It's quite possible to legally pay no federal income tax with a six-figure budget in early retirement.
During our years of wealth accumulation, a.k.a. working, we pay a pretty penny in taxes. We become accustomed to knowing that after a certain point, we might only see about half of each additional dollar earned. Adding up federal & state income tax and property taxes, many physicians will have annual tax bills exceeding $100,000. If you’ve managed to accumulate a sizable nest egg over 20 years or less, you’ve no doubt contributed at least$1 millionto the coffers of the taxman.
Fear not. Much, much lower tax rates are on the horizon for the aspiring early retiree. Let’s crunch some numbers and examine what you might expect to pay when you hang up the stethoscope for the last time.
Take the example of someone likeDr. Benson from the 4 Physicians articlewho was on track to retire with $3 million in about 20 years with $120,000 in annual spending. As you’ll see below, he ended up with $3.3 million. Will he require $120,000 a year in retirement? Of course not. He paid off his $36,000 a year mortgage, he’s no longer contributing to a 529, and his children are off on their own.
To maintain the lifestyle he and his wife have enjoyed, his spending will be closer to $70,000. Since they expect to travel more, let’s give them $80,000 a year for a comfortable retirement. This represents a super-safe 2.4% withdrawal rate. With $100,000 in annual spending, the withdrawal rate would still be a paltry 3%. They can expect to watch their nest egg grow most years in retirement with this level of spending.
Taking a look at how Dr. B arrived here in his early fifties, we see that he wisely has his nest egg spread out among different account types. He maxed out his tax-deferred savings, while contributing to personal and spousal backdoor Roth IRAs. His HSA has grown nicely, and more than a third of his nest egg is in a taxable account. Allow me to display this saving andcompoundingin a handy little spreadsheet. I do like spreadsheets.
We’re assuming 4% real (inflation adjusted) returns, so spending power is preserved. For the taxable account, I accounted for a half percenttax drag*, so that account has returned 3.5%.
*This tax drag assumes a portfolio of passive index funds with 2% qualified dividends taxed at 25%. The tax on qualified dividends could be as low as 15% if you have no state tax and keep AGI under $250,000, avoiding the 3.8% medicare surcharge. In that best case scenario, the Bensons could have had a 3.7% real return on their taxable account in the working years.
The Bensons, having paid a little over $1 million in federal income tax alone, don’t want to pay that anymore. Like, not at all. Zero. Zilch. Can we get them $80,000 to spend without incurring federal income tax? Sure. Why not aim for $100,000? Plugging some reasonable numbers into Intuit’sTaxCasterusing 2015 tax rates gives us the following results.
In this example, the Bensons get their spending money from the following sources:
They owe0federal income tax. In fact, with only $44,400 in taxable income, they could have had a much higher taxable income and still paid no income tax. This could be considered a wasted opportunity. Nice going, Bensons. Way to go.
How much more capital gains could they have taken without owing federal income tax?
The Bensons sold a whopping $109,000 worth of mutual funds that had doubled. Their cost basis being $54,500 meant a long-term capital gain of $54,500.
. Why? If you have a taxable income of $74,900 or less in 2015, your long-term capital gains and qualified dividends have a 0% tax rate. If you get lazy or goof up and end up with $75,000 in taxable income, don’t worry, you haven’t fallen off a cliff. You won’t owe 15% on all of your capital gains and qualified dividends, you’ll just owe on the portion that exceeds the limit. If you exceed the limit by $100, you owe $15 in taxes.
Still no tax
In the first 2 examples, we assumed the kids were long gone. Not in college, not dependents. But what it that weren’t the case? What if they were in college, considered dependents, and the Bensons paid $4000 out of pocket towards their education?
TheAmerican Opportunity Tax Credit (available to married couples with MAGI under $160,000) will match the first $2000 paid toward tuition with a $2000 tax credit (that’s free money, folks) and provide an additional $500 credit for the next $2000. In this case, the Bensons can take a lot more from the 457(b) ordo some Roth conversions from the 401(k), provided it is rolled over to a traditional IRA first.
Rather than increasing the 457(b) withdrawal, they could have maintained it at $18,000 and converted $32,000 of traditional IRA (previously 401(k)) money to a Roth IRA. What is the advantage of doing this? Reducing required mandatory distributions (RMDs) which will be enforced at age 70.5, thereby avoiding future taxable income.
What if the Bensons still had children in junior high when they retired? SayHello to the child tax credit of $1000 per child. The children must live at home, be under 17 years of age, and taxable income (MAGI) must remain below $110,000 for the married joint filers. Easy enough.
The child tax credit only applies to taxes due, so the Bensons either took more from the 457(b) or did some Roth conversions in December to get their “taxes due” as close to $2000 as possible. Since you most likely will not have the ability to adjust your 457(b) income on an annual basis, it is probably best to use Roth conversions to keep taxable income flexible during early retirement.
Note that in 2 of these examples, the Bensons had spending money exceeding 4% of their nest egg of $3.3 million (= $132,000). It might be OK for them to do so in a year with good market returns, particularly if they are planning on using a variable withdrawal strategy. The point of this exercise is not to show much they can spend each year without depleting their nest egg, it is to show how much money can be made available without paying federal income tax in early retirement.
The take home lessons from this exercise are many:
What is the take-home message for you? Do these analyses make you more or less likely to consider an early retirement? How likely is it that the tax code will remain largely intact by the time you will be ready?