply not growing as fast as her husband’s 401(k) was growing. She thought it probably had something to do with them needing to withdraw about $10,000 per year from her brokerage account to pay income taxes!
 
Remember what I often tell you, Cutter Family Finance readers, a solid retirement plan includes three things: investment planning, income planning and advanced tax planning. That last piece, tax planning, is often the most overlooked of the trio, but Butch and Teresa’s story is a testament to the fact that tax planning should be an integral part of a well-designed retirement plan.
 
Like many of us, Butch and Teresa accumulated savings in a tax-deferred retirement account; Butch’s 401(k) is now worth about $500,000. Butch invested his portfolio in stocks and bonds, which had an average growth rate of about 6 percent per year. (Unlike many of us, Butch also was given a wonderful pension of about $75,000 per year, but this is only scheduled to continue until he and Teresa turn on their Social Security at age 66.) In addition, Teresa inherited about $500,000 from her mother and placed the money into a brokerage account. The couple’s stock broker invested the funds in Teresa’s brokerage account in preferred stocks and interest-bearing corporate bonds. Butch and Teresa were making about $30,000 per year from each account, and assumed that meant a return of return of about 6 percent.
 
Unfortunately, Butch and Teresa have learned that, without proper planning, investment income is typically taxed at ordinary income tax rates, which is less favorable than long-term capital gains tax rates. For this reason, it is imperative to understand and determine our “after-tax” rate of return in order to evaluate the performance of our investment portfolios and make proper planning adjustments. Of course, Teresa quickly determined that the after-tax rate of return of her husband’s 401(k) was 6 percent, because this account was growing tax-deferred. Not true for Teresa’s brokerage account.
 
When Butch and Teresa’s stock broker recommended the investments for their brokerage account, he advised them that their income tax rate was only about 13 percent. He based this conclusion on the fact that the previous year, the couple paid about $13,000 of federal and state income taxes on their income, which totaled about $100,000. He and the couple concluded that taxes would not significantly affect the growth of the account. They reasoned that the after-tax rate of return would be about 5.2 percent, 6 percent less .8 percent in taxes (13 percent average tax rate multiplied by 6 percent growth). Teresa was both confused and frustrated. She saw checks being written from her brokerage account that were much more than 13 percent of her growth! In fact, the checks were almost $10,000 per year—33 percent of her growth. So, what gives?
 
The answer lies in marginal tax rates. More specifically, as our taxable income grows, our tax rate actually increases. Thus, we must always know and understand what our marginal tax rate is, because this is the rate at which dividend and interest income will be taxed. In Butch and Teresa’s case, their marginal tax rate is about 33 percent not 13 percent! Let me explain.
 
Our tax system is based on progressive tax rates . . . the more you make, the more you pay. If you look at the tax tables, you see that taxpayers who are married and filing jointly with more than $74,900 of income will pay $10,312.50 plus 25 percent in federal income taxes on any amount of income over $74,900. Don’t forget, however, that those taxpayers are also required to pay state income taxes. Because Butch and Teresa’s taxable income increased by about $30,000 (the dividend and interest income paid out from Teresa’s taxable brokerage account), that additional income was taxed at their marginal tax rate. In other words, that investment income was subject to combined federal and state income taxes of about 30 percent.
 
Now we are getting somewhere. Teresa could finally calculate her after-tax rate of return and she determined it was only 4 percent. Let’s do the math. The tax cost is calculated by multiplying the combined federal and state tax rates, 30 percent, by the return of 6 percent, which totals 1.8 percent. Thus, the after-tax rate of return is the 6 percent growth less the tax cost of 1.8 percent, or, a 4.2 percent after-tax rate of return. About one-third of the growth in Teresa’s taxable account was going to the IRS! Now the picture comes into focus . . . Butch’s 401(k) was growing at 6 percent, doubling every 12 years, while Teresa’s account was growing at only 4.2 percent, doubling every 17 years. If we look at this calculation over 36 years, then Butch’s account could be worth about $4 million when he turns 94, while Teresa’s account could only be worth about $2 million! That is a huge difference.
 
Having a handle on the problem, Butch and Teresa can now start making wise investment and planning choices. For example, they can analyze investments while understanding the impact of taxes and can choose from taxable, tax-deferred and tax-exempt investments. More specifically, the funds in Teresa’s brokerage account could be invested in tax-exempt municipal bonds for tax-free income; or high dividend yielding stocks that would pay qualified dividends, that is, dividends that are qualified for a reduced tax rate. On the other hand, the couple could invest in tax-deferred vehicles, like a “no commission” variable insurance trust, that would defer the taxes on their stocks and bonds, much like Butch’s 401(k).
 
Problem solved. Butch and Teresa are now on the path to an enlightened retirement, thanks to a little old-fashioned tax and investment planning.