Potential spending jump due to taxes later in retirement

[SugarMountain]

As I'm (hopefully) winding down towards, I've been looking more closely at spending, particularly later in retirement.  I've often heard that "taxes go down in retirement".  That may be true for an ER, but that's not always the case and certainly might not be for later in retirement. 

Here's an imaginary portfolio.  It assumes money is in 2018 dollars and that the ACA & tax rates stay the same.
- Married couple, age 50
- $2.5MM stache, $1.25 MM in tax able accounts, $1.25 MM in tax deferred accounts (401k, IRA, not Roth)
- $100k spending
- 4% WR

So for at least the first 9 years, the couple needs to use the $1.25 MM in taxable accounts to cover expenses.  Let's assume half of this money was saved, i.e. already taxed, and half is capital gains.  It throws off 2% dividends & interest, so $25k per year, at least at the start.  That means the couple needs to sell $75k worth of equities to make up the rest.  For the $25k in D & I, maybe $12k in non-qualified dividends & interest, $13k in qualified dividends and half of the $75k is capital gains so $37.5k.

This couple will end up with $0 in Federal income taxes their first year, since the $26k standard deduction will cover the non-qualified dividends & interest, and the qualified dividends and capital gains aren't taxed when AGI is < $77k.

When they hit 59 1/2 they may start to use their IRA/401k money.  Hopefully they don't need to, but it's probably close.  Let's assume their tax able accounts are empty by the time they hit 62 and they move on to use social security and their tax deferred accounts.
 
Now let's imagine they get $25k/year in social security and the other $75k from their IRA/401k.  All of that is taxed as income.  Now instead of $0, the couple is paying $19k x 10% + $55k x 12% = $8,500.  And since they're not medicare eligible yet, they get hit hard by losing ACA subsidies, for maybe another $10-20k depending on the state. 

Definitely seems like something to keep an eye on when doing projections and simulations.  It may make sense to be doing some Roth conversions in their 50s, but they'll want to keep an eye on both the ACA subsidy cutoffs and the capital gains tax cutoffs (and probably some simulations on how much paying taxes when doing the conversions will cost them over the long term).

[ixtap]

In your scenario, this couple saved up 2.5 million by 50 but were eligible for traditional, deductible IRAs their whole careers and are now eligible for less than average social security? All while spending $100k above and beyond payroll taxes?

[Laura33]

I think the key is the $77K threshold for 0% CGs.  Many MMMers plan to RE on well less than $100K/yr.  So as long as your annual income needs keep you below the $77K threshold, you're in like Flynn.  It's only if you find yourself at the point of needing at least $77K from taxable sources that you get into trouble.  This is also the value of the Backdoor Roth, to have that completely untaxable pot of money to make up shortages without tripping some tax threshold.

In addition, I expect that even in the given scenario, taxes will still be lower than they were pre-retirement.  A couple who has managed to build a $2.5M nest egg by 50 were very likely high earners for many years and so probably were paying some pretty high income taxes during those years.  So even if they paid some tax now, it's still likely a lot less -- just not zero.

I also agree with ixtap.  By comparison, I had several years where I didn't have access to a 401(k), but I have also been able to sock away extra profit-sharing for the past @13-14 years.  And my 401(k)/IRAs just hit $1M around the time I turned 50.  Many places didn't even offer 401(k)s when many current 50-yr-olds began working, and many that did didn't offer awesome matches.  So a couple with those numbers would very likely have Roth IRAs instead of tIRAs, and would also have probably double the assumed SS benefits (either from two workers or from one full worker and one spouse at 1/2 pay), even accounting for the cuts for taking early at 62.

OTOH, I do agree that what this illustrates is that you need to start thinking about tax planning 5+ years before you RE -- and you should not assume that all of your savings will be available for you to spend without considering those tax impacts.

[Calvawt]

I think a lot of times when people say lower taxes in retirement they are also factoring in the lack of payroll taxes (SS and Medicare are 6.2% and 1.45%).  Income tax really depends on your distributions, strategies, etc.

[Bateaux]

The scenario does somewhat fit our current situation.  I'm 49 and our combined NW is almost as much.  We'll no doubt pay less taxes than we currently do on earned income.  I'd doubt we'll spend that much in retirement and since we likely won't we may just write big checks to our charities if situations such as required minimum distributions come into play.

[UnleashHell]

nothing to stop you doing a sep(72)t drawdown from the 401k's at 50 and use that as part of your income. That will then preserve the post tax investments for later and smooth it out.

[dude]

I'll actually be in a similar situation in retirement. Between pension + RMDs + SS, it's very likely I'll be taking home more money at age 70 than I did when I was working. Am planning to try to convert trad 401k money to Roth IRA after I retire next year.

[boarder42]

you should use something like the i-orp calculator to help you maximize your whithdrawal strategies.  and pulling from the 1.25MM the first 9 years isnt a MUST.  72t and roth conversions / previous contributions / roth ladder could work as well.

[TheWifeHalf]

THH and I are are at  5:1, tIRA/Roth. He is going to retire in January, at 62, but not file for Social Security until he is 70. We are going to use those years to convert the tIRA to Roth. We will use our taxable accts to live on, cap gains tax be damned.

I have the DNA that makes us think I might make it to 95. If he goes at 85, that's 10 years taxed as a single.
We feel that the higher cap gains tax is still going to be better than if it's taxed at as single later. 
If we don't make it that long, yeah for the kids!!!!

[MDM]

you should use something like the i-orp calculator to help you maximize your whithdrawal strategies.  and pulling from the 1.25MM the first 9 years isnt a MUST.  72t and roth conversions / previous contributions / roth ladder could work as well.

+1

Yes, see Optimal Retirement Planner - Extended Parameter Form.

SugarMountain, don't be surprised if it suggests traditional->Roth conversions well past the standard deduction amount.  Paying 10%, 12%, or even 22% now is better than paying 24% or even 22% later, particularly when taxes on those conversions can be paid from cash on hand, as you can.

[SugarMountain]

In your scenario, this couple saved up 2.5 million by 50 but were eligible for traditional, deductible IRAs their whole careers and are now eligible for less than average social security? All while spending $100k above and beyond payroll taxes?

1) Not sure where I said they contributed to deductible IRAs their whole careers. Previous job 401k's can get rolled into IRAs regardless of contribution eligibility.  And rich 50 year olds probably weren't so rich at 25.
2) The Social Security # was if they started taking at 62.  And if they stop contributing at 50 and didn't make that much from 20-40, they may have only max contributed for 10 years.  Remember, social security calculation is based on your best 35 years.  If you look at your "estimated benefit" that comes with your statement, it's assuming you are making at least what you currently are all the way to 67 I believe.

[SugarMountain]

In addition, I expect that even in the given scenario, taxes will still be lower than they were pre-retirement.  A couple who has managed to build a $2.5M nest egg by 50 were very likely high earners for many years and so probably were paying some pretty high income taxes during those years.  So even if they paid some tax now, it's still likely a lot less -- just not zero.

Right, I'm sure our income taxes will be way lower, possibly even $0 initially when we retire.  My point is more that they will quite likely go up once we start withdrawing from our tax deferred accounts and get social security. This is something I really hadn't been thinking about.  Originally, I had been estimating taxes immediately after retirement higher than they likely will be.  But as I came around to the realization that they'd be quite low initially I eventually realized they'll be higher later in retirement and this really isn't reflected in the various firecalc/cfiresim/fidelity simulators. 

So if we start at $100k spending and that's it because taxes are $0, not only are we going to get hit with inflation, but increased taxes later in life and this has implications when considering the 4% rule of thumb.  Even if we manage things during a roth conversion so that it gets taxed at 10%, it has implications to the over all stache value.

[Scandium]

S

In your scenario, this couple saved up 2.5 million by 50 but were eligible for traditional, deductible IRAs their whole careers and are now eligible for less than average social security? All while spending $100k above and beyond payroll taxes?

This couple managed  to save up $2.5M by 50 while spending $100k per year, after tax? So they probably made $250k, putting them in the 33% tax bracket while working (current rates). So since OP's calc puts them in the 12% bracket now that's quite an improvement IMO. So yes indeed; taxes are lower in retirement. Obviously you still have to account for taxes, which vary depending on your spending level. You only need $25k/year you can probably assume zero tax. You need $100k? No you will have to pay some tax. I'm pretty sure everyone here are well aware of this so not sure what the revelation was?

[SugarMountain]

S

In your scenario, this couple saved up 2.5 million by 50 but were eligible for traditional, deductible IRAs their whole careers and are now eligible for less than average social security? All while spending $100k above and beyond payroll taxes?

This couple managed  to save up $2.5M by 50 while spending $100k per year, after tax? So they probably made $250k, putting them in the 33% tax bracket while working (current rates). So since OP's calc puts them in the 12% bracket now that's quite an improvement IMO. So yes indeed; taxes are lower in retirement. Obviously you still have to account for taxes, which vary depending on your spending level. You only need $25k/year you can probably assume zero tax. You need $100k? No you will have to pay some tax. I'm pretty sure everyone here are well aware of this so not sure what the revelation was?

The revelation is that said couple will likely have $0 in taxes for a number of years, even at $100k in spending, however that will increase to $5-10k later in retirement.  So if said couple were strictly planning on following the 4% rule, they might get surprised in their 60s when their inflation adjusted spending level also gets hit by tax increases.

Really, I had two revelations. First, that we might be able to pay $0.00 in Federal Income tax for a number of years, and second, that will eventually stop when we have to pay income tax on tax deferred accounts and social security. (Now once we start getting social security it will likely offset the taxes on the IRA/401k money.)  Basically, previously I was modeling too much spending on taxes, and then modeling not enough in taxes.

For the couple it may look like this (again 2018 dollars and the years are not necessarily exactly when these things would occur, depends on when they hit their tax deferred accounts and start getting social security):
2017 - 6 figures during accumulation
2018 - 6 figures during accumulation
2019 - $0.00 in taxes ($100k comes from cash on hand, harvesting capital losses to offset capital gains, $25k in dividends and interest, $26k deduction, $0 in taxes)
2020 - $0.00 in taxes  ($12.5k interest/non-qual div, $12.5k qual div from taxable acct, $50k of stocks sold mostly already taxed, $25k capital gains. after $26k deduction = $0)
2021 - $0.00 in taxes ($12.5k interest/non-qual div, $12.5k qual div from taxable acct, $50k of stocks sold mostly already taxed, $25k capital gains. after $26k deduction = $0)
.
.
.
2030 - $7,500-8,000 in taxes ($75k IRA/401K, $25k social security. $100k taxable ordinary income-$26k std deduction leaves $74k at 10-12%.)

So it seems that the trick will be to maximize converting to roth in our fifties, but need to avoid ACA cutoffs, and capital gains cutoffs.

[Daisy]

you should use something like the i-orp calculator to help you maximize your whithdrawal strategies.  and pulling from the 1.25MM the first 9 years isnt a MUST.  72t and roth conversions / previous contributions / roth ladder could work as well.

boarder42, you are a wealth of good information. All of my time on this forum, I have never seen a reference to i-orp. Now I found a new way to waste time optimizing FIRE.

I went to the website but there were currently gateway errors so I will try again later.