Pay Attention to Marginal Tax Rates and Not Tax Brackets

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As an author of over 200 journal articles, several books, and a leading scholar on tax-efficient withdrawal strategies in retirement, I want to highlight how the analytic framework for providing retirement income planning advice can be improved compared to what is used by industry experts and in the curriculums of leading credential programs.

Here are three decisions that investors sometimes need to make: (1) whether to convert funds this year from a tax-deferred account (TDA), like a 401(k), to a Roth account; (2) whether to contribute this year to a TDA or a Roth account; and (3) how to tax-efficiently withdraw funds in retirement, where withdraw is interpreted broadly to include Roth conversions.

In this article, I present examples that clearly show the proper analytic framework for making these decisions should be based on comparisons of marginal tax rates (MTRs) across years, where the MTR is the tax rate paid on the next dollar of ordinary income. Unfortunately, many financial professionals think these decisions should be made based on comparisons of tax brackets across years. To illustrate the wide use of advice based on tax brackets instead of MTRs, I use recent publications by Ed Slott (2021) and Michael Kitces (2021). Separately, I then discuss a detailed case that Pfau (2021b) uses to illustrate a tax-efficient withdrawal strategy in retirement that is based on efficient MTR management. However, he mislabels this strategy as an example of “tax-bracket management.” Finally, I note that the top two retirement income credentials – American College – the Retirement Income Certified Professional (RICP) and Investment and Wealth Institute – Retirement Management Analyst (RMA) – emphasize the use of “tax bracket management” and “tax bracket planning” when selecting a withdrawal strategy in retirement.

I chose to discuss these works by Slott, Kitces, and Pfau, when I could have discussed works of others, because they are recognized leaders in the investment profession. Since these recognized leaders and the top retirement credential programs in our industry are making this mistake , I am confident that many other investment professionals are also doing so.