Confused on tax burdens on 4% withdrawals

[Tom52]

I am in the early stages of planning for FIRE. I understand the basic concept of the 4% withdrawal rate and am currently tracking our spending since May 1 this year. Of course spending is after tax $ while money withdrawn from investments is subject to taxes.

I am sure this is more complex than I think, but how do I estimate what my tax burden will be on that gross 4% withdrawal number? I have 401K, IRA, CD, I-Bonds that will be drawn from in the gap between RE and SS. To offset taxes during the gap period the only tax deductions I will likely have are property taxes. I will also have to pay for 100% of my medical insurance which has always been 100% paid by my employer, but that will disappear when I leave. Is medical insurance tax deductible, or are only actual medical expenses in excess of a certain level?

Sorry for such naïve questions, but I don’t know where to start.

 

[retire@40]

You have two choices:

1. Try to do a pro forma tax return based on the amounts you have.

2. Hire a CPA to do this for you.

 

[FIRE'd@51]

Unreimbursed medical expenses (including medical insurance) are deductible on Schedule A to the extent that they exceed 7.5% of your Adjusted Gross Income.

 

[Rich_by_the_Bay]

Tom, your withdrawals from a 401K are just like ordinary income; you have to "gross them up" to allow for taxes and meet your expenses after taxes. Better be sure you incorporated that into your projections. If you need $50k to live on you may need to withdraw $62.5 to cover 20% taxes.

Medical insurance premiums (and certain other business costs) might be fully deductible if you are self-employed, so keep that in mind. That's a big deal for many (as is obtaining that insurance in the first place).

 

[Rustic23]

Pick up a copy of Turbo Tax. Go to the second had software shop and buy an old copy cheap. Then play like you are retired. It should give you a pretty good idea what you are in for.

 

[LOL!]

Pick up a copy of Turbo Tax. Go to the second had software shop and buy an old copy cheap. Then play like you are retired. It should give you a pretty good idea what you are in for.

That's a GREAT answer for almost ALL your tax questions. Just run the scenario in TurboTax. I would just get the latest version every year. You are gonna need it to do your taxes anyways. One can have multiple scenarios by doing multiple tax returns. Simply use "File / Save As ... " to save a new scenario to a different file.

 

[W2R]

So, suppose you figure that your entire tax burden and any other deductions will probably amount to about 25%, and you want to follow an SWR of 4%, then really you will be living on 3% after taxes.

Is that correct? This is something I have been assuming but wasn't sure about either.

 

[audreyh1]

My experience over the last 7 years has been that taxes on my portfolio (all taxable investments, not IRA or 401K) have averaged about 0.5%. This means I can count on an after tax withdrawal of about 3.5%.

If you are withdrawing from an IRA or 401K, then you should just look up the taxes on the amount taking into account deductions, etc., to figure out what the tax hit will be.

Audrey

 

[lazygood4nothinbum]

check me on this but i think if you need to withdraw early from 401k or tira that monies paid from there for medical expenses (including insurance premiums) would be subject to normal income tax but not to early withdrawal penalties.

 

[jIMOh]

Use a Roth IRA and money is tax free.

If using a traditional IRA, 401k, or other tax defferred vehicle, I use fairmark web site to check tax rates.

Here is a link
Reference Room

basics (married, filing jointly)

first 10,900 is tax free (standard deduction).

tax owed:

first $16,050 is taxed at 10% (max owed of $1605)
money between $16051 and $65150 is taxed at 15% (max owed is $65150-$16051=49099*15%=$7365, plus $1605 from previous bracket is $8970 total).
money between 65151 and 131450 is taxed at 25%. (max owed is $131450-$65151=$66299*25%=$16575, plus $8970 from previous brackets is $25,545).

The brackets are "graduated", with a 28%, 33% and 35% if you withdraw more.

Use the tables, or post income needed here, and I can post the math I would use.

Your state taxes are not included in this.

 

[youbet]

Tom52

Since you have multiple possibilities for your withdrawal scenarios, the advise given above to use TurboTax, or another tax software package, to run some estimates is best.

You'll probably have dividends which are taxed at 15%, interest taxed as ordinary income, stock sales taxed as short or long term capital gains, etc. Of course, when you cash that CD, only the interest, not the withdrawn principal, is taxed.

Sit down with TurboTax and run some scenarios. Making the withdrawal decisions will be tougher than actually calculating the tax. But, until you decide how and where your withdrawals will take place, you won't be able to estimate the taxes.

 

[Rustic23]

Jimoh,
So in reality:

0-10900 - 0
10900 - 26950 - 1605
26950 - 75050 - 7365
75050 - 142,350 - 16,575

as the $10,900 is added to each bracket. The only reason I put this up is the $75,050 becomes of interest to me as I figure out how much to convert from regular IRA to Roth.

 

[FIRE'd@51]

Here is a link
Reference Room

basics (married, filing jointly)

first 10,900 is tax free (standard deduction).

Actually, for 2008, at least the first 17,900 is tax-free for married, filing jointly, since there would be at least two 3500 exemptions

 

[SecondCor521]

So, suppose you figure that your entire tax burden and any other deductions will probably amount to about 25%, and you want to follow an SWR of 4%, then really you will be living on 3% after taxes.

Is that correct? This is something I have been assuming but wasn't sure about either.

Depends on what you mean by that 25%. If you mean that you have an effective tax rate of 25% and you live on $X per year, and you have a portfolio value of $Y of which you want to withdraw 4%, we have:

$X + 0.25 * $X = 4% * $Y
1.25 * $X = 4% * $Y
$X = (4% * $Y) / 1.25
$X = 3.2% * $Y

So you'd really be living on a 3.2% withdrawal rate.

Sorry if I sound pedantic, but since $Y is probably a relatively big number to most people, the 0.2% increase may be significant to someone.

Also, be sure to realize that, due to exemptions, deductions, credits, and other tax things, an effective tax rate of 25% is far different from a marginal tax rate of 25%. Someone with a marginal tax rate of 25% might easily have an effective tax rate of 14%. Learn and understand the difference.

2Cor521

 

[Nords]

I am sure this is more complex than I think, but how do I estimate what my tax burden will be on that gross 4% withdrawal number? I have 401K, IRA, CD, I-Bonds that will be drawn from in the gap between RE and SS. To offset taxes during the gap period the only tax deductions I will likely have are property taxes. I will also have to pay for 100% of my medical insurance which has always been 100% paid by my employer, but that will disappear when I leave. Is medical insurance tax deductible, or are only actual medical expenses in excess of a certain level?

You'd be deducting medical insurance/expenses if they were greater than 7.5% of your adjusted gross income, as already mentioned, AND only if they were greater than the standard deduction. If your AGI is $63,000 then your deductible medical insurance/expenses would start at $4725, but the standard deduction is $10,700 this year so you'd have to have substantial expenses to beat the standard deduction. Of course if COBRA premiums run $1000/month then it's no problem...

If your AGI is around $63K then most of your dividend income will be taxed at the 15% bracket and most of your long-term cap gains will be taxed at 5% or less. (This is fraught with exceptions but within $500 or so of the tax you'll owe.) You'll probably find yourself paying about 10-15% above your income as taxes. In our five years of ER we've paid from 2%-13% of taxable income, with the 2% coming after a lot of home energy improvements (and a pile of tax credits). This year we'll probably be closer to 11-12%.

If the success of your entire ER planning rests on the "single point of failure" of calculating your taxes down to the nearest percent, then it might be better to build more portfolio or trim back the expenses.

 

[FIRE'd@51]

If your AGI is around $63K then most of your dividend income will be taxed at the 15% bracket and most of your long-term cap gains will be taxed at 5% or less.

Actually your dividend income would be taxed at 5% as well in this scenario. Next year, dividends and LT capital gains which fall into the 10% and 15% brackets will be taxed at zero. So in 2008, a couple filing a joint return and taking the standard deduction whose entire income comes from dividends and LT capital gains would actually pay no federal tax on the first 83K of income.

 

[Nords]

Actually your dividend income would be taxed at 5% as well in this scenario. Next year, dividends and LT capital gains which fall into the 10% and 15% brackets will be taxed at zero. So in 2008, a couple filing a joint return and taking the standard deduction whose entire income comes from dividends and LT capital gains would actually pay no federal tax on the first 83K of income.

Good point, lemme restate:
"... your dividend income will be taxed at the 15% income tax bracket"...

Then there's that whole issue with qualified dividends, non-qualified dividends, dividends subject to foreign tax...

 

[whitestick]

Next year, dividends and LT capital gains which fall into the 10% and 15% brackets will be taxed at zero. So in 2008, a couple filing a joint return and taking the standard deduction whose entire income comes from dividends and LT capital gains would actually pay no federal tax on the first 83K of income.

Let me ask an expanded question around that statement. IF a couple had 20k of pension income, 57k of Short Term CG, and 125k of Long Term CG for 2008, what would that work out to be for taxes, for each part. I'm having trouble understanding the interrelationships with the various income types, and the total AGI that number causes for taxes for each. Oh and the LTCG is to pay off the house and high interest debts, so it would be a one time thing, but holding it off till 2008 seemed to be a better way to go for tax purposes, I think
Oh and Thanks for the help, I'm not trying to be lazy, I just don't understand this.

 

[FIRE'd@51]

Let me ask an expanded question around that statement. IF a couple had 20k of pension income, 57k of Short Term CG, and 125k of Long Term CG for 2008, what would that work out to be for taxes, for each part. I'm having trouble understanding the interrelationships with the various income types, and the total AGI that number causes for taxes for each. Oh and the LTCG is to pay off the house and high interest debts, so it would be a one time thing, but holding it off till 2008 seemed to be a better way to go for tax purposes, I think
Oh and Thanks for the help, I'm not trying to be lazy, I just don't understand this.

Using your numbers and assuming you take the standard deduction, you have 77k (20k pension plus 57k STCG) which will be taxed at ordinary income rates. So 6k (83k - 77k) of your 125k LTCG will be taxed at 0% and the other 119k at 15%. This is for 2008. For 2007, the 83K number is 81k (the 83k comes from indexing the brackets, standard deduction, and exemptions for inflation). So applying your numbers to 2007, you would have 4k (81k - 77k) of the 125k LTCG taxed at 5% and 121k taxed at 15%. The net savings on the LTCG for delaying until 2008 would thus be 5% on 4k plus 15% on 2k = $500. My numbers are approximate since I have rounded the 81k and the 83k to the nearest thousand.

Of course, this would have to be weighed against the after-tax cost to carry the 125k debt for the months involved.