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How to model taxes in retirement
Old 09-04-2008, 02:42 PM   #1
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How to model taxes in retirement

50% of portfolio is in taxable accounts (of which some will be principle and some will be taxed at capital gains tax rate)

50% of portfolio is in traditional IRA (a very small portion will be principle and the rest will be tax at income tax rate)


If I know what I predict to spend in a year, how do I calculate how much to take out of my accounts to cover the taxes?


This is an important question for retirement modeling purposes. If I can figure out an average tax rate, then I can simply apply that to my predicted expenses to come up with the amount I need to withdraw each year.
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Old 09-04-2008, 03:03 PM   #2
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It seems like it will largely depend on how you choose to withdraw from the two halves of your portfolio.

If you withdraw funds completely from the taxable accounts, then your taxes will be essentially calculated at the capital gains rate.

If you withdraw funds completely from the IRA, then your taxes will essentially be at ordinary income tax rates.

A simplistic way that would probably get you close enough:

1. Get out a copy of an IRS 1040 and your state equivalent (if you have state income taxes), or break out the copy of Turbotax or whatever you bought to do your taxes this last year.

2. Make a guess as to what proportion of your withdrawals are going to come from each half.

3. For the half that comes from the taxable accounts, make a guess as to what proportion of that will be gain and what will be principle. If you're not sure, contact your broker and find out what percentage of the overall account is unrealized gain and use that as a proxy.

4. Plug the capital gain from step 3 and whatever income from your traditional IRA into the 1040 or Turbotax and see what it calculates as a tax liability after accounting for exemptions, deductions, and the tax bracket.

That will probably get you in the ballpark.

Two other things:

1. You might want to check with a CPA or tax person to see if you will need to make quarterly estimated income tax payments.
2. You might want to model several different withdrawal strategies over the next decade or even the remainder of your lifespan. How and when and in what proportion you choose to withdraw could very well affect your tax bill tremendously. While your doing this you may need to evaluate the estate tax aspect of things as well.

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Tax calculator
Old 09-04-2008, 03:12 PM   #3
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Tax calculator

You could play around with a calculator like this:

1040 Tax Calculator - Financial Calculators from Dinkytown.net

Assume different levels of IRA and capital gains income to compute your taxes. Then add a perecentage for the state tax (if any).

It goes without saying though, that taxes will probably be higher in the future. The exact rates and mix of rates is an unlnown.
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Old 09-04-2008, 04:58 PM   #4
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It seems to me that my expenses don't have a lot to do with my tax liability. Since most of my portfolio(dwindling as it may be) is in mutual funds , it is the dividends and capital gains distributions1098(?) income that will be my taxable income; and that is the gain on the whole portfolio not my expense budget.

If I take $30k from a MMF then my income is $600( at 2%) If I take it from a Index 500 fund I've owned for a few years then my income is $800. j/k Don't know what the gain/loss is in that account.

What I'm saying is I have no clue how to budget for taxes. My plan, if it can be called a plan, is to take the taxes that were caused by the portfolio out of those funds in addition to my spendable cash. See "no clue" above.
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You're Making this TOOO Hard!
Old 09-04-2008, 06:16 PM   #5
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You're Making this TOOO Hard!

Quote:
Originally Posted by lemming View Post
It seems to me that my expenses don't have a lot to do with my tax liability. Since most of my portfolio(dwindling as it may be) is in mutual funds , it is the dividends and capital gains distributions1098(?) income that will be my taxable income; and that is the gain on the whole portfolio not my expense budget.

If I take $30k from a MMF then my income is $600( at 2%) If I take it from a Index 500 fund I've owned for a few years then my income is $800. j/k Don't know what the gain/loss is in that account.

What I'm saying is I have no clue how to budget for taxes. My plan, if it can be called a plan, is to take the taxes that were caused by the portfolio out of those funds in addition to my spendable cash. See "no clue" above.
Sounds like you are making this too hard.

First of all, your expenses are important as they will drive how much you withdraw from your accounts. You can withdraw income earned form your money market and investments, principle from your money market, or you can liquidate a mutual fund.

Your example, above, assumes everything is in your brokerage account. So if you need $30,000, then you can expect 12-15% of it will be taxed, assuming no large deductions.

As others have said, you can put this into the income tax calculator on dinkeytown.net and get reasonably close.

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Old 09-04-2008, 06:24 PM   #6
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Google up The Optimal Retirement Planner - and play to see if it helps you any.

Note - I believe this a Monte Carlo type calc. But when you fool around with the inputs - starting tax brackets/ taxable/deferred/Roth/estate/life expectency/ cap returns - you can waste a whole evening.

heh heh heh -
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Old 09-04-2008, 06:29 PM   #7
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Get TurboTax or one of the free deals like H&R Block offer. Plug in various scenarios and see what you get. DW will retire in January or one year later -- it has been reassuring to see how our tax brackets will plummet.
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Old 09-04-2008, 06:44 PM   #8
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Also, in years where you use post-tax money to live on you may wish to take out enough of your IRA money to almost fill up your 15% bracket.

You'll pay tax on that distribution, but at that low rate. Put it in a Roth or just save it. This will both reduce your future RMDs, and possibly be a tax savings if your future marginal rate is over 15% as you eventually transition to straight IRA distributions (i.e. taxable income).
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Old 09-04-2008, 11:28 PM   #9
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Originally Posted by maldini View Post
50% of portfolio is in traditional IRA (a very small portion will be principle and the rest will be tax at income tax rate)
Maybe you just misstated this, but everything coming out of a Trad IRA will be taxed as ordinary income. You don't get to take out principal tax free. One exception would be if you made non-deductible contributions, which is pretty rare, but if so, then forget what I said.
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Old 09-04-2008, 11:32 PM   #10
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Don't forget that the first tax bracket is 0%. Yep, you will pay no taxes on lots of that money coming out of the IRA, so contrary to what Gardnr wrote, you will be able to take some principal out tax-free. On the taxable account side of things, don't forget that return of capital is tax-free.

So do what the others have suggested, run several scenarios throught TurboTax. You may find that you don't pay any income taxes!
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Old 09-04-2008, 11:40 PM   #11
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Don't forget that the first tax bracket is 0%. Yep, you will pay no taxes on lots of that money coming out of the IRA, so contrary to what Gardnr wrote, you will be able to take some principal out tax-free. On the taxable account side of things, don't forget that return of capital is tax-free.

So do what the others have suggested, run several scenarios throught TurboTax. You may find that you don't pay any income taxes!
This is only in the very unusual situation where you have no income generating assets outside your IRA.

I have been either in the 25 or 28% marginal brackets for > 5 years. I would have to look it up to see when it was lower.

If you spend money, you either have to earn it outside your tax free account, or take it out of the tax deferred account. In either case if you are enjoying a nice standard of living, you will pay more tax than many expect. And this is without Obamafication.

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Old 09-05-2008, 12:18 AM   #12
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This is only in the very unusual situation where you have no income generating assets outside your IRA.
That's why you want to have no income generating assets outside your IRA. That is, you should have all your fixed income INSIDE your IRA. Your stock index funds will generate some dividends, but those will be qualified dividends taxed at a favorable rate if you have set things up correctly. And maybe you have capital losses so that you can deduct up to $3000 a year against your ordinary income.

Of course, folks who have a pension will have income, but pensions are supposedly become more rare in the future. I do not have a pension and must rely on my investments for expenses.

And only old folks will be drawing on Social Security. You should try to get all your traditional IRA converted to a Roth IRA while you are in the 0% tax bracket before you start drawing your SS.
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Old 09-05-2008, 01:33 AM   #13
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That's why you want to have no income generating assets outside your IRA. That is, you should have all your fixed income INSIDE your IRA. Your stock index funds will generate some dividends, but those will be qualified dividends taxed at a favorable rate if you have set things up correctly. And maybe you have capital losses so that you can deduct up to $3000 a year against your ordinary income.

Of course, folks who have a pension will have income, but pensions are supposedly become more rare in the future. I do not have a pension and must rely on my investments for expenses.

And only old folks will be drawing on Social Security. You should try to get all your traditional IRA converted to a Roth IRA while you are in the 0% tax bracket before you start drawing your SS.
Thank you sir.

Ha
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Old 09-05-2008, 02:17 AM   #14
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Depending on your situation... don't forget the SS tax torpedo.
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Old 09-05-2008, 07:35 AM   #15
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Maybe you just misstated this, but everything coming out of a Trad IRA will be taxed as ordinary income. You don't get to take out principal tax free. One exception would be if you made non-deductible contributions, which is pretty rare, but if so, then forget what I said.
you are correct. Every deposit made into my Traditional IRA has been non deductable. I have never been eligible to use a deductable Traditional IRA.

So I am pretty sure all of my years "5k" type deposits can come out tax free. All growth and roll overs from 401k's will be taxed at ordinary income (at least thats my understanding)
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Old 09-05-2008, 07:52 AM   #16
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Guess it "depends". I would also suggest: learning the rules of the "money" and Excel (or the FREE OO Calc) and model away -- I have a model I developed that models finances out to age 112 (when my IRA RMD withdrawals will reach $0)--admittedly a bit excessive but with a SS you can really "model it to your hearts content" and fine tune it as you go and as laws change and impact your finances.
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Old 09-05-2008, 08:08 AM   #17
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Depending on your situation... don't forget the SS tax torpedo.
That's what I was thinking. There are some who will have a higher income and marginal tax bracket after full retirement age than they do in ER, related to pensions, SS, and RMDs, for example.

In that case it may be better to draw down their IRAs early up to a point. I'm no financial expert, but have realized that it is dicey to generalize how to withdraw in FIRE -- too many individual factors to consider.
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