Update 11/22/2019: After I published a shorter version of this piece on MarketWatch and the story was picked up by YahooFinance as well I got a lot more readers! Thanks and welcome to my blog! Make sure you subscribe to be notified of future blog posts! Both on Yahoo and MarketWatch I saw the expected assortment of hate comments. They fall into two categories, see below plus my response:
- “I’m a CPA and this doesn’t make any sense!” My response: You’re either not a CPA at all or you’re a really bad & incompetent one. The standard deduction and the 0% bracket for capital gains are all very well-known in the financial/tax planner community. The same goes for the taxability worksheet for Social Security.
- “How unfair that you retired already and don’t pay taxes while I’m working so hard and pay a lot of taxes!” My response: I hear ya! I’ve paid a ton of taxes throughout my work life. A seven-figure sum, more than most people pay over their entire lifetime. Keep that in mind if you complain about the unfairness of the U.S. federal tax system!
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The question “how much can we earn without paying federal income taxes” is relatively easy to answer for most people. The standard deduction for a married couple is $24,400 in 2019 (if both are under 65 years old) and the top of the no-tax bracket for capital gains is $78,750. So, we can make a total of $103,150 per year, provided that our ordinary income stays below the standard deduction and the rest (2nd bracket + any leftover from the std. deduction) comes from long-term capital gains and/or qualified dividends. With our daughter, we also qualify for the child tax credit ($2,000 p.a.), so we could actually generate another $13,333 per year in dividends or capital gains, taxed at a 15% so that the tax liability of $2,000 exactly offsets the tax credit for a zero federal tax bill.
Once people file for Social Security benefits, though, things become a bit more complicated. That’s due to the convoluted formula used to determine how much of your Social Security is counted as taxable income, see last week’s blog post! So, calculating and plotting the tax-free income limits is a tad more complicated. Oh, and talking about tax planning in retirement: as promised, I will also go through an update on the Roth Conversion strategy for the Becky and Stephen case study from two weeks ago.
Let’s get started…
First, a disclaimer: This exercise is for federal taxes only! That’s good enough for us personally because we live in Washington State, one of the few places without an additional state income tax. If you do have state income taxes, you will probably start owing state income taxes at much lower income levels! Also, all the other disclaimers apply here as well: contact a tax expert before you apply any of this yourself in real life! 🙂 I will also frequently mention capital gains and dividends as tax-advantaged income because long-term capital gains and qualified dividends are taxed at a lower rate. Below, I may sometimes drop the terms “long-term” and “qualified” because it doesn’t always fit into the chart axis labels. But keep in mind that short-term capital gains and non-qualified dividends will fall into the ordinary income bucket, taxed at a higher rate!
Tax-free income limits without Social Security
Just to warm up, here are the income limits for a married couple (both under 65 years old) who file a joint federal tax return. They face a $24,400 standard deduction in 2019 as well as a $78,750 upper limit on the cap-gains no-tax bracket to fill up with long-term capital gains. So, to stay tax-free we need to stay under the blue line in the chart below. That way we’re guaranteed to fill up the standard deduction with either ordinary income or long-term capital gains/qualified dividends and the top off everything with a maximum of $78,750 with capital gains in the first two federal brackets at a 0% marginal rate. Since we have a kid and are eligible for the child tax credit, which could theoretically offset $2,000 in taxes. So, we can push the income limits a little higher:
- To just under $45k if relying purely on ordinary income, by completely maxing out the 10% brackets and briefly touching the 12% federal bracket,…
- To over $116k by adding another $13,333 in capital gains/dividends taxed at the 15% rate (provided these are long-term capital gains and/or qualified dividends)
- Or a combination of ordinary income and tax-advantaged income between the kink points.
Tax-free income limits with Social Security
What about 25 years down the road, when we no longer claim our daughter as a dependent and we file for Social Security? With Social Security, things become a little bit more complicated. Instead of two, we now have three separate major income categories with their own distinct impact on the federal tax
Taxable Social Security = F1(Social Security , Ordinary Income + Capital Gains)
Tax = F2( Taxable Social Security + Ordinary Income , Capital Gains )
(side note: there’s even a fourth category: Municipal Bond interest income, because that enters the Social Security worksheet formula as well – see last week’s post – but stays tax-free otherwise. But I disregard Muni bond interest for the purpose of today’s post because it’s already messy enough as is)
So, it’s no longer feasible to display the tax-free income limits in a simple one-size-fits-all chart because our tax liability depends on three distinct variables and I can’t easily plot that zero-tax boundary in three dimensions. So, here’s how I propose displaying the boundary.
- Start with Social Security on the x-axis. I use a range of $0 to $90k, which is probably close to the absolute maximum two spouses can haul home in combined benefits.
- On the y-axis, plot the maximum of the “other income” to guarantee zero federal taxes. This is the combination of all ordinary income and dividends and capital gains (i.e., Line 3 in the SS worksheet).
- How much “other income” is sustainable at zero taxes clearly depends on the composition: ordinary income vs. tax-advantaged income (LT CG and Dividends). So, I plot a line for three different cases: 100%/0%, 50%/50%, and 0%/100% in the two income buckets.
- I also assume that this is for a couple where both spouses are 65 years or older to increase the standard deduction to $27,000 p.a. ($24,400 base plus $1,300 extra per spouse above age 65!)
Let’s look at the results in the chart above:
- The lowest tax-free income allowance prevails if all of the other income is ordinary income. Say, you get $50k in combined Social Security, then you can make around another $20k in other ordinary income. The sustainable amount of income gradually declines because more Social Security income will become taxable and limit the amount of other income you can make before hitting the $27k standard deduction. But you can still haul in a lot of income: $50k in SS and another $20k in ordinary income. Or $90k in Social Security plus another close to $11k in other ordinary income for a total of more than $100k! Not bad!
- Not surprisingly, that boundary shifts up if part of the “other income” is long-term capital gains. That’s because less of the income pushes against the standard deduction limit. Capital gains and dividends become taxable only if we go beyond the second federal tax bracket! Of course, capital gains still impact the Social Security taxable calculation in the IRS worksheet, see last week’s post.
- If all of the other income comes from capital gains, we get the slightly peculiar looking green boundary. I had to double-check and triple-check my math here because of that drop at around $31k Social Security income. But it’s legit! For Social Security low enough, even with a lot of capital gains income, 85% of SS is taxable and we simply stay below the standard deduction as long as 0.85*SS<$27,000 and we fill up the rest with capital gains to get to the top of the second federal tax bracket. But once we hit $27,000/0.85=$31,765, we have to instantly and drastically lower the other income to push the taxable portion of SS back to $27k.
Same data, sliced differently
Here’s another way to slice and dice the data: I created a chart with capital gains on the x-axis and other ordinary income on the y-axis for one fixed Social Security level at a time, going from $0 to $90k in $5 steps. The capital gains and other income levels go in steps of $1,000 and I plot the different ranges of tax levels with dots: green = no federal tax at all, blue = average tax rate of 0 to 5% and red dots for 5-10%. If you go beyond the red region, you guessed it, you’ll owe more than 10% on average.
Because I didn’t want to publish 19 different charts here, I just put this all into a gif animation, please see below:
(See this zip-file on my Google Drive if you like to check out the 19 underlying charts)
So, if you wonder how a math/finance geek like me spends early retirement, this is it! Making gif animations out of Matlab Charts! Never a dull moment in my home office here! 🙂
But anyway, I was positively surprised that in retirement, we should be able to keep taxes quite low. Social Security will likely be taxable at a much lower rate than the 85% maximum. So you can still have a total income in the high-five-figures, potentially even six-figures and still keep federal income taxes low or even at zero! And then on top of that, you got Roth distributions and the tax-free basis in the taxable account withdrawals. Even folks in the FatFIRE community will hardly pay federal income taxes or avoid them altogether!
A Roth Conversion case study
As promised, and as an application of some of the things I’ve learned here, I wanted to do the Roth Conversion plan for the Becky and Stephen case study from two weeks ago.
If you recall, the idea here is that on the one hand, if you do the Roth conversions too aggressively (likely converting into and all the way to the top of the 12% federal marginal rate) and you eliminate all other income in retirement to rely only on Social Security and Roth IRA distributions, you’ll likely leave money on the table because taxable Social Security will stay below the standard deduction and distributions from the Roth are completely tax-free anyway! On the other hand, if you don’t do enough of the Roth conversions, you might have to distribute from the 401k at a marginal tax of around 18.5% to 22.2% when withdrawing and facing the Tax Torpedo.
So, planning the Roth conversions becomes a real tightrope! But how do we find the sweet spot in the middle? Here’s one idea: First, determine how much in additional ordinary income we can generate each year before we hit the standard deduction (and the Tax Torpedo if we go beyond). One additional challenge when mapping out this Roth conversion strategy: the kink points in the Social Security worksheet are apparently not adjusted for inflation, while all of the other relevant tax parameters (standard deductions, tax bracket, etc.) are. Thanks to my blogging buddies Dr. David Graham (FiPhysician.com) and Harry Sit (The Finance Buff) for pointing this out!
In the table below, I factor in the Social Security benefits over time (as recommended by the OpenSocialSecurity.com calculator, see the post from two weeks ago). All numbers are real, CPI-adjusted numbers, so some of the tax parameters (standard deduction, tax brackets, etc.) stay constant in real terms, but the kink points in the Social Security worksheet are deflated by 2% p.a., see lines 9 and 11. I then solve for the amount we can generate in Line 3 (up to the closest $100) to ensure we don’t hit the standard deduction.
We also have to take into account that later in retirement, probably around the year 2040 or so, one of the spouses might die and the survivor will have to file taxes as a single. So, the tax-free ordinary income will be lower in that situation:
So, let’s take the upper bounds of ordinary income we can generate in years 2025 and onward and plug them into an Excel sheet. Let’s assume the portfolio gives you a 1.5% p.a. real return, not a bad assumption for a bond portfolio. Again, as mentioned in the case study, I propose shifting the bond portion into the tax-deferred accounts and it may not be a bad idea to put the equities (high expected return) into the Roth and the bonds (lower expected returns) into the 401k to keep a lid on the growth rate in the 401k, while keeping equities in the Roth IRA where they can grow completely tax-free.
Anyway, the trick here is to work backward! Let’s start at the beginning of the year 2054. We withdraw $4,400 at the beginning of the year which is the maximum anticipated amount we distribute from the 401k before hitting the Tax Torpedo. So if we plan to exhaust the 401k we need exactly that amount at the beginning of the year 2054. That means we need $4,400/1.015+$4,500=$8,835 at the beginning of the previous year. And so on, all the way to 2025 where we get a $259,018 target 401k level.
(see this link for how the table below was calculated)
If we start with $490,000 today we simply use the PMT function in Excel to determine how much we withdraw over the first 5 years of retirement to exactly hit the 259,018 at the end of 2024:
=PMT(0.015,5,-490000,259018,1) 0.015 = rate of return 5 = # of years 490k = today's value 259018 = target future value 1 = for cash flow at the beginning of the year
And this tells us to convert $51,410 over the years 2020-2024. I’m assuming the conversions occur at the beginning of the calendar year. If you want to switch to the end of the year (might be better to be able to respond to other tax events) you’d use the 0 instead of the 1 as the final input in the PMT formula and this will get you to $52,181. Not a huge difference. So, there you go, the ideal Roth strategy would do pretty aggressive conversions, but certainly not all the way to the top of the 12% bracket. Which is great, because you have a slightly lower tax liability for the first few years in retirement before Social Security starts.
Some caveats about this approach:
- In this particular example, we never got into trouble with the Required Minimum Distributions (RMDs). That may not be true for all retirees! So, when doing this exercise we’d potentially have to also keep those pesky RMDs in check!
- We don’t know the returns, much less the real returns that far into the future. Luckily, we’re talking about a bond portfolio with a lot less volatility than a stock portfolio. If you believe that 1.5% is too meager for a bond return (recall this is the real return over and above inflation!) and/or you have equities in the 401k with a higher expected return, you’ll probably have to walk up the initial Roth conversions to make a bigger dent in the 401k portfolio! Even at a 5% real return, though, the target Roth conversions go up to only about $74,600 for the first five years. Still manageable if you want to stay in the 12% bracket in the years 2020-2024.
- There are reasons to believe that taxes will go up in the future both on the Federal and State level. But of course, there’s no telling when and how. As a hedge against that possibility, you probably want to err on the side of caution and do the Roth conversions a bit more aggressively. Becky and Stephen certainly have some extra space in their 12% tax bracket.
- Related to the above, another reason for more aggressive Roth conversions: estate planning. There is no guarantee that the last survivor will even live until the year 2054. Chances are, the last survivor will pass away well before then and it’s likely better to leave a Roth IRA to your kids than the tax liability of an inherited 401k. Or more precisely, the 12% marginal you pay today for the Roth conversion will very likely be lower than what you kids pay in 2054!
- So, I’d view the $51k in Roth conversion as the lower bound of what you want to convert per year from 2020 to 2024!
Is it really worth it to go through this whole computation? I had the impression that on the ChooseFI podcast two weeks ago we talked a little too much about the tax planning. I think that getting the safe withdrawal rate calculations right is a lot more important! If you are forced to withdraw some of the funds in retirement and face the tax torpedo (an 18.5% marginal rate vs. a 12% rate you could have gotten during the conversion period) on maybe $10,000 of 401k distributions, that’s not the end of the world. Sitting in a $150k a year nursing home at age 90 and running out of money, now, that’s a bigger concern!
What gets lost sometimes in the whole Safe Withdrawal Rate discussion is that all those calculations are normally based on gross numbers! You still have to account for taxes! But I’m encouraged by today’s exercise! At least on the federal level, there is a large range of income combinations that are absolutely, completely tax-free. And if you’re willing to part with a small portion of your withdrawals, maybe 5%, you expand that range significantly. You almost have to try really, really hard to even reach a 10% average tax rate on your taxable portion. And notice that you can still generate additional retirement cash flow because part of the withdrawals will come from the cost basis in taxable accounts and all of your Roth IRA distributions are tax-free. Same with your Health Savings Account.
So, after spending waaayyyy too much time on taxes in the last few weeks, I’d like to refocus on my favorite topic again: the finance portion of early retirement, the safe withdrawal rates. Most people can actually assume that your gross retirement income is equal to the net income, especially if you’re lucky enough to live in a state without income taxes. And if you do face a state income tax, maybe apply a haircut of a few % to account that. I’m not saying that tax planning is irrelevant. But it’s a lot of effort and even if you get it slightly wrong it’s not the end of the world. Concentrate on what’s really important in retirement: the withdrawal rate math!
So much for today! Thanks for stopping by and please leave your comments and suggestions below!
Title picture credit: BoredPanda.com