Why are the Taxes in My Plan So Low?

Sometimes, a plan has some years where, despite a fairly high total income, the estimated taxes for that year are quite low. This can be surprising if you're just looking at the bottom-line numbers and not seeing the makeup of the income in that year and the complexities of the tax system. Here are a few reasons you may see lower-than-expected taxes in a given year and some ways to explore what in the plan is leading to those low-tax years.

Withdrawals from Taxable Accounts

Withdrawals from taxable (non-qualified) accounts are treated as containing proportional amounts of gains and basis. For example, if $100,000 is being withdrawn from a $500,000 taxable account with $400,000 in cost basis (80% of the account), that $100,000 is treated as containing $20,000 in long-term capital gains and $80,000 in cost basis. Both the gains and the basis will appear in Life Hub and in the Tax Lab as "income". However, the $80,000 in basis will be categorized as Other Non-Taxable Income and will appear in the 0% ordinary income tax bracket.

Keep in mind that basis builds up over time in taxable accounts if that account includes dividends and turnover that are taxed each year. So, even if you enter $0 basis for an account now, that basis could be non-zero by the time withdrawals are taken.

It's also important to remember that the U.S. tax code includes a 0% bracket for long-term capital gains. In 2024, this bracket is over $94,000 for those who file married filing jointly (and over $47,000 for singles). This 0% bracket is eroded by taxable ordinary income. For example, if you have $20,000 in taxable ordinary income, there is only $74,000 or so in tax-free long-term capital gains still available.

This interplay between ordinary and long-term capital gains income is why, in the Tax Lab's Explore section, you'll see the yellow long-term capital gains income floating on the right, and beginning exactly where ordinary income leaves off.

This view, which you can find in Tax Lab > Explore > Income, is the best place to see how the different categories of income stack up in a given year. Keep in mind that this graph shows total income, not taxable income. There is a 0% ordinary income tax bracket shown in this graph that contains both non-taxable income (e.g., withdrawn cost basis, Roth distributions, non-taxable distributions like qualified charitable distributions (QCDs), non-taxable Social Security income, and more), as well as deductions, whether standard or itemized.

If a year contains a large amount of withdrawals from taxable accounts, this may be a reason taxes are so low that year.

Taxability of Social Security

It is also surprising to many clients that Social Security taxability may be lower than expected in some years. The rules around the taxability of Social Security benefits are complex and include other taxable income. So, in years when taxable income from other sources is low, Social Security may be untaxed or taxed at a very low level. For more on Social Security taxability, see our article titled "Why don't I see exactly 50% or 85% of Social Security benefits being taxed?".

Effective Tax Rates vs Tax Brackets

Often, a client may be surprised that the total estimated taxes are lower than their tax bracket. For example, they may know that they are in the 24% Federal bracket but see that they are only paying, say, 11% in taxes on their total income. That's because the US tax system is progressive, with a lower tax rate paid on the first income earned. The same is true for many states.

In a progressive tax system, especially one with deductions and exemptions, it is impossible for someone's effective tax rate (total taxes paid / total income) to be as high as their tax bracket.