Managing Taxes in Retirement using the Effective Marginal Tax Rate

Wade Pfau and Joe Elsasser

Two corrections were made to this article on November 15, 2023: The first is that Exhibit 6 was not included, and it now appears in the article. The second is that the title for exhibit 9 should say RMD instead of IRA.

Research on tax-efficient retirement distribution strategies aims to sequence withdrawals from taxable, tax-deferred, and tax-exempt accounts to maximize after-tax spending. That can be either in terms of meeting an after-tax spending goal for as long as possible or preserving the most after-tax legacy after meeting spending needs over a specified timeframe.

We will simulate different strategies to determine which strategy provides the greatest tax efficiency in terms of supporting the most after-tax spending and legacy for retirees. We focus on how to source retirement spending needs as well as deciding whether to generate additional taxable income through Roth conversions.

The challenge is not just balancing taxable income over time in the face of our progressive federal income tax brackets, but managing the potential large tax impacts of important nonlinearities in the tax code that can cause effective marginal tax rates to wildly diverge from the federal income tax brackets. We will investigate how retirees can create efficiency in the face of these nonlinearities:

  • The Social Security “tax torpedo” applies when an increase in taxable income uniquely causes a greater percentage of the Social Security benefit to become taxable.
  • Preferential income sources (qualified dividends, long-term capital gains) stack on top of ordinary income and have their own tax schedule. An increase in ordinary taxable income can uniquely push preferential income into higher tax brackets.
  • An increase in taxable income above certain thresholds triggers increases to Medicare Part B and Part D premiums two years later (called Income-Related Monthly Adjustment Amounts, or IRMAA).
  • The net investment income tax (NIIT) applies when investment income exceeds relevant thresholds.