Pralana Online calculates effective tax rates in the Review>Expenses>Taxes tab, but doesn't use that rate in Review>Balance Sheet; instead, the latter uses what the user enters in Build>Management>Effective Tax Rate, which defaults to 20%, and remains fixed throughout the balance sheet's annual projections. Why not use the actual effective rate that the tool has already calculated for each year?
@docfiddle Well, that is a good question. It has come up a couple times before, but I have not spent any significant time on it.
There are some questions and challenges with doing this.
1) How would it be calculated? Average of Federal Effective Tax rate for each plan year? Or marginal tax rate? Presumably one would want to include any applicable state tax and some states do and some don't tax IRA withdrawals. Would we assume it all comes out at one time leading to a very high tax bill?
2) Would it be calculated for individual years or some sort of weighted average for all scenario years?
3) A lot of the optimizations solve for highest effective final savings by varying some input like withdrawal priority or social security start ages. If the effective tax rate were dynamically calculated, it would likely be different for the various optimization iterations and skew the results.
On the other hand, how is a user supposed to decide what value to to enter??? I think Pralana could at least provide specific supporting info to help the user decide...more than it does now.
I look forward to more ideas on this from you and others.
Charlie Stone, Pralana
I agree it's quite uncertain. Completely ignoring the issue understates the value of Roth Conversions. Since it is an end of plan adjustment, the only time it really matters is end of plan, but you can't really track the absolute $ throughout without applying the end of plan correction.
If you are giving the residual IRA balance to charity and/or if you intend to give it away via QCDs, then the tax rate will be zero.
If you haven't made an allowance for long term care for the last couple years of life, it might be a good plan to do so, those will be tax deductible, so the IRA is a perfect place to get the money and just like you don't want to understate the value of Roth Conversions, you don't want to way overstate it either.
If the residual t-IRA money is going to individuals, you have to make a stab at what tax rate they will be in if they inherit your stash and have to get the money out of the IRA in 10 years. Really tough to do since you are guessing far into the future about others' finances and how they will act when they inherit. If you are nearing retirement age, your kids may not even be fully launched yet and their own careers may have unforeseeable ups and downs.
If you have no close relatives or just don't care whether your heirs vs. the government gets the money, then you should probably spend more, so see what happens to your own tax bracket if you take more than just the RMDs from your IRA.
When looking at tax costs for heirs, there can be lots of pieces, some not so obvious - state taxes, IRMAA, NIIT, interference of the inherited IRA withdrawals with the heir's own plans for ACA premium credits or Roth Conversions, the tax phase-in on their Social Security benefit, the tax drag in taxable due to the t-IRA money arriving an average of 5 years earlier into taxable than Roth money, the extra taxable balance that causes tax drag for 10 years vs. someone that did Roth Conversions.
I use something in the 20-25% range, figuring that even folks that would otherwise be solidly in the 12% bracket may get pushed into having ACA premium credit phase-out or LTCG taxes phased-in that bump up their marginal tax cost into the mid 20's and the post inheritance tax drag issues can add a couple of percent. If you know your kids will be the next Elon Musk, you may want to increase that. The number doesn't have to be super-precise (and obviously can't be), you just want something in the ballpark.
Thanks @charlie and @ricke, for considering this. I’m not the fine-grained kinda guy most Pralana users are — I need a ballpark figure about taxes because I don’t think of this tool as a substitute for tax prep software. It’d be fine with me if the effective tax rate column in the Net Worth section of the Balance Sheet just used the Effective Federal Income Tax Rate column in Review>Expenses>Taxes tab, or even all the tax categories/AGI. What doesn’t help is having me concoct a fixed number out of thin air in Build>Management.
I know, I know, that’s got issues of its own, but I figure that if this thing can run simulations with consumption smoothing algorithms, it can tackle this one.
I am also struggling with how to calculate the Effective Tax Rate.
First off, why an Effective Tax Rate vs. Marginal Tax Rate?
Second, whose Effective Tax Rate and why have me calculate it?
If it's a Couples or Surviving Spouse don't you already have that information in the model?
If it's my beneficiaries then how do I handle the complexities of their various rates (from 0-37%)?
I suspect a SWAG is about the best we can do, just another uncertainty in the Roth Optimization process.
One suggestion is to include some discussion of the options in the manual to help guide an informed decision.
Going back to your original post, at the risk of being Captain Obvious here, I think it may help to clarify the difference between what you are seeing in Review > Taxes and the Effective Tax Rate you are seeing on the Balance Sheet. The taxes and tax rates you are seeing in Review > Taxes are OUTPUTS calculated by Pralana - the various income taxes you will pay and various rates you will be subject to each year of your plan. These outputs, of course, depend on your income, which is itself a group of calculated outputs, which in turn depend on a host of inputs.
The Effective Tax Rate you see on the Balance Sheet is an INPUT, not an Output. As such, it has nothing to do with the taxes you pay during your lifetime. You input it at BUILD > FINANCIAL ASSETS > MANAGEMENT > EFFECTIVE TAX RATE.
It is the average rate, taking all the various taxes into account, that you expect your heirs to pay on the balance of your tax deferred account when you die. So if the year-ending balance in your TIRA is $1 million, and the Effective Tax Rate = 25%, then a column in your Balance Sheet shows $250K in taxes due, and your TIRA is valued at $750,000 for calculating your “effective” (i.e. after all taxes have been paid on your TIRA) net worth.
@ricke has comments up thread on why this is complicated, but the foregoing distinction may make it easier for you to understand why he says 20% - 25% is a good starting point, even though those numbers may be very different from what you are paying during your lifetime.
It is the average rate, taking all the various taxes into account, that you expect your heirs to pay on the balance of your tax deferred account when you die.
Are we sure? I'll have to check the doc but I always interpreted it as being used to figure out what portion of your pretax accounts belong to you and what portion belong to the IRS. In other words, your net worth isn't really the sum total of your property and account balances (minus debt), some of that isn't yours and needs to be accounted for in order to get a true net worth (and how much you can spend, etc).
So I'd think you'd want to look at what your effective tax rate is during the years you'll be withdrawing this money (and paying taxes on it) and take a ballpark average. Including inherited IRAs also! It feels like this should be calculated by Pralana, as this is a moving target as soon as you start doing roth conversions, modeling a spouse passing early, etc.
As you noted, your suggested understanding of how to set the Effective Tax Rate would mean it is a useless feature as Pralana already tracks taxes while you are alive. Pdxcess has shown you a much more powerful use for the feature by setting it at the estimated tax rate that heirs will have to pay on the money when you pass so it can help you understand the effect of Roth Conversions on your heirs.
Seems obvious to me which way I would set it.
@ricke Duly noted! Gets down a rabbit hole though, as it would require one to then use a crystal ball to guess the heir's tax rate at that future time, during the ten year clean out period (moving target, so averaged...), if that's still a thing when this happens 🙂
