in today's video I'm going to walk through and explain what I believe is one of the most important Tools in retirement tax planning this is a tool that we use every day with clients and without it your year-to-year tax planning will be far less effective and much more difficult the tool I want to talk about today is the marginal tax graph this chart on an annual basis combined with a forward-looking tax plan is really the core of what you need in tax planning for retirement now if you've seen some of our videos before you've probably seen me share graphs like this maybe you had questions about what exactly this is or how you can get your hands on this type of graph for your situation well in this video I want to really break this tool down and show why it's so valuable for your ongoing tax planning now as we walked through this presentation reading this graph is fairly straightforward on the y- AIS you will see percentage values this denotes the marginal rate you are paying on a given level of income marginal rate is a tax rate specific to an amount of income for instance if you have $11,000 worth of income at the very top of the 22% tax bracket your marginal tax rate on that income is 22% if you withdraw another $1,000 worth of income and it pushes you into the 24% bracket your marginal rate on the next $1,000 is 24% the xais then shows ordinary income that you would be withdrawing so if this was your situation and you withdrew $30,000 worth of income from your IRA you would be paying a marginal rate of 29.5% on the most recent income you withdrew before that you would have paid 52.4% on a portion 24.7% on a portion and so on there are a lot of hurdles you will face in retirement that need to be accounted for for effective tax planning as you are deciding where to pull your income from you absolutely need to know the tax consequences you are forcing yourself into and so let's dive into this a bit more here's how most retirees Envision the tax brackets and as you can see the brackets are pretty simple pull up any tax table on the internet you will see tax brackets at 10% 12% % 22% and so on now these tax rates are simple what complicates things for retirees is how certain income streams like Social Security are taxed or how having some capital gain income and some Ira income can transform this tax bracket so this shows a very simplified look at the tax consequences of having ordinary income but keep in mind there are two tax charts that we will need to continually focus on in retirement if you pull income from your IRA it will be ordinary income but if you sell assets your taxable account to live on or you live on dividends those will be taxed at capital gain rates so here's a simplified chart showing the tax consequences of taking capital gain income we need to keep in mind both of these charts when making our withdrawal decisions because as you can see we have different tax consequences between these two accounts so now let's start with our first and most common income stream that complicates this tax chart Social Security on the screen I'm showing a single retiree with $32,000 of Social Security benefits you'll notice here that the tax brackets changed from 10% 12 and 22% to 15% 18 1.5% 22.2% and 40.7% before finally dropping back down to 22% well how is this possible to understand this graph we need to understand how Social Security is taxed there are two steps in determining how much of your benefit will actually be taxed the first step is finding your provisional income then the second step involves plugging this provisional income into this table below now let's walk through an example here because there are some common mistakes that I see when retirees are figuring out exactly how much of their social security benefit will be taxed let's say we are looking at this chart and this retiree decides they need to pull $30,000 worth of Ira income to live on in addition to Social Security you will see they in the 22.2% marginal bracket when pulling the last 8,000 or so of this income well how do we get to a 22.2% rate well going back to the provisional income equation we would have $30,000 of income from our Ira withdrawals since our social security benefit in this example is $32,000 taking 50% of this would be 166,000 for a total of 46,000 to be clear tax exempt income refers to mun bond interest which we do not have in this example so we're going to take this $46,000 number and plug it into the table below we're using a single filer here now a mistake that some make is assuming this table table is like a tax Cliff meaning $46,000 of provisional income is larger than the $34,000 threshold in the table so just 85% of this person's benefit is taxed that's not how Social Security taxation works it's a sliding scale the table is calculated on a prata basis for instance since our provisional income is above that top threshold we have full taxability in the 50% range in this table because there's $9,000 in this range we would take 9,000 and multiply it by 50% for $4,500 then $46,000 is $122,000 above the top $34,000 threshold so we would take $122,000 and multiply it by 85% adding these two zones together and we would find what your taxable social security benefit is which in this example is 14,700 now pause the video momentarily and you'll see how we arrived at these numbers we then want to take this taxable social security benefit add it into our other income then plug it into us tax tables following the calculation on the screen you will see our taxable income after the standard deduction comes to $ 28,1 15 now this would put the single filer in the 12% bracket and this might make you scratch your head a bit how do we get from a 12% bracket to a 22.2% marginal rate well you can really only understand this by increasing that IRA withdrawal by $1,000 more dollars if we do this we basically need to rerun all of the calculations we just ran now for this for the sake of time I'm not going to go step by step through these calculations but I would urge you to as it will help you increase your understanding I'll just give you the explanation high level if we increase Ira withdrawals by $1,000 we're going to increase that provisional income number by $11,000 which in turn makes another $850 of Social Security taxable running through this calculation further we can see that even though we just added $1,000 of extra income we actually forced $1,850 of extra taxable income at 12% that ends up with us owing $222 of taxes but again we owe $222 of taxes because of just $1,000 of extra income leading to a marginal tax rate of 22.2% as you keep stepping through this scale this is how you reach this High marginal tax through this purple area on the screen it stops when Social Security becomes fully taxable at 85% but through this area you're going to see your marginal tax rate Rise by 50 to 85% because of this double taxation effect and so as we start to look at a marginal tax graph for the year the first step in creating this graph is to start with what you believe your expected income for the year will be for instance at the beginning of the year we know exactly what we're going to receive from Social Security pension and annuity income we're going to know what our forced withdrawals like required minimum distributions would be and more then we have a pretty good idea of what dividends wages and Rental income will be based on some other simple estimates the reason I want to preload this tax graph is because I want to know what the tax implications will be of the decisions that we're able to make for instance we don't choose to have $32,000 of Social Security benefits but we do choose what we take from our IAS I want to know if we take $20,000 from our IAS versus our taxable account versus our Roth account what the tax consequences actually are let's take a look at another simpler hurdle that trips up a lot of retirees this is called the capital gain bump zone now we're going to take Social Security out of the equation for Simplicity here and instead add in $20,000 of expected dividends throughout the year these are qualified dividends by the way once again we see two marginal tax spikes on the graph but what is causing this obviously it has something to do with the dividends as we're adding dividends in this example for a specific reason well let's look at the tax brackets here for a little extra Insight on the le- hand side of the table you will notice the ordinary income rates we've already discussed to the right of this however you will notice that there are long-term capital gains that span from anywhere from a 0% tax rate all the way up to 23.8% it is the interplay between these two tax systems that creates this Spike notice the longterm capital gains have a lower rate in every category of income versus ordinary income taxation but there is a really important thing to note here capital gains stack on top of ordinary income and so what can happen here is at a specific level of ordinary income you might be taxed at 0% on your dividends but as you increase that ordinary income base you push up the taxation of those dividends here's a visual representation of what I mean on the left hand side of the screen this person is not subject to this capital gain bump Zone their dividends fit perfectly in a way where this person is able to maintain 0% taxability but let's say they add another $5,000 of ordinary income thus increasing That Base by increasing this base you overflow capital gains or dividends into the next bracket okay so you might understand this conceptually but why does this create an increase Zone well let's say you have $5,000 of ordinary income displacing $5,000 of dividends into the next capital gains bracket what is exactly Happening Here well on that $5,000 of ordinary income you will owe a 12% tax rate but that's not all you will also have $5,000 of dividends that went from being taxed at 0% up to 15% triggered by that $55,000 of ordinary income so 12% plus 15% would mean your marginal rate rises in this instance to 27% just all from that $5,000 extraordinary income withdrawal then the third and final tax hurdle that I had on the original tax graph we showed were signified by the dotted lines these dotted lines signify Medicare increases also known as Irma when you show a certain level of income you will be penalized and owe more for your Medicare expenses now know that Irma is something we call a tax Cliff which is why it's shown as a dotted line and not as a marginal increase here a tax Cliff means it doesn't matter if you're $1 over threshold or $110,000 over you have the same onetime cost so if you show this as a marginal tax hike it would mess up the scale of the graph because $1 of income forces a $1,050 penalty that would make this graph look really wonky nonetheless knowing where these zones are and avoiding them or pushing through them is extremely important the last thing you want is to be $50 over a threshold Zone and then you owe an extra $1,500 in Medicare cost for just that extra $50 of income and so now to zoom back out and look at all of these tax issues together we can see the more complex tax graph that we started this presentation out with we have now added in Arizona state income tax here as well what you'll notice that's quite interesting is how these tax hurdles can stack on one another you'll notice the Social Security taxation Zone coordinate with the capital gain bump Zone to create a new 50 plus% marginal rate zone then about $25,000 after these increase zones you see you have to start dealing with Medicare increases for retirees this can be a tax mine field at times well this is exactly why this type of graph is so important crossing a mine field becomes a whole lot easier when you have a map of where the mines are located now one thing to mention here is I'm not giving any hard rules when navigating these tax hurdles some retirees may need to push through these high tax zones because there are worse tax issues lying down the road and they need to be doing things like Roth converting other retirees may have the ability to avoid all of these zones all together this is where the context around your situation is extremely important also as I mentioned earlier there are two tax graphs that we need to consistently keep in mind here's the same situation but shown if they start filling in with capital gain income rather than ordinary income again the graph looks completely different and each dollar of ordinary income or capital gain income will change the starting point and shift these graphs slightly so finding the best spot to end up is an process now from time to time I have people comment saying that this is the wrong way to look at tax planning that showing a marginal graph makes things look a lot scarier some say I should be using total tax or effective tax rate instead I wholeheartedly disagree and I don't know any tax strategist who would agree here is a graph showing the total tax you would owe at various levels of ordinary income it's the exact same situation that we've been working through throughout this presentation now imagine never showed you any of the marginal graphs up to this point tell me by looking at this graph how you would make any reasonable or strategic decisions you couldn't because this type of graph is simply a summary graph with no decision-making power now the next question many will have is how can I get this type of marginal tax graph customed to my situation unfortunately I don't know of too many softwares that allow for this and for the average person doing this by hand is incredibly difficult our staff here uses a software called holista plan and they do a fantastic job unfortunately I believe this software is only for advisors your account may have a similar tool and I would start by asking them if they can generate this type of graph for you as of right now I don't believe Turbo Tax has this ability or this feature however I urge everyone to find and work with an advisor or accountant that has the ability to create this type of graph because you can see how powerful it can be in making strategic decisions on an annual basis as you can see there are maor savings to be had every dollar in taxes saved does not just mean you save a dollar but rather you save what that dollar can turn into through compounding growth if you'd like to learn more about tax planning for retirement here's a video that might surprise you in this video I talk about why you shouldn't have the goal of having a tax-free retirement click here to learn more and always remember you don't need more money you need a better plan we look forward to seeing you in the next video