How Retirees Pay Zero Taxes

[youbet]

Great article Onward. Thanks for posting!

With six years to go until RMD's come crashing down on us, DW and I have been second guessing our heavy use of 401k, 403b and TIRA's over our working years. It's likely we wouldn't do anything different, even if we could, but seeing how much farther Uncle's hand will soon be dipping into our pockets is an eye opener.

I've done some pro-forma tax estimating using 2012 Turbo Tax and, like the author, have come to grips with the fact that RMD's (for us anyway) will keep us from enjoying the nirvana of "zero retirement taxes." Almost 100% of the income that funds our retirement spending will be taxed as ordinary income.

The trade off between tax deferral vs. paying taxes on LTCG's and qualified divs as ordinary income (at RMD time) seemed favorable while we were receiving the benefits of the tax deferrals. Now that the time to pay the piper is on the horizon, not so much!

 

[Beryl]

My understanding is that the self employed get audited more often. I wonder if that is profiling.

I had the same understanding since the IRS already knows most of the income of everyone else. Don't many charities disclose donor information? I figured that the IRS already knew about MegaCorps's employee charitable deductions so we were only confirming what they knew and adding more on our tax forms.

There is very little the IRS doesn't know about the income and expenditures of the average Josephine I thought.

Don't know about profiling though.

 

[meierlde]

Great article Onward. Thanks for posting!

With six years to go until RMD's come crashing down on us, DW and I have been second guessing our heavy use of 401k, 403b and TIRA's over our working years. It's likely we wouldn't do anything different, even if we could, but seeing how much farther Uncle's hand will soon be dipping into our pockets is an eye opener.

I've done some pro-forma tax estimating using 2012 Turbo Tax and, like the author, have come to grips with the fact that RMD's (for us anyway) will keep us from enjoying the nirvana of "zero retirement taxes." Almost 100% of the income that funds our retirement spending will be taxed as ordinary income.

The trade off between tax deferral vs. paying taxes on LTCG's and qualified divs as ordinary income (at RMD time) seemed favorable while we were receiving the benefits of the tax deferrals. Now that the time to pay the piper is on the horizon, not so much!

Lets do a little example assume you have $1. Pay taxes and put it in a taxable account, or defer it in a 401k and you also defer taxes on the income it earns. So assume the 25% tax bracket, and start with $1 you have $.75 in the taxable account and $1 in the deferred account. Now assume you earn 4% and pay a rate of 25% on the earnings. So the taxable account earns after taxes 3%. Now run this for 10 years and pay the 25% tax on the deferred account. If my spread sheet is correct you have $1.06 from the deferred account and .98 from the taxable account. So although the difference is small its still about 8% after 10 years. These numbers should improve for a 20 year period as well as the compounding provides more and more For 20 years it is 1.58 after paying taxes on the 401k and 1.32 on the taxable account, or about 20 %

 

[gerntz]

We're currently targeting 0% Fed taxes by living off our taxable accounts, not taking SS, not making IRA withdrawals, using munis, & taking LTCG's in the 0% tax bracket, & making charitable gifts - not to religious orgs - that give us deductions that allow more LTCG.

We're also not making state income tax quarterly payments but will estimate that amount & near the end of the year will make IRA withdrawal designating 99% go to state taxes & then immediately redeposit to the IRA this year saying "oops, we didn't mean to do that" & thus avoid Fed taxes on the withdrawal.

 

[packrat44]

We're currently targeting 0% Fed taxes by living off our taxable accounts, not taking SS, not making IRA withdrawals, using munis, & taking LTCG's in the 0% tax bracket, & making charitable gifts - not to religious orgs - that give us deductions that allow more LTCG.

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If your tax bracket is going to substantially higher after RMDs kick in, you might find it beneficial to be doing some tIRA to ROTH conversions while in a low tax bracket. And/or it might be beneficial to take some of your LTCG at this time and immediately buy the same equities back. This would reset the cost basis thereby lowering taxes due at a later date.

 

[pb4uski]

I was really up-in-the-air about taking advantage of 0% capital gains in my taxable accounts (~2-3 years worth) or tIRA>Roth conversions to reduce RMDs after I'm 70. I looked at my projected taxable income/marginal tax rate after age 70 and decided to focus on the former for now. I'll still have ~10 years to do tIRA>Roth conversions before SS and RMDs kick in.

Obamacare is really messing up my plan as 10 years of tIRA>Roth withdrawals from 400% FPL to the top of the 15% bracket is substantial but the economic cost of those conversions would be exorbitant - much more than my tax rate after age 70. After I'm on Medicare/off Obamacare I'll ratchet up my tIRA>Roth conversions from 400% FPL to the top of the 15% bracket.

So if you will be buying health insurance I think it is important to look not only at the taxes on conversions but also any lost Obamacare HI subsidies.

 

[urn2bfree]

Lets do a little example assume you have $1. Pay taxes and put it in a taxable account, or defer it in a 401k and you also defer taxes on the income it earns. So assume the 25% tax bracket, and start with $1 you have $.75 in the taxable account and $1 in the deferred account. Now assume you earn 4% and pay a rate of 25% on the earnings. So the taxable account earns after taxes 3%. Now run this for 10 years and pay the 25% tax on the deferred account. If my spread sheet is correct you have $1.06 from the deferred account and .98 from the taxable account. So although the difference is small its still about 8% after 10 years. These numbers should improve for a 20 year period as well as the compounding provides more and more For 20 years it is 1.58 after paying taxes on the 401k and 1.32 on the taxable account, or about 20 %

Whoa! Can you run that with a more realistic scenario, please?
I call BS on taxing earning from the investment in the taxable account at 25%...Depending on your Adjusted Gross Income, that tax is likely to be on Dividends and Cap Gains which could be 0% or 15%...Never going to be 25%. Also since half the investment gains are likely to be Cap gains and NOT taxed until you take them, you cannot reduce the gain for taxes every year, only at the end when the gain is taken.
That along with the possiblity that at higher income the tax on RMD or any tax deferred withdrawl the tax could be even higher than 25% and this is going to be much less likely favoring tax deferral as the best strategy...

 

[youbet]

meierlde and urn2bfree........

Thanks to both of you for your analysis. Two different examples with different assumptions. My case would more closely resemble urn2befree's viewpoint.

My thoughts now in hindsight.......

DW and I maxed 401k, 403b and TIRA's for many years. We were not eligible for direct Roth contributions and this was in the pre-backdoor time period. Some of the TIRA's were after tax contributions. Had I known how the investment returns and tax laws were going to work out, I would have toned the deferred contributions down a bit and put that money into tax managed investments.

Since retiring (11 yrs DW and 7 yrs me), we've deferred one of our pensions and used that space to do some Roth conversions. We didn't get on this right away (only 4 yrs ago) and I wish we would have started sooner. Once the second pension and RMD's kick in, we'll be in a higher tax bracket than the single pension plus Roth conversion years.

We'll have very little tax management flexibility once RMD's start in 5 - 6 years. Pension + RMD will be more than our budget so we'll actually be paying tax on ordinary income of more than we spend.......

We're doing fine and have been enjoying a comfortable middle class lifestyle in our FIRE years. No complaints. We'll pay whatever tax we have to pay and go on. I only mentioned our scenario since it is similar (just smaller numbers) to the scenario in the article posted by Onward in post #125. There will be no tax holiday for us in retirement........ And I think a lot of other folks on this board as well.

 

[scrabbler1]

Whoa! Can you run that with a more realistic scenario, please?
I call BS on taxing earning from the investment in the taxable account at 25%...Depending on your Adjusted Gross Income, that tax is likely to be on Dividends and Cap Gains which could be 0% or 15%...Never going to be 25%. Also since half the investment gains are likely to be Cap gains and NOT taxed until you take them, you cannot reduce the gain for taxes every year, only at the end when the gain is taken.
That along with the possiblity that at higher income the tax on RMD or any tax deferred withdrawl the tax could be even higher than 25% and this is going to be much less likely favoring tax deferral as the best strategy...

It is quite possible to have investment earnings taxed as ordinary income (25% in meierlde's example). It could come from taxable interest or short-term cap gain distributions (which, for tax purposes, are treated as ordinary dividends).

In my own investment earnings, I have lots of dividends from my corporate bond funds taxed as ordinary income. But I also have some dividends from muni bond funds, long-term cap gain distributions, and qualified dividends, all taxed at lower rates (zero, for me) And that doesn't take into account the variations of taxation at the state level.

 

[packrat44]

It is quite possible to have investment earnings taxed as ordinary income (25% in meierlde's example). It could come from taxable interest or short-term cap gain distributions (which, for tax purposes, are treated as ordinary dividends).

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This is why it is handy to place investments that generate ordinary income (dividends, REITs, equities you trade on a short term basis, etc) or create tax complications (MLPs) in a ROTH.

 

[scrabbler1]

This is why it is handy to place investments that generate ordinary income (dividends, REITs, equities you trade on a short term basis, etc) or create tax complications (MLPs) in a ROTH.

I don't dispute your advice, but as an early retiree I need this investment income to cover my expenses. So a Roth IRA would not be useful. I do, however, rarely make redemptions or exchanges in my taxable accounts because they create a taxable event (short-term or long-term).

My income tax bill is very low anyway, around 5% (federal) of income.

 

[packrat44]

I don't dispute your advice, but as an early retiree I need this investment income to cover my expenses. So a Roth IRA would not be useful. I do, however, rarely make redemptions or exchanges in my taxable accounts because they create a taxable event (short-term or long-term).

My income tax bill is very low anyway, around 5% (federal) of income.

Since your taxes are very low now, it might be a benefit to take some LTCGs and immediately buy back the same equities. Doing that now you would pay little or no taxes and would reset the cost basis. Repeat occasionly while in a low tax bracket. Later in life when you are in a higher tax bracket you would be taxed on the lower gains.

 

[urn2bfree]

It is quite possible to have investment earnings taxed as ordinary income (25% in meierlde's example). It could come from taxable interest or short-term cap gain distributions (which, for tax purposes, are treated as ordinary dividends).

In my own investment earnings, I have lots of dividends from my corporate bond funds taxed as ordinary income. But I also have some dividends from muni bond funds, long-term cap gain distributions, and qualified dividends, all taxed at lower rates (zero, for me) And that doesn't take into account the variations of taxation at the state level.

I did not say none of the investment gains would be ordinary just that most gains are going to be capital gains and dividends that will not be taxed above 15%(under current law).
So the example that used 25% as the yearly tax siphoned off of the gains in the taxable account is simply not a fair comparison. It is a strawman for any but the most cluelessly and carelessly constructed of investment portfolios. It artificially shows an advantage to tax deferral that is not real. I do not know how much if any advantage tax deferral provides at various levels, but calculating should not be based on inaccurate and unrealistic assumptions.

 

[scrabbler1]

Since your taxes are very low now, it might be a benefit to take some LTCGs and immediately buy back the same equities. Doing that now you would pay little or no taxes and would reset the cost basis. Repeat occasionly while in a low tax bracket. Later in life when you are in a higher tax bracket you would be taxed on the lower gains.

I use FIFO for my cost basis and right now the bulk of my stock fund shares are priced quite high because they are those I bought in the late 1990s. I could tax loss harvest but I prefer to wait because most of it would offset LTCG distributions which are not taxable right now.

 

[kramer]

Since your taxes are very low now, it might be a benefit to take some LTCGs and immediately buy back the same equities. Doing that now you would pay little or no taxes and would reset the cost basis. Repeat occasionly while in a low tax bracket. Later in life when you are in a higher tax bracket you would be taxed on the lower gains.

Yes, this is what I do every year. Near the end of the year, I take capital gains in order to get my total income as close as possible to the top of the 15% ordinary income bracket. There is no tax on the capital gains that I take.

It can affect one in other ways though: State income taxes, raise the price of your subsidized health insurance, increase taxation on your social security.

Fortunately, none of these factors affect me at this time.

 

[pb4uski]

I do the same and was perturbed that my federal tax bill was zero but I owed about 3% of my gains in state income tax - not a surprise but annoying nonetheless. And in 2014 I'll scale down any gains to stay under 400% FPL.

 

[Chuckanut]

I was on schedule to pay little or no income tax this year, until I started thinking it would be a good idea to do some Reg IRA to Roth IRA conversions.

 

[Chuckanut]

Oh, I remember now. Actually I was proud to be able to structure my finances so that my federal income tax last year, my first full year of retirement, was zero! Probably the first time since I was a young teenager.

Obviously, you have joined up with the other dangerous radicals who haunt this site.

 

[pb4uski]

Guilty.

I suppose that the NSA will be barging in the door at any moment.

 

[tmm99]

This scenario has a person hauling in $200,000 and only gives $5000 in donations? People I know who earn $50K donate at least that.

Really