There's a lot of fear out there about taxes. People don't want to pay taxes in retirement. This fear is often used to sell physicians inappropriate financial products such as whole life insurance. Sometimes the fear looks like this:
Look at our government spending! There's no way we can handle this without tax rates going way up in the future!
Sometimes it looks like this:
All that tax-deferred money? Your RMDs are going to be so huge you're going to get killed on the taxes!
What these folks don't tell you, however, is that for many retirees, taxes are an almost trivial expense. Let me explain, but just for fun, let's take it to an extreme. Let's imagine a retiree who is spending $200K a year while paying $0 in federal income tax. How can that be possible?
Well, let's imagine a married couple, both 60 years old, with a $2 Million traditional IRA, a $500K Roth IRA, a $100K HSA, a paid for $600K house, and a $1 Million taxable account. They have no rental properties, have no pensions, and take the standard deduction. They have one kid still in college and they paid some of his tuition during this tax year. What is their tax bill? Well, it depends, but there are a number of ways to make it $0.
How to Pay Zero Tax in Retirement
Method #1
Take all $200K out of the Roth IRA. Voila, no taxes due!
Method #2
Have the $1M invested completely in municipal bonds. Perhaps it spits out $30K in income and you sell another $170K of them and the basis is the value. Again, no tax due.
Method #3
Take out a $200K home equity line of credit against the house. Spend it. No tax due.
Not realistic? Okay, fair enough. Those are all a little extreme, but you're starting to see how this process works. Let's come up with a more realistic scenario and show that the tax bill could still be zero.
Let's say half that taxable account is invested in muni bonds paying 3%, basis about equal to value. The other half is invested in stock index funds with a yield of 2% where basis is 75% of value. Besides that tax-free interest ($15K) from the munis and those qualified dividend/long-term capital gains (LTCGs) from the stocks ($10K), they'll need a few other sources of spending money. Let's say they take $48K from their traditional IRA, $2K (spent on health care) from the HSA, $50K from the Roth IRA, and sell $50K of the munis and $25K of the stock index funds. How is each source of spending money taxed?
- Traditional IRA withdrawal – taxed at ordinary rates
- HSA withdrawal spent on health care – tax-free
- Roth IRA withdrawal – tax-free
- Muni bond interest – tax-free
- Stock index fund qualified dividends – qualified dividend rates
- Sale of muni bonds – tax-free
- Sale of index funds – 1/4 ($7,250) taxable at LTCG rates
Let's add it all up.
You've got $135,750 that is completely tax-free. That leaves us $64,250 in taxable income, $48K at ordinary rates and $16,250 at the lower qualified dividend/LTCG rates. Subtract out the $25,100 standard deduction (2021 MFJ). Now you're left with $22,900 at ordinary rates and $16,250 at LTCG rates. That puts them just a little into the 12% bracket as shown below in this graphic courtesy of The Tax Foundation.
So the tax bill right now is 10% * $19,900 + 12% * ($22,900 – $19,900) = $2,350.
But what about those capital gains? Well, let's take a look at those brackets:
What do you see there? Look at the middle column, first line. That's right. 0%. That $16,250K in qualified dividends and long-term capital gains? Tax-free.
Getting to a $0 Tax Bill in Retirement
So we're still at a tax bill of $2,350. That's not very high, but it's not $0 either. How can we make it zero? Remember that college kid? He doesn't qualify for the child tax credit. That phases out at 17. But his parents did pay tuition for him. What kind of tax benefit could there be for that? The American Opportunity Tax Credit is only partially refundable and only up to $2,500 spent on tuition, books, and fees. Since they spent at least that much on Junior, that takes $2,500 off their tax bill.
$2,350 – $2,500 = a $150 refund. They got to spend $200K and owe $0 in Federal income tax. $0 in Social Security tax. $0 in Medicare tax. Probably $0 in state income tax. Sure, they've still got some property tax, gas tax, and sales tax to pay and those little nickel and dime fees on their cell phone bills, but compared to what this couple was paying during their working years? Not even close. Notice this didn't require any fancy, schmancy tax techniques. There's no home equity loan or margin account. No whole life insurance policy or annuity. Just boring old mutual funds inside the usual investing accounts we talk about all the time around here.
Isn't it amazing what an understanding of the tax code plus the use of tax-protected accounts can do! Note that this isn't necessarily how the couple should manage their money. Honestly, they should probably be paying more in taxes now voluntarily in order to pay less later by doing Roth conversions and spending tax-deferred money instead of Roth money. They should also probably be using taxable bonds instead of muni bonds given their tax bracket, but I just wanted to show you what is possible.
How to Minimize Retirement Taxes While Drawing Social Security
This 60-year-old couple didn't qualify for Social Security, but what if we turned the clock ahead a decade. Now they're 70, junior is a couple of years out of his own residency, they're required to start taking RMDs, and they're collecting $30K a year in Social Security benefits. How does the income stack up now?
Well, the RMD at 70 is 3.6%, so on a $2M IRA, $72K/year.Social Security is paying them $30K, 85% of which is taxable as ordinary income.
Those munis are still kicking out $15K a year in tax-free income and the index funds are kicking out $10K/year of qualified dividends. They're paying their Medicare premiums out of the HSA and between that and their health care expenses, they pulled out $8K from the HSA this year. That leaves $65K to come from somewhere. Let's say they sell $30K of the muni bonds and withdraw $35K from the Roth IRA. How is all that taxed?
- RMD $72K – ordinary income tax rates
- SS $30K * 85% = $25,500 – ordinary income tax rates.
- $8K from HSA – Tax free
- Muni interest $15K – tax-free
- Muni bond sales $30K – tax-free (basis equal to value)
- Index fund dividends $10K – dividend tax rates
What's the tax bill look like?
Well, if you subtract the $25,100 standard deduction from the $97,500 taxed at ordinary income tax rates, that leaves you with $72,400. The tax bill on that is 10% * 19,900 + 12% * ($72,400 – $19,900) = $8,290 plus something like $1,400 more for the taxable portion of the qualified dividends. $200K to spend and less than $10K in taxes. Does that sound like a “tax bomb” to you? It doesn't to me either.
Only Thing We Have to Fear Is Fear Itself
Don't let anybody scare you into doing something stupid with your investments with the implications of rising taxes, being in higher brackets, or required minimum distributions. You'll probably be paying something in taxes during your retirement, but it will likely be less money than you paid in taxes as a resident. Max out your tax-protected accounts, especially the tax-deferred ones during your peak earnings years and the tax-free ones in other years. Do Backdoor Roth IRAs. Invest in an HSA if you use a high deductible health plan (HDHP). Invest in a tax-efficient way in your taxable accounts. Be smart how you withdraw from the accounts and you'll be fine without any sort of extreme solution.
What do you think? Did you know that you could spend that much in retirement without paying any taxes? How can you combine a knowledge of the tax code with the use of tax-protected accounts to further reduce your taxes? Comment below!
Great post. I do not have time this morning for a thoughtful response. The key is ditching all that earned income. The RMD thing does not mean go out and buy whole life. It means be aware and try to do some roth conversions.
Love the scenarios showing possible ways of maneuvering around and taking advantage of the tax codes.
People who retire early also have a longer opportunity to do Roth conversions and if done right can do that tax free as well (need cash equivalents for living expenses during the Roth conversion years and as long as in the lower tax bracket the tax rate would be 0% to do so).
RMDs can be an issue later on and can make your social security payments taxable as well as cause increase in Medicare premiums etc so I still think it is wise to try and reduce that as much as you can before it kicks in.
I would just assume that the entire 85% of your SS payment will be taxable. I really don’t want to be in a place where it is possible that anything less than that of mine is not going to be taxable. That represents a pretty low level of assets. That’s only something like $34K of income.
Good thought experiment!
Tax planning for de-accumulation isn’t just a one year process though. Those 60 year olds above are in their “tax planning window” and as you mentioned likely should be doing Roth Conversions to max out their 24% tax bracket. (RMDs on 2M in the IRA will put them above the 24% tax bracket soon).
I have a blog on the Tax Time Bomb that I hope you will let me share.
Thanks,
David Graham, MD
http://www.fiphysician.com/the-tax-time-bomb-ready-to-blow-up-40-of-your-retirement/
I always enjoy posts like this one. I think I remember reading something similar that POF did. It really drives home the point that knowledge is power.
Knowing how the tax code works is key to success. I love the idea of Roth ladders and utiliIizing municipal bonds.
Either way, completely agree that scare tactics are not a good reason to invest in bad products.
TPP
The whole life tax bomb sales scenario sounds legitimate until you learn how taxes are calculated. People pay less in taxes in retirement than their working years, many times significantly less, so paying taxes during your working years to avoid them in retirement isn’t a strategy that makes sense to me.
Really good illustration. Whenever someone asks about traditional vs Roth contributions in their peak earnings years, this post should be a good guide.
is it prudent to max out the 24% bracket for roth conversions?
Listened to Ric Edelman and he felt roth conversions are a wash
What about taking excess contributions to buy munis?
It depends. For some, yes. For others, no. For still others, it’ll be a wash.
No, I wouldn’t take excess contributions.
I meant excess DISTRIBUTIONS not contributions
my wife and I have 4.3m in ira’s age 68-69(130k only in Roths)
ANY ADVICE? both collecting ss
I can do 80k roth conversion to stay in the 24% bracket
Back of the envelope calculations show your RMD’s will be about 300-400k when you are in your 80-90’s (assuming 50/50 portfolio). Ouch.
Not much to do this late in the game. You might consider Roth conversions if you have estate planning goals (would you rather leave your heirs Roth money that is tax free or IRD that is fully taxable likely during their peak income years?)
Of course, keep in mind that $300-400K may be the same as $150-200K now. Keep inflation (and the fact that the tax brackets rise with inflation) in mind.
Yea, spend that money before you’re too old to do so, taxes be darned.
Once you are both collecting SS and any pensions you’ll get, the attractiveness of the Roth conversion goes down quite a bit.
Great post Jim. I have clients that approach me all the time about retirement planning and they have this huge concern about taxes they might pay as retirees. In most cases their fears are simply unfounded. And it is not just the ridiculous sales tactics and sales products sold by financial advisors that create this fear but some bloggers, who, in an effort to be clever, create this concern as well.
How would this change if you had tremendous financial success during your working years? What if your accounts had double or triple (or more) in value? Onviously you couldn’t get to $0 taxes (don’t want to let the tax tail wag the dog- I think it is better to still put away more money if you can)
Not trying to poke a hole in your article- this is a great thought experiment to help folks figure out what to worry about (and what not to worry). Would love a post for this subset (albeit much smallwr) of your readers.
Keep up the great work for everyone!
You still could even with tons of assets, so long as they weren’t in tax-deferred accounts. (i.e. put it all in munis or do massive Roth conversions). But again, you probably don’t want to.
One thing Jim didn’t write about is that if you are in your RMD period you could assign your RMD’s to charity (Qualified
Charitable Distribution) and get a really nice tax benefit while not needing to itemize. I think this is even more important now that the standard deduction went up to $24,000, especially for people with $0 state income tax (retired individuals) and $0 mortgage interest.
Yes, giving money away to charity is another great way to lower your tax bill. Can’t put everything into every blog post, but here’s one a couple of recent posts on QCDs, my favorite way for a retiree to give to charity.
https://www.whitecoatinvestor.com/qualified-charitable-distributions/
https://www.whitecoatinvestor.com/7-ways-irs-supports-charitable-desires/
as a fla resident my effective federal taxes of 250k income is around 17%
at 300k its 18%
MOST of we retirees who spend 200k yearly will need a gross income of around 250k including ss unless they have a huge muni bond portfolio
I would not touch my roth ira unless there was a strong reason to do so
Not really. That was the point of the post. You simply chose to pay more in tax now by not touching your Roth IRA nor doing Roth conversions earlier. Many spending $200K will pay a lot less than you are in taxes.
Did your standard MFJ deduction include the additional $2600 a couple would get after turning 65?
Good point, nope. Forgot that. But it kind of supports my point, doesn’t it?
yes guess I have a good problem
should have done roth conversions years ago but was still working in NJ and did not consider it
have no problem paying 24% tax on roth conversions age 68 going forward yearly unless tax rates change for the worse
Given your move from NJ to FL, you may have done exactly the right thing not doing Roth conversions.
touching your roth ira in retirement without it being an emergency or necessity does not seem wise
roths should be the last account to touch
Why? The point of having tax-free and tax-deferred accounts in retirement is to allow oneself to choose your tax rate. You take out tax-deferred up to the top of the nearest tax bracket, then tax-free above that.
1000 people/day moving to fla
ny lost 1.2 billion in taxes from rich guys leaving the state as well
I’m amazed they have any docs at all, working or retired, given the tax benefits of leaving.
there are roth conversion calculators and I did one and the difference was not significant
would hate to do a significant conversion and see a big stock loss but I would put it into bond funds
How did we calculate that ” $135,750 that is completely tax-free” ??
Maybe I am just slow but where is this figured and how ?
Thanks
This is important, so I’ll walk you through it.
From the post:
Besides that tax-free interest ($15K) from the munis and those qualified dividend/LTCGs from the stocks ($10K), they’ll need a few other sources of spending money. Let’s say they take $48K from their traditional IRA, $2K (spent on health care) from the HSA, $50K from the Roth IRA, and sell $50K of the munis and $25K of the stock index funds.
HSA withdrawal spent on health care – tax-free $2K
Roth IRA withdrawal – tax-free $50K
Muni bond interest – tax-free $15K
Sale of muni bonds – tax-free $50K
Sale of index funds – tax-free $18,750
Total = $135,750
Probably the index funds is what threw you off- since 75% of them are basis, there is no capital gains taxes due on 75% of what they’re sold for.
Hi, I know this is a small thing and a drop in the proverbial bucket, but I think the suggestion that they take medical expenses out of an HSA is not right once you take your SS, or so I’ve been told. I am working full time, Getting SS which automatically requires me to at least take Medicare Part A. And I’m not allowed to have an HSA or FSA because of that. I don’t know what would have happened if I already had an HSA account prior to taking my SS…would that have made a difference? Also, I am Head of Household as the sole supporter of my 9 yr old grandson who lives with me, and this year I was not allowed to take a deduction for him under the new tax law and my SS is now being taxed at close to 50%. I’m just a Family Doc so my income is nowhere near the level of most of the docs I see posting on here (have been lurking for months trying to build up enough confidence to post!), and although things have been pretty straightforward up till now figuring my own taxes, I’m thinking that this year I may have to hire a tax advisor/accountant. But I know that’s pretty expensive so I’m just not sure it will benefit me that much to go to that extra expense. Especially with a student loan burden of $3000/month. (I started REALLY late – Graduated med school in 2006, didn’t start full-time practice until age 60. Needless to say, I don’t plan to retire any time soon, but I don’t want to be stupid about handling my finances either. I’m thinking 80ish is a good goal to retire – fortunately I have long-lived genes and the example of parents/grandparents that are, or have been active well into their 90’s!) Anyway, as it is, my take-home pay is about that of a relatively experienced Nurse Practitioner – maybe – which means I don’t have a lot of money to spare so I just don’t know whether I can afford to pay for a tax advisor – but I don’t know if I can afford NOT to. It’s a conundrum so if anyone has any suggestions, I’m open to consider them!
You cannot contribute to an HSA if you are on Medicare but if you had one previous to starting Medicare then you could still use it.
You can HAVE an HSA, you just can’t CONTRIBUTE to an HSA.
BTW- there are plenty of “lower income docs” on here and plenty of people that make less than docs, so don’t let some of the big time earners scare you off.
Tax prep isn’t that expensive. If you need help, get it and just learn what they do and you can probably do it yourself next year.
I will attest to that. I’m actually quite broke. I lurk, as Catherine does, so that on the eve of not being broke, I will have had access to good information and know what to do with myself.
Excellent illustration of the reality of taxes in retirement, particularly when you have good tax diversification with money in taxable and Roth accounts.
It’s not uncommon that someone argues it’s foolish to assume you’ll have lower income in retirement, as if that means you’ll have a lower standard of living. There can be a HUGE difference between taxable income and annual spending.
That 0% capital gains bracket is particularly important, and the point about the AOTC for paying college tuition is a good one. Another is the child tax credit of $2,000 per child for those of us brazen of us to retire with kids under age 17.
Cheers!
-PoF
Nice post, which muni bonds are you guys all buying? I made an error and put vanguard total bond index in my taxable. The gains are not high and I may switch to municipal bonds.
I just use the intermediate Vanguard fund.
I am looking at the vanguard site and checking out the vanguard intermediate fund vs total bond vanguard fund.
Vanguard Intermediate-Term Bond Index Fund Investor Shares (VBIIX)
Returns before taxes 10 years 4.36%
Returns after taxes 10 years 2.96%
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)
Returns before taxes 10 years 3.31%
Returns after taxes 10 years 2.14%
So both of these of the same tax drag. So I’m not exactly sure how one is better than the other?
I think he means Vanguard intermediate tax exempt.
VWITX
Got it. Thanks for that!
Aseges
Exactly.
Could you pls suggest a Fidelity fund similar to VWITX? Fidelity suggested FLTMX but its not an index fund and the expense ratio is higher (0.34%). Thanks.
https://fundresearch.fidelity.com/mutual-funds/summary/31638R204?type=sq-NavBar
Fidelity doesn’t have as many index funds as Vanguard does. Sorry. I agree FLTMX is likely your best bet among Fidelity funds. Or just buy the Vanguard ETF VTEB if you have to invest at Fidelity. You could do one of the state specific funds too if it is applicable.
As time goes on and you spend down the muni fund in the example and you have to dig deeper in your stock fund to lower basis shares the tax will start to rise. Is this correct? Am I missing something? Will it make a difference in a significant amount?
Yes, it could increase tax a bit. Significant? In the eye of the beholder I guess.
Livesoft, is that you?
https://www.bogleheads.org/forum/viewtopic.php?t=87471
https://www.bogleheads.org/forum/viewtopic.php?t=79510
No, but certainly there was some inspiration there.
Questions on social security income. They make 40k in social security but are only tax at 85% of 30k as ordinary income?
Good catch. Typo. Fixed it. It’s $30K.
It’s equally interesting to run through the worst case example(s). The couple is retired, so presumably no earned income at higher rates.
What’s the most tax disadvantaged place to pull $200K out of investments?
e.g. Sell off $200K in securities from the taxable account at one time. That’s $121,250 subject to LTCG @ 15% (assuming worst case basis).
Is that the absolute worst case? For me, paying $18K in taxes on $200K in annual spending is hardly a catastrophe that requires special planning. Even someone doing absolutely everything wrong in the scenario just doesn’t have that much tax exposure. And realistically, the greater risk is the $3.6M portfolio simply doesn’t support $200K annual withdrawals.
The usual 4% withdrawal would drop annual spending to $144K with a corresponding drop in federal taxes to under $10K. The most incompetent tax advisor imaginable could probably cut that $10K in half without hurting anyone. With $3.6M in assets, it’s hardly a pressing issue to resolve.
p.s. No state taxes? 😉
Worst case scenario would be $200K in taxable bond interest or other income that is fully taxable at ordinary income tax rates.
State taxes ignored for simplicity’s sake. Probably should have mentioned that in the assumptions somewhere. Although if you live in WA, NV, AK, FL, TX etc….
That would *definitely* be worse. And one helluva portfolio to generate those kinds of taxable returns.