anticipating tax rate in retirement

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anonyvestor
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anticipating tax rate in retirement

Post by anonyvestor »

I have been deliberating excessively over converting a 401k to a traditional vs. Roth 401k or IRA. I need to decide soon, since the 401k is anticipated to be closing because the business is no longer operational.

I am in a high tax bracket, and may well find myself in a nearby bracket in retirement.

The difficulty is projecting one’s tax bracket in retirement. And assessing which returns will be taxed as ordinary income.

Including:

1. Stock dividends
2. Bond dividends
3. Capital gains
a. Including distinguishing between short vs. long term
4. Social security (presuming high income and high muni allocation)
5. 401k/IRA RMDs
6. Real estate or other business income
7. K-1 partnership revenue
8. Trust income

My understanding is that 1,2, 5, 6, 7 and 8 are taxed as ordinary income, but I am confused about dividend income – I thought SOME were taxed similarly to LT cap gains.

One of my primary questions is how much 3, 4, 5 and 8 will elevate my marginal and effective tax rates. 3 and 8 (as well as 1 and 2) are likely to remain substantial in retirement.

Lastly I presume I should assume the 3.8% Medicare surtax will apply if I maintain high investment income - even if I continue to generate a nominal personal income.

Can anyone simplify this for me, or direct me to a concise resource??? I will speak with an accountant, but I would like to have a better understanding first.
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grabiner
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Re: anticipating tax rate in retirement

Post by grabiner »

anonyvestor wrote:The difficulty is projecting one’s tax bracket in retirement. And assessing which returns will be taxed as ordinary income.

Including:

1. Stock dividends
2. Bond dividends
3. Capital gains
a. Including distinguishing between short vs. long term
4. Social security (presuming high income and high muni allocation)
5. 401k/IRA RMDs
6. Real estate or other business income
7. K-1 partnership revenue
8. Trust income

My understanding is that 1,2, 5, 6, 7 and 8 are taxed as ordinary income, but I am confused about dividend income – I thought SOME were taxed similarly to LT cap gains.
"Qualified" dividends are taxed at the LT gain rate. Most US stock dividends are qualified, and a large fraction of international dividends are qualified; typically, Total Stock Market has 100% qualified dividends and Total International has 70%. Bond dividends are not qualified.

If you have high income, 85% of your Social Security will be taxed as ordinary income.

Real estate income is taxed as ordinary income, but only net income is taxed. If you own a house and receive $40,000 in rent, pay $20,000 in expenses, and take $10,000 of depreciation, the net income is $10,000 and you will pay tax on that. (The depreciation reduces your basis; you will pay it back as capital-gains tax when you sell, and the decrease due to depreciation is taxed at 25% rather than 15%.) Similarly, partnerships don't pay taxes but pass the net income through to the partners at their own rates.
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retiredjg
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Re: anticipating tax rate in retirement

Post by retiredjg »

I think a lot of people confuse wealth in retirement and high taxes and/or high tax bracket in retirement.

A person can be very wealthy and still be in a low tax bracket if they don't have a lot of taxable income. Or be in a high tax bracket with a low overall tax rate. For example if your income is mostly stock dividends, you could be in the 35% bracket but if most of your income is taxed at 15% (the long term capital gains rate) your taxes will actually be low even though your "bracket" is high. This is why some very wealthy people pay a lower percentage in taxes than their secretaries (an issue that came up a few years ago).

If 2, 5, 6, 7, and 8 will bring in a lot of taxable income, you might very well be in a high bracket in retirement. Bond dividends should not be a big issue since you can hold bonds in a tax-advantaged account or use tax-exempt bonds. You should be able to control short term cap gains if you don't do a lot of selling and buying (or donate those shares to charity). SS hardly even counts since the max of 85% is going to be taxed (as ordinary income) for you no matter what.

Your question seems to be what to do with your 401k when the business closes? I would not convert to Roth unless it is clear that you will be in a higher bracket later. But that's just a generalized guess based on very little information.
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dratkinson
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Re: anticipating tax rate in retirement

Post by dratkinson »

Misinformation removed.
Last edited by dratkinson on Sun Oct 26, 2014 1:53 pm, edited 1 time in total.
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kaneohe
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Re: anticipating tax rate in retirement

Post by kaneohe »

dratkinson wrote:
grabiner wrote:...

If you have high income, 85% of your Social Security will be taxed as ordinary income. ...
From the SS worksheet in the 1040 instructions, believe that is 85% of 50%-of-SS-income. So ~43% of SS income is taxed as ordinary income. This taxation level can come on in the top of the 15% tax bracket, with enough tax-exempt income. Or with taxable bond dividends, in the bottom of the 25% bracket.
grabiner is correct.....up to85% of SS can be taxed as ordinary income.

dratkinson........what you are looking at w/ the 50% of SS is the test to calculate how much of it is taxable. The 50% of SS is combined w/ the other income to perform the test.
The last 2 lines of the worksheet:

17. Multiply line 1 by 85% (.85) ......................................................... 17.
18. Taxable social security benefits. Enter the smaller of line 16 or line 17. Also enter this amount
on Form 1040, line 20b ......

line 1 is SS so line 17 is 85% of SS. If income is high, line 17 is smaller than line 16 so 85% of SS is taxable.
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grabiner
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Re: anticipating tax rate in retirement

Post by grabiner »

dratkinson wrote:
grabiner wrote:...

If you have high income, 85% of your Social Security will be taxed as ordinary income. ...
From the SS worksheet in the 1040 instructions, believe that is 85% of 50%-of-SS-income.
You are confusing two things. 50% of SS is counted as income when determining how much SS is taxable. (This makes some sense because this 50% was based on employer contributions which were never taxed.) Then, up to 85% of SS can be taxed, depending on the total income.

There is an outline of the forumula on the wiki.
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scrabbler1
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Re: anticipating tax rate in retirement

Post by scrabbler1 »

As an early retiree for the last 6 years, I have investment income taxed at many different rates (and don't forget that your state may tax income types differently than the Feds do).

I have the following types:

(1) stock fund dividends
(2) taxable bond fund dividends
(3) tax-exempt bond fund dividends
(3a) Federally only tax-exempt bond fund dividends
(3b) Federal and state tax-exempt bond fund dividends.
(4) Long-term Cap Gains (from distributions ad sales)
(5) Short-term Cap Gain distributions

For me, (1), (3a), (3b), and (4) are all taxed at 0% federally. Only (3b) is taxed at 0% on the state level.

Even the 0% federal marginal rate hs not always been a pure 0%. For example, an extra dollar of (1) and (4) are very slightly taxable if I have Schedule A medical expense deductions because the 'x%-of-AGI" exclusion rises a little bit, lowering my deductible medical expenses.
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Watty
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Re: anticipating tax rate in retirement

Post by Watty »

Can anyone simplify this for me....
One thing you can do is make up a dummy tax return with your expected retirement number in tax software then add and subtract $100 to the various numbers to see what the affect is. The nice thing about this is that it will also calculate your state taxes and catch any phase outs of deductions and credits.
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grabiner
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Re: anticipating tax rate in retirement

Post by grabiner »

scrabbler1 wrote:As an early retiree for the last 6 years, I have investment income taxed at many different rates (and don't forget that your state may tax income types differently than the Feds do).

I have the following types:

(1) stock fund dividends
(2) taxable bond fund dividends
(3) tax-exempt bond fund dividends
(3a) Federally only tax-exempt bond fund dividends
(3b) Federal and state tax-exempt bond fund dividends.
(4) Long-term Cap Gains (from distributions ad sales)
(5) Short-term Cap Gain distributions

For me, (1), (3a), (3b), and (4) are all taxed at 0% federally. Only (3b) is taxed at 0% on the state level.
You probably shouldn't have (3a) and (3b) (tax-exempt bond funds) if you are in the 15% tax bracket; you'll get more after tax from taxable bond funds of the same risk, unless you are in some AGI-based phase-out that gives you a marginal tax rate well over 15%. And when you start getting Social Security, if you are in the phase-in range, your marginal tax rate on tax-exempt bond funds will be 12.75%, so you still don't get a benefit by using them rather than taxable bond funds taxed at 27.75%.
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scrabbler1
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Re: anticipating tax rate in retirement

Post by scrabbler1 »

grabiner wrote:
scrabbler1 wrote:As an early retiree for the last 6 years, I have investment income taxed at many different rates (and don't forget that your state may tax income types differently than the Feds do).

I have the following types:

(1) stock fund dividends
(2) taxable bond fund dividends
(3) tax-exempt bond fund dividends
(3a) Federally only tax-exempt bond fund dividends
(3b) Federal and state tax-exempt bond fund dividends.
(4) Long-term Cap Gains (from distributions and sales)
(5) Short-term Cap Gain distributions

For me, (1), (3a), (3b), and (4) are all taxed at 0% federally. Only (3b) is taxed at 0% on the state level.
You probably shouldn't have (3a) and (3b) (tax-exempt bond funds) if you are in the 15% tax bracket; you'll get more after tax from taxable bond funds of the same risk, unless you are in some AGI-based phase-out that gives you a marginal tax rate well over 15%. And when you start getting Social Security, if you are in the phase-in range, your marginal tax rate on tax-exempt bond funds will be 12.75%, so you still don't get a benefit by using them rather than taxable bond funds taxed at 27.75%.
I have greatly reduced my holdings in muni bond funds since I ERed 6 years ago. The income from those funds represents about 6% of my total income. As I have written in other theads, I use my muni bond fund holdings as my second-tier emergency fund. At age 51, I am at least 11 years away from thinking about SS, too.
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dratkinson
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Re: anticipating tax rate in retirement

Post by dratkinson »

kaneohe, grabiner, thanks for correction. That is a significant oversight. Will correct. :oops:

For me, SS is a few years away but had been doing some pre-planning to compute then-taxable income: modify income/withholdings-estimate annual spreadsheets. Obviously didn't look close enough at SS worksheet. Corrections made here, too. Thanks.
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dratkinson
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Re: anticipating tax rate in retirement

Post by dratkinson »

The short answer. Download this Excel-based 1040 to run tax simulations on your PC: https://sites.google.com/site/excel1040/


The long answer.

Feeling somewhat chagrined by above mistake, thought I'd study a little deeper. Re-read Wiki SS explanation and thought a hands-on example would reinforce learning: implement SS taxation worksheet in Excel. But of course, might as well include taxable income, QDI/LTCG handling, IRS tax rate table lookup, ....

Long story short. Was working away when it dawned on me that I'd seen this before... and went searching.

For "Excel income tax reporting", google returned: https://sites.google.com/site/excel1040/

Then I remembered, searched, and found his 2007 version on my PC. (I'd thought about using it, but since it didn't do state taxes, used something else.)

It looks to be very simple to use and has provision for inputting income (earned, retirement, SS, distributions) and reporting Sch B, D,....

Looks to be easy to use to play what-ifs. (I've tried Taxcaster and couldn't get it to do what I wanted.)

No need to reinvent the wheel, just run simulations using Mr. Reeves' Excel-lent tool.


Finding/posting this tool link is all the penance I'm doing.
d.r.a., not dr.a. | I'm a novice investor; you are forewarned.
Topic Author
anonyvestor
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Re: anticipating tax rate in retirement

Post by anonyvestor »

Thanks for the responses so far. They have been very helpful.

Converting to a Roth has some appeal which others might not appreciate, such as increasing asset protection to some degree, diversifying against the risk of potential future tax increases, and increasing the (after tax) value of funds which can be used for rebalancing without generating a taxable event.

That being said, I would like to be able to estimate the effective tax rate on any future RMDs from a traditional 401k/IRA

Presumably, this would be my marginal tax rate AFTER taking into consideration income generated from TAXABLE (e.g. excluding munis) investments in categories:

2
4 (estimating 85% of this value)
6 (noting grabiner’s clarifications), 7 (distributed income) and 8

Potentially in addition to categories 1 and 3 (LT Cap Gains and Qualified Dividends) – which are the primary focus of my question.

Someone suggested LT Cap gains and dividends would elevate my effective tax rate for RMDs, but frankly this does not make obvious sense to me.

For instance: If I have $100,000 income generated from LT Cap Gains/Qual dividends, does this increase my federal tax rate on RMDs???

Meanwhile, I will likely take Watty’s suggestion. - Thanks
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grabiner
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Re: anticipating tax rate in retirement

Post by grabiner »

anonyvestor wrote:Someone suggested LT Cap gains and dividends would elevate my effective tax rate for RMDs, but frankly this does not make obvious sense to me.

For instance: If I have $100,000 income generated from LT Cap Gains/Qual dividends, does this increase my federal tax rate on RMDs???
It can increase the actual tax rate if your total income is in the 39.6% bracket, because long-term gains and qualified dividends in that bracket are taxed at 20% rather than 15%.

It can also cause you to hit a phase-in or phase-out, such as the Medicare surtax on income over $250,000 (which would add 3.8% to the tax rate), or the phase-out of itemized deductions at high incomes.
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dratkinson
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Re: anticipating tax rate in retirement

Post by dratkinson »

anonyvestor wrote:...
That being said, I would like to be able to estimate the effective tax rate on any future RMDs from a traditional 401k/IRA
...
I don't know how to compute effective tax rate, but did this to guesstimate after-tax income for different cases.

Played with above 1040 Excel tool last night. After entering 2013 tax data and duplicating filed return, had hoped-for simulation results, so no need to change course.
  • After tax income using muni bonds.
    +line 43, taxable income*
    -line 61, total tax owed
    +line 8b, tax-exempt interest
    After tax income

    After tax income using taxable bonds.
    +line 43, taxable income*
    -line 61, total tax owed
    After tax income

    * Determines tax bracket.

    Ran my specific case simulations with preferred bonds: VWIUX (IT muni, adm) VWLUX (LT muni, adm), VBTLX (TBM, adm), VICSX (IT corp, adm). And with and without anticipated SS income.

    Guesstimated bond dividends for each case as: total $bond investment * current SEC yield. (Couldn't think of anything better to predict the future.)
    • VWIUX dividends = $bonds * 1.73% = $AAAA
      VWLUX dividends = $bonds * 2.48% = $BBBB
      VBTLX dividends = $bonds * 2.14% = $CCCC
      VICSX dividends = $bonds * 2.69% = $DDDD
    Single Sch B entry constructed for easy case recall/construction:
    “VWIUX ($AAAA), VWLUX ($BBBB), VBTLX ($CCCC), VISCX ($DDDD)”

    Entered taxable bond dividends on Sch B, muni dividends on line 8b.

    Entered SS income on obvious tool worksheet.
Should be easy enough to run your after-tax-income simulations after entering your tax data (duplicating your 2013 fed tax return) and guesstimating your RMDs.

Excel has a Scenario tool (multiple user-selected cells considered/changed together to create each scenario). It's supposed to make it easy to quickly switch among cases/scenarios to view results. Tried it. Couldn’t get it to work. Believe it may be because tool has merged cells and I don’t know how to handle them for scenario creation. But pencil/paper still works.
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