How much can we earn in retirement without paying federal income taxes?

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…

Continue reading “How much can we earn in retirement without paying federal income taxes?”

Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope

I was always working under the assumption that once we claim Social Security, 85% of our benefits will be counted as ordinary income on our federal tax return. That may also be a good assumption for a lot of retirees, especially if their overall income in retirement – pensions, capital gains, dividends, distributions from retirement accounts, Social Security, etc. – is high enough. Then, indeed, exactly 85% of your benefits will be taxed. This 85% figure is also the absolute maximum you’ll ever have to include in your federal taxable income. So, as a conservative estimate, it’s fine to use this 85% figure for our retirement cash flow and tax planning.

But in practice, the calculation is a lot more complicated. In fact, that share is calculated through a pretty convoluted formula that takes into account not just your Social Security benefits but also other income, even some ostensibly tax-free income like Municipal bond interest. In the chart below, the x-axis is for the annual Social Security benefits for a married couple filing a joint return (0-$80k), and each line corresponds to a level of all the other income (e.g., pensions, annuities, interest, capital gains, dividends, etc.) also going from $0 to $80,000 in $1,000 steps, so there are exactly 81 lines going from blue via yellow to red. When I plotted this function it looks like the folks at the IRS created a piece of art; that portion in the upper left looks almost like a Bifurcation diagram or Mandelbrot fractal!

SocSecTaxes Chart01
The share of Social Security subject to Federal Income taxes (Married filing Jointly). x-axis=Social Security benefits and each line is for a different level of other taxable income (e.g., pensions, annuities, interest, capital gains, dividends, etc.). There are 81 “other income” lines corresponding to income levels from $0 to $80,000 in steps of $1,000.

In any case, for retirement planning, doing a more thorough analysis of our tax on Social Security rather than using the lazy rough estimates has at least four advantages:

  1. The 85% estimate is likely way too conservative so you may over-prepare for retirement and over-accumulate assets. Why not enjoy your money now? Case in point, the Becky and Stephen case study last week; I was way too cautious with the tax assumptions in retirement and underestimated the sustainable, historical fail-safe retirement budget by about $2,500 per year!
  2. The exact calculation of taxes on Social Security benefits has implications on your Roth conversion strategy: There’s no need to be aggressive with your Roth conversions if only a tiny fraction of Social Security is taxable and you have not much other income to fill up your federal Standard Deduction!
  3. But for others, the convoluted formula also has a different, not-so-nice side effect. For some retirees, 401k or Traditional IRA distributions might be taxed at a higher rate than you might think. It’s called the retirement “Tax Torpedo,” more details on that below. So, if you don’t do enough Roth conversions and then later distribute money from a 401k you might face a higher tax burden than expected!
  4. Even some of the ostensibly tax-free income (municipal bond interest or dividends/long-term capital gains in the first two federal tax brackets) may not be so tax-free after all. Because that income is included in the Social Security tax computation, you might face backdoor taxation of seemingly tax-free income. How sneaky!!! It might be optimal to do some tax gain harvesting prior to claiming Social Security!

So, in any case, I will go through some detailed calculations here today, and also link to an easy-to-use Google Sheet I created for you if you want to calculate your own retirement tax estimates. Let’s take a look…

Continue reading “Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope”

Stuck With a High-Expense-Ratio Fund? Here’s a Google Sheet to Weigh the Pros and Cons of Dumping that “Stinker” in Your Portfolio!

This is a question that’s been on my mind for a while, partially out of curiosity and also because it’s been raised by readers a few times: Suppose you didn’t get the “memo” on passive investing early enough in your life and you now have some high-expense-ratio funds in our portfolio. So, is it too late to switch to a low-cost fund now? Maybe you’re lucky and your funds are actively-managed and they actually beat the broad index reliably. Good for you, but more often than not people are unhappy with the performance of their high-fee funds and like to switch to a low-fee, passively-managed index mutual fund at Fidelity, Schwab or Vanguard. Or move to one of the many index ETFs. Fees will be in the low single-digit basis points, around 0% to 0.015% for some of the Fidelity index funds and around 0.035% for the “Admiral Shares” Vanguard funds. Of course, if this is a fund in a tax-advantaged account where you can just switch between funds without any tax consequences you should just do so if you have that option. But the story gets a lot more complicated in a taxable account! We now have to weigh the pros and cons of switching to a low-cost fund:

Pro: You get rid of that “stinker” mutual fund and replace it with a low-fee, or even zero-fee index fund and eliminate the drag from the high expense ratio. We could be talking about a 0.5% difference in fees and maybe as much as 1.0 or 1.5%. And that’s every year! This can accumulate to a very large pile of cash over time!

Cons: You may have to realize capital gains today. There is a tax inefficiency from having to realize capital gains before you actually need the money in retirement. And this inefficiency takes two forms:

1) for most of you, there’s a good chance that marginal tax rates will be lower in the future, especially in retirement. Your high income right now might put you into a high marginal tax bracket (both Federal and State), while in retirement you might face much lower (or potentially zero) marginal rates. It’s best to defer capital gains until then!

2) even if your future projected tax rate is the same, there’s a potential inefficiency due to realizing capital gains twice; once today when switching to the new fund and once in the future when liquidating that fund in retirement, thus compounding the drag from taxes. It’s best to defer capital gains and pay taxes only once in retirement.

So, depending on how much in built-in capital gains you have right now, how much you can lower your expense ratio and what your current and projected future tax rates are, it may be optimal or suboptimal to dump that high-expense fund. In other words, it is the choice between two evils: The one evil is the drag from the high expense ratio and the other is the drag from tax inefficiency. Which one outweighs the other? Hard to tell, unless you put some numbers in a spreadsheet and do a proper “horse race.” And that’s what we do here today. Let’s take a look…

Continue reading “Stuck With a High-Expense-Ratio Fund? Here’s a Google Sheet to Weigh the Pros and Cons of Dumping that “Stinker” in Your Portfolio!”

Here’s an idea for a new ETF

Actually, not one ETF, but two! Or more! How can there be a need for a new ETF? Aren’t there enough already? Earlier this year, Motley Fool argued there are too many ETFs (1,929 at that time, probably over 2,000 by now) and they are covering pretty much every thinkable (and unthinkable) benchmark. Soon we might have more ETFs than publicly traded equities in the U.S., how crazy is that??? Why would I propose a new ETF that doesn’t already exist?

Here’s some background. I’m an index investor at heart and I like tax optimization. For so many years now, I’ve held equity index ETFs and Mutual Funds in both taxable accounts and tax-deferred accounts (both retirement and deferred compensation at work). It’s so painful to see the dividend payments in the taxable accounts getting taxed every year. Sure, it’s only about 1.9% dividend yield in the S&P500 right now but for us, that’s taxed at 15% federal, 10+% state (California!) and 3.8% Obamacare tax, for a total of almost 30% marginal tax! Isn’t there a better way? Sure! Simply put the taxable equity allocation into stocks that pay zero (or close to zero) dividends and keep the high-dividend stocks in the tax-deferred account where they can compound in peace and be taxed only once upon withdrawal rather than every year along the way! So, the two ETFs that I wish existed would exactly replicate the S&P500 if held in equal shares. But individually they’d have non-index weights and one would hold the equities with the lowest dividend yield and the other with the high-yield equities!

Notice that most folks already do this tax optimization across asset classes: Hold the tax-inefficient asset classes (bonds, REITs, etc.) in tax-deferred accounts and equities in taxable accounts. So, why not do this within the equity asset class as well for additional tax efficiency? How much extra after-tax return would we get out of this? Let’s look at the numbers…

Continue reading “Here’s an idea for a new ETF”

Meet Mr. Millionaire Math! (Plus Three Year-End Smart Money Moves)

Welcome! We hope everyone had a very Merry Christmas! Between the holidays when we are all still digesting all the excess calories there’s probably less demand for heavy-duty safe withdrawal rats simulations, so let’s do something on a lighter note today. I have always been wondering, what is it with MMM? Mr. Money Mustache started it all, of course. Now we have Mad Money Monster, Millenial Money Man, and Miss Millenial MD. Am I forgetting anyone? Even some obscure corporation up North, Minnesota Manafucaturting & Mining, jumped on that same MMM bandwagon, no doubt to leech off Pete’s fame. Obviously their lawyers were smart enough to put the label “3M” instead of “MMM” on their little post-it notes packages, otherwise, they’d probably get a nasty letter from the lawyers in Longmont. OK, just kidding about 3M. But still, it got me thinking, if I hadn’t picked “Early Retirement Now” as the blog name what would I have picked in the MMM universe? Easy!

Mr. Millionaire Math!

That seems to convey the essence of the blog pretty nicely, don’t you think? I also got a nice project for Mr. Millionaire Math: How much (or how little) effort and how much time would it have taken to become a millionaire by now? We’ll do some (light!) number-crunching on that topic today. And I’ll throw in some last-minute, end-of-the-year smart-money moves as well…

Continue reading “Meet Mr. Millionaire Math! (Plus Three Year-End Smart Money Moves)”

Good and Bad Reasons to Love the Mortgage Interest Deduction

Welcome back to the Early Retirement Now blog! I hope everybody had a safe and relaxing Fourth of July holiday. And if you don’t live in the U.S. and had to go to work yesterday we hope you had a nice Fourth of July, too! We are currently on vacation in Paris and I am sure even here I smelled some barbecue in the air yesterday, so folks seem to celebrate worldwide!

In any case, as we detailed last week, we plan to rent during early retirement, at least in the beginning. But even if and when we buy a house we’d likely pay cash and forego the mortgage deduction. Won’t we miss the deduction? Probably not! We found a few reasons to really appreciate this tax deduction but also two very bad reasons. Let’s start with the bad reasons! Continue reading “Good and Bad Reasons to Love the Mortgage Interest Deduction”

You want to know our savings rate? Which one?

Last week, I read a nice post on Chief Mom Officer on the challenges of calculating savings rates. Right around that time I was also revisiting our 2017 budget and the projections of how much we are going to save this year. This is the last full calendar year before our planned retirement in early 2018 and it’s imperative that we stay on track and keep a high savings rate on the home stretch. But how high is our savings rate? Is there even a generally accepted way of calculating a savings rate? What are some of the pitfalls? We were surprised about how easy it is to mess up a calculation as seemingly trivial as the savings rate.

Continue reading “You want to know our savings rate? Which one?”

Why would anyone have a mortgage and a bond portfolio?

We are homeowners with a pretty sizeable mortgage but we also accumulated a nice retirement nest egg, which is actually many times larger than our mortgage. Even our taxable investments are several times larger than the mortgage. Still, we don’t pay off the mortgage because we like the benefit of leverage. We have a liability with a low-interest rate and assets with a much higher expected rate of return, so our overall expected rate of return is higher than without a mortgage. Our friend FinanciaLibre (now a defunct site) did some nice number crunching on this topic recently and we agree wholeheartedly.

Moreover, if you follow our blog you’ll also remember that we take a pretty dim view on bonds:

So, personally, we skip the bond allocation altogether. Others have written about this, too, check Physician on Fire’s 2-part guest post here and here. In light of all of this, here’s one question that occurred to us:

Why would anybody have a 30-year mortgage at about 3.50% and a bond portfolio currently paying around 1.8 to maybe 2.5% interest for safe government bonds?

Leverage works only when the asset has a higher expected return than the liability!
Continue reading “Why would anyone have a mortgage and a bond portfolio?”

We just saved $42,000 by not switching to Betterment

There is a popular car insurance commercial featuring someone who “just saved a ton of money by switching to GEICO.” How much is a ton of money? $400? Well, by that measure we just saved more than “100 tons of money” or a whole century worth of car insurance savings. And we didn’t do so by switching, but by not switching our brokerage account. Ka-Ching, how easy was that? Continue reading “We just saved $42,000 by not switching to Betterment”

Tax Loss Harvesting: what is it and how large is the expected benefit?

Tax Loss Harvesting is the rage now. Robo-advisers do it for you, and every DIY saver should seriously consider the benefits. Let’s look at what Tax Loss Harvesting is, how and why it works and how large (or small) the expected benefits can be. Continue reading “Tax Loss Harvesting: what is it and how large is the expected benefit?”