The same disconnect between marginal tax rate and effective tax rate also happens when Social Security benefits become taxable.
For a married couple with a modified adjusted gross income* under $32k, Social Security benefits are not taxable. Between $32k and $44k, 50% of the MAGI above $32k are taxable. Above $44k, $6,000 plus 85% of the MAGI above $44k are taxable.
* Modified adjusted gross income for this purpose includes gross income plus one-half of the Social Security benefits plus tax-exempt interest.
This means when your income is in a certain range, additional $1,000 in income makes another $850 in Social Security benefits taxable. When more Social Security benefits are phased into being taxable, the marginal tax rate can be as high as 46%!
For instance, suppose a married couple, both 63, receive $40k in Social Security benefits and another $29k from pre-tax IRA withdrawals. Their total federal income tax after the standard deduction and two personal exemptions is $1,999.
Now suppose they decide to withdraw $1,000 more from their pre-tax traditional IRA. This makes another $850 in Social Security benefits taxable. Their total federal income tax is now $2,276.
From $1,999 to $2,276, that’s a tax increase of $277 tax on additional $1,000 income, or a 28% marginal tax rate for a couple with a $70k income whereas the 28% marginal tax rate normally only kicks in at over $160k for people not on Social Security.
The larger picture though, still shows that this couple on Social Security pay only 3.2% of their $70k income in federal income tax. That’s very low in my book.
On the other hand, a married couple working and earning $70k in wages will pay $6,611 in federal income tax. Their marginal tax rate is 15%. Their effective tax rate is 9.4%. We are not even including the 15.3% payroll tax the working couple pay from their wages and through their employers.
Would you rather have (a) a high marginal rate with a low effective rate or (b) a low marginal rate with a high effective rate? I would take (a) any day.
A high marginal tax rate does not tell the full story. The effective tax rate is the true measure of one’s tax burden. Next time you hear about high taxes after Required Minimum Distributions start after age 70-1/2, think effective tax rate. It’s still very low.
[Photo credit: Flickr user DonkeyHotey]