Taxes in retirement too good to be true?

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mrspock
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Taxes in retirement too good to be true?

Post by mrspock » Wed Sep 12, 2018 1:56 am

I've been running some scenarios for taxes in retirement, and I'm having a hard time believing what Intuit's TaxCaster is telling me. Here's the scenario:

Retirement Assumptions
- Single, head of household
- State without state taxes (Washngton/Nevada/Florida etc).
- 3% withdrawal rate
- No mortgage (8k property taxes)

Retirement Assets:

Taxable Account: $3M, 80/20 mix (let's go with this for now...I know 60/40 is more realistic).
$2.4M VTI + VOO (100% qualified dividends?)
600k National muni bond fund (VTEB)

Let's say VTEB pays out 2.5% per year, so $15k of income tax free, leaving $75k to come from dividends + long-term capital gains (LCG) from VTI + VOO.

I plug all this in and it yields an answer of ~$500 taxes owing each year. If instead, I assume 100% comes from LCG + Dividends, I get a number like $3500. Does this sound correct? Is this because the $38.6k of LCG is tax free + the standard deduction of $12k makes only [90k - 12k - 38.6k] = $39.4k eligible for taxation @ 15%?

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Re: Taxes in retirement too good to be true?

Post by AlohaJoe » Wed Sep 12, 2018 1:58 am

Sure, sounds right.

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JoMoney
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Re: Taxes in retirement too good to be true?

Post by JoMoney » Wed Sep 12, 2018 2:09 am

I think a muni-bond fund is the wrong choice in that scenario. Tax bracket is so low that you may not be getting compensated for the lower yield + with the $12,000 standard deduction you could be using for income that is less tax efficient than qualified dividends and LTCG.

What does your planned spending/expenses actually looking like? Are you already deducting the cost basis from the "$75k VTI+VOO dividends + long-term capital gains" ?

Do you already own property/home in one of those states? Or would you be selling assets or getting a mortgage (maybe interest deductions) to pay for it?
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Re: Taxes in retirement too good to be true?

Post by mrspock » Wed Sep 12, 2018 2:45 am

JoMoney wrote:
Wed Sep 12, 2018 2:09 am
I think a muni-bond fund is the wrong choice in that scenario. Tax bracket is so low that you may not be getting compensated for the lower yield + with the $12,000 standard deduction you could be using for income that is less tax efficient than qualified dividends and LTCG.

What does your planned spending/expenses actually looking like? Are you already deducting the cost basis from the "$75k VTI+VOO dividends + long-term capital gains" ?

Do you already own property/home in one of those states? Or would you be selling assets or getting a mortgage (maybe interest deductions) to pay for it?
That's a good point on VTEB, are you suggesting moving to BND instead?

Planned spending:
- Food, utilities, cable/internet, clothes, entertainment, vacations - $5k/month; based off of my current budget which I routinely come under by $1-2k (depends if I'm traveling or buying "discretionary toys")
- Health Insurance (Silver ACA plan?) - $500/month (Silver ACA plan?); I'll be in my early 40s, so this is based off of some Google'ing I did...
- Property Taxes - $700-800/month; I could be way off here given I have no clue about property taxes in various states, I'm just basing this off of what I pay now.
- Leaves around $900-800 as cushion (Car fund? HSA?)

I have no home in another state yet, so I'd have to dispose of my current home which is fully paid, so I'd pretty much "trade" one place for another (maybe free up more cash if I find a place cheaper as I live in a HCOL area).

"Are you already deducting the cost basis" --- That's a really good point, so the taxes would be even lower...wow.

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Re: Taxes in retirement too good to be true?

Post by mhalley » Wed Sep 12, 2018 3:01 am

The problem with this scenario is you are assuming a taxable account. Most people will have the majority of funds in an IRA ir 401k. Then you have to think about rmds, Roth conversions, etc

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Re: Taxes in retirement too good to be true?

Post by aristotelian » Wed Sep 12, 2018 6:20 am

When SS hits that will eat up your lower brackets.

Roth accounts would give you even more flexibility. However, it is generally advantageous to save more dollars pretax accounts, but those withdrawals would be subject to tax.

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Re: Taxes in retirement too good to be true?

Post by cas » Wed Sep 12, 2018 6:52 am

mrspock wrote:
Wed Sep 12, 2018 1:56 am
I plug all this in and it yields an answer of ~$500 taxes owing each year. If instead, I assume 100% comes from LCG + Dividends, I get a number like $3500. Does this sound correct? Is this because the $38.6k of LCG is tax free + the standard deduction of $12k makes only [90k - 12k - 38.6k] = $39.4k eligible for taxation @ 15%?
1. (more minor point. See much more major point listed after this.) The tax numbers look a little funny to me, but maybe it is just early in the morning, and my brain hasn't kicked in. Given that you mentioned "single, head of household" in your post, is TaxAct maybe using the "head of household" numbers for standard deduction? ($18,000, rather than $12,000 for single) and the dividing line between 0%/15% LTCG tax rates for head-of-household rather than single (dunno what that is ... somewhere around the 12%/22% tax bracket dividing line of $51,800 for head-of-household, maybe (rather than $38,600 for single))

In any case, using the filing-single $12,000 and $38,600 numbers that you list, I'm getting much higher tax. (But, again, it is early. Haven't had breakfast.)

Case 1: 75K QDI/LTCG + 15K tax-exempt - 12K standard deduction - 38.6K (0%/15% QDI/LTCG dividing line filing single) = $24,400 taxable at 15% LTCG rate = $3660.

Case 2: 90K QDI/LTCG + 0K tax-exempt - 12K standard deduction - 38.6K (0%/15% QDI/LTCG dividing line filing single) = $39,400 taxable at 15% LTCG rate = $5910.

2. (Much more major point). Be very sure that you thoroughly understand how having very high qualified dividend/LTCG income relative to ordinary income can cause unexpectedly high marginal tax rates: Boglehead's wiki "Common Examples of High Marginal Tax Rates" 2nd paragraph: https://www.bogleheads.org/wiki/Margina ... inal_rates

Given 75K (or 90K) of QDI/LTCG income, filing single, you will effectively replace the 0%, 10%, and 12% ordinary income nominal tax brackets with 15%, 25%, and 27% marginal tax brackets. Maybe FiveK will read this thread and generously generate a graph showing this phenomenon with pictures rather than words.

But, in words ... If you add any ordinary income (e.g. taxable bonds or bank account, Roth conversions. Later on, social security* & RMDs) to the mix above, each $1 of ordinary income will also "push" $1 of QDI/LTCG from the 0% tax rate to the 15% tax rate. So...

- in the nominal 0% tax bracket, the $1 of ordinary income will incur $0 of tax and the $1 of QDI/LTCG it "pushed" into the 15% tax rate will incur $0.15 of tax. Net effect: $0 + $0.15 = $0.15 tax because you added $1 in ordinary income => 15% marginal tax rate

- in the nominal 10% tax bracket, the $1 of ordinary income will incur $0.10 of tax and the $1 of QDI/LTCG it "pushed" into the 15% tax rate will incur $0.15 of tax. Net effect: $0.10 + $0.15 = $0.25 tax because you added $1 in ordinary income => 25% marginal tax rate

- in the nominal 12% tax bracket, the $1 of ordinary income will incur $0.12 of tax and the $1 of QDI/LTCG it "pushed" into the 15% tax rate will incur $0.15 of tax. Net effect: $0.12 + $0.15 = $0.27 tax because you added $1 in ordinary income => 27% marginal tax rate

-Once your ordinary income reaches the 22% tax bracket, you've already pushed all your QDI/LTCG into the 15% tax bracket, so the marginal tax rate is also 22%. (Yes, counterintuitively, at this point your marginal tax rate would drop because you added more income. Unless you were hitting up against NIIT (Net Income Investment Tax) or the Medicare IRMAA (Income Related Medicare Adjustment Amount) AGI limits at that point, which might well be the case.

*Note: if social security income was also involved in the mix, the marginal tax rates could be even higher. But since you say you are much younger than SS age, I left those considerations out.

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Re: Taxes in retirement too good to be true?

Post by MikeG62 » Wed Sep 12, 2018 7:24 am

OP, I would say it is not too good to be true. Most of your income is coming from low/no tax sources. This is the advantage of having a sizable amount of assets in taxable accounts (which I advocate as highly advisable if one plans to retire early).

Do you really have no tax deferred retirement savings (no old 401k or IRA). Hard to believe this could be true.

Great job on saving a large sum of money as a single in your early 40's.
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Re: Taxes in retirement too good to be true?

Post by mrspock » Wed Sep 12, 2018 11:07 am

cas wrote:
Wed Sep 12, 2018 6:52 am

1. (more minor point. See much more major point listed after this.) The tax numbers look a little funny to me, but maybe it is just early in the morning, and my brain hasn't kicked in. Given that you mentioned "single, head of household" in your post, is TaxAct maybe using the "head of household" numbers for standard deduction? ($18,000, rather than $12,000 for single) and the dividing line between 0%/15% LTCG tax rates for head-of-household rather than single (dunno what that is ... somewhere around the 12%/22% tax bracket dividing line of $51,800 for head-of-household, maybe (rather than $38,600 for single))

In any case, using the filing-single $12,000 and $38,600 numbers that you list, I'm getting much higher tax. (But, again, it is early. Haven't had breakfast.)

Case 1: 75K QDI/LTCG + 15K tax-exempt - 12K standard deduction - 38.6K (0%/15% QDI/LTCG dividing line filing single) = $24,400 taxable at 15% LTCG rate = $3660.

Case 2: 90K QDI/LTCG + 0K tax-exempt - 12K standard deduction - 38.6K (0%/15% QDI/LTCG dividing line filing single) = $39,400 taxable at 15% LTCG rate = $5910.
You are quite correct, I'm not eligible for HOH, so I'm getting higher numbers as you are, but still really low though to my eyes (6.7% marginal rate) ...granted I'm used to much higher taxes right now (>40% w/ state taxes added in). In actuality, the real number should be lower, since as a prior poster indicated, I've not taken into account my cost basis for the VOO/VTI shares in my calculation.
cas wrote:
Wed Sep 12, 2018 6:52 am
2. (Much more major point). Be very sure that you thoroughly understand how having very high qualified dividend/LTCG income relative to ordinary income can cause unexpectedly high marginal tax rates: Boglehead's wiki "Common Examples of High Marginal Tax Rates" 2nd paragraph: https://www.bogleheads.org/wiki/Margina ... inal_rates

Given 75K (or 90K) of QDI/LTCG income, filing single, you will effectively replace the 0%, 10%, and 12% ordinary income nominal tax brackets with 15%, 25%, and 27% marginal tax brackets. Maybe FiveK will read this thread and generously generate a graph showing this phenomenon with pictures rather than words.

But, in words ... If you add any ordinary income (e.g. taxable bonds or bank account, Roth conversions. Later on, social security* & RMDs) to the mix above, each $1 of ordinary income will also "push" $1 of QDI/LTCG from the 0% tax rate to the 15% tax rate. So...

- in the nominal 0% tax bracket, the $1 of ordinary income will incur $0 of tax and the $1 of QDI/LTCG it "pushed" into the 15% tax rate will incur $0.15 of tax. Net effect: $0 + $0.15 = $0.15 tax because you added $1 in ordinary income => 15% marginal tax rate

- in the nominal 10% tax bracket, the $1 of ordinary income will incur $0.10 of tax and the $1 of QDI/LTCG it "pushed" into the 15% tax rate will incur $0.15 of tax. Net effect: $0.10 + $0.15 = $0.25 tax because you added $1 in ordinary income => 25% marginal tax rate

- in the nominal 12% tax bracket, the $1 of ordinary income will incur $0.12 of tax and the $1 of QDI/LTCG it "pushed" into the 15% tax rate will incur $0.15 of tax. Net effect: $0.12 + $0.15 = $0.27 tax because you added $1 in ordinary income => 27% marginal tax rate

-Once your ordinary income reaches the 22% tax bracket, you've already pushed all your QDI/LTCG into the 15% tax bracket, so the marginal tax rate is also 22%. (Yes, counterintuitively, at this point your marginal tax rate would drop because you added more income. Unless you were hitting up against NIIT (Net Income Investment Tax) or the Medicare IRMAA (Income Related Medicare Adjustment Amount) AGI limits at that point, which might well be the case.
Wow, thanks for this information, this is a critical piece of information, as if I do a side hustle, work part-time or move to BND from VTEB it would change the math considerably. The key piece here (if I'm understanding this right) is that for ADI/LTCG you get a nice wide $0-38.6k band of 0% taxation (after subtracting the standard deduction!), for regular income you get no such break and thus the strange effect you speak of.

MikeG62 wrote:
Wed Sep 12, 2018 7:24 am
Do you really have no tax deferred retirement savings (no old 401k or IRA). Hard to believe this could be true.
I do have a small amount in a 401k + Roth 401k/Roth IRA, around $200k/$100k, I didn't include this in my tax calculations as I won't take money from my 401k until I'm required to do so (RMDs?), and the Roth should only serve to lower my taxes as (if I understand correctly) I can withdraw my contributions tax free. Is my reasoning sound here?

I admit I'm a strange case :) . Thanks to everyone who replied on this thread, the information has been invaluable.

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Re: Taxes in retirement too good to be true?

Post by MikeG62 » Wed Sep 12, 2018 11:27 am

mrspock wrote:
Wed Sep 12, 2018 11:07 am
MikeG62 wrote:
Wed Sep 12, 2018 7:24 am
Do you really have no tax deferred retirement savings (no old 401k or IRA). Hard to believe this could be true.
I do have a small amount in a 401k + Roth 401k/Roth IRA, around $200k/$100k, I didn't include this in my tax calculations as I won't take money from my 401k until I'm required to do so (RMDs?), and the Roth should only serve to lower my taxes as (if I understand correctly) I can withdraw my contributions tax free. Is my reasoning sound here?

I admit I'm a strange case :) . Thanks to everyone who replied on this thread, the information has been invaluable.
OP, correct under current rules all earnings withdrawn from a Roth are withdrawn tax free.

Have you thought about doing systematic partial Roth conversions (from your tax deferred account) up to the top of your current tax bracket? [You might need to roll the 401k into a Rollover IRA first to enable this.] It could make a lot of sense if all of your QD's and LTCG's are being taxed at a 0% rate. This would be the case as long as your taxable income does not exceed $38,600. When adding in your standard deduction that translates to AGI of $50,600. So if your dividends are around $37,500 (given your equities are in ETF's, they should have zero or near zero LTCG's) and if continue to hold the muni's, that would give you about $13,000 per year of room to Roth convert (at a 12% tax rate).
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Re: Taxes in retirement too good to be true?

Post by bradpevans » Wed Sep 12, 2018 11:27 am

[/quote]I do have a small amount in a 401k + Roth 401k/Roth IRA, around $200k/$100k, I didn't include this in my tax calculations as I won't take money from my 401k until I'm required to do so (RMDs?), and the Roth should only serve to lower my taxes as (if I understand correctly) I can withdraw my contributions tax free. Is my reasoning sound here?

I admit I'm a strange case :) . Thanks to everyone who replied on this thread, the information has been invaluable.
[/quote]

you might use the Roth to "fill up" certain tax brackets to your advantage in certain years.
Additionally, with taxable, you get to "live" on the sell amount but only are taxed on the gain amount.
You may wish to google on "tax GAIN harvesting" - essentially you up your basis in years when you
still have room in the 0% LTCG bucket, which could easily happen if you sell 80,000 in stock
but your basis is 40-50K of that 80K
Last edited by bradpevans on Wed Sep 12, 2018 1:56 pm, edited 1 time in total.

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Re: Taxes in retirement too good to be true?

Post by curmudgeon » Wed Sep 12, 2018 11:40 am

It's definitely possible to have pretty low income taxes in retirement if you have the right asset placement and sources. When you have been used to big tax bills, it can be a bit of a pleasant shock. There are occasional gotchas, so it pays to do evaluation and planning. Muni bonds are helpful some of the time, but occasionally that income gets added back in (for things like ACA subsidy calculations). DO remember that health insurance rates go up sharply with age, which may increase your cash needs.

The interactions of qualified dividends and various cutoff points can be odd, especially when you add SS taxation into the mix. I've done some scenarios where I see us hitting an effective 49% marginal fed tax rate (but only for a few $K of income range, then it drops back to 22%) because of the various phase-outs and phase-ins (additional income makes more of SS benefit taxable and also pushes QDIVs out of 0% tax at at same time). I find this tool fairly helpful in doing various analysis: https://www.mortgagecalculator.org/calc ... ulator.php

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Re: Taxes in retirement too good to be true?

Post by livesoft » Wed Sep 12, 2018 1:38 pm

Property taxes don't go away just because you have paid off the mortgage. Neither does property insurance.
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Re: Taxes in retirement too good to be true?

Post by HomerJ » Wed Sep 12, 2018 1:41 pm

livesoft wrote:
Wed Sep 12, 2018 1:38 pm
Property taxes don't go away just because you have paid off the mortgage. Neither does property insurance.
But you can live anywhere once you no longer have a job.
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Re: Taxes in retirement too good to be true?

Post by random_walker_77 » Wed Sep 12, 2018 1:47 pm

Don't forget that inflation is also taxed, so tax rates ought to be low enough to incentivize making capital available to companies. Consider if inflation is 3% and you've invested 100K, and get a return of 3%. You've no real gains, but now you owe taxes on 3%, so you're losing money. If you get a return of 4%, and are in the 25% bracket, congrats, you've now broken even, which isn't much of a reward for taking on risk.

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Re: Taxes in retirement too good to be true?

Post by FiveK » Wed Sep 12, 2018 2:28 pm

cas wrote:
Wed Sep 12, 2018 6:52 am
Given 75K (or 90K) of QDI/LTCG income, filing single, you will effectively replace the 0%, 10%, and 12% ordinary income nominal tax brackets with 15%, 25%, and 27% marginal tax brackets. Maybe FiveK will read this thread and generously generate a graph showing this phenomenon with pictures rather than words.
Assuming $15K of tax-exempt interest, $40K of QD/LTCG, and under age 65, one gets
Image

Adding $20K of SS benefit and over age 65, one gets
Image

Starting traditional->Roth conversions ASAP, to reduce the high marginal rate impact of eventual RMDs, is well worth considering.

See the personal finance toolbox spreadsheet (download to Excel) to run other scenarios.

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Re: Taxes in retirement too good to be true?

Post by cas » Wed Sep 12, 2018 2:50 pm

Thanks FiveK! A picture is worth a thousand words!

(Note to OP: If you are wondering about the spikes in the second (after age 65) graph, those show where increased income is causing IRMAA (Medicare) modified AGI thresholds to be crossed and triggering an increase in Medicare Part B and D premiums.)

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Re: Taxes in retirement too good to be true?

Post by JoMoney » Wed Sep 12, 2018 3:07 pm

Glockenspiel wrote:
Wed Sep 12, 2018 12:23 pm
mhalley wrote:
Wed Sep 12, 2018 3:01 am
The problem with this scenario is you are assuming a taxable account. Most people will have the majority of funds in an IRA ir 401k. Then you have to think about rmds, Roth conversions, etc
This scenario is why, in my opinion, the USA should increase taxes on capital gains and decrease taxes on middle class income.
IRA or 401k withdrawals won't be paying OASDI/Medicare, get the standard deduction ($12,000), and pay less than 12% on the first $38,000 above that (for a single filer)... on money they paid no taxes on going in (unlike the taxable account that was taxed potentially several times (when it was earned, transactions, dividends).
Middle-class income gets a pretty good deal.
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Re: Taxes in retirement too good to be true?

Post by FiveK » Wed Sep 12, 2018 3:54 pm

cas wrote:
Wed Sep 12, 2018 2:50 pm
(Note to OP: If you are wondering about the spikes in the second (after age 65) graph, those show where increased income is causing IRMAA (Medicare) modified AGI thresholds to be crossed and triggering an increase in Medicare Part B and D premiums.)
Thanks for adding that!

I' think that tool includes only the effect on Part B premiums. Any Part D increases would be extra. Part D increases are less than those for Part B so at least it captures the main effect.

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Re: Taxes in retirement too good to be true?

Post by mrspock » Wed Sep 12, 2018 7:18 pm

bradpevans wrote:
Wed Sep 12, 2018 11:27 am
You may wish to google on "tax GAIN harvesting" - you up your basis in years when you
still have room in the 0% LTCG bucket, which could easily happen if you sell 80,000 in stock
but your basis is 40-50K of that 80K
I just did some research as you advised, this just blows my mind, very cool. I’ll add this to my list of financial hobbies I’ll do in retirement (along with rebalancing, Roth conversions, and tax loss harvesting).

Thanks for pointing me in this direction.
bradpevans wrote:
Wed Sep 12, 2018 11:27 am
you might use the Roth to "fill up" certain tax brackets to your advantage in certain years.
What do you mean by this?

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Re: Taxes in retirement too good to be true?

Post by MikeG62 » Wed Sep 12, 2018 7:54 pm

mrspock wrote:
Wed Sep 12, 2018 7:18 pm
bradpevans wrote:
Wed Sep 12, 2018 11:27 am
you might use the Roth to "fill up" certain tax brackets to your advantage in certain years.
What do you mean by this?
OP, read this...

https://www.kitces.com/blog/using-syste ... t-buckets/
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Re: Taxes in retirement too good to be true?

Post by rgs92 » Thu Sep 13, 2018 12:17 pm

What mhalley said above is true about most retirement portfolios not being in taxable accounts.

You would have needed to have given up the benefits of tax deferral for decades or do expensive Roth conversions.
That would have cut into your gains (a lot), so getting up to many millions with this drag is quite difficult for most people.
Last edited by rgs92 on Thu Sep 13, 2018 6:54 pm, edited 1 time in total.

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Re: Taxes in retirement too good to be true?

Post by LadyGeek » Thu Sep 13, 2018 3:34 pm

This is a "no politics" forum. I removed several posts and replies expressing opinions on future tax rates (proposed legislation). See: Politics and Religion
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Re: Taxes in retirement too good to be true?

Post by WhiteMaxima » Thu Sep 13, 2018 3:57 pm

OP could do Roth conversion before take the RMD and SS. 3 mil is more than enough for single. Don't know how single could file as head of houshould.

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