Thought experiment and why Fed taxes are not that big a deal for ER.

[kelly1mm]

Hello everyone, I was doing a thought experiment as to what my tax (federal, state, real estate, ACA premium) would be in retirement - basically those things I have little control over depending on the amount of income I have or withdraw in early retirement.  I add in ACA premiums not to be political or start a debate, but just because they are based on reported income.  We (wife and I) can live quite well on less than $22,000 (in todays dollars) if we have our home paid for, but used that as the baseline to not get put in Medicaid.  So, what I did with a copy of TurboTax, a link to an ACA calculator, and a link to the Maryland state real estate property tax credit page (linked below) is make a chart based on income segments from $22k to 30k listing the federal taxes due, MD state taxes due, MD Real estate taxes due, and ACA premium.  Also to set the stage our home is assessed at 185k and RE taxes are currently 2.5k per year so all RE tax numbers would be a discount (due to tax credit) and the ACA premium is for 2 adults, age 53 and 55, non-smokers.  One last thing, all ACA premiums listed are for Silver plan with $4500 max OOP.

Income     fed tax     MD tax      RE tax       ACA premium    TOTAL  % of income
22,000      201         859           960           775                   2795       12.7%
23,000      303         921           1050         898                   3172       13.8%
24,000      404         985           1140         1012                 3541       14.8%
25,000      503         1048         1230         1192                 3973       15.9%
26,000      603         1110         1320         1251                 4284       16.5%
27,000      703         1177         1410         1379                 4669       17.3%
28,000      803         1251         1500         1513                 5067       18.1%
29,000      903         1325         1590         1653                 5471       18.9%
30,000      1021       1399         1680         1799                 5899        19.7%
31,000      1103       1473         1770         1951                 6297       20.3%
32,000      1203       1547         1860         2087*               6533       21.1%
33,000      1303       1621         1950         2226                 7100       21.5%
34,000      1403       1695         2040         2371                 7409       22.1%
35,000      1503       1769         2130         2519                 7921       22.6%
36,000      1603       1843         2220         2676                 8339       23.2%
37,000      1703       1917         2310         2830                 8760       23.8%
38,000      1811       1991         2400         2993                 9195       24.2%
39,000      1961       2065         2500**     3156***            9682       24.8%
40,000      2111       2139         2500         3312                10062      25.2%
41,000      2261       2213         2500         3471                10445      25.5%
42,000      2411       2287         2500         3634                10832      25.8%
43,000      2561       2361         2500         3801                11223      26.1%
44,000      2711       2435         2500         3972                11618      26.4%
45,000      2861       2509         2500         4146                12016      26.7%

* total OOP max goes up to $10,400 (I call this a definite break point!)
** at regular RE tax so no more discount, but this will not go up any more either, flattening the total tax rate.
*** OOP max per year goes up again, this time to $12,700

What are my takeaways from this?  Well, Federal taxes should be one of my absolute lowest expenses in retirement.  Even at their highest they are little more than 3.33% of total income and less than any other cost at all points on the above graph.  Also, it is OK to live in a high RE tax state if you can get some type of credit if your income qualifies.  In the above example, between 66% to 33% off 'normal' RE taxes.  Last, despite all the bickering and politics (and believe me I understand the arguments against ACA and made some myself!) the ACA is probably one of the best things financially for early retirees in a LONG time.  If it is sustainable in it's current form is another thing all together.

Just thought my thought experiment may be interesting to others so I thought I would share.

Links:
http://kff.org/interactive/subsidy-calculator/
http://www.dat.state.md.us/sdatweb/htc.html

[MooseOutFront]

Great post.  Thank you for taking the time to do it.  I would love to see how your chart works out from 30-40k and even from 40-50k.  The crazy high marginal tax is what jumps out to me as well.  I assume most of that is lost ACA subsidies as income goes up?

[AlanStache]

yes, great stuff.  Also would love to see it extended a bit higher, will the ACA and state taxes "level" out and the relative increase moderate?

Also this is based on the assumption that you can dial in your income to match your spending.  You would do that by controlling your stock sales and (if any) rental income?  Would seem harder to dial in dividend income to match spending.  I am far from FIRE but I have got the impression from reading MMM that he sort of makes what he makes and invests what he does not spend with little regard to minimizing income for tax purposes.  But I am not sure he has directly addressed this.  Also would not taking gains so you can rebalance bump your taxes higher?  Is it a good problem to make to much :-)

[Vinivedivichi]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.  Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

[beltim]

Very, very interesting chart.  An effective marginal tax rate around 40% at that income is fairly astonishing!  But, that happens with a lot of subsidies intended for people with lower incomes, such as the earned income tax credit or retirement savings contributions credit.  Your chart shows how two different subsidies (the MD real estate tax credit and the ACA premium credit) combine to make such a higher marginal tax rate.  And it's pretty evenly distributed - 10% federal, 7.4% state, 9% real estate, and 14-ish% ACA.

[gillstone]

This was touched on in "The Millionaire Next Door".  Those who accrue a large base of assets pay a much smaller portion of their overall wealth in taxes relative to those who are high income & low savings who pay a large portion of their realtively meager wealth in taxes each year.  Building a large nest-egg is the best insulation from whatever the hell happens to tax code in any given year.

[tomq04]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.  Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

I haven't figured that one out either, take your benefit now and move to roth later when you can afford to in your 40's/50s in years that have very low income.

[Jamesqf]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.

That sort of depends, doesn't it?  For instance, if (like me) you've been sticking money in 401k/IRA plans for about as long as they've existed, you've probably built up a decent stash.  Then one day you look at what your required minimum distributions are likely to be, add in expected SS payments, and income from work that you keep doing 'cause you enjoy it... And you realize that you just might wind up in a higher tax pracket once you hit the official 'gotta take the SS & RMD' age.

And yeah, I do realize there are probably lots of people who'd like to have this 'problem' :-)

[wtjbatman]

Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

That's why when I talk about the Roth IRA, I try and point out how nice it is for someone like me (15% tax bracket) who plans for their income to be significantly higher in the future.

[Undecided]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.  Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

I haven't figured that one out either, take your benefit now and move to roth later when you can afford to in your 40's/50s in years that have very low income.

Many of us have to pay the taxes on the amounts we contribute/convert into our Roths whether we contribute/convert those amounts into a Roth or not. So having no choice on paying the taxes on the initial income, I prefer to take the future growth free from taxes.

[beltim]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.  Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

I haven't figured that one out either, take your benefit now and move to roth later when you can afford to in your 40's/50s in years that have very low income.

Well, the median individual and household is solidly in the 10% federal tax bracket, so you're significantly overstating the current tax burden for most people.  And most people think tax rates will go up before they retire, and a Roth IRA is an effective hedge against that.

That said, it's crazy for people not to have at least as much in a pre-tax retirement account to withdraw the amount of the standard deduction and exemption.  There are far more pre-tax retirement accounts (and balances in those accounts) than in Roths, though.

[Tyler]

Don't forget that your federal and state taxes also can vary quite a bit based on your chosen investments, as not all income is treated equally by the IRS.  For example, long-term capital gains under $72,500 (married filing jointly) are currently tax free at the federal level.

Based on my own personal calculations, at mustachian level retirement spending and with proper tax planning I'll pay (most years) 0% federal tax, 0% state tax (no state income tax in TX) and only will be on the hook for property tax.  ACA bronze premiums (and even some silver ones in my area) are basically free for a low-income retiree -- in fact, the trickiest part is to manage my investment income to have enough income to qualify at the $22k minimum level. 

Progressive tax policies definitely benefit those with low income.  A society still living in the paradigm of of working until you're 60 has its perks for those who choose to live differently, and I don't see enough people adopting a Mustachian attitude to shift the political dial any time soon.

[Vinivedivichi]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.  Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

I haven't figured that one out either, take your benefit now and move to roth later when you can afford to in your 40's/50s in years that have very low income.

Well, the median individual and household is solidly in the 10% federal tax bracket, so you're significantly overstating the current tax burden for most people.  And most people think tax rates will go up before they retire, and a Roth IRA is an effective hedge against that.

That said, it's crazy for people not to have at least as much in a pre-tax retirement account to withdraw the amount of the standard deduction and exemption.  There are far more pre-tax retirement accounts (and balances in those accounts) than in Roths, though.

Agree.  For most people, in lower rates, a Roth IRA is not a bad deal at all.  And I actually want to amend my previous statement...as long as you FIRST max out your regular 401k/IRA, then investing in a Roth is fine since if your wealth grows tax free in a Roth (as opposed to investing outside a tax-incentive retirement account where you would be taxed on earnings). 
 

[Vinivedivichi]

Therefore, I don't really understand why folks put money into a Roth IRA, taxed currently at 25-30%+ rates, when it's likely that when you retire your tax rate will be much lower.

That's why when I talk about the Roth IRA, I try and point out how nice it is for someone like me (15% tax bracket) who plans for their income to be significantly higher in the future.

Even at 15% I would consider putting at least as much into a 401k/traditional IRA.  Even as a single person, you can make around 20k and still be in the 10% bracket these days - if you can live on 20k or less when you're retired then a 401k/traditional IRA is the way to go (unless you expect rates at the lower end of the spectrum to increase in the future (FWIW, I think that is much less likely than rates at the higher end to go up)).  And even if you think that you may need to go above 20k, the most effective strategy would be to put most in a traditional IRA and some in a Roth IRA so that you can effectively manage your tax rate in retirement.

[wtjbatman]

Agree.  For most people, in lower rates, a Roth IRA is not a bad deal at all.  And I actually want to amend my previous statement...as long as you FIRST max out your regular 401k/IRA, then investing in a Roth is fine since if your wealth grows tax free in a Roth (as opposed to investing outside a tax-incentive retirement account where you would be taxed on earnings). 
 

You said "401k/IRA", not sure if you realize IRAs are capped. If you max out a Traditional IRA then that means you can't invest in a Roth IRA. Unfortunately you can only put $5500 total in an IRA each year, TIRA and Roth combined.

I assume you just meant max out your 401k first with the goal of reducing your taxable income. Again though, that's not always the best option tax-wise. I make such a "low" income that there are several reasons it makes more sense for me to fund a Roth. My tax rate is lower now than it will be in the future. A Roth has more flexibility than 401k with both distributions and how the money can be invested (my 401k provider decides what funds I can invest in, my Roth is at a brokerage where I can pick what I want to invest in). And Roth money will be withdrawn tax free in the future when, unless trends change, taxes are likely to be higher than they are today.

[Vinivedivichi]

This highlights one thing that I think a lot of folks tend to overlook - generally, when you're retired your income is lower (especially if your a member of this forum) and thus your taxes will be fairly insignificant.

That sort of depends, doesn't it?  For instance, if (like me) you've been sticking money in 401k/IRA plans for about as long as they've existed, you've probably built up a decent stash.  Then one day you look at what your required minimum distributions are likely to be, add in expected SS payments, and income from work that you keep doing 'cause you enjoy it... And you realize that you just might wind up in a higher tax pracket once you hit the official 'gotta take the SS & RMD' age.


And yeah, I do realize there are probably lots of people who'd like to have this 'problem' :-)

That is an excellent problem to have!

[beltim]

Even at 15% I would consider putting at least as much into a 401k/traditional IRA.  Even as a single person, you can make around 20k and still be in the 10% bracket these days - if you can live on 20k or less when you're retired then a 401k/traditional IRA is the way to go (unless you expect rates at the lower end of the spectrum to increase in the future (FWIW, I think that is much less likely than rates at the higher end to go up)).  And even if you think that you may need to go above 20k, the most effective strategy would be to put most in a traditional IRA and some in a Roth IRA so that you can effectively manage your tax rate in retirement.

This depends on your earnings trajectory.  If your salary is relatively stable over your working years, sure.  But most people have starting salaries quite a bit lower than the salaries they have 5-10 years later.  In this case you're far better off contributing to your Roth IRA when your salary is low, then filling up your traditional IRA bucket when your salary is higher.

[wtjbatman]

Even at 15% I would consider putting at least as much into a 401k/traditional IRA.  Even as a single person, you can make around 20k and still be in the 10% bracket these days - if you can live on 20k or less when you're retired then a 401k/traditional IRA is the way to go (unless you expect rates at the lower end of the spectrum to increase in the future (FWIW, I think that is much less likely than rates at the higher end to go up)).  And even if you think that you may need to go above 20k, the most effective strategy would be to put most in a traditional IRA and some in a Roth IRA so that you can effectively manage your tax rate in retirement.

This depends on your earnings trajectory.  If your salary is relatively stable over your working years, sure.  But most people have starting salaries quite a bit lower than the salaries they have 5-10 years later.  In this case you're far better off contributing to your Roth IRA when your salary is low, then filling up your traditional IRA bucket when your salary is higher.

Ding ding. A lot of the MMM audience are established in their careers and/or have a relatively high income (Source), but that still doesn't make the blanket statement that 401k/TIRA's are superior to Roths true. It might be the case for a lot of the forum goers here, but there are exceptions.

[FIreDrill]

According to some quick numbers my wife and I would have to break 100k gross in order to get into the 25% tax bracket.  As of now we are planning to contribute to Roth accounts until we hit the 25% bracket which will probably be a couple years.  We are in our early 20's so the issue I have with traditional accounts is we can't access it in early retirement without getting fees.  One of the things I love about Roth accounts is you can access contributions tax free before you are 59 1/2.  Idk, maybe I am missing something here but it seems like a Roth would be the way to go unless your in a 25%+ tax bracket.

[kelly1mm]

Great post.  Thank you for taking the time to do it.  I would love to see how your chart works out from 30-40k and even from 40-50k.  The crazy high marginal tax is what jumps out to me as well.  I assume most of that is lost ACA subsidies as income goes up?

Ask and you shall receive:

Income     fed tax     MD tax      RE tax       ACA premium    TOTAL  % of income
22,000      201         859           960           775                   2795       12.7%
23,000      303         921           1050         898                   3172       13.8%
24,000      404         985           1140         1012                 3541       14.8%
25,000      503         1048         1230         1192                 3973       15.9%
26,000      603         1110         1320         1251                 4284       16.5%
27,000      703         1177         1410         1379                 4669       17.3%
28,000      803         1251         1500         1513                 5067       18.1%
29,000      903         1325         1590         1653                 5471       18.9%
30,000      1021       1399         1680         1799                 5899       19.7%
31,100      1103       1473         1770         1951                 6297       20.3%
32,000      1203       1547         1860         2087*               6533       21.1%
33,000      1303       1621         1950         2226                 7100       21.5%
34,000      1403       1695         2040         2371                 7409       22.1%
35,000      1503       1769         2130         2519                 7921       22.6%
36,000      1603       1843         2220         2676                 8339       23.2%
37,000      1703       1917         2310         2830                 8760       23.8%
38,000      1811       1991         2400         2993                 9195       24.2%
39,000      1961       2065         2500**     3156***            9682       24.8%
40,000      2111       2139         2500         3312                10062      25.2%
41,000      2261       2213         2500         3471                10445      25.5%
42,000      2411       2287         2500         3634                10832      25.8%
43,000      2561       2361         2500         3801                11223      26.1%
44,000      2711       2435         2500         3972                11618      26.4%
45,000      2861       2509         2500         4146                12016      26.7%

* total OOP max goes up to $10,400 (I call this a definite break point!)
** at regular RE tax so no more discount, but this will not go up any more either, flattening the total tax rate.
*** OOP max per year goes up again, this time to $12,700

My main take aways from this part of the chart is the relatively high marginal rate (about 40%) until capping the RE taxes and how much crappier ACA insurance is when you hit $32,000 of income.  An OOP cap at $4500 is significantly more enticing than a $10,400 or $12,700 OOP cap!

[kelly1mm]

yes, great stuff.  Also would love to see it extended a bit higher, will the ACA and state taxes "level" out and the relative increase moderate?

Also this is based on the assumption that you can dial in your income to match your spending.  You would do that by controlling your stock sales and (if any) rental income?  Would seem harder to dial in dividend income to match spending.  I am far from FIRE but I have got the impression from reading MMM that he sort of makes what he makes and invests what he does not spend with little regard to minimizing income for tax purposes.  But I am not sure he has directly addressed this.  Also would not taking gains so you can rebalance bump your taxes higher?  Is it a good problem to make to much :-)

As for the dividend 'problem', one suggestion is to have dividends (an my case) be about 20-22k per year.  Although they do fluctuate a bit you know pretty close to what you should be getting.  The remaining income, up to whatever point I want, can come from 403b/401k/IRA depending on the circumstances.

[AlanStache]

With the traditional IRA you start to lose the immediate tax benefits (as a single dude) at 59k Modified Adjusted Gross Income when you have an employer 401k.  If you are over that are there other redeeming factors that someone should consider vs the much higher roth income limits?  Sorry if I am totally off the mark here have not looked at the difference between the two in year - working the roth on autopilot.

[kelly1mm]

One more note to point out the marginal tax rates issue.  Looking at the 22k line and the 44k line we see the following:

22,000      201         859           960           775                   2795       12.7%

44,000      2711       2435         2500         3972                11618      26.4%

So, with a 100% increase in income, we have a 415% increase in taxes paid.  The total tax at 22k is $2795 and at 44k it is 11,618, a difference of $8,823.  Thus, on the second 22k of income, the marginal rate is 40.1%.  WOW!

[MooseOutFront]

wow indeed.  I would have a hard time accepting that.  Would have to keep piling into 401ks or whatnot to get down to $22k even if I "needed" the money.