Author Topic: How do you pay your taxes post-FIRE? Where is the money coming from?  (Read 919 times)

bigote2032

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Hello all dear post-FIRE mustachians

This question is for folks living only with index fund investments (this is the route I want to take, so no spouse working, no side job, no rentals, etc).

Say you are FIRE and you need $40K a year to live your early retirement life.  For example, assuming you are living of your dividend and capital gains and you estimate that your taxes for $40K a year would be 5K, do you get $45K so you have money to afford taxes or where is the tax money coming from?  I am mentally challenged in tax matters so please forgive me.

I was debating posting this in the taxes forum but figured that I need examples of folks that are post-FIRE and actually have experience doing this.

Thanks in advance for your insight!

gerardc

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #1 on: November 14, 2017, 12:54:01 AM »
Interesting question, I was wondering the same thing. Let's see.

Note: I'm not directly answering your question of when/how, rather calculating an approximate tax amount using your circumstances; since it is small, I assume you don't need to make payments throughout the year.

Let's assume your $40k is 4% of your $1m stash invested in a taxable account in 100% stock index funds, for simplicity.

Those funds usually yield 2%, and you'll have ~6% capital gains on average on top of that.

So dividend income = $20k.
http://www.moneychimp.com/features/tax_calculator.htm
The tax depends on how much of that is qualified dividends.
If none are qualified, tax = $974.
If $10k+ are qualified (likely), tax = 0.
This is federal tax only; you'd need to account for a little more for state taxes, if applicable. The total amount is still small.

Now, capital gains. This is where it gets interesting.
Assuming you're single and your capital gains are predominantly long-term, you'd be in the 10% tax bracket, i.e. 0% capital gains rate.

But let's assume that for some reason your capital gains rate is 10%, to get an idea of the consequences.
You withdraw $20k every year, and we want to figure out how much is cost basis, and how much is capital gains.
Of course it depends on the accounting method you use for your cost basis -- with specific identification, your gains will vary depending on the lots your pick. But let's assume you use average cost basis, to get an idea of the average capital gains.

Let's also assume that the initial capital gains fraction is 50%; this is the total capital gains "growth" you got on your investments since you started investing. Obviously if your earning career was shorter, or you had worse returns, this will be lower; and vice-versa.
So 50% of $20k = $10k in capital gains -> $1k of taxes.

Over time, in FIRE, the fraction of capital gains in your stash will tend to increase from the initial value (50% in our example). This is because each year, the expected value of your stash increases slightly (say by 1% real after your 4% withdrawals), but the principle always decreases, since your withdrawals eat away at it partially. This means that on average, your total capital gains in your stash will increase, and since you're using average cost basis, the capital gains fraction will tend to increase too, so you'll pay proportionally more taxes. In practice, with 5% real average return and 3% inflation, the capital gain fraction in your stash would go from 50% in year 1, to 53% in year 2, 55.6% in year 3, to 75% in year 13, 94% in year 40, etc., the closer you get to 100% the slower it increases, the closer you are to 0% the fastest it increases (if you start at 0% it increases ~5.8% per year). Anyway, your $1k of cap gain taxes will top out at $2k (inflation-adjusted) after 40+ years. Remember this is all in the assumption of 10% capital gains rate, in practice you'll probably get 0%.

So that's it! Very likely 0 taxes!
« Last Edit: November 14, 2017, 01:13:26 AM by gerardc »

HawkeyeNFO

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #2 on: November 14, 2017, 08:58:15 AM »
OP, run the numbers through some tax software or use taxcaster (google that if unfamiliar).  Your federal taxes should be zero using your scenario.

Frankies Girl

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #3 on: November 14, 2017, 09:27:09 AM »
Been doing this for going on 3 years. No side income, no rentals, just investments. Zero taxes.

The very simple answer is to stay under the 15% tax rate for your situation and you pay zero taxes. So that would be a range of $9,276 to $37,650 for a single filer at this time. If you need more, then you'd pay taxes on that amount over the ~$37K, and likely just take more out in cap gains or sell offs. But as geradc pointed out, some stuff like LTCG are taxed at a lower rate, so you have a bit more wiggle room. It's highly likely you'd pay almost nothing in taxes on $40K generated from dividends/LTCG/selling of funds. If anything, it would be a few hundred not thousands.


http://gocurrycracker.com/never-pay-taxes-again/
^ good reading for this subject matter
I frequently have no idea what I'm talking about. Like now.

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ShortInSeattle

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #4 on: November 14, 2017, 10:44:57 AM »
We use software to forecast our tax liability and withdraw enough to pay it. Think of taxes as just another expense line in your budget.

To put it another way, if you plan to live off 4% of your portfolio, the 4% should include your tax payments.

SIS

MDM

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #5 on: November 14, 2017, 10:53:07 AM »
...where is the tax money coming from?
The same place the milk, bread, and gas money is coming from, wherever that is.

The "4% rule" includes all expenses, and taxes are just another expense.

As others have noted, if much of your income is from dividends and LTCG, federal tax may be $0.  State taxes, depending on the state, may not be.

jim555

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #6 on: November 14, 2017, 12:13:09 PM »
Zero Federal for me.  Qualified divs and LTCG are great things.

dude

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #7 on: November 14, 2017, 12:26:22 PM »
...where is the tax money coming from?
The same place the milk, bread, and gas money is coming from, wherever that is.

The "4% rule" includes all expenses, and taxes are just another expense.

As others have noted, if much of your income is from dividends and LTCG, federal tax may be $0.  State taxes, depending on the state, may not be.

Yep, ^this.  Your expenses ($40k) should include your taxes. I've run a ballpark estimate of what my expenses are pre-tax, then I've gone to a tax calculator to figure out what number I'd need to get to that amount after paying taxes.

My income will come from pension + 401k, so will be taxed at ordinary income rate.

bigote2032

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Re: How do you pay your taxes post-FIRE? Where is the money coming from?
« Reply #8 on: November 15, 2017, 12:00:29 AM »
@gerardc - thanks for taking the time to analyze my case.  A few more details (most you assume right):
* My index funds are 100% stock
* Very likely, all or close to all the dividends will be qualified
* I am using "average" cost basis in all my funds
* I live in Washington state so I don't pay state tax

Follow up question: in the part where you say that I sell index funds to get the missing $20K.  Do I really need to do that? I checked and all my index funds allow me to get a check for capital gains, so if these checks are good enough to make it to $20K I don't need to worry about selling funds right?  In this case I will need to worry about the capital gains tax rate for those checks.

So based on your analysis, taxes, if any, will be minimal.  It's still early for me to think how much I will need every year, will try to do my best to stay in the lower income bracket, but we will see.

@HawkeyeNFO - tax caster looks great, thanks for the recommendation, I will play with it!

@ Frankies Girl - thanks for the insight and great to know I am not the only one doing the index funds only FIRE.  Yes, time will say if I will need to be over the 15% bracket but based on your answer and others, taxes won't be too much if going to next bracket.

@ShortInSeattle - thanks for your comment, yes, I have been checking some tax calculators recommended by some folks here, I will play with them and estimate my total amount including taxes.  I am also in Seattle, but will move out of here when I reach FIRE for sure to minimize costs, some good towns in WA to retire :)

@MDM - yes, I will indeed include it in my planning, BTW, no state tax for me since in WA, thanks!

@jim555 - good deal!!!

@dude - thanks for your suggestion, I will do the same from now on.