Why are you taxed at 18.5% in the 10% marginal tax bracket?
Posted on April 19, 2024

When you are retired and receiving Social Security, the 10% and 12% marginal tax brackets on ordinary income are a myth. Most all of your distributions from your traditional IRAs – such as your RMD – are taxed at 18.5% or 22.2%. Very little is taxed at 10% or 12%. The culprit is the calculation that increases the amount of Social Security that is taxed. For most all of the 10% and 12% brackets, each added $1,000 of ordinary income increases the amount of taxable Social Security income by $850. Each $1,000 from your traditional IRA results in $1,850 of taxable income. That’s 85% more tax than you’ve probably assumed.



This effect holds true until you’ve added enough ordinary income to reach the maximum of 85% of Social Security that is taxed. The way this exactly works will be different for you than it is for Patti and me, but I think our graph is representative of how it would look for you: for us, the first $52,000 of distributions from our traditional IRAs is taxed at an average of 20.7%. Distributions more than that are then taxed at 22% until the 24% marginal rate and/or an IRMAA tripwire; those points are at much greater distributions than shown on the graph. (You can see the worksheet that I used to calculate taxes here.)


None of our distributions from our IRAs is taxed at 10% and just $3,000 of the first $52,000 of distributions from our IRAs is taxed at 12%. We pay an effective rate of 20.7% on the first $52,000 of distributions.




Social Security is taxed from 0% to a maximum of 85%. A somewhat complex formula calculates the percentage that is taxed. Here’s my spreadsheet. You can input the numbers from your tax return for a normal year and calculate the percentage of Social Security that is taxed for each increment of distributions from your traditional IRA.


== Does this matter? ==


• Current retirees can’t do anything about this. Traditional swamps Roth for most all of us: Roth didn’t exist until 1997 and employers didn’t start offering it as part of their 401k plans until 2005. It turns out, though, that traditional IRAs were the right choice. Marginal tax rates we avoided were perhaps 16 to 23 percentage points greater in some years than the 22% tax that we pay today.




An IRA gives a basic ~20% advantage relative to the same investment in a taxable account. The math of avoiding 38% tax then and paying 22% now means you pick up an added 26%. You just aren’t getting another 15% to 20% benefit on top of that if your distributions were really taxed at 10% or 12%.



• Younger folks in the save and invest phase can benefit from this information: emphasize Roth. You really don’t make a mistake by picking Roth if you are in the 22% marginal tax bracket, and I think I’d argue that Roth is just fine if you are in the 24% bracket.


If you assumed ALL your distributions for desired spending were from after-tax Roth, a 1040 tax return would be simple, and you’d be in a very in a low tax bracket. For Patti and me our 1040 with no taxable distributions from IRAs gives this result:


– 32% percent of our Social Security is taxed.


– That taxable amount + all other ordinary income (primarily money market dividends for us) keeps us in the 10% marginal tax bracket for ordinary income.


– We’d pay NO TAX on dividends qualified for capital gains tax and NO TAX on our normal amount of capital gains from our sales of securities for our spending. We don’t get close to the threshold of taxable income that triggers the 15% capital gains taxes.



Conclusion. Most folks think that they’ll be in a lower tax bracket when they are retired. That’s basically a myth. I found that Patti and I effectively pay ~21% tax on the first $53,000 of distributions from our traditional IRAs and then 22% thereafter (until the distant 24% marginal bracket).


The culprit is the way the taxable portion of your Social Security benefit is taxed: each $1,000 of income from distributions from our traditional IRAs triggers an added $850 of taxable Social Security income. In the 10% bracket, we are really paying 18.5% on each added $1,000; for most all the 12% bracket, we are paying 22.2% on each added $1,000.


Traditional (pre -tax) IRAs were the right choice for current retirees. Marginal tax brackets were much higher in the past: in some years, retirees contributed to their traditional IRAs and avoided paying perhaps 38% marginal tax then. Paying 22% now means they picked up another 26% on top of the basic 20% advantage of a retirement account.


Younger folks in the save and invest phase of life who are in the 22% bracket really can’t go wrong with 100% going to Roth. A traditional IRA is ~never better than Roth. Retired folks who could use Roth IRAs solely for their spending will likely be in the 10% tax bracket. They may not even pay any tax on dividends and gains that qualify for capital gains tax rates.

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