There was a discussion on Bogleheads.org started in late 2011 about how a married couple with 6-figure expenses in retirement could pay zero income taxes. I also recently read an article at Forbes, titled, “How Retirees Pay Zero Taxes.”
A member of Bogleheads.org named Livesoft posed the following scenario:
Married, filing jointly, ages 55.
They need $100,000 a year after-tax to pay for expenses. Typical rule of thumb is that the sustained withdrawal rate from a portfolio is 4%, but they also have the possibility of Social Security benefits that would go towards that $100K, so give the couple $2 million in a portfolio split half in taxable and half in tax-advantaged. Of the tax-advantaged, 94% is in tax-deferred 401(k), 403(b), traditional IRA accounts and 6% in Roth IRAs.
They have been diligently tax-loss harvesting and the stock market had large losses in the recession, so their net gains in the taxable assets are essentially zero. That is, they have enough carryover losses to deduct $3,000 from ordinary income each year for quite a while. If they sell any taxable assets, the net capital gain will be essentially zero for a number of years. Their taxable portfolio generates 2% in qualified dividends each year. They get a foreign tax credit as well. They live in a state with no state income taxes.
They have a kid in college and one in high school who will go to college, thus they will get education credits, but they pay for college partially out of 529 plans (not included in portfolio described above).
They have no debts and own their home mortgage-free. They take the standard deduction in odd years and bunch property taxes and charitable contributions into even years.
They will delay taking SS until age 70 while converting their tax-deferred assets to Roth IRAs between ages 55 and 70.
Using the Optimal Retirement Planner calculator, with inputs outlined above, ORP gives the following withdrawal report. The columns are
Age: Age in years of the retiree.
TaxDef: The amount of money withdrawn from the Tax-deferred Account; investments on which taxes have not been paid. The amounts shown are before taxes have been paid. Withdrawals are assumed to be made at the first of the year.
If you begin Tax-deferred account withdrawals before the age of 59½ ORP’s optimal withdrawal level honors the IRS requirement to fix all withdrawals before the age of 59½ at the same level.
AfterTax: The amount of money withdrawn from the After-tax Account, investments on which taxes are paid annually. Withdrawals are assumed to be made at the first of the year. There are no additional taxes on After-tax account withdrawals.
RothIRA: The amount of money distributed from the Roth IRA Account. No tax is paid on Roth IRA withdrawals. For IRA to Roth IRA rollovers there is a 10% penalty charged for the withdrawal of the increase in account value within five years of the deposit in a Roth IRA. ORP conservatively assumes that the 10% applies to all of the early distribution. This will cause ORP to assess a larger than necessary economic penalty on early distributions and will cause ORP to prefer to avoid early distributions.
IRA2Roth: The amount of money to be rolled over from the Tax-Deferred Account into the Roth IRA during the year. This will occur when there is sufficient money in the After-tax Account to live on for the year without paying significant income taxes on the rollover. Then tax-deferred money can be rolled over to a Roth IRA while paying a low tax rate on the tax-deferred distribution. Remember that tax has to be paid on all tax-deferred distributions, even when rolling them over into a Roth IRA. There may be a significant tax advantage in rolling over at a low tax rate early in retirement and then distributing out of the Roth IRA tax free at a later year when Tax-deferred distributions put taxes into a higher bracket.
SocSec: The amount of before-tax Social Security benefits, after adjusting for inflation.
Taxes: The amount Federal and state income tax paid in each year. These are taxes paid on Tax-deferred Account withdrawals, Social Security income, earned income, and pension income. It does not include taxes paid each year on the After-Tax account returns.
Spending: During retirement the spending values show the after-tax, inflation adjusted money available each year of retirement to live on.
*Dollar values are in thousands.
The i-orp output suggests that they will pay $2K in taxes in the 1st and 2nd years of retirement, and zero income taxes until age 70. It also suggests that those $2K in taxes are at the 10% marginal income tax rate and that the couple is never above the 15% marginal tax bracket. Conversions to Roth IRA are between $28K and $34K a year. Of course, all this is an estimate and makes no use of some of the initial details, so let’s go use TaxCaster and put in some of those details.
Give the couple $20K in qualified dividends, the two kids, the college expenses and a $3K capital loss. This gives them some tax credits which are very helpful. I will ignore any foreign tax credit for now, but they may be eligible for $600 foreign tax credit though I am not sure about this since they won’t be paying any taxes for a while. Maybe the FTC can be carried over to the future? TaxCaster says that they can convert about $58,400 to a Roth IRA and pay no income taxes. That’s quite a bit different than the $34K calculated by I-ORP and there is no $2K tax.
That was all with the standard deduction (say an odd year). For even years, give them $12K in property taxes and $16K in charitable donations ($6K and $8K per year). With itemizing these deductions, TaxCaster says that they can convert about $74,500 to a Roth IRA and pay no income taxes.
That sets the stage for a more detailed analysis with TurboTax itself. Can the couple get all their tax-deferred assets converted to Roth IRAs by age 70? Maybe. Maybe not. The average conversion in the first few years is more than $66K per year. It is true that the youngest kid will graduate from college in 6 to 7 years. Also do not forget that their taxable assets have no net gains that will eventually be used up. Hopefully, the value of those assets will increase, but at the same time withdrawals may diminish the amount of qualified dividends received.
Just a reminder: That money that went into the tax-deferred 401(k) and traditional IRAs was tax-free going in and it appears to be tax-free coming out. That’s way better than a Roth IRA and a Roth 401(k). This thread should put to rest which is better: Roth 401(k) or Traditional 401(k).
Living mostly off taxable investment income for the first 11 years of retirement helps to keep the couple within the 15% income bracket. That means that they pay zero Federal tax on qualified dividends and capital gains. They could also use their tax loss carry forward of $3,000/year to zero out taxes on any interest in their taxable accounts. As the table shows, they were also able to convert quite large amounts of tax deferred savings to Roth savings with no taxes. (Taxcaster says they could convert even more.) Being able to convert from tax deferred to tax exempt savings is a huge benefit of this retirement withdrawal strategy.
It sounds pretty good to me.