Author Topic: 0% income tax in retirement?  (Read 6755 times)

sol

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0% income tax in retirement?
« on: August 13, 2013, 06:13:24 PM »
Please point out any flaws in my plan.
 
In a few years my wife and I will retire from our cushy high paying office jobs.  With a paid off mortgage, our family expenses are about 30k/yr for groceries and bills and vacations, to which I'm planning to have to add the costs of private health insurance (costs unknown yet but I'm figuring 6k/yr from a state exchange after subsidies for being "low income") and property taxes (6k/yr on a 300k home) for a total pretax required income $42k/yr.  We will no longer have childcare or work-related expenses.
 
What's the effective tax rate on 42k/yr?  We live in a state with no income tax.  Our deductions should include:
12k for the married-filing-jointly standard deduction
4k for our one anticipated remaining dependent child
all 6k of the healthcare expenses
4k for the college tuition credit for older child
the 6k for property taxes
500 for state sales tax deduction
 
Totals 32.5k in deductions.
 
To which I expect to be able to add about $15k year in tax free "income" by withdrawing from our Roth IRA principal (tax free) and taxable investment account.
 
32.5k plus 15k is greater than our 42k/yr in anticipated expenses, which means I will have zero income tax liability unless I've grossly miscalculated something, we decide to inflate our spending, or the tax laws change.  If health insurance turns out to be significantly more or less expensive, the tax deduction changes by the same amount so it has no effect on my tax rate.
 
Have I missed any other expenses or deductions that might change the outcome?
 
If I'm doing this right, then it appears I don't really care what federal tax rates do because I'm not going to be paying them.  As long as Congress doesn't butcher the current list of exemptions, I think we can live tax free.
 
 
p.s. and by "tax free", I'm obviously excluding property taxes, long term capital gains, and taxes already paid on invested funds.)
 
 
 

 

velocistar237

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Re: 0% income tax in retirement?
« Reply #1 on: August 13, 2013, 06:37:23 PM »
Sounds about right. You've listed all the deductions I'm familiar with.

My federal taxes are already extremely low, except for FICA, which you won't have.

sol

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Re: 0% income tax in retirement?
« Reply #2 on: August 13, 2013, 06:41:50 PM »
If it's about right, then it seems to be a pretty strong argument in support of maximizing your 401k BEFORE putting anything in your Roth, at least for people who currently pay income tax.

Deferring taxes until you have no tax liability is a better deal than paying high taxes now and then having tax free investments when you don't owe any taxes.
 

 

xocotl

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Re: 0% income tax in retirement?
« Reply #3 on: August 13, 2013, 06:42:25 PM »
12k for the married-filing-jointly standard deduction
4k for our one anticipated remaining dependent child
all 6k of the healthcare expenses
4k for the college tuition credit for older child
the 6k for property taxes
500 for state sales tax deduction
 
Totals 32.5k in deductions.

Property taxes and state sales tax are below the line (itemized) deductions, if I recall correctly. You can't take both those and the standard deduction. You, however, left out your personal exemptions, which for both of you would be about $8k. I don't remember all the details, but for college tuition there are both credits and deductions available (you can only take one at a time). If you can get most of your income to go away with deductions, it should be really easy to wipe out the remainder of your tax liability with a small tax credit, since the small remaining income would be in the 10% bracket.

sol

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Re: 0% income tax in retirement?
« Reply #4 on: August 13, 2013, 06:54:54 PM »
Property taxes and state sales tax are below the line (itemized) deductions, if I recall correctly. You can't take both those and the standard deduction.

You're right, of course.  Can you tell that wife is the one who does our taxes?

That will make it slightly harder to reach exactly 0% income tax liability, but I think it's still possible with a little careful planning and some tax-advantaged accounts to draw on.

Either way, it's going to be a whole lot closer to zero than our current (stupidly high) marginal rate, which is what we pay on all Roth IRA contributions.

velocistar237

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Re: 0% income tax in retirement?
« Reply #5 on: August 13, 2013, 06:55:59 PM »
Property taxes and state sales tax are below the line (itemized) deductions, if I recall correctly. You can't take both those and the standard deduction.

Good point. I just checked, and state sales tax and real estate tax are both on Schedule A.

For sure, if you do end up paying taxes, you'd be in the 10% bracket, so no big deal.

mcneally

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Re: 0% income tax in retirement?
« Reply #6 on: August 13, 2013, 06:59:43 PM »
Your taxes could very well be negative if you claim an education credit.

Medical expenses are deductible to the extent that they exceed 7.5% of your AGI, so after you take that into account, you will be using the standard deduction of $12,200 (2013 figure) if you listed all of your itemized deductions there.

If you have $42,000 in income with a family of 4 and at least $4,000 in education expenses (for a dependent in their first 4 years of college), your federal income tax would be negative $1,000.

DoubleDown

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Re: 0% income tax in retirement?
« Reply #7 on: August 14, 2013, 01:12:36 PM »
I'll bet your estimates are pretty close and even if you do end up paying something, it will be small. Since I use turbotax to do our taxes, I've just used it to play around with future scenarios like this. I think I found that on a $50k/year income, we'd end up paying about $1000 - 2000 in federal taxes. We could then wipe out those taxes with Roth contributions if desired against any small side income.

If you want to get a closer estimate, there are plenty of free tax preparation calculators available. Turbotax is free until you file, so you could use it to play around with different scenarios, in great detail for an exact calculation if you want, all for free.

bo_knows

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Re: 0% income tax in retirement?
« Reply #8 on: August 14, 2013, 01:17:39 PM »
I think that they routinely do these sort of mental exercises on minimizing taxes in retirement over at bogleheads forums. 

This thread really opened my eyes when I first read it: http://www.bogleheads.org/forum/viewtopic.php?t=87471

skyrefuge

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Re: 0% income tax in retirement?
« Reply #9 on: August 14, 2013, 01:56:42 PM »
You've surely read this, but for general sharing and corroboration:

http://www.mrmoneymustache.com/2012/06/04/the-lovely-low-taxes-of-early-retirement/

Quote from: MMM
...the income taxes paid by a family like mine living  on a retirement-level income are still approximately zero. This is why I rarely mention taxes when calculating things like the safe withdrawal rate.

seattlecyclone

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Re: 0% income tax in retirement?
« Reply #10 on: August 14, 2013, 03:16:45 PM »
Your income taxes will be very low, hardly worth worrying about.

As others pointed out, your list of deductions is a bit off. You will receive the following deductions:
* Standard deduction: $12,200 in 2013 (and indexed for inflation in future years)
* Personal exemptions: $3,900 each for yourself, spouse, and dependent children (college students still count as dependents as long as you pay at least half of their expenses). If you have two kids (one in college and one still living at home), that's a $15,600 deduction in 2013 (and indexed for inflation in future years)

The sum of these two means that your first $27,800 of income will be completely free of tax. Past this, your next $17,850 is taxed at 10%. So if you have $45,650 of regular income, you will owe only $1,785 in income tax, or a 4% effective tax rate.

This number only applies if all of your income is "regular income" (i.e. wages, interest, distributions from traditional IRAs/401(k)s, short-term capital gains, etc.). For people in your tax bracket, long-term capital gains and dividends are taxed at 0%. If you have $27,800 or less of "regular income" and the rest of your income comes from long-term capital gains and qualified dividends, you will pay no tax.

But wait, it gets better!

If either of your children are under 17 when you retire, you can claim a child tax credit of $1,000 per child. This is a credit, not a deduction. This means that it subtracts money straight from your tax rather than from your income before calculating the tax. If you have no income from work, the credit is not refundable (i.e. it's limited to the amount of tax you owe before the credit). Even so, having one under-17 child cuts $1,000 off your tax bill.

But wait, it gets better!

There are tax credits for college students, as well. There are two different options here: American Opportunity Credit and Lifetime Learning Credit. The American Opportunity Credit is usually better if your kid qualifies for it. For your income level, this credit will generally be worth $2,500, of which $1,000 is refundable.

For a family of four, with one child under 17 and the other in college, you get $27,800 of income completely tax free, you get non-refundable tax credits for the first $2,500 in tax, and you get a $1,000 refundable tax credit on top of that. This means that if your gross regular income is $50,416, you can subtract $27,800 to get your taxable income of $22,616, which translates into a tax of $2,500, which is negated by your $2,500 in non-refundable tax credits. Then you get a $1,000 refundable tax credit, making your total tax for the year be $-1,000. That's right, you can have income over $50k and pay taxes of negative one thousand dollars.

Remember also that long-term capital gains and qualified dividends are taxed at 0% up to $72,500 in taxable income. This means you could have an additional $49,884 of this type of income on top of your $50,416 of regular income, and still have a total tax bill of $-1,000.

One practical consequence of this for an early retiree is that you should take advantage of your tax-free thresholds as much as possible. Once your kids finish college and no longer qualify as dependents, your threshold for tax-free regular income will get a lot lower (it's only $20k for an under-65 couple with no dependents or tax credits). When you get $50,416 of tax-free regular income, use that limit to its fullest. Roll over part of your 401(k) into a Roth until you get up to that threshold. Sell some stocks that you've had for more than a year until you get to the $49,884 threshold as well. Re-invest the proceeds in the same funds if you wish. There's no sense waiting for next year to realize income when you can do it tax-free today.

seattlecyclone

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Re: 0% income tax in retirement?
« Reply #11 on: August 14, 2013, 03:33:43 PM »
One caveat to what I wrote above is related to the Obamacare insurance premium tax credits. These are on a sliding scale up if your income is less than 400% of the federal poverty line (I think the adjusted gross income is used for this calculation, but I'm not sure). This amount is currently $94,200 for a family of four. Below this level, you'll be eligible for a tax credit for the amount that a typical insurance premium exceeds 9.5% of your income (or an even smaller percentage if your income is low enough). Above this amount, there's a "cliff" where you'll be expected to pay the full cost of your insurance even if the cost of a typical plan exceeds 9.5% of your income. Depending on what insurance ends up costing on your state exchange, you may find it very advantageous to keep your gross income below 400% of the federal poverty limit for your family size.

beltim

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Re: 0% income tax in retirement?
« Reply #12 on: August 14, 2013, 04:54:39 PM »
Property taxes and state sales tax are below the line (itemized) deductions, if I recall correctly. You can't take both those and the standard deduction.

You're right, of course.  Can you tell that wife is the one who does our taxes?

That will make it slightly harder to reach exactly 0% income tax liability, but I think it's still possible with a little careful planning and some tax-advantaged accounts to draw on.

Either way, it's going to be a whole lot closer to zero than our current (stupidly high) marginal rate, which is what we pay on all Roth IRA contributions.

In addition to xocotl's additions, I'd just point out that you can take 72(t) withdrawals from your Roth IRA, so you're not limited to withdrawing principal.  These are also possible for regular IRAs, so if you think you're going to be in the 0% or 10% tax bracket, you're much better off investing in regular IRAs or 401(k)'s instead of the Roth version if you're currently in a higher tax bracket.

aj_yooper

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Re: 0% income tax in retirement?
« Reply #13 on: August 14, 2013, 05:20:04 PM »
seattlecyclone, you are a whirlwind!

MrsPete

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Re: 0% income tax in retirement?
« Reply #14 on: August 14, 2013, 08:55:08 PM »
Do note that the deductions for college expenses are a temporary thing.  Likely you'll file taxes as empty-nesters more years than you'll file as the parents of a college student. 

notquitefrugal

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Re: 0% income tax in retirement?
« Reply #15 on: August 14, 2013, 09:12:35 PM »
If it's about right, then it seems to be a pretty strong argument in support of maximizing your 401k BEFORE putting anything in your Roth, at least for people who currently pay income tax.

Yes. You might consider conservatively doing some Roth conversions from any non-Roth accounts once you're in a lower tax bracket.

sol

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Re: 0% income tax in retirement?
« Reply #16 on: August 14, 2013, 10:03:25 PM »
All very helpful, thanks to the community.

The next time somebody posts here about deciding between traditional and roth options, send them this way.  For most people, traditional looks like the hands down winner.

I was planning on doing Roth conversions anyway as part of the 5 year pipeline method of accessing traditional IRA balances prior to retirement age.  Having a clearer plan for figuring out how much I can convert without paying any taxes (or penalty!) is helpful.

With that in plan in mind, and the above comment about taking 72(t) SEPPs from an IRA, does anybody know what happens to your Substantially Equal Periodic Payments from a traditioanl IRA if you subsequently roll over part of the balance to a Roth IRA?  In my fantasy world, I could set up the 72(t) payments based on the high initial balance in order to maximize the monthly payment, then start rolling over parts of the balance every year to my Roth IRA while keeping the same SEPP amount.  I don't know if SEPPs get recalculated if your balance changes, though, which would void this plan.