Struggling with all the tax calculations for early retirement

[poker-wont-help-me-fire]

I am finding it EXTREMELY complex to calculate/optimize what taxes will be during early retirement.  I am still at least a few years out, but I want to understand the best strategy. Here’s what I am figuring so far (numbers are just for illustrative purposes):

Let’s say I retire in January with $2 million, divided as follows: $100k in cash, $900k in taxable brokerage accounts (let’s say 50% of which is gains), $800k in tIRA and $200k in Roth. I have a family of 3, with 1 dependent child of 6 and 2 adults 42 and 45. I need $80k per year for my expenses.  I plan on using the ACA exchanges and getting subsidies for healthcare. 

Our standard deduction as a married couple is $29,200, so I can convert this amount of my tIRA to a Roth in 2024 without paying any Federal taxes.  But I would still need $80k for my living expenses after I did this. 

I would get about $12k in qualified dividends from my $900k taxable brokerage account.  In order to get the other $68k I need for the year, I could take $20k from cash and sell another $48k in stock from my brokerage account.  This would mean I would have $36k in capital gains ($12k in dividends plus 1/2 of $48k).  This would also be tax free, since up to $94,050 of capital gains are tax free for a married couple. 

My income for the year would be $65,200, and I wouldn’t pay any taxes on it.  I could theoretically sell more stock to harvest more gains tax free, but that would mean my ACA subsidies would be less.  At an income of $65,200, I get a subsidy of $819 per month and a silver family plan would cost only $244 per month. Each additional dollar of income would lessen my ACA subsidy.

Are all of these calculations and assumptions correct?

I don’t really know how to juggle the following: Child tax credit, savers credit, EITC. It seems if we work a little bit, we might be able to qualify for these credits, but we’d have to keep our income really low, which would mean utilizing more of our cash and less of our taxable investments, which means cash would only last for a few years before we ran out.

Also, part of our expenses would be our mortgage which is at 2.5% and which we’d still owe $300k on at retirement.  We could pay off the mortgage in one chunk, which would lessen our monthly bills by $1,300.  This would give us a lot more flexibility in retirement, and increase our ability to qualify for various credits.  But our funds would be seriously depleted and we’d be paying off a very low interest mortgage…

[MDM]

Have you seen Roth Conversion and Capital Gains On ACA Health Insurance?  If not, that might be helpful - is it?

[SeattleCPA]

I think you're overthinking and over-worrying.

Some observations:

You can draw on your tIRA and basically have the withdrawal sheltered by your standard deduction. E.g., if you draw $30K a year from that, that income will get sheltered by the roughly $30K standard deduction. Thus you do not need to do Roth conversions. You'll be draining the tIRA account without paying taxes anyway.

The qualified dividends and long-term capital gains on your brokerage account--if you're investing in a tax efficient way like by using cheap stock index fund--would be taxed on 0% tax returns.

P.S. I can't imagine it makes sense to pay off a 2.5% mortgage when you could instead invest in 5%-ish treasuries.

[Josiecat22222]

@SeattleCPA- I'm a bit confused by your answer, but I suspect I am missing something.  You stated that OP could shelter approx 30K annually by withdrawing from tIRA directly as it is covered by standard deduction and thus avoid a Roth conversion.  Isn't that subject to a 10 percent penalty for withdrawing from retirement account before age 59.5?

I've been doing Roth conversions to approximately equal the amount of the standard deduction as part of my tax optimization strategy, but if I can skip the Roth and cashout directly, I would be glad to do so!!

[SeattleCPA]

I was assuming taxpayer would begin a series of draws thus allowing him to dodge the penalty. Sorry for not making that clear.

I think there's a discussion of Section 72(t) at top of this subforum?

[secondcor521]

It is complicated.  I think I mostly understand my own situation after being FIREd for 8 years.  But the tax laws change over time, and my situation changes over time, and my understanding grows and changes over time - all of which means it's a moving target.

My comments:

1.  It's helpful to have some margin and wiggle room in your retirement plan.  This will reduce the amount of pressure on you to do everything optimally.  I was very prepared, very knowledgeable, and I still wasn't optimal.  You won't be optimal.

2.  Technical nitpick, you wouldn't have $36K in capital gains.  You would have $24K in capital gains and $12K in qualified dividends.  The latter are taxed much like the former, and I think that was your point was the taxability.

3.  Assuming you live in the continental US, it looks like you'd be at about 262% of FPL ($65,200 / $24,860) (https://obamacarefacts.com/federal-poverty-levels-for-aca-coverage/).  If you can get that down to 250% of FPL, your family would qualify for Silver CSRs, which might be marginally beneficial.

4.  In that FPL range, you're going to lose your subsidy at about a 15% rate (https://seattlecyclone.com/aca-premium-tax-credits-2021-edition).  It'll be something to pay attention to.

5.  The rules for the child tax credit keep changing.  This year, some of it is non-refundable, and some is refundable as long as your income is high enough.  What I would probably do (and in fact did), was to do a pro forma tax return every December and increase my income (via Roth conversions) until my child tax credit and any ACA subsidy repayment were used up.

6.  The saver's credit requires putting money into (generally) retirement savings.  You're wanting to FIRE and spend from retirement savings.  It's nearly impossible, as far as I can tell, to do both at the same time.  I'd give up on trying to get the credit personally.  It's small and your situation really doesn't apply.

7.  The rules for EITC change sometimes as well.  If you have more than $11K in investment income, you would be disqualified, so under your current plan you wouldn't be able to qualify (you're at $36K with the numbers you gave).  I'd give up on this credit as well.

8.  I don't understand about how working would make your cash run out more quickly.  If you were working a bit, and/or got any of the credits, those both would create spendable income, which would reduce the draws required on your savings and retirement accounts.

9.  I paid off my mortgage, mostly for cash flow and simplicity reasons.  And I did get some nice savings as a result (mostly FAFSA related) and enjoyed the simplicity.  However, in retrospect it probably reduced my net worth, because the arbitrage opportunity between my 2% mortgage and my ~10% stock returns over the remaining term of my mortgage would have likely outweighed the tax benefits.  With your 2.5% mortgage, were I in your shoes I would keep it, pay the minimums, and work the plan assuming that the mortgage stays.  (I don't have the numbers to prove it's better that way, that's just my gut feel.  Your situation would be different anyways.)

10.  @Josiecat23503, yes, you do have to meet one of the exceptions otherwise the 10% penalty would be due if withdrawing prior to 59.5.  Roth ladder and 72(t) are two exceptions, there are a few others -- see IRS Form 5329 for a list.

11.  I prefer a Roth ladder to a 72(t) at age 45.  Too much can change between 45 and 59.5 that is hard to predict - kids' college, going back to work, inheritance, investment returns, lifestyle changes, etc.  I like the Roth ladder for the increased flexibility.  But you do need to find a way to get it "primed" with 5 years of living expenses, which can require either planning ahead (which is what I did) or financial gymnastics for the first five years (which is possible too).

12.  Don't forget state income taxes if any, and FAFSA effects when the kid gets close to college age.

13.  I'd work on reducing your expenses.  Every dollar you don't spend is $25 you don't have to have saved up.

[poker-wont-help-me-fire]

Have you seen Roth Conversion and Capital Gains On ACA Health Insurance?  If not, that might be helpful - is it?

Yes, that is helpful, thanks.  I will need to spend some time filling this out, but it should provide me more clarity.

[poker-wont-help-me-fire]

I was assuming taxpayer would begin a series of draws thus allowing him to dodge the penalty. Sorry for not making that clear.

I think there's a discussion of Section 72(t) at top of this subforum?

Well I was planning on doing Roth conversions first while I draw down my cash and taxable accounts.  This would probably take me through to at least 59.5 without having to draw from my retirement accounts.  But if I did need to draw from them, I could 5 years after I started my Roth conversion ladder. 

[poker-wont-help-me-fire]

P.S. I can't imagine it makes sense to pay off a 2.5% mortgage when you could instead invest in 5%-ish treasuries.

The reason why it’s not clear to me whether to pay off the mortgage before retiring is because it would lower my bills by about $16k per year, which means my income needs would be lower, so my ACA subsidies would be higher. 

[SeattleCPA]

I was assuming taxpayer would begin a series of draws thus allowing him to dodge the penalty. Sorry for not making that clear.

I think there's a discussion of Section 72(t) at top of this subforum?

Well I was planning on doing Roth conversions first while I draw down my cash and taxable accounts.  This would probably take me through to at least 59.5 without having to draw from my retirement accounts.  But if I did need to draw from them, I could 5 years after I started my Roth conversion ladder.

The thing with Roth accounts is, you want to compare the marginal tax rates you pay on the money. If you'll pay a zero tax rate on the conversion but would have paid a zero tax rate anyway when you withdrew from the tIRA? You're actually not even saving tax.

BTW if you understand this and you've worked through the numbers? You're good. But most people, my experience, don't understand the numbers on Roth accounts.

A longer blog post, actually the first in a three-part series, that bludgeons poor readers with the math: https://evergreensmallbusiness.com/are-roth-iras-and-roth-401ks-really-a-good-deal/

[SeattleCPA]

P.S. I can't imagine it makes sense to pay off a 2.5% mortgage when you could instead invest in 5%-ish treasuries.

The reason why it’s not clear to me whether to pay off the mortgage before retiring is because it would lower my bills by about $16k per year, which means my income needs would be lower, so my ACA subsidies would be higher.

Hmmm. I guess that makes sense. And maybe part of the reduction in income effect is because of the principal part of the payment?

[Josiecat22222]

@SeattleCPA - I am doing Roth conversions to "use up" the standard deduction space (0% tax rate) while in early retirement as part of a long term tax strategy as well as to decrease my RMD in 25-30 years.  Is that what you mean by using Roths effectively in early retirement? 

[SeattleCPA]

That works sure. And what you're doing is reporting the income (from conversions) when your tax rate is zero... and if your tax rate is zero in retirement, you won't have saved any money of course. But you won't have lost anything either.

And then what if tax rates go up? I.e., you're at zero today or when converting but at 10% or 20% on the margin when you draw from IRAs. In that case, you do save by converting now.

I personally don't think the RMD thing needs to matter much to savers or retirees. There are other ways to drain a tIRA or 401(k) with little tax consequence. E.g., use money for big medical expenses... or use standard deduction, 10% and 12% rates to shelter or mostly shelter the income from taxes.

BTW where the RMD thing does, to me, cause a problem is with heirs and the new "drain in ten years" law. I personally don't have an RMD issue. But it's very possible my kids will have a problem with an inherited IRA they get from me. They could need to drain balances in the final decade of their earning years.