Taxes as an expense in FIRE math/WR calculations?

[2Birds1Stone]

DW and I were W-2 employees our entire accumulation phase, therefore taxes always came out before our income hit our tax deferred accounts and bank on payday. We always calculated savings rate based on a combo of net/tax deferred income.

This is the first year we have no earned income, and no tax withholdings. I just finished our 2024 taxes and we owe the Fed and state.

I'm wondering how to count this in our spreadsheets. I understand that it's an actual expense in retirement and won't get paid out of thin air......but it does mess up the consistency of our WR%/Expense math.

Curious how others account for taxes pre/post retirement and work it into their charts/projections.

Thanks in advance.

[shuffler]

You were doing it wrong before.  It's been an "actual expense" all along.
You have all the data.  You know your gross pay each year and how much you paid in taxes.
Go back and re-do your numbers from past years so they're correct.
Then it'll all be consistent/comparable.

[2Birds1Stone]

You were doing it wrong before.  It's been an "actual expense" all along.
You have all the data.  You know your gross pay each year and how much you paid in taxes.
Go back and re-do your numbers from past years so they're correct.
Then it'll all be consistent/comparable.

I understand what you mean and why, but nearly every single FIRE blogger, forum member with a detailed monthly earning/expense report, article on the topic excludes the w-2 taxes from FIRE calculations because for most of us it would make the rest of our expenses negligible.

Otherwise, the whole "Shockingly Simple Math Behind Early Retirement" blog post MMM did in 2012 would be almost useless. No one that has decent earnings is going to have a 50-80% savings rate when their effective tax right might be 20-40%.

[shuffler]

Heh, perhaps saying "wrong" was a bit strong on my part.  ;)

I guess it depends on what you're trying trying to measure, and why you want it to be "consistent"?

If you literally want to measure expenses (in the sense that we mean them when we say things like "withdrawal rate" as in your post), then it really should include taxes and it's likely going to be discontinuous around the year you FIRE'd.  Maybe also later in life, if you're doing forward projections, when RMDs kick in.  That's fine.  I feel like this is the measure that most retirees want, because they want to compare against the canonical 4% yardstick.  I do this in retirement, and it was the basis of my first response.

If you want to measure something more akin to "household spending" (intentionally exclusive of taxes) as either a dollar amount or as a % of NW, then go ahead and do that.  It's more likely to be consistent year to year, and is easily comparable to pre-FIRE years.  It'd be a fine way to check your spending, but I wouldn't use it (in isolation) as a measure of FIRE health.

If you want to go crazy, you could do something like taking the amount of "household" (tax-exclusive) spending you did in pre-retirement years, and then estimate how much taxes you would have had to pay to support that level of spending as if it were a retirement year.  Then you could figure ([Non-tax spending] + [Estimated Taxes])/[Net Worth] for each of those past years. 
But it seems like more trouble than it's worth to me.

So what do you really want to measure, and why?  And why do you want it to be consistent back through pre-FIRE years?

No one that has decent earnings is going to have a 50-80% savings rate when their effective tax right might be 20-40%.

Not that it matters, but looking back, I can say that we met this mark.  Mid-six-figures, ~22% fed, no state tax, ~4% SS & Medicare, ~15% household spending == 41% expenses == 59% savings rate.  Heh, maybe "mid six figures" isn't decent enough income.

[NotJen]

Pre-FIRE I always included taxes in my spending.  It was my biggest expense - seemed weird to ignore it!  I also calculated a post-tax savings rate to me feel better, but it didn’t change the math at all.

When determining my post-FIRE spending to get my 25x number, I included taxes.  I assumed every dollar I spent (minus std ded) would be taxed as income tax, which I consider to be conservative because I have a mix of investments - some will be taxed as income, some as cap gains, some not taxed as all. Plus a few little deductions.

My FIRE spending had about $3k per year allocated for taxes.  In reality, it’s been $0 Fed each year and $700 or less for State. Just another category I’m underspending so far!

[bluecollarmusician]

Hey @2Birds1Stone

I don't think there is a "perfect" answer, and I really think a lot of it comes down to whatever Jedi Accounting you want to use.

After FIRE, or at least after leaving W-2 work those tax payments take up a much bigger piece of the pie on the spending graph- and I am sorry to say I don't have an elegant answer to your question.

With no earned income, surprised you all had a tax liability- going forward with a little thought/experimentation I bet you could maintain income and minimize this given how favored capital gains and dividends are.  I think you can have something like 125k in income and as long as 30 or less of it is "regular" income (interest, earned, etc.) you owe 0 in tax.  It's crazy.

Rando question- how did you account for tax refunds when/if you ever got them?

I am sure you have played with it... but I like this calculator:
https://engaging-data.com/tax-brackets/

[Sandi_k]

We have always started with our gross income, and included all taxes as expenses. I have also calculated all saving as a percentage of GROSS income, never net.

It was a revelation to me about 5 years ago, when I realized that we would NOT be in a lower tax bracket in retirement, and I would NOT be able to control our income. With a pension and two Social Security checks, that is non-controllable. What I COULD do was to start to convert some of our traditional retirement savings into Roth accounts, which would help us in terms of which IRMAA tier we'd be in.

In retirement, after this year of partial employment, I expect taxes to be our #1 expense (27.5% of gross income), then housing (22.5%).

[GilesMM]

Depending on how much you withdraw in retirement from where you withdraw it, your income tax could range from 0% up to nearly 50% adding in high state taxes.  And then there is property tax which can vary from almost nothing to 3% of current home value.  And sales taxes, which can be 0% in some states to nearly 10% in the worst cases.

[Ron Scott]

Treat taxes like food. It’s an expense period, no “it depends”.

[Telecaster]

Otherwise, the whole "Shockingly Simple Math Behind Early Retirement" blog post MMM did in 2012 would be almost useless.

The blog post is wrong, for the reasons discussed above.  But I wouldn't say almost useless.   Most people's taxes go way down in retirement, so you don't have to replace that portion of your income (at least not entirely).  And you don't have to replace that portion of your income that you saved when you were working.   So, it is technically wrong, but a good first approximation.

[VanillaGorilla]

The first $94,000 of long term capital gains is federally tax free. So depending on your state and asset allocation, many people should pay zero in federal taxes when living off their portfolios.

For you to owe federal taxes means either you're invested in assets whose returns are not treated under long term capital gains rules, or you realized more than $94k in cap gains. The latter seems unlikey, so @2Birds1Stone , do you mind sharing some details? Did you earn a lot in money market interest that's taxed as income? Or realize REIT distributions that are also treated as income?

In California LTCP are taxed as income. In early years of retirement I guesstimate that I would withdraw roughly 50% principle and 50% gains, so my tax rate would be roughly 6% on 50% of my withdrawal, so an effective tax rate of 3%. That's small enough to seem negligible. Other states are even more amenable, so ignoring taxes in a FIRE context has never seemed like an unjust exaggeration to me.

[2Birds1Stone]

For you to owe federal taxes means either you're invested in assets whose returns are not treated under long term capital gains rules, or you realized more than $94k in cap gains. The latter seems unlike, so @2Birds1Stone , do you mean sharing some details? Did you earn a lot in money market interest that's taxed as income? Or realize REIT distributions that are also treated as income?

You nailed it, we had ~$24k in interest payments from CD's/MM that were paying attractive rates before the rate cuts (RIP), ~$8k in ordinary dividends, and ~$8k Roth IRA Conversion for a total AGI of ~$40k.

We "reside" in a state with income tax (NY) with a standard deduction of $16k, so well below the federal one ($29.2k).

We didn't realize any capital gains, because in NY we need to keep AGI <~$50k for some really awesome free health insurance that's above Medicaid but keeps us off the typical ACA exchange plans.

Our total tax liability was ~$600 fed and ~$900 state. So not a huge liability, and at $1.5k will be about 2.5-4% of our total spending for the year.

This was more of a thought exercise in case future years we don't need/want the NY health insurance and possibly make larger Roth conversions or have higher tax liabilities for other reasons.

Otherwise, the whole "Shockingly Simple Math Behind Early Retirement" blog post MMM did in 2012 would be almost useless.

The blog post is wrong, for the reasons discussed above.  But I wouldn't say almost useless.   Most people's taxes go way down in retirement, so you don't have to replace that portion of your income (at least not entirely).  And you don't have to replace that portion of your income that you saved when you were working.   So, it is technically wrong, but a good first approximation.

That makes sense......in our situation, the last 5-6 high earning years, our fed/state taxes were WAY higher than our combined spending on everything else. So it also does seem silly to say we "dropped our spending" by 50%+ in retirement just because we no longer have to pay taxes on W-2 income.


@Ron Scott, I guess, but we could have forgone the Roth IRA conversion and been at ~$0-500 tax liability, I can't say the same for feeding two highly active adults.

@GilesMM, we're on the leaner side of FI and have most of our assets in after tax accounts so it should be a lot closer to 0% than 50% most years.

@Sandi_k, right on. I've always been aware that the tax man is taking huge chunks of my income, but as a W-2 employee with no itemized deductions during my entire working career, there wasn't anything I could really do about it, so we always used net income, assuming (mostly correctly) that we would pay little to no taxes in early retirement.

@bluecollarmusician, yea as I shared above with VG, we had quite a bit of interest this year from high interest CD's. I'm moving some of those funds into VUSXX as they mature to avoid taxes on the fed side of things. NY will continue to take their <$1k/yr until we igure out a better state residency solution. For now the health insurance we get is worth the bill to be a resident, that can change though......I didn't have too much time at the end of the year to run every scenario.

@NotJen, thanks for sharing your accounting methods. This is exactly the type of info/feedback I was looking from folks who have been on both side of the work/retirement line.

@shuffler, yea I think I was looking for more consistency in the pre/post math. My 2024 tax liability doesn't skew the numbers too much, as pointed out above, the liability was only $1.5k on ~$40k in income, and our spending is going to fall somewhere around $50-60k for the year (maybe less if history repeats itself). But I was wondering in terms of future years where maybe we do bigger roth conversions or just in general for folks who do end up calculating a net savings/WR and then end up with bigger tax liabilities for whatever reason. I know someone like @chasesfish did huge Roth conversions upfront the past few years to minimize lifetime tax liability, so the spending would get waaaay skewed those years......for the benefit of the long term.

@All, I do realize it's all mental accounting/finessing the charts/graphs. Taxes are absolutely an expense, our bill was six figures our last few working years.......it stung, so I used net savings rate to feel better about getting shafted with no lube.

[achvfi]

Our total tax liability was ~$600 fed and ~$900 state. So not a huge liability, and at $1.5k will be about 2.5-4% of our total spending for the year.

Yep, this is exactly what I was thinking. For a couple who spends about median household income with diverse set of funds spread between taxable and tax advantaged accounts, retired early with little to no wage income. Taxable gains are taxed at 0% if income stays in 12% bracket. You could spread Roth conversions over time. Tax liability should be just a few percent of spend.

If a couple also has children, tax credits will likely cover tax liability. Just a little bit more than you need in a portfolio can cover it and tax liability should not be a big deal.

[MrGreen]

I'm going to give you a different take on this. We could support our lifestyle with a fairly low taxable income each year. If a significant percentage of your stash is in tax-deferred accounts, the challenge with this approach is that you're going to pay the piper when RMDs hit. Perhaps you aspire to donate tons of money so you don't care about this. However, we also recognize that life is unpredictable so having access to more of our money by shifting it from tax-deferred to after-tax is worth paying a little bit of tax. Right now, my modeling for our specific scenario indicates that 10% in total taxes is a good target. So unless we're aware of significant medical expenses on the horizon that could benefit from the lower deductibles and max out-of-pockets that come from ACA insurance plans under 150% or 200% FPL, we generate enough taxable income each year such that the sum of state and federal taxes, and ACA insurance premiums (which we treat as a tax) are about 10% of that income. In 2025 that is projected to be an AGI of 90k, with us paying 9k in taxes. This is outside of the amount we take for living expenses annually, though we look at the gross figure including taxes when considering our withdrawal rate.

In the end, AGI is fairly decoupled from living expenses. We might spend 50-60k in 2025, including all our travel, then add 9k in taxes on an AGI of 90k. The bulk of the income is Roth conversions so in the end we're moving that money to a bucket that is available after 5 years. We are young enough that this will accumulate to hundreds of thousands of extra dollars available to us in our 50s when there would otherwise still be a tax penalty. And if we choose to leave someone money when we die, the smaller the tIRA bucket is the better now that inherited IRAs have to be completely withdrawn in 10 years. I imagine working a job and needing to clean out a large figure inherited IRA will create quite a large tax bill.

If most of your money is already in after-tax accounts you can probably disregard everything I just wrote.

[2Birds1Stone]

@GilesMM, we're on the leaner side of FI and have most of our assets in after tax accounts so it should be a lot closer to 0% than 50% most years.

I'm going to give you a different take on this. We could support our lifestyle with a fairly low taxable income each year. If a significant percentage of your stash is in tax-deferred accounts, the challenge with this approach is that you're going to pay the piper when RMDs hit. Perhaps you aspire to donate tons of money so you don't care about this. However, we also recognize that life is unpredictable so having access to more of our money by shifting it from tax-deferred to after-tax is worth paying a little bit of tax. Right now, my modeling for our specific scenario indicates that 10% in total taxes is a good target. So unless we're aware of significant medical expenses on the horizon that could benefit from the lower deductibles and max out-of-pockets that come from ACA insurance plans under 150% or 200% FPL, we generate enough taxable income each year such that the sum of state and federal taxes, and ACA insurance premiums (which we treat as a tax) are about 10% of that income. In 2025 that is projected to be an AGI of 90k, with us paying 9k in taxes. This is outside of the amount we take for living expenses annually, though we look at the gross figure including taxes when considering our withdrawal rate.

In the end, AGI is fairly decoupled from living expenses. We might spend 50-60k in 2025, including all our travel, then add 9k in taxes on an AGI of 90k. The bulk of the income is Roth conversions so in the end we're moving that money to a bucket that is available after 5 years. We are young enough that this will accumulate to hundreds of thousands of extra dollars available to us in our 50s when there would otherwise still be a tax penalty. And if we choose to leave someone money when we die, the smaller the tIRA bucket is the better now that inherited IRAs have to be completely withdrawn in 10 years. I imagine working a job and needing to clean out a large figure inherited IRA will create quite a large tax bill.

If most of your money is already in after-tax accounts you can probably disregard everything I just wrote.

I totally get that logic, and have been following closely in your journal and @chasesfish who is also doing this (he actually Roth Converted huge chunks the past few years).

We're only ~31% tax deferred, so we can do Roth Conversions very slowly and move this over the next 35 years, which is how long I have till we have to worry about RMDs.

[MrGreen]

@GilesMM, we're on the leaner side of FI and have most of our assets in after tax accounts so it should be a lot closer to 0% than 50% most years.

I'm going to give you a different take on this. We could support our lifestyle with a fairly low taxable income each year. If a significant percentage of your stash is in tax-deferred accounts, the challenge with this approach is that you're going to pay the piper when RMDs hit. Perhaps you aspire to donate tons of money so you don't care about this. However, we also recognize that life is unpredictable so having access to more of our money by shifting it from tax-deferred to after-tax is worth paying a little bit of tax. Right now, my modeling for our specific scenario indicates that 10% in total taxes is a good target. So unless we're aware of significant medical expenses on the horizon that could benefit from the lower deductibles and max out-of-pockets that come from ACA insurance plans under 150% or 200% FPL, we generate enough taxable income each year such that the sum of state and federal taxes, and ACA insurance premiums (which we treat as a tax) are about 10% of that income. In 2025 that is projected to be an AGI of 90k, with us paying 9k in taxes. This is outside of the amount we take for living expenses annually, though we look at the gross figure including taxes when considering our withdrawal rate.

In the end, AGI is fairly decoupled from living expenses. We might spend 50-60k in 2025, including all our travel, then add 9k in taxes on an AGI of 90k. The bulk of the income is Roth conversions so in the end we're moving that money to a bucket that is available after 5 years. We are young enough that this will accumulate to hundreds of thousands of extra dollars available to us in our 50s when there would otherwise still be a tax penalty. And if we choose to leave someone money when we die, the smaller the tIRA bucket is the better now that inherited IRAs have to be completely withdrawn in 10 years. I imagine working a job and needing to clean out a large figure inherited IRA will create quite a large tax bill.

If most of your money is already in after-tax accounts you can probably disregard everything I just wrote.

I totally get that logic, and have been following closely in your journal and @chasesfish who is also doing this (he actually Roth Converted huge chunks the past few years).

We're only ~31% tax deferred, so we can do Roth Conversions very slowly and move this over the next 35 years, which is how long I have till we have to worry about RMDs.

Sorry, I missed that comment to GilesMM. You're in the butter zone then. Low/no taxes 4 life! Lol

[Maximus28]

I think you could save some money on state taxes if you held treasuries instead of cds and money market. SGOV is a 0-3 month treasury bond ETF that could replace money market funds in your post tax cash allocation. The interest earned from US treasury bonds should be tax exempt at the state level.

Somewhere around 96% of SGOV is attributable to US government obligations. So about 96% of SGOV dividends would avoid state income tax.

[2Birds1Stone]

I think you could save some money on state taxes if you held treasuries instead of cds and money market. SGOV is a 0-3 month treasury bond ETF that could replace money market funds in your post tax cash allocation. The interest earned from US treasury bonds should be tax exempt at the state level.

Somewhere around 96% of SGOV is attributable to US government obligations. So about 96% of SGOV dividends would avoid state income tax.

Thank you, I have been shifting all of my CD's to VUSXX as they mature. I am pretty sure it's mostly Fed and NY state tax exempt.

Edit to Add: 97.9% treasuries as of todays date, I do know it dropped to like 80% a few years ago......not sure if that can/will happen again in the future.

[2sk22]

When my wife (eventually) retires, this is what we will definitely be paying taxes on:
- Dividend income in our taxable brokerage accounts ($50k)
- Interest income: about $10k

Also if I need to sell shares from our brokerage account, I will be able to minimize capital gains taxes by selecting lots (probably pay nothing).

The unknown part is how much tax we are going to pay when and if we start doing Roth conversions. I'm still on the fence about whether to do Roth conversions but, thankfully, I don't have to make any decision right now.

[bluecollarmusician]

Circling back on this, as it's something I have given some thought to (so thanks for the good question @2Birds1Stone )

I am not sure if I ever answered your questions directly:  how do you handle it; basically our "taxes" paid portion of spending went up considerably after leaving my W-2 job, and I just added it as an expense. But I do plenty of mental juggling to compare prior years...

While I understand @Ron Scott 's point about expenses, I think that all expenses are not the same. Food is a consumption expense, and taxes are a production expense.  While not a capital expense, they are really just a cost of doing business.  I don't know if that make sense or not, but regarding how I consider it in our spending picture I recognize that our taxes are generally higher when our income is higher and this is a somewhat unavoidable cost of doing business and is directly correlated with income and not expenses.  I.e. while our taxes might be higher in the future, under current laws our taxes will not be more unless our income goes up (by quite a lot.)

In this regard, food and taxes are both expenses but not the same. 

Maybe a way you could handle this in order to keep your "numbers' consistent from year to year is to take it off your income side.  Treat it as negative income rather than as an expense on your accounting: this way it is correlated with income and not expenses.  And your expenses, core spending, household spending or what have you will be consistent from year to year?

I totally understand your desire to continue tracking in a way that is consistent so you can model how things go and change over time.  I do think regarding the income side of things it's easiest just to track everything as it is: Dividends are Dividends, interest is interest,  GC's are CG's, earned income is earned income, etc.  And much of the mental juggling people do is to make it make sense in their own minds (I.e. "I treat my house like a bond, or my annuity, or my pension or whatever." ) It is what it is, however they all have like and unlike characteristics.

And in the end, I do really think with your current plan as I understand it and with a little tax planning (def think that some NY state tax-free bonds or the like) you will find that your tax burden is just a small additional blip on your spending radar.

[Car Jack]

I've talked about X as in 25X for 4% to be defined as Retirement Spending.  And this includes everything you spend money on including taxes.  I know it's an estimate before you retire and it can vary widely IN retirement.  I'll give you me as an example.

For 2024, I had about $10k in interest, dividends, tradeline sale money, zero long term cap gains and $200k in Roth conversions.  Federal tax about $30k, state, $10k.

For 2025, I'm going opposite world.  I'll do just under $100k in Long Term Cap gains, and $30k in Roth conversions, interest, tradeline sales and dividends.  My fed tax will be zero.  State $5900.

So yah, tax is in my spending.  And depending on what I'm doing for the year on the tax strategy line will make a huge difference in spending. 

[Retire-Canada]

When figuring out my WR and WR% I use planned spend and expected taxes combined. At retirement that was $40K spend and $6K taxes so $46K total WR per year. I was shooting for a 4%WR so I needed $1.15M to pull the plug.

Ultimately your portfolio doesn't know or care if you take out $1 to pay taxes or $1 to buy a taco.

[2Birds1Stone]

When figuring out my WR and WR% I use planned spend and expected taxes combined. At retirement that was $40K spend and $6K taxes so $46K total WR per year. I was shooting for a 4%WR so I needed $1.15M to pull the plug.

Ultimately your portfolio doesn't know or care if you take out $1 to pay taxes or $1 to buy a taco.

If only $1 got us a to(Yoda) (Taco)ma.

[Retire-Canada]

If only $1 got us a to(Yoda) (Taco)ma.

I mean I'd be pretty happy if $1 bought a soft taco these days!**

** - a real taco not Taco Bell junk food.

[swashbucklinstache]

Another option:
Count only taxes on dividends, interest, and capital gains as expenses both before and after retirement. You just probably had zero capital gains. I think this works well enough for your pre/post mix as long as your stache doesn't explode in size. To the point where the above is several multiples of your life expenses. That would be my preference. I'd do it for WR calculations but mentally throw it in the same "too much money problems" bucket of RMDs.

Another version of this, perhaps simpler, is just applying an approximate tax modifier to your stache value now e.g. multiply by .92 then ignore taxes later for WR purposes. That works for your slow and steady Roth conversion plan.  It solves the "problem" of your stache growing at the cost of underestimating taxes, which either corrects itself if you spend more or just doesn't matter at all. It fits nicely on a napkin / at a glance.

Of course none of these are superior to a full cash flow plan for the next 50 years. But that's not too valuable either for something like this.

[bluecollarmusician]

I've talked about X as in 25X for 4% to be defined as Retirement Spending.  And this includes everything you spend money on including taxes.  I know it's an estimate before you retire and it can vary widely IN retirement.  I'll give you me as an example.

For 2024, I had about $10k in interest, dividends, tradeline sale money, zero long term cap gains and $200k in Roth conversions.  Federal tax about $30k, state, $10k.

For 2025, I'm going opposite world.  I'll do just under $100k in Long Term Cap gains, and $30k in Roth conversions, interest, tradeline sales and dividends.  My fed tax will be zero.  State $5900.

So yah, tax is in my spending.  And depending on what I'm doing for the year on the tax strategy line will make a huge difference in spending.

Hi @Car Jack your point about variability of tax is an excellent argument for why the tax portion of expenses can/should be viewed differently than other expenses when determining X- as variability in income and NOT variability in consumer spending/lifestyle costs is the driver of the change.

As is said frequently- every person has a somewhat unique situation.  I don't think anyone has or would suggest that income taxes are not an expense that you need to account for- I think the point that's interesting is how to thoughtfully account for it for people who track spending closely from year to year.

[Sandi_k]

If only $1 got us a to(Yoda) (Taco)ma.

I mean I'd be pretty happy if $1 bought a soft taco these days!**

Our local strip mall joint does Taco Tuesday, where small tacos are $1 each. DH and I can order 3/2 tacos each, plus a Topo Chico, and get out of there for $13, even including a generous tip.

[leevs11]

Your total taxes paid should be a part of your overall expense calculation. The tricky part is that they should be much lower than what you are paying now once you don't have a W2 income. They will also be partly based on contributions which aren't taxed and partly based on capital gains, which are. So it's hard to predict.

Or are you just asking about the specific extra amount paid this year due to underwitholding? I just include that as negative Income in my current budget calculations.