by Carolyn Rothwell on October 11, 2012

Golden Years - Understanding the Index Rate for Federal Tax Calculations


Golden Years projections include yearly tax calculations.  Income taxes are calculated using IRS marginal tax brackets.  The federal tax brackets can be “indexed” each year to compensate for the effects of inflation.

No one knows exactly how the tax brackets will change year by year, so we allow the planner to enter the “index rate” that is applied to the tax brackets.  This is typically the same rate the assumed inflation rate for the projection, because the actual federal brackets will be adjusted each year for inflation.  The index rate will also apply to the dollar amounts used for personal exemptions and standard deductions.

The index rate for federal tax tables and exemptions is located in the Tax Data section on the File Status/Options tab, shown below: 

Index rate

If you set the “index rate” to 0%, the program will use the current tax brackets, personal exemption and standard deduction amounts throughout the projection.  Leaving this to 0% would be the most conservative assumption.

2012 Breakpoints – For Married Filing Jointly:

$0               10%
$17,400        15%
$70,700        25%
$142,700      28%
$217,450      33%
$388,350      35% 

If the clients have $150,000 of taxable income in today’s dollars, using the current tax breakpoints their tax would be:

First $17,400 * 10% = $1,740
Next $53,300 * 15% = $7,995
Next $72,000 * 25% = $18,000
Last   $7,300 * 28% = $2,044

Total Taxes: $29,779

Assuming a 3% inflation, that same $150,000 in today’s dollars would be equal to $201,587 in ten years.

If we leave the index rate to 0%, the tax breakpoints will not change, so taxes due on the $201,587 would be:

First $17,400 * 10% = $1,740
Next $53,300 * 15% = $7,995
Next $72,000 * 25% = $18,000
Last $58,887 * 28% = $16,488

Total Taxes: $44,223

If we index the brackets at 3%, the adjusted breakpoints in ten years would be:If you set the “index rate” to 3%, the program will increase the tax brackets, personal exemptions and standard deduction amounts at 3% each year.  This will help compensate for the effects of inflation. 

$0              10%
$23,384       15%
$95,015       25%
$191,777     28%
$292,235     33%
$521,910     35% 

Again, assuming 3% inflation, the $150,000 in today’s dollars would be equal to $201,587 in ten years.  If set the index rate to 3%, the taxes due on the $201,587 would be:

First $23,384 * 10% = $2,338
Next $71,631 * 15% = $10,745
Next $73,378 * 25% = $18,345
Last $33,194* 28% = $9,294

Total Taxes: $40,722

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Carolyn Rothwell

Carolyn enjoys spending her time building Money Tree Software's brand and products. Her experience creating and delivering financial plans for a full-service financial planning firm and supporting advisors working to provide the best planning to their clients as a Money Tree support member has provided an excellent understanding of the importance of financial planning.