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?
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
No fear here. She knows the proceeds from this picture are going straight to her Roth IRA.
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!
like I said paying 18% effective tax rate on 300k is better than I would have paid working
I could easily use my roth and muni bonds to pay zero tax but not sure if that is prudent
think a combination of taxable, tax deferred, and roths is the way to go
Michael kitces writes about that as well-tax diversification in retirement
my iras are mostly in fixed and I can live with 4% returns and withdraw the same
not looking for absolute returns, but preserving capital and income stream
I personally like the monthly tax free income from my individual munis and rather not touch my roth iras
most will pay more than 18k with 200k annual spending in federal taxes
We should be able to spend around $125k in retirement and pay around $11k in federal income taxes and zero in state income taxes (tax-free state). We’ll withdraw up to the top of the 12% bracket from tax-deferred accounts, withdraw additional funds from Roth accounts, and pay for medical expenses tax-free with our HSA. It won’t be tax-free, but we won’t have paid any income taxes on the tax-deferred accounts contributions or the HSA account and only 12% on the Roth accounts’ contributions. I’m good with that.
I’d love to see a calculator that could crunch the numbers and tell me what is best for me as I near retirement. I have similar assets as the example and it would take a lot of trial and error (and calculations) to get the ideal withdrawals. Spreadsheet anyone?
Haven’t seen one, but wouldn’t be that hard to make for yourself. The hard part is projecting it out a decade or two.
The Bogleheads forum has addressed this topic. Here’s a very good post on the topic from 2016, so the tax rates have obviously changed since then: https://www.bogleheads.org/forum/viewtopic.php?t=196404#p2997950
Same here: I may do one of my own. I’m wondering if I can actually create one whereby I simply input what I need for the year, put “0” for SS (assuming I’m not collecting yet), input my tax rates, and ACA limit, and have it tell me exactly the right “blend” to use of ROTH vs. TRAD withdrawals.
I’m wondering though, do HSA withdrawals, though not taxable if used for med expenses, count toward your MAGI for determining eligibilty for the ACA subsidy? (i.e. our insurance premium is $18,000 per year for family of 3, $6,500 deductibles, but only $1,200 per year if our MAGI is less than $80,000)
No, I don’t think they show up on your tax return anywhere.
HSA withdrawals do show up on your tax return on Form 8889, to certify that they were for qualified medical expenses (since otherwise they are taxable). As long as all withdrawals are for medical expenses, they do not add to income or MAGI.
I agree with premise of this article. I also agree that is is probably suboptimal for most to shoot for this as its usually better to smooth your tax rate in retirement before and after drawing SS and taking RMD’s – at least get Federal taxable income up to the top of the 12% tax bracket.
My only quibble is that someone spending $200K per year in retirement would likely have more assets than assumed in the example. After all, spending $200K on a portfolio of $3.6 million is an annual WD rate of 5.6%. If this hypothetical couple were using a WD rate of 4.0% or 3.5%, their assets would be more like $5.0 million to $5.7 million. I’d submit most of this increase could be in taxable accounts (as I think it more likely one could early retire and live off taxable) with the increase invested in equity index ETF’s or muni bonds. So it would not blow up the premise of the article.
I agree. In the post, the reason that much of the income is tax-free in retirement is because it was taxed (probably at fairly high rates) already during the person’s career. Prepaying taxes is often not an optimal strategy, but in many instances, it might be the only one.
Read retire secure by James lange
He likes Roth conversions and proves it with examp,es
I hope this hasn’t already been addressed: What I LOVE about H.S.A. use is that WHEN I retire, a PORTION of my income is going to be “medically related”. Hence I’ll use the HSA for those expenses, thereby having my cake and eating it to. I used it to shelter income each year, it grew tax free, then I used it after age 59.5 for the 10% of my annual spending that was medically related, thereby withdrawing tax free. The HSA nearly makes me giddy …
exactly true that someone spending 200k a year most likely is 5m and higher in net worth
in lange’s book retire secure he uses an example of 8% return on someone who converts 100k at age 65 in the 28% tax bracket
after 20yrs the gain is 51k; after 30yrs about 200k
most retirees today will not garner 8%/yr
well I found the schwab ira conversion calculator that gives you the results after you type in all your info
in a conservative portfolio at age 65 and converting, the increase after 15-20 years is not that much; it all depends on your tax bracket and estimated returns
Why do the conversion taxes increase at all after 15-20 years?
i meant that after 15-20years the gain in the portfolio by converting some traditional to roth is not that great
after 30 yrs its much greater
but it all depends on the returns on those converted dollars
Ah, thanks. Misunderstood the original comment.
Love these examples. I am a real life example. The first year of my retirement I payed zero taxes. I didn’t see it coming and missed some great opportunities to take, in the zero tax bracket. I wrote about it in a piece called Tax Surprises in my Retirement Year and you can read it
here:
https://drcorysfawcett.com/tax-surprises-my-retirement-year/
I had some people say I must be lying because you can’t live the life I did, and spend $100,000 without paying taxes. Well I did it. And the examples given here are not out of the ordinary. I did it by accident, but you can plan to have zero or almost zero taxes if you want.
I’m putting this article in Fawcett’s Favorites this Monday. Thanks for the cool examples.
Dr. Cory S. Fawcett
Prescription for Financial Success
If you live in California give VCAIX or VCADX a look. Regarding Roths. Every year since they were legislated I asked my accountant if I should do a Roth. Answer was no, it won’t work well for you. I am now retired a little less than 3 years. I have never been great at math, so I would never try to figure this out on my own, but assuming you all have accountants who are competent, suggest you simply ask your accountant if a Roth makes sense. Regarding Muni’s, I have a lot of them and like them but there were some tense moments during the last tax law changes. Had Muni tax law been changed it would have been catastrophic for me, my accountant was really worried at the time.
I wonder if your accountant is competent if he/she has been recommending against a Backdoor Roth IRA for years. It’s certainly better than the taxable account it sounds like you’ve been investing in.
ROTFL. You know nothing about me or my financial situation or the accounts I am investing in. But you raise an interesting point – should we always believe our accountants even if they specialize in tax law, as mine does? Perhaps we should all get second opinions. Nobody is perfect, even NASA makes mistakes.
Jim’s right: your accountant may not be competent. As long as you’re not withdrawing the funds prior to age 59.5, it’s impossible for a taxable account to beat a Roth IRA. Contributions to both are made with after-tax dollars, but while the taxable account is then subject to long-term capital gains taxes and ongoing tax drag, the Roth isn’t.
The only possible way the taxable account that I can see for a taxable account to come out ahead is if the desired investment cannot be made within a Roth IRA. For instance, buying real estate through an IRA is possible but potentially problematic.
Doc William: not to nitpick here, but absolutes are seldom correct. For people in certain tax brackets (i.e. retired people), annual long-term capital gains and qualified dividend tax rates are exactly zero. Furthermore, you can tax-loss-harvest in a taxable account, which you cannot in a Roth. Those losses can be deducted against up to $3k per year of ordinary income in addition to offsetting any capital gains. So, it’s NOT impossible for a taxable account to beat a Roth IRA. Don’t get me wrong, most of the time I would take the Roth… but lets not overstate it.
At best, the taxable and Roth accounts will result in the same after-tax wealth. But in the real world, they almost certainly won’t because the taxable account will experience tax drag.
There’s no need to tax loss harvest in a Roth because the withdrawals will be tax-free after age 59.5.
I am not savvy enough to figure California/Fed tax laws which is why I pay someone to do that for me. I do like internet forums, read the WSJ every day, and subscribe to newsletters (two) for advice on investing stocks/bonds. I retired age 62 almost 3 years ago. As you might suspect, I follow the newsletters exactly. Basically this is what happened with my investments. The stock portion is part 401K and part deferred compensation and has done great. The deferred comp I have been getting every year since retirement and will continue into 2022 and is regular income. The 401K money I suspect I will never have to touch but it is there if I need it. When the state bond crash occurred a number of years ago I bought a whole lot of California Muni bonds at about 82 cents on the dollar. This has evolved over the years into a massive amount of Californi Muni bonds which pay out about 3% (current rates) is completely tax free (although it does affect my gross income in some cases). This is actually enough money for me to live on although I will not turn that spigot on until I turn 65 years old. When I turn 65 TPMG will give me 1,000,000.00 dollars as a lump sum (and I pay full taxes on it), which will be added to the Muni bonds. TPMG also will start my pension when I turn it on, every year I wait to turn it on the amount increases 8%, since some states do not tax pensions seems smart to wait and see if I wind up in one of those states. TPMG also pays all my medicare/medical expenses. I think the big difference between my finances and some of yours is the Muni bonds. I will be in a lower tax bracket than many of you however that could change if I sell the Munis. That is unlikely because my spouse is very happy with the Munis ( I know that is a bad reason but we have been married 31 years and she is a very conservative investor). Finally my mom is 92 years old, is in renal failure, and has more money than I ever will. Assuming she does not write me out of her will, eventually that will be another big bolus of money, although her mom lived to be 101. Now if you can figure out what to do next, happy to hear it. I like forums. Have at it 🙂
Should I list the several major mistakes my highly recommended, real estate savvy, $400 / hour CPA made in preparing our not particularly complicated business and personal returns a few years back? We had to file amended returns for two prior years along with throwing out the invoice when he attempted to bill me for the extra work.
Those were obvious mistakes made because he was overbooked and didn’t give a damn about our business. I found them easily enough only to learn he’d already filed the tax returns without informing me in advance. That was something I specifically requested in order to review them since it’s not the first time tax discussions didn’t make their way correctly into the filed tax returns.
Specializing in tax law doesn’t mean someone is running a tight ship or provides excellent services at all times. It means they specialize in a field so obscure that few people can readily challenge their judgments. Tax law is completely grey with little black and white areas. The more complicated the fact pattern, the more easily you can find any number of professionals who will loudly recommended completely different approaches. Professionals in any field who categorically dismiss something in wide use without explanation are automatically suspect in my hiring world.
schwab has a roth ira conversion calculator online to see if it is profitable
In Method #3, you wrote, “Sale of index funds – 1/4 ($7,250) taxable at LTCG rates”
Is that a typo, in that the amount in parentheses, should be $6,250 instead of $7,250?
Hey
I’ve been meaning to contact you.
Many physicians have uncashed checks sitting in the state coffers. I suggest all your bloggers check their state treasury departments for unclaimed funds not only in their names, but in their practice names as well. I also suggest checking in states you may have lived in.
No lie! My late FIL had searched the state unclaimed money site when he first got internet 🙂 and then looked for us as well. He found $3K that Scott & White had set aside for my CME which I had never used when I worked there. It clearly seemed to be mine after a few inquiries, so I took it (declaring it as taxable income to my Sched C physician business). Every few years we do another nationwide search in our names.
Can you succinctly describe the downside and pitfalls possible of converting a large IRA to an Indexed Universal Life Insurance policy with premiums allocated over a 5 year period? This strategy is offered primarily to avoid the potential tax consequences that you have so eloquently described in this article.
There’s no such thing as “converting.” You’re basically suggesting cashing out the IRA, paying all the taxes at once, paying a 10% penalty on it all, then giving a huge chunk of it to a salesman as a commission, and then hoping, despite all evidence to the contrary, that you will have a nice investment return from a policy designed to be sold, not bought. If it’s not obvious from the way I phrased that, this is a really dumb idea. More details here about someone trying to get people to do exactly that:
https://www.whitecoatinvestor.com/missed-fortune-a-critique/
LOL another way is to get divorced. Have your after tax investments spread all over the place, especially outside of the country if possible.
The next step is to make sure that your ex has a stupid lawyer. Then hen you propose that instead of trying to liquidate all these various assets from Hong Kong and Switzerland or wherever that you’ll just hang on to those and pay your ex from the IRA dollar for dollar.
You have just traded pre-tax dollars for after-tax dollars.
Of course I’m just speaking hypothetically here.