The single most important thing to understand about the U.S. tax code is the difference between gross income and taxable income.
Let’s introduce John and Judy. They have $100,000 in gross income. What do you think their tax bracket is?
Most people will see a married couple with $100,000 income and think they are in the 22% tax bracket. But that is incorrect.
Taxable Income vs. Gross Income
Your federal tax bracket is actually based on your taxable income not your gross income. Taxable income is the net amount you have after you take the various deductions and/or exemptions that are available.
So, let’s assume John and Judy do not itemize their taxes. The only deduction they have is the standard deduction.
Under the new tax bill, (TCJA 2017), tax payers under 65 years old can take $12,000 in standard deductions. Taxpayers 65 and older have a standard deduction of $13,300. Assuming John and Judy are both over 65, they would subtract $26,600 from their $100,000 of gross income. Their taxable income would then be $73,400, which puts them in the 12% bracket. They will pay $8,426 in federal income tax.
But what happens if they add $10,000 by taking a distribution from a Traditional IRA? Now their taxable income is $83,400 which puts them in the 22% tax bracket. Their tax is $10,227, an increase of around $1,800.
Put another way, that $10,000 distribution accounted for 9.1% of their total income yet 17.6% of their total tax bill.
Look at the table below and you can see how the $10,000 IRA distribution affected John and Judy’s taxes.
Most taxpayers understand that tax rates go up as income increases. What gets overlooked is that the actual percentage of that increase is huge. In John and Judy’s case, it was a 50% increase!
How? Because that $10,000 distribution cost them $1,801 in additional tax, meaning their effective tax rate on that distribution was 18.01%. If they have remained in the 12% bracket their tax would have been $1,200.
What would happen if that $10,000 IRA distribution came from a Roth though?
Roth distributions are tax free so that $10,000 will not be included in any taxable calculation. They have that extra $10,000 to spend. They just don’t pay tax on it.
Now, you might argue, “Yes, Josh, your numbers are sound but they received a deduction on the money going into the IRA to begin with. You would have to compare the tax they pay now to the savings they had before.”
This is correct. We certainly need to look at the tax savings of the IRA deduction against the tax free withdrawals of the Roth.
However, my experience is that many working taxpayers don’t have near the taxable income they think they do given varying tax deductions and credits: mortgage interest, credits for children, real estate tax, etc. In fact, let me ask you, do you know what the number on line 47 of your own 1040 is? That is your total tax. How much of that tax was reduced by your itemized deductions?
Unfortunately, most taxpayers actually retire into higher tax brackets because their Required Minimum Distributions put them there and they no longer have any itemized deductions, which is exactly what happened to John and Judy. At that point, there is not much they can do other than pay the tax. But keep on reading and you’ll see the many other overlooked benefits of the Roth.