Question About Effective Tax Rates in Early Retirement

[nico08]

Hello:

I am trying to estimate the amount of federal and state tax in my early retirement budget. I used an online calculator from H&R Block to do the federal tax estimate. I assumed that 15% of my retired early income would come from bond interest, 60% came from dividends and 25% would come from long term capital gains.

I ended up with 3.98% effective federal tax rate and a 2.92% effective state tax rate (I used New Jersey as the residence state). If these estimates are a good approximation of my federal and state tax liability during early retirement, I can then add these tax numbers to my cost of living budget to obtain an accurate estimate of my annual cost when I retire early.

Based on your experience in early retirement, or your own planning for a future early retirement, do these effective federal and state tax percentage estimates sound about right to you?

Thank you for your advice.

 

[Rich_by_the_Bay]

You are aware that any savings in a tax-deferred account (e.g. IRA, 401k) will be taxed as ordinary income, (even if it is from dividends, gains, etc.) when you withdraw it, right?

 

[haha]

This is pretty much a hopeless undertaking for many different reasons.

Better IMO to jsut do few projections on your income, and see how much tax you would pay, then add that to your living expenses. All parts of your equation will be moving- tax rates, apportionment of rates to different income categories, inflation rates which willy-nilly boost real taxation, market results and interst rates which affect where your income will fall ina given year. I have been a taxpayer for over 50 years, and everything changes whenever they want to change it.


One thing I think we can count on- rates will rise, even nominal rates, and the special treatment of dividends will disappear. That is a relic of "the ownership society". How long since you have heard about that?

We are closer now to "the expropriation society".

Ha

 

[nico08]

You are aware that any savings in a tax-deferred account (e.g. IRA, 401k) will be taxed as ordinary income, (even if it is from dividends, gains, etc.) when you withdraw it, right?

The tax calculator that I used from H&R Block did not distinguish between income from tax-deferred or taxable accounts, but I assume any tax rate differences would be built into the tax estimator/calculator. Thanks!

 

[nico08]

This is pretty much a hopeless undertaking for many different reasons.

Better IMO to jsut do few projections on your income, and see how much tax you would pay, then add that to your living expenses. All parts of your equation will be moving- tax rates, apportionment of rates to different income categories, inflation rates which willy-nilly boost real taxation, market results and interst rates which affect where your income will fall ina given year. I have been a taxpayer for over 50 years, and everything changes whenever they want to change it.


One thing I think we can count on- rates will rise, even nominal rates, and the special treatment of dividends will disappear. That is a relic of "the ownership society". How long since you have heard about that?

We are closer now to "the expropriation society".

Ha

I did do a projection based on my estimated annual cost of living in early retirement. Instead of using income from wages, I just characterized my income as coming from dividends, interest and long term capital gains. I was just surprised that the effective federal and state tax rates were as low as they were- 3.98% federal and 2.92% state. My current effective tax rates as a wage earner are much higher than those rates.

I just wondered what other people's experiences were on this tax issue in early retirement. Thanks!

 

[LOL!]

Would you mind just using 4% and 3% for your tax rate? Three significant digits makes it read like you really believe those numbers are accurate. Maybe even haha will calm down with one significant digit.

I like to use Intuit's Taxcaster.

I'm surprised your tax rate is not 0%. What happened?

 

[haha]

I did do a projection based on my estimated annual cost of living in early retirement. Instead of using income from wages, I just characterized my income as coming from dividends, interest and long term capital gains. I was just surprised that the effective federal and state tax rates were as low as they were- 3.98% federal and 2.92% state. My current effective tax rates as a wage earner are much higher than those rates.

I just wondered what other people's experiences were on this tax issue in early retirement. Thanks!

I see that you are not exactly interested in the sense of what I answered, so I will answer your specific request as best I can, though I expect it to be useless.

My experience in 25 years of retirement is that I have never experienced any rates even remotely close to your projected rates, except this year when I have no SS, no earned income, no withdrawals from retirement accounts, minimal interest, and I and took large advantage of something available only this year and next-0% tax on LTCG and qualified dividends that fall within the 15% bracket. With all these limited time only breaks(and they do mean this) my federal tax as a % of AGI is between 6 and 7%. In addition I paid some tax at the source on foreign dividends which was not completely rebated by the foreign tax credit.

However, the level of income and it's components are very important, as is the exact algorithm to arrive at your requested ratio. Some people pay no income tax, because they have very low incomes, even though their consumption spending is not necessarily low. This is the magic of asset allocation, rebalancing, and total return investing. So their income tax as a % of money available for consumption may be as low as 0%.

Ha

 

[W2R]

My income is a mixture of dividends, pension, and TSP withdrawals.

Last year was my first year of retirement, and my income taxes (federal and state combined) came to 9.5%. I am sure some others do better than that. I hope that I will too as I become more tax savvy, since I am a novice retiree and still learning.

 

[Rich_by_the_Bay]

The tax calculator that I used from H&R Block did not distinguish between income from tax-deferred or taxable accounts, but I assume any tax rate differences would be built into the tax estimator/calculator. Thanks!

I wouldn't make that assumption without verifying. It can make a huge difference.

If I want to withdraw $50K for a fancy car and I do it from a taxable deferred, I need to actually withdraw, say, $60K to cover taxes on the distribution. If it is from a post-tax account, I just draw the $50k and I am done (other than the capital gains or losses, as always). Big difference.

 

[donheff]

The tax calculator that I used from H&R Block did not distinguish between income from tax-deferred or taxable accounts, but I assume any tax rate differences would be built into the tax estimator/calculator. Thanks!

If you just input generic "income" it would treat it all as income but if the calculator categorizes the sources (e.g. W2s, pension income, IRA distributions, dividends, CGs, etc.) then it is reasonable to assume that it is applying the right rules. I learned that to run scenarios with turbo tax it is important to get the sources right to get a good estimate.

 

[nico08]

My income is a mixture of dividends, pension, and TSP withdrawals.

Last year was my first year of retirement, and my income taxes (federal and state combined) came to 9.5%. I am sure some others do better than that. I hope that I will too as I become more tax savvy, since I am a novice retiree and still learning.

Your response was helpful. Thank you.

 

[walkinwood]

I think the most accurate is to buy/use a 2010 turbo tax or equivalent program and enter your dividend/cap gain distributions from last year (2010), add in any portfolio liquidation (Tax exempt/taxable) and pensions/SS.

In 2009 when we had no earned income, our effective fed tax rate was 0% in spite of a IRA/ROTH conversion. Distributions weren't great and we're too young to tap into tax deferred accounts & do not have pensions. I did not do my calculations correctly or I would have converted from IRA to ROTH up to the 10% limit.

That example was just to illustrate that there are many moving parts and it is hard to generalize.

 

[rescueme]

If I want to withdraw $50K for a fancy car and I do it from a taxable deferred, I need to actually withdraw, say, $60K to cover taxes on the distribution.

Actually, I did just that. In addition, it also pushed me into a higher tax bracket (should have just made payments, other than pay cash )...

 

[scrabbler1]

In 2009, my first full year of ER, my effective tax rate as a percentage of total gross income was 4.1% for federal and 2.9% for state (New York).

Most of my income was taxable bond fund dividends, taxed as ordinary income. A small part of it was muni bond fund dividends which were tax-free at the federal level but partly taxable at the state level. I had a overall capital losses on stock funds of just under $3,000.

In 2010, I had an unexpectedly large short-term cap gains distribution from one of my bond mutual funds so it was taxable as ordinary income. The overall capital losses I had in 2009 became capital gains, albeit not very large (but not taxable because it was barely in the 0% bracket). These boosted my tax bills by a factor of just under 3 for federal and just over 2 for state.

What I do is to prepare skeleton tax forms in a spreadsheet which I can update at any time. So when I had that unexpected ST cap gains distribution in the middle of last year, I was able to see right away how it would impact my income taxes. I was able to modify my budget so I could make some additional estimated tax payments later in the year.

And earlier this month, I changed health insurance plans which will lower my premiums and raise my taxes (federal mainly, NY is barely affected) because of the reduced HI itemized deduction.

 

[nico08]

In 2009, my first full year of ER, my effective tax rate as a percentage of total gross income was 4.1% for federal and 2.9% for state (New York).

Most of my income was taxable bond fund dividends, taxed as ordinary income. A small part of it was muni bond fund dividends which were tax-free at the federal level but partly taxable at the state level. I had a overall capital losses on stock funds of just under $3,000.

In 2010, I had an unexpectedly large short-term cap gains distribution from one of my bond mutual funds so it was taxable as ordinary income. The overall capital losses I had in 2009 became capital gains, albeit not very large (but not taxable because it was barely in the 0% bracket). These boosted my tax bills by a factor of just under 3 for federal and just over 2 for state.

What I do is to prepare skeleton tax forms in a spreadsheet which I can update at any time. So when I had that unexpected ST cap gains distribution in the middle of last year, I was able to see right away how it would impact my income taxes. I was able to modify my budget so I could make some additional estimated tax payments later in the year.

And earlier this month, I changed health insurance plans which will lower my premiums and raise my taxes (federal mainly, NY is barely affected) because of the reduced HI itemized deduction.

Thank you for sharing your experience. It sounds like you have a pretty good tracking system set up to assess your tax situation throughout the tax year.

 

[kaneohe]

Actually, I did just that. In addition, it also pushed me into a higher tax bracket (should have just made payments, other than pay cash )...

........so is this income primarily from tax deferred accounts? If so, you probably should have entered the income as wages/interest so as to get an ordinary income rate as Rich was suggesting. If you input as qualified dividends/ LT capital gains, you are telling the calculator that this income is from a taxable (not tax deferred) account w/ preferential (low) rates that may be misleading.

 

[Zero]

I use this tax calculator and this year "after" I did my actual taxes using TurboTax, I then used the exact numbers from my 1040 from and put into the calculator. It estimated my taxes tow within $37 of what I actually paid.

It was 99% correct.
Bankrate.com Tax Calculator

 

[kaneohe]

I don't think the accuracy of the tax calculator is being challenged. Both the HR Block and Taxcaster ones are also good. The challenge is whether they are being used correctly in relation to the taxable nature of the income.

 

[Zero]

I don't think the accuracy of the tax calculator is being challenged. Both the HR Block and Taxcaster ones are also good. The challenge is whether they are being used correctly in relation to the taxable nature of the income.

I'd be interested in your opinion of the "correctness" of the Bankrate calculator, if you have a few minutes to try it out. My own assessment was that it covered the vast majority of tax situations and performed very well against TurboTax.

I'm interested because I plan to use it as part of my own future planning.

 

[Zero]

Here are the income inputs from the Bankrate calculator. I think it covers most types of income.

 

[Rambler]

Midnighter777, it really will make a difference if you are pulling money out of your tax deferred accounts (401k, IRA) or your taxable accounts or Roth. Say you make $100k a year from a job. If you pull $100k out of your tax deferred 401k or IRA, everything else being equal, you will pay the same in taxes as you did from the $100k job. If you take the same 100k from your taxable accounts, then you pay the lower rate on dividends and cap gains, and pay nothing on withdrawn principle. Also, when taking from your taxable account, you may have muni bonds that throw off fed and state tax free interest. So, this issue of taxes is pretty individual and depends a lot on how and where you saved, and in what it is invested if it is in a taxable account.

I'm not FIREd yet, but for my own planning purposes, I keep my estimated tax rate at about 25% of income after itemized deductions. I believe this is a high estimate, but you never know. I have run several tax calculators based on my own investment situation (60% equity with an estimated 2.5% dividend yield, 40% bonds of which most are tax free munis yielding around 5.8%) and find that this 25% figure can equate to about 6-8% effective over all my income streams. All of that is from taxable accounts. 6 year after I FIRE, my deferred compensation plan starts paying out. When that happens, uncle Sam, and uncle Jerry in California start to cash in, for 10 years. This is simply too far off to estimate, as the tax laws are likely to change dramatically between now and the start of the payout in 8-10 years.

Good luck.

R

 

[kaneohe]

I'd be interested in your opinion of the "correctness" of the Bankrate calculator, if you have a few minutes to try it out. My own assessment was that it covered the vast majority of tax situations and performed very well against TurboTax.

I'm interested because I plan to use it as part of my own future planning.

Sorry, I clicked on your link because I had never heard of that calculator and was curious about it, but it appears to need something downloaded that I don't have on the Mac. So I'll just turn it around and provide you the link for Taxcaster (also made by TT) TurboTax® TaxCaster - Free Tax Calculator - Free Tax Estimator

I think I like it better than the HR Block one because it's easier to play what if w/o having to enter data all over again. You can also enter gross SS w/o having to figure the taxable part.....kind of looks like yours might require the taxable part but I might be wrong.

 

[haha]

I'd be interested in your opinion of the "correctness" of the Bankrate calculator, if you have a few minutes to try it out. My own assessment was that it covered the vast majority of tax situations and performed very well against TurboTax.

I'm interested because I plan to use it as part of my own future planning.

I just tried it and found it quite helpful looking ahead at 2011. There are small bracket changes between 2010 and 2011, but not meaningful.

As far as accuracy, seems very likely that it would be accurate. If there is one thing computers do well it is add and subtract, and the relevant algorithm once you have categorized income is straightforward.

This beats loading up my TTax files with dummy tax scenarios, I thank you for posting it.

Ha

 

[haha]

Sorry, I clicked on your link because I had never heard of that calculator and was curious about it, but it appears to need something downloaded that I don't have on the Mac. So I'll just turn it around and provide you the link for Taxcaster (also made by TT) TurboTax® TaxCaster - Free Tax Calculator - Free Tax Estimator

I think I like it better than the HR Block one because it's easier to play what if w/o having to enter data all over again. You can also enter gross SS w/o having to figure the taxable part.....kind of looks like yours might require the taxable part but I might be wrong.

I tried this one also. For me, the plus is that SS is entered as received. But I like the format and output of the one at Bankrate better.

I suppose there may be situations in the future when my SS is not taxed to the max, but it hasn't happened yet. I restart this year after my payback and refile, so I will have a partial SS payment this year relative to expected payments in future years.

Ha

 

[nico08]

Midnighter777, it really will make a difference if you are pulling money out of your tax deferred accounts (401k, IRA) or your taxable accounts or Roth. Say you make $100k a year from a job. If you pull $100k out of your tax deferred 401k or IRA, everything else being equal, you will pay the same in taxes as you did from the $100k job. If you take the same 100k from your taxable accounts, then you pay the lower rate on dividends and cap gains, and pay nothing on withdrawn principle. Also, when taking from your taxable account, you may have muni bonds that throw off fed and state tax free interest. So, this issue of taxes is pretty individual and depends a lot on how and where you saved, and in what it is invested if it is in a taxable account.

I'm not FIREd yet, but for my own planning purposes, I keep my estimated tax rate at about 25% of income after itemized deductions. I believe this is a high estimate, but you never know. I have run several tax calculators based on my own investment situation (60% equity with an estimated 2.5% dividend yield, 40% bonds of which most are tax free munis yielding around 5.8%) and find that this 25% figure can equate to about 6-8% effective over all my income streams. All of that is from taxable accounts. 6 year after I FIRE, my deferred compensation plan starts paying out. When that happens, uncle Sam, and uncle Jerry in California start to cash in, for 10 years. This is simply too far off to estimate, as the tax laws are likely to change dramatically between now and the start of the payout in 8-10 years.

Good luck.

R

Thank you for explaining that there is difference if I am taking money out of my tax deferred accounts (401k, 437) or my taxable accounts or Roth. Initially, most of the withdrawal money will come from my taxable accounts. Twelve years from my planned early retirement date, I will be eligible for a defined benefit pension and then after that I will be eligible for Social Security too.

The 6-8% effective tax rate over all of your income streams is useful to know. Thanks.