Marginal vs Effective Tax Rates and Tax Bracket Arbitrage

Tax Bracket Arbitrage and a Comparison of Marginal vs Effective Tax Rates

You have a silent partner in your pre-tax retirement accounts. As the money grows, so does the liability—taxes to Uncle Sam. If you want to buy him out of your retirement, you need to understand tax bracket arbitrage. When should you harvest/accelerate income, and when should you avoid/defer it?

Do you think taxes are going up in the future? Well, that is an important consideration, but don’t forget that pre-tax retirement account contributions come off the top of your marginal tax bracket. And later, when you withdrawal it (or convert to a Roth), it fills the lower tax brackets of our progressive tax system. That is called Tax Bracket Arbitrage. Save at high taxes, and spend at low.

Let’s look at tax brackets and learn about marginal vs effective tax rates, then take a deep dive into tax bracket arbitrage.

Marginal vs Effective Tax Rate

When you are in your peak earning years, the tax bite is hard to swallow. Many don’t quite understand taxes, especially when we are taking about effective vs marginal taxes.

What makes it even more confusing is that neither one shows up on your tax return. Is my refund the marginal amount or my effective bit? Ouch. I won’t accuse you of that tax fraud; you are, after all, nerdy enough to read a blog about tax bracket arbitrage…

Let’s look at the difference between effective and marginal tax rate over a range of high incomes.

The Difference Between Marginal and Effective Tax Rates

Marginal and Effective Taxes over a range of incomes

Marginal and Effective Taxes over a range of incomes

This is a great graph that we should understand. The left side percentages (in red) and the red line are the effective tax rate. The effective tax rate is the average tax paid on your total income. That is, you take your taxes over your total income, and the percentage you pay to the government in taxes in your effective rate.

The effective tax rate translates into a dollar amount, which is the total federal taxes in green. So for an adjusted gross income of 100k, your effective tax rate is about 9% and you pay about $9000 in taxes. For an AGI of 350k, we get 19% and $67k

Note along the bottom, the adjusted gross income increases. See how it affects the federal marginal tax brackets as they stair steps up at irregular intervals? This is a progressive tax code; the more you make, the progressively high taxes your marginal (last) dollar is exposed to.

The tax brackets are your marginal tax rate. That is—your marginal rate is the percentage of federal tax you pay on your last dollar. All other dollars must fill up the lower brackets until you earn enough to get to the next rung or step of the ladder.

The important point to note here: your effective tax rate is always lower than your marginal tax bracket. As you approach infinite income, the curve of your effective tax rate approaches the asymptote of your marginal bracket. Who is the nerd now?

Where Can I Find Effective and Marginal Tax on my Return?

Folks occasionally want to know their effective and marginal tax brackets. Well, good luck finding them, as they are nowhere to be seen on a tax form!

You can calculate them, however. Just take your line 9 (total income) from the 1040, and add back in your retirement account contributions. Remember, when you are a W2 employee, your 401k contributions are taken out and don’t hit your top line. Then find line 24 (total tax) and divide 24 by 9. Federal taxes over total income (add your State taxes back if you want to do so). That is your effective tax rate, the average percentage of taxes you pay on your income. And by the way, they keep re-designing the 1040 so the lines above may not match up with the one you are looking at. The IRS is the real nerd. Postcard indeed.

Next, the marginal brackets change every year. Google the year and your the filing status to find the current numbers, but below let’s look at an example I like.

How to Calculate Taxes via Effective Tax Rate

How to Calculate Marginal and Effective Tax Rate

How to Calculate Effective Tax Rate

Above, you can see the taxable income and how it fits into the tax bracket. What I like about this example is you can see how much you owe in federal taxes as you go through the tax brackets.

For instance, say you make 200k. You see that you owe $29,211 plus 24% of the amount greater than $171,050. So, 200k-171k times 0.24 is another 7k you add to the 29k to get your tax amount. But that’s why there are computers and TurboTax. And the fancy programs CPAs use.

I like the table above better than the ones you usually see:

Marginal Tax Brackets

Marginal Tax Brackets

For instance, above shows that if you make 200k you are in the 24% tax bracket, but it does not let you calculate the amount of tax you pay on your income. It does not show the progressive amount each prior tax bracket adds on to your taxes.

Ok, now that we understand marginal and effective tax rates, we need to understand that they change over you lifetime as you income goes up and then goes down, and then goes up again (when required minimum distributions start). This change in your income is what allows tax arbitrage to happen!

Effective Tax Rate 

Your effective tax rate changes over time.

When you don’t earn a lot of money, you have a low tax bracket. Thus, at the beginning of your career it is often a great time to do Roth IRAs and Roth contributions to your retirement plan. At low tax brackets, go Roth all day long.

When you start earning more money, it pays to defer taxes until later. You might “earn” less in retirement, and thus have access to your lower tax brackets where you can recognize the deferred income. Save high, buy low.

Let’s see and example of an effective tax rate over time.

Effective Tax Rate Over Time

Effective Tax Rate over Time

Effective Tax Rate over Time

Above is a graph of someone’s effective tax rate while working from 46-55, and then in retirement from 56 on. Note the big change at retirement, and then again at age 72 when RMDs kick in.

Also note the effective tax rate is not zero during retirement, as there is still investment income coming in. Remember, you might owe ordinary taxes on interest, non-qualified dividends, and short term capital gains. If you have actively-managed high turn-over mutual funds in your brokerage account, you might owe a lot of ordinary taxes!

But also above the 12/15% tax bracket, you owe 15% on long term capital gains. Capital gains may be taxed at the zero rate in retirement (before RMDs), but remember that long term capital gains stack upon ordinary income.

Ok, let’s talk capital gains for a second. When you are considering your effective tax rate, you include taxes paid on capital gains. There is a separate, parallel system of taxation for capital gains which goes into your effective but not marginal tax rate. Remember, the marginal rate is on your last dollar of ordinary income, which does not include capital gains and qualified dividends. Does that make your head hurt, too?

Back to the graph above. Taxation also include FICA while working. You pay ½ if W2 and all of it if 1099. State taxes are also interesting to consider in retirement, as sometimes they are due on income, but not on social security, pensions, and/or RMDs. Each state is a little different; is your state Retirement friendly?

In this example, the effective tax rate is 30% prior to retirement and drops down below 5% until RMDs kick it back above 20%. Effective tax rate will slowly increase through retirement as RMDs become larger over the years.

Next, let’s look at the marginal tax brackets over time.

Marginal Tax Brackets over Time

Marginal Tax Brackets over Time

Marginal Tax Brackets over Time

Above we can see the same scenario for the marginal tax bracket over time as we saw for the effective tax rates before.

Here, you are above the 32% tax bracket (which becomes 33% when TCJA expires in 2026). So your marginal tax rate is 35%. You pay 35 cents in federal taxes on the last dollar you earn. 

During early retirement, income on investments keeps you in the 22% tax bracket.

Then, note that RMDs kick you right back up in the 35% bracket. Too bad they didn’t do Roth conversions up to the 25 or even 28% tax bracket. They would have saved a ton in taxes over time…

Speaking of saving a ton of taxes, let’s talk (finally) about tax bracket arbitrage.

What is Tax Bracket Arbitrage?

Tax bracket arbitrage is using the tax code to pay less in taxes. Understand the break points and play on either side of the breaks. Money is fungible, so get it in your pocket by paying less in tax on it. This is how you can buy uncle Sam out of your retirement.

If you are going to make a lot of money at some point in your career, do Roth IRAs/401k when you are young and not earning much. By doing so, you pay more taxes at a lower marginal rate in order to save money in a tax-free account. This grows and you can spend it later without bumping up your “income” in retirement, thus being exposed to higher marginal taxes later in life.

Then, during your peak earnings years, you defer as much money as you can. This can be via a traditional retirement plan, or something like a non-governmental 457 or other non-qualified retirement plan.  The income you defer comes out of your top marginal tax rate and lowers (albeit slightly) your effective tax rate.

Next, do Roth conversions (from qualified plans) or spend the money (from non-qualified plans, or qualified plans if you need the money) during your Tax Planning Window. Your tax planning window is the time after you have earned income and before you have to recognize social security and RMDs as income. That’s the way to do tax bracket arbitrage!

What is Tax Bracket Arbitrage?

What is Tax Bracket Arbitrage? Source Kitces

How Tax Bracket Arbitrage Works

In order to see how tax bracket arbitrage works, let’s look at an example of a dollar. During your peak earning year, you save 35 cents in taxes to defer it. Sweet!

Next, in retirement, you owe 25 cents in taxes to get that dollar back in order to spend it. You saved a dime! That’s 10% of your money saved by tax bracket arbitrage!

Or conversely, if you are doing partial Roth conversions in retirement, you spend 25 cents to liberate it from tax-deferred into tax-free. This might prevent you from being bumped into the 35% tax bracket in the future. Would you pay 25 cents now in order to not be forced to pay 35 cents later? Sounds like a pretty good deal!

This is how tax arbitrage works: Save 35 cents to defer it, then later spend 25 cents to get it back. Or, if you are going to spend 35 cents to get it in the future, pay 25 cents to get it now. If you have too much in your pre-tax retirement accounts, RMDs might force you to take out more deferred money than you need in order to live on! Paying the taxes now (doing Roth conversions), you might spend 25 cents now so that it doesn’t cost you 35 cents in the future! I call that debulking an IRA via Roth Conversions.

Summary: Tax Bracket Arbitrage

In summary, defer taxes and avoid income during peak income years, and accelerate taxes and harvest income during low income years. That is tax bracket arbitrage!

Oh, if it were that simple! But tax bracket arbitrage should make sense to you if you understand the progressive nature of marginal taxes.

Of course, it gets more complicated. If your heirs are in a high vs low tax bracket, your strategy changes. And there are QCD’s to use for charity. Don’t forget about NIIT and the capital gains tax brackets! And IRMAA.

But now you understand Tax Bracket Arbitrage and marginal vs effective tax rates. Defer when high, recognize when low.

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3 Comments

  1. Although qualified dividends and long term capital gains are taxed at 0% for the 12% and below marginal tax brackets and at 15% for the 22% and above marginal tax bracket, the “effective” tax rate on the additional taxable income is usually 27% not 15%.

    For example, if for 2021, a married couple taxable income would have been $81,050 including $1000 of qualified dividends, the $1000 of qualified dividends would be taxed at 0%.

    However, if the total amount of qualified dividends was an extra $2,000 bringing the taxable income up to $83,050, then the extra $2,000 of qualified dividends would be taxed at 27% (15% plus 12%).

    So, if doing a series of Roth IRA conversions (say after retirement), even if the Roth IRA appears to be taxed at 12%, the actual tax rate may be 27%, if a portion of the conversion causes untaxed qualified dividends and long term capital gains to be taxed at 15%

    • Close, but not quite. You are taking about Kitces Bump Zones. It doesn’t affect the effective tax rate, it increases the combined ordinary/capital gains marginal tax rate on your last dollars only. Optimizing for the bump zone is incredibly difficult (you need to control all the sources of ordinary income, and the amount of dividend paying stocks you own in your brokerage account) and has a smaller effect on the effective tax rate than you might think.

      That all said, yes, you are loath to do small Roth conversions to the top of the 12% bracket that push you into the higher combined ordinary/capital gains marginal tax bracket. Thanks for the comment!

    • A Roth conversion will be taxed as ordinary income, at the marginal rate. The fact that it had dividends and capital gains is irrelevant.

      The difficulty anyone has in this entire discussion is that AGI and dividends and capital gains also generate other taxes at some income levels, like IRRMA and NIIT. So two couples with the same AGI can have different tax rates…even if both use the standard deduction.

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