Why You Shouldn’t Focus on Your Effective Tax Rate

June 28, 2023

In this highlight, we discuss why you shouldn’t focus on your effective tax rate and how you should approach this topic.

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Next up is a question from Harley. How do you calculate the effective income tax rate? Also, at what effective tax rate would you consider pre-tax over Roth for a 25-year-old married couple?

Man, okay, so we get a lot of questions about this, right? Because, look, I’m going to say it, I’m going to say it, I’m going to say it. Our tax code’s not the easiest in the world to figure out. Like, it’s fairly complicated. There’s like a gazillion pages in it, and it doesn’t often pass a lot of common sense. It doesn’t make a lot of sense. And so, we hear these terms out there: your marginal tax rate, your effective tax rate, your federal tax rate, your state tax rate. We talk about how to know when to go pre-tax or Roth. Well, there’s some vocabulary that we should probably walk through. I’m gonna go through the first two real quick, and I’ll leave something on there for you.

Your effective tax rate is when you look at the total tax that you pay and you look at your income. It’s the percentage that you paid. It is some combination of the blended rates as you run through our progressive tax system. It is very helpful in telling you essentially what percentage of your pay you’re paying in income tax.

From a planning standpoint, not incredibly helpful because most of the decisions we make when it comes to financial planning are made on the margin. They’re made with our next dollar. So, what you really want to focus on, Harley, is not your effective tax rate. You want to focus on your marginal tax rate. What is the next dollar that I will be taxed at? Because that’s the one that matters. If you’re in the 22% federal tax bracket, you’ve already worked through the lower tax bracket. So, the next dollar of income you have coming in is going to be taxed at 22%. The next dollar that you defer will save 22%. So, when it comes to planning, I would argue that the marginal rate is the one that you want to focus on, not the effective rate. Okay, how do I do that? Go look at last year’s tax return. Look at your taxable income line. Go pull a tax table. See where taxable income falls. That’s how you actually find your marginal tax rate.

It’s not like the easiest thing in the world to do if you’re not super comfortable with a tax return. It’s really difficult to do if you’re just a gross income earner, right? You can kind of figure it out, but once you have deductions and that kind of stuff in there, it makes it a little harder.

When it comes to making financial decisions, Brian, like pre-tax versus Roth, which ones we look at and how do you know where to fall on the spectrum? Now, look, there’s a lot that goes into this. I feel like I have to give that disclaimer because, as a young person, I mean, when you have 30-40 years of compounding growth, even if you’re in a higher tax bracket, maybe sometimes it makes sense to have some of the Roth.

It also, I’ll put it on the bookend or donut hole, in the fact that sometimes a 65-year-old, I think we have a brilliant client that’s in a higher tax bracket, they’re doing Roth too, just a little bit, because they want the estate planning opportunity of building more money that’s growing tax-free. So, they’re okay paying more taxes currently. So, it’s one of those things where you have to take this to your personal situation. Neither one of those things I just described was wrong, but we still had to give general guidelines so that somebody who’s doing their due diligence and research for their situation knows some things they can at least think about. So, I had a case recently for a client looking at their income, and it put them squarely in the 24% marginal tax bracket. That was their federal marginal rate, but that’s not where taxes stop. We also know that many states charge a tax rate, so you’ll have to figure out what the marginal rate is for the state. This client lived in a state where they were being charged 5.3 percent. If you add those two together, that is a 29.3 percent marginal tax rate. The next dollar would be taxed at almost 30 percent.

Well, we’ve always given the guidance that if somebody is in a marginal tax bracket and their federal and state obligations together are below 25 percent, historically, with all the obligations of our federal government and everything else, it seems like you’re probably not going to get a better deal than that. So, if it lines up and you’re young enough to have opportunities for exponential growth and your tax rate is low enough, that’s a pretty good indicator that Roth accounts may be good for you. You have the opportunity to let assets grow tax-free, and paying the taxes now is not the worst thing in the world.

Between 25 and 30 percent is kind of a gray zone for us. So, even this client fell into that category because 30 percent is still pretty good from a historical standpoint. Yeah, I love the tax-free growth. So, if you’re young enough, you probably won’t want to do Roth on that. But if you’re older and worried about taxes, maybe you don’t. You’re hoping that down the road, when you retire and lose your earned income and wages, if you’ve done the right three-bucket strategy where you have tax-free, after-tax, and tax-deferred accounts, hopefully, your tax rates will go down in retirement. That will create opportunities for Roth conversions.

So, it’s in that gray zone of 30 percent and greater where we kind of like it. But once again, this is something where you really ought to look long and hard. Do you have the mindset that taxes will be lower in retirement? You’re taking some guessing on that because we don’t know what tax policy could change from Congress. But looking at all this, the variables that you know, do you think your tax rate and taxes paid in retirement will go lower? And do you have enough time? They’ve also expanded required minimum distributions now to 75 for most people. That gives you more time. So, even if you retire at 60, there will be a 15-year period where potentially your income will have the opportunity to be lower than your earned income wages, and then you could use that to do Roth conversions.

So, all of this comes into play. That’s why I always say building wealth is so simple. It doesn’t mean it’s easy, but it is so simple that I want you to structure it for inevitable wealth building, removing the friction, creating an automatic plan that actually builds that wealth for you. But I know without a doubt that as you have success, you’ll need somebody like us because these are the types of equations we work with clients on all the time. But when you’re younger and starting out on the journey, let this be an important thing that you check the box on. But don’t let it be the noise that keeps you from actually saving and investing because when you’re young, that’s even more important than getting into some of these complex issues because it’s just not the time or place yet. For more information, check out our free resources here.



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