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Pay zero tax in retirement...part 2.

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I've been studying how to minimize or eliminate taxation in retirement. To more deeply understand what I'm teaching myself, I've done a write up that could be used to teach others. For anybody willing to dig into a wall of text, I invite you to correct any inaccuracies you find and to add additional helpful information.

Terminology
In reality, many of the terms I use throughout this text have fairly complex definitions. I wanted to keep things simple and so I'm using these terms in a fairly limited scope:

  • Roth Conversion = Money moved from a Traditional account to a Roth account.
  • Capital Gain = Profit generated by selling shares in a Taxable Account.
  • Ordinary Income = Unqualified Dividends in a Taxable Account + Roth Conversions.
  • Qualified Income = Qualified Dividends in a Taxable Account + (long term) Capital Gains from a sale in a Taxable Account...generally given preferential tax rates.
  • Deductions = A deduction made to Ordinary Income before calculating taxes. The most common is the $24,000 Standard Deduction for married couples.
  • Taxable Income = Ordinary Income - Deductions + Qualified Income.
  • Progressive Taxation = The concept that taxation is broken into brackets where your first dollars are taxed at the lowest rate, the next Y dollars are taxed at a higher rate, the next Z dollars at taxed at an even higher rate, and so on.

0% Tax on Qualified Income
You've probably been told that Qualified Income is taxed at 15%, but that's an oversimplification. The tax rate applied to Qualified Income isn't flat, it's progressive in nature. Qualified Income in the $0-$77,200 bracket is taxed at 0%, Qualified Income in the $77,201-$479,000 bracket is taxed at 15%, and additional Qualified Income is taxed at 20%. However, your Deductions and Ordinary Income play a role in determining which brackets your Qualified Income falls in and I think this is best explained through a few examples:

Example #1 --- 15% Bracket

  • Standard Deduction = $24,000
  • Ordinary Income = $101,200
  • Qualified Income = $50,000

When you subtract the Standard Deduction from the Ordinary Income you're left with $77,200. That amount will fill up the entire 0% bracket, which means all $50,000 of Qualified Income will spill over into the 15% tax bracket. As a result the Qualified Income will generate a $7,500 tax bill.

Example #2 --- 0% Bracket

  • Standard Deduction = $24,000
  • Ordinary Income = $25,000
  • Qualified Income = $76,200

When you subtract the Standard Deduction from the Ordinary Income you're left with $1,000. That amount partially fills up the 0% bracket, which leaves us with $76,200 of space in the 0% bracket. As luck would have it the Qualified Income is exactly $76,200, which will will fill up the entire 0% bracket. As a result the Qualified Income will generate a $0 tax bill.

Example #3 --- 0% and 15% Bracket

  • Standard Deduction = $24,000
  • Ordinary Income = $25,000
  • Qualified Income = $77,200

This example is identical to the previous except there's an extra $1,000 of Qualified Income. Since the 0% bracket was already full, that $1,000 will spill over into the 15% bracket. As a result the Qualified Income will generate a $150 tax bill.

Example #4 --- It's a Trap

  • Standard Deduction = $24,000
  • Ordinary Income = $0
  • Qualified Income = $101,200

You're probably tempted to apply the Standard Deduction to the Qualified Income, which would be reduced to $77,200. That would allow you to fill up the entire 0% bracket and get away tax-free. As you may have guessed by now, the Standard Deduction can only be used to reduce Ordinary Income. That means the Qualified Income will fill up the 0% bracket and $24,000 will spill over into the 15% bracket. As a result the Qualified Income will generate a $3,600 tax bill.
    
Key Points

The main points you should walk away with are:

  • You want to have enough Ordinary Income to fully utilize your Deductions.
  • Beyond that, minimizing your Ordinary Income will maximize the tax-free portion of your Qualified Income.
  • The Capital Gains component of Qualified Income is based on profit, which you means you can withdraw quite a bit of money from a Taxable Account without generating an equal amount of Qualified Income. For example, if your shares are worth twice as much as you bought them for, then you'd be able to withdraw $60,000 from a Taxable Account and only generate $30,000 of Qualified Income.
  • The progressive tax brackets associated with Qualified Income are more complicated than they may seem. You can't see that the 0% bracket has a $77,200 limit, generate $77,200 of Qualified Income, and expect that you won't generate a tax bill. You have to account for your Deductions, Qualified Income, Ordinary Income, and how Dividends are often split between the two

    
0% Tax on Ordinary Income
Our previous discussion regarding minimizing (or eliminating) taxation on Qualified Income alluded to the fact that it's also possible to minimize (or eliminate) taxation on Ordinary Income as well. This is possible if your Ordinary Income is less than or equal to your Deductions (Tax Credits play a role too, but we'll save that for later).

Example #1 --- Ideal Case

  • Standard Deduction = $24,000
  • Ordinary Income = $24,000

When you subtract the Standard Deduction from the Ordinary Income, you're left with $0. As a result the Ordinary Income will not generate a tax bill.

Example #2 --- Exceeding the Standard Deduction

  • Standard Deduction = $24,000
  • Ordinary Income = $43,050

When you subtract the Standard Deduction from the Ordinary Income, you're left with $19,050 which fills up the 10% bracket. As a result the Ordinary Income will generate a $1,905 tax bill.

Example #3 --- Wasting the Standard Deduction

  • Standard Deduction = $24,000
  • Ordinary Income = $5,000

When you subtract the Standard Deduction from the Ordinary Income, you're left with a negative number. As a result the Ordinary Income will not generate a tax bill, but you've left $19,000 of Deductions unused. As far as I know, there is no other way to make use of it, so it just goes to waste.

Summary of 0% Taxation
We've learned that taxes are assessed on both Ordinary Income as well as Qualified Income. Furthermore, we've learned that it's possible to receive a 0% tax rate on both Ordinary Income and Qualified Income. Usually our income during our working years is high enough that it spills beyond the 0% tax brackets. However, during retirement we have the ability to limit our income to the 0% tax brackets!

Consider the three types of accounts you're likely to have in retirement:

  • A Roth IRA allows money to grow tax free each year and money can be withdrawn tax-free whenever you choose. Since this account is beyond the reach of the IRS, we'll want to focus on extracting as much tax-free money from the other accounts before we begin to deplete this account.
  • A Traditional IRA allows money to grow tax-free, but withdrawals are treated as Ordinary Income and therefore may generate a tax bill. Additionally, when you're old enough, you'll be forced to take a Required Minimum Distribution (RMD) every year. The fact that you can't control the size of an RMD means that it may force you into higher tax brackets for both Ordinary Income as well Qualified Income.
  • A Taxable Account generates dividends every year, which are split between Qualified Income and Ordinary Income depending on how the mutual fund is managed. Additionally, withdrawals generate Qualified Income based on the Capital Gains tied to the shares you sold in the account.

Using all of this knowledge allows us to develop a basic game plan to eliminate taxation in retirement:

  • The Dividends from your Taxable Account will consume part of your Deductions, but the remaining portion of the Deductions should be used to move as much money as possible from your Traditional IRA to your Roth IRA (Roth Conversion), without having to pay any tax.
    • Reducing the balance of your Traditional IRA minimizes a significant source of future taxation.
    • You'll want to take advantage of this right away. In future years, your Deductions may be partially or entirely consumed when you're "forced" to draw on other forms of Ordinary Income (Social Security, RMDs, etc), which would severely impact (or eliminate) your ability to perform tax-free Roth Conversions.
  • Always sell enough from your Taxable Account to fill up the 0% bracket associated with Qualified Income.
    • Given that nearly all of your Ordinary Income is being used to perform tax-free Roth Conversions, you'll likely have to sell a portion of your Taxable account just to pay the bills.
    • However, when you sell enough from your Taxable Account to fill up the 0% bracket, you'll likely have far more money than you actually need for living expenses. In that case, you'd immediately invest the excess money in a similar mutual fund. This is referred to as "Tax Gain Harvesting" because at no tax cost to you, you're effectively reducing the amount of Capital Gains in your Taxable Account. This will be useful later on if you're ever forced to exceed the 0% tax bracket because you'll be able to sell shares that have minimal (possibly no) capital gains.
    • I don't want to get into the details, but you'll need to familiarize yourself with something called "Specific Identification" when selling shares from your Taxable Account.

Example
Now we have a rough understanding of how the tax code works and how we can utilize that knowledge to avoid taxation in retirement, let's try to gain a more concrete understanding through the example of a hypothetical married couple. Suppose our couple's annual living expenses are $60,000 and suppose they have a Taxable Account, Traditional IRA, and Roth IRA.

Throughout the year their Taxable Account generated $15,000 of Dividends, which is divided into $13,000 of Qualified Dividends and $2,000 of Unqualified Dividends. As of this moment, our couple's tax situation is as follows:

  • Ordinary Income = $2,000
  • Qualified Income = $13,000

As we've already learned, the Standard Deduction allows for $24,000 of tax-free Ordinary Income per year. Our couple understands that their $2,000 of Unqualified Dividends count towards that limit and they decide to convert $22,000 from their Traditional IRA to their Roth IRA. After doing that, our couple's tax situation is as follows:

  • Ordinary Income = $24,000 (2k + 22k)
  • Qualified Income = $13,000
  • Standard Deduction = $24,000
  • Taxable Income = $13,000

It's fantastic that our couple was able to convert $22,000 to their Roth IRA without paying taxes, but how will they cover their $60,000 yearly expenses? They've only received $15,000, so they'll have to turn to their Taxable Account to cover the $45,000 shortfall. Let's simplify the math by assuming everything they own in their Taxable Account is worth 2x as much as they paid for it. Therefore, when they withdraw $45,000 from their Taxable Account it'll generate $22,500 of Capital Gains. As of this moment, our couple's tax situation is as follows:

  • Ordinary Income = $24,000 (2k + 22k)
  • Qualified Income = $35,500 (13k + 22.5k)
  • Standard Deduction = $24,000
  • Taxable Income = $35,500

If our couple were to stop right now, they wouldn't owe any tax at all. Their Ordinary Income wouldn't be taxed because it is less than or equal to the Standard Deduction and their Qualified Income wouldn't be taxed because their Taxable Income is less than or equal to the $77,200 limit of the 0% tax bracket for Qualified Income. However, our couple wants to prepare for future tax years that may require them to increase spending and potentially push them beyond the 0% tax brackets that they're currently enjoying. They know that in those circumstances they could always utilize their Roth IRA for tax-free income, but they'd like to give themselves another option because utilizing the Roth account should be a last resort.

With this in mind, our couple decides to make use of the remaining room in the 0% tax bracket by Tax Gain Harvesting. Currently their Taxable Income is $35,500, which means they can realize another $41,700 of Capital Gains and still remain below the $77,200 limit of the 0% bracket. Therefore, our couple decides to sell $83,400 from their Taxable Account and immediately reinvest that money in a similar fund. As of this moment, our couple's tax situation is as follows:

  • Ordinary Income = $24,000
  • Qualified Income = $77,200 (13k + 22.5k + 41.7k)
  • Standard Deduction = $24,000
  • Taxable Income = $77,200

As you can probably calculate on your own, our couple will not owe a single penny in taxes despite $167,400 worth of transactions throughout the year:

  • $24,000 was converted from a Traditional IRA to a Roth IRA
  • $15,000 of dividends from the Taxable Account was used to pay the bills.
  • $45,000 was withdrawn from the Taxable Account to pay the bills.
  • $83,400 was exchanged within the Taxable Account to eliminate capital gains tied to the Taxable Account.

Tax Credits
Full disclaimer, I haven't fully researched the portion of the tax code yet, so I'm speaking based on a general understanding. Suppose you have a $750 foreign tax credit, it's in your best interest to stretch your income just a bit beyond the 0% tax bracket such that you generate a $750 tax bill. The two will cancel each other out and you'll walk away without paying any taxes. It isn't clear to me if this should be accomplished by additional Tax Gain Harvesting or by additional Roth Conversions, but clearly you'll want to take advantage of one or the other.
    
Healthcare and Other Subsides
There may be several programs for low income folks that you might want to consider taking advantage of. Medicaid and ACA subsidies are first on my mind because I'll be retiring before I can qualify for Medicare. Like most (all?) income restricted programs, Medicaid and ACA subsidies will almost certainly prevent you from maximizing the 0% tax brackets as we did in the previous example. I haven't done the math to determine whether subsidized health care is more valuable than maximizing that tax-free space, but that is something well worth examining. Although I don't currently have a deep understanding of Medicaid and ACA subsidies, I wanted to document what I've absorbed just by existing in society, that way I can use that information as a starting point for future research/verification...

The ACA introduced something called Premium Tax Credits as a mechanism to reduce the amount of money low income folks have to spend on premiums for policies purchased through an ACA Marketplace. To temporarily oversimplify the matter, this subsidy is structured in a way that requires folks to spend a fixed percentage of their (limited) income on premiums and the subsidy covers the rest. This is fantastic because it fully insulates folks with flat incomes from rising premiums! In order to qualify for these subsidies, your Modified Adjusted Gross Income (MAGI) must fall within a certain range based on the Federal Poverty Line (FPL).

If you live in a state that didn't expand Medicaid as part of the ACA, then your MAGI must fall between 100% - 400% of the FPL in order to receive a subsidy. I'm under the impression that these states have such restrictive requirements for Medicaid that (tens of?) millions of people either make too much to be covered by Medicaid or are disqualified in other ways, but make too little to receive an ACA subsidy...I think this is the primary structural reason why the US has so many uninsured folks relative to other industrialized nations.

If you live in a state that expanded Medicaid as part of the ACA, then your MAGI must fall between 138% - 400% of the FPL in order to receive a subsidy. I'm under the impression that Medicaid expansion was done in a way that ensures almost everybody below 138% of the FPL is covered by Medicaid and therefore ineligible for an ACA subsidy.

To calculate the value of the subsidy (in absolute dollars) you have to start with the cost of the 2nd lowest "silver" plan available in your area. Assuming that plan costs $6,000 for the year, we can use your MAGI to calculate the value of your subsidy:

  • If MAGI < 100% of FPL, then Subsidy = $0
  • If MAGI < 133% of FPL, then Subsidy = $6,000 - MAGI * 2.08%
  • If MAGI <= 300% of FPL, then Subsidy = $6,000 - MAGI * Y, where Y ranges from 3.11% to 9.86% depending on how close your MAGI is to 300%.
  • If MAGI < 400% of FPL, then Subsidy = $6,000 - MAGI * 9.86%
  • If MAGI >= 400% of FPL, then Subsidy = $0

Although we've calculated the absolute value of your subsidy based in part on the 2nd lowest cost silver plan, you aren't required to purchase that plan. If you buy a more expensive plan, the subsidy will remain the same (in absolute dollars) and you'll have to spend more than 2.08% of your MAGI on premiums. If you buy a less expensive plan, the subsidy will remain the same (in absolute dollars) and you'll get to spend less than 2.08% of your MAGI (possibly even $0) on premiums...if the cheaper plan actually costs less than the subsidy, I'm not sure if you're refunded the difference or not.
    
Other Disclaimers
My desired lifestyle in retirement requires a Taxable Income that is low enough to allow for a tax-free retirement. However, for those who plan to have more income in retirement they can still apply these principles to minimize taxation. For example, when performing their yearly Roth Conversions perhaps they'll convert an additional $19,050 to fill up the 10% tax bracket. This will generate a $1,905 tax bill, but for a variety of reasons that may be a price worth paying.

I care very little about leaving an inheritance and so these plans don't account for those considerations in any way. If you care about what happens to your estate when you're gone, there may or may not be a better course of action, I don't know.

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3 hours ago, EdLaFave said:

I've been studying how to minimize or eliminate taxation in retirement. To more deeply understand what I'm teaching myself, I've done a write up that could be used to teach others. For anybody willing to dig into a wall of text, I invite you to correct any inaccuracies you find and to add additional helpful information.

Terminology
In reality, many of the terms I use throughout this text have fairly complex definitions. I wanted to keep things simple and so I'm using these terms in a fairly limited scope:

  • Roth Conversion = Money moved from a Traditional account to a Roth account.
  • Capital Gain = Profit generated by selling shares in a Taxable Account.
  • Ordinary Income = Unqualified Dividends in a Taxable Account + Roth Conversions.
  • Qualified Income = Qualified Dividends in a Taxable Account + (long term) Capital Gains from a sale in a Taxable Account...generally given preferential tax rates.
  • Deductions = A deduction made to Ordinary Income before calculating taxes. The most common is the $24,000 Standard Deduction for married couples.
  • Taxable Income = Ordinary Income - Deductions + Qualified Income.
  • Progressive Taxation = The concept that taxation is broken into brackets where your first dollars are taxed at the lowest rate, the next Y dollars are taxed at a higher rate, the next Z dollars at taxed at an even higher rate, and so on.

0% Tax on Qualified Income
You've probably been told that Qualified Income is taxed at 15%, but that's an oversimplification. The tax rate applied to Qualified Income isn't flat, it's progressive in nature. Qualified Income in the $0-$77,200 bracket is taxed at 0%, Qualified Income in the $77,201-$479,000 bracket is taxed at 15%, and additional Qualified Income is taxed at 20%. However, your Deductions and Ordinary Income play a role in determining which brackets your Qualified Income falls in and I think this is best explained through a few examples:

Example #1 --- 15% Bracket

  • Standard Deduction = $24,000
  • Ordinary Income = $101,200
  • Qualified Income = $50,000

When you subtract the Standard Deduction from the Ordinary Income you're left with $77,200. That amount will fill up the entire 0% bracket, which means all $50,000 of Qualified Income will spill over into the 15% tax bracket. As a result the Qualified Income will generate a $7,500 tax bill.

Example #2 --- 0% Bracket

  • Standard Deduction = $24,000
  • Ordinary Income = $25,000
  • Qualified Income = $76,200

When you subtract the Standard Deduction from the Ordinary Income you're left with $1,000. That amount partially fills up the 0% bracket, which leaves us with $76,200 of space in the 0% bracket. As luck would have it the Qualified Income is exactly $76,200, which will will fill up the entire 0% bracket. As a result the Qualified Income will generate a $0 tax bill.

Example #3 --- 0% and 15% Bracket

  • Standard Deduction = $24,000
  • Ordinary Income = $25,000
  • Qualified Income = $77,200

This example is identical to the previous except there's an extra $1,000 of Qualified Income. Since the 0% bracket was already full, that $1,000 will spill over into the 15% bracket. As a result the Qualified Income will generate a $150 tax bill.

Example #4 --- It's a Trap

  • Standard Deduction = $24,000
  • Ordinary Income = $0
  • Qualified Income = $101,200

You're probably tempted to apply the Standard Deduction to the Qualified Income, which would be reduced to $77,200. That would allow you to fill up the entire 0% bracket and get away tax-free. As you may have guessed by now, the Standard Deduction can only be used to reduce Ordinary Income. That means the Qualified Income will fill up the 0% bracket and $24,000 will spill over into the 15% bracket. As a result the Qualified Income will generate a $3,600 tax bill.
    
Key Points

The main points you should walk away with are:

  • You want to have enough Ordinary Income to fully utilize your Deductions.
  • Beyond that, minimizing your Ordinary Income will maximize the tax-free portion of your Qualified Income.
  • The Capital Gains component of Qualified Income is based on profit, which you means you can withdraw quite a bit of money from a Taxable Account without generating an equal amount of Qualified Income. For example, if your shares are worth twice as much as you bought them for, then you'd be able to withdraw $60,000 from a Taxable Account and only generate $30,000 of Qualified Income.
  • The progressive tax brackets associated with Qualified Income are more complicated than they may seem. You can't see that the 0% bracket has a $77,200 limit, generate $77,200 of Qualified Income, and expect that you won't generate a tax bill. You have to account for your Deductions, Qualified Income, Ordinary Income, and how Dividends are often split between the two

    
0% Tax on Ordinary Income
Our previous discussion regarding minimizing (or eliminating) taxation on Qualified Income alluded to the fact that it's also possible to minimize (or eliminate) taxation on Ordinary Income as well. This is possible if your Ordinary Income is less than or equal to your Deductions (Tax Credits play a role too, but we'll save that for later).

Example #1 --- Ideal Case

  • Standard Deduction = $24,000
  • Ordinary Income = $24,000

When you subtract the Standard Deduction from the Ordinary Income, you're left with $0. As a result the Ordinary Income will not generate a tax bill.

Example #2 --- Exceeding the Standard Deduction

  • Standard Deduction = $24,000
  • Ordinary Income = $43,050

When you subtract the Standard Deduction from the Ordinary Income, you're left with $19,050 which fills up the 10% bracket. As a result the Ordinary Income will generate a $1,905 tax bill.

Example #3 --- Wasting the Standard Deduction

  • Standard Deduction = $24,000
  • Ordinary Income = $5,000

When you subtract the Standard Deduction from the Ordinary Income, you're left with a negative number. As a result the Ordinary Income will not generate a tax bill, but you've left $19,000 of Deductions unused. As far as I know, there is no other way to make use of it, so it just goes to waste.

Summary of 0% Taxation
We've learned that taxes are assessed on both Ordinary Income as well as Qualified Income. Furthermore, we've learned that it's possible to receive a 0% tax rate on both Ordinary Income and Qualified Income. Usually our income during our working years is high enough that it spills beyond the 0% tax brackets. However, during retirement we have the ability to limit our income to the 0% tax brackets!

Consider the three types of accounts you're likely to have in retirement:

  • A Roth IRA allows money to grow tax free each year and money can be withdrawn tax-free whenever you choose. Since this account is beyond the reach of the IRS, we'll want to focus on extracting as much tax-free money from the other accounts before we begin to deplete this account.
  • A Traditional IRA allows money to grow tax-free, but withdrawals are treated as Ordinary Income and therefore may generate a tax bill. Additionally, when you're old enough, you'll be forced to take a Required Minimum Distribution (RMD) every year. The fact that you can't control the size of an RMD means that it may force you into higher tax brackets for both Ordinary Income as well Qualified Income.
  • A Taxable Account generates dividends every year, which are split between Qualified Income and Ordinary Income depending on how the mutual fund is managed. Additionally, withdrawals generate Qualified Income based on the Capital Gains tied to the shares you sold in the account.

Using all of this knowledge allows us to develop a basic game plan to eliminate taxation in retirement:

  • The Dividends from your Taxable Account will consume part of your Deductions, but the remaining portion of the Deductions should be used to move as much money as possible from your Traditional IRA to your Roth IRA (Roth Conversion), without having to pay any tax.
    • Reducing the balance of your Traditional IRA minimizes a significant source of future taxation.
    • You'll want to take advantage of this right away. In future years, your Deductions may be partially or entirely consumed when you're "forced" to draw on other forms of Ordinary Income (Social Security, RMDs, etc), which would severely impact (or eliminate) your ability to perform tax-free Roth Conversions.
  • Always sell enough from your Taxable Account to fill up the 0% bracket associated with Qualified Income.
    • Given that nearly all of your Ordinary Income is being used to perform tax-free Roth Conversions, you'll likely have to sell a portion of your Taxable account just to pay the bills.
    • However, when you sell enough from your Taxable Account to fill up the 0% bracket, you'll likely have far more money than you actually need for living expenses. In that case, you'd immediately invest the excess money in a similar mutual fund. This is referred to as "Tax Gain Harvesting" because at no tax cost to you, you're effectively reducing the amount of Capital Gains in your Taxable Account. This will be useful later on if you're ever forced to exceed the 0% tax bracket because you'll be able to sell shares that have minimal (possibly no) capital gains.
    • I don't want to get into the details, but you'll need to familiarize yourself with something called "Specific Identification" when selling shares from your Taxable Account.

Example
Now we have a rough understanding of how the tax code works and how we can utilize that knowledge to avoid taxation in retirement, let's try to gain a more concrete understanding through the example of a hypothetical married couple. Suppose our couple's annual living expenses are $60,000 and suppose they have a Taxable Account, Traditional IRA, and Roth IRA.

Throughout the year their Taxable Account generated $15,000 of Dividends, which is divided into $13,000 of Qualified Dividends and $2,000 of Unqualified Dividends. As of this moment, our couple's tax situation is as follows:

  • Ordinary Income = $2,000
  • Qualified Income = $13,000

As we've already learned, the Standard Deduction allows for $24,000 of tax-free Ordinary Income per year. Our couple understands that their $2,000 of Unqualified Dividends count towards that limit and they decide to convert $22,000 from their Traditional IRA to their Roth IRA. After doing that, our couple's tax situation is as follows:

  • Ordinary Income = $24,000 (2k + 22k)
  • Qualified Income = $13,000
  • Standard Deduction = $24,000
  • Taxable Income = $13,000

It's fantastic that our couple was able to convert $22,000 to their Roth IRA without paying taxes, but how will they cover their $60,000 yearly expenses? They've only received $15,000, so they'll have to turn to their Taxable Account to cover the $45,000 shortfall. Let's simplify the math by assuming everything they own in their Taxable Account is worth 2x as much as they paid for it. Therefore, when they withdraw $45,000 from their Taxable Account it'll generate $22,500 of Capital Gains. As of this moment, our couple's tax situation is as follows:

  • Ordinary Income = $24,000 (2k + 22k)
  • Qualified Income = $35,500 (13k + 22.5k)
  • Standard Deduction = $24,000
  • Taxable Income = $35,500

If our couple were to stop right now, they wouldn't owe any tax at all. Their Ordinary Income wouldn't be taxed because it is less than or equal to the Standard Deduction and their Qualified Income wouldn't be taxed because their Taxable Income is less than or equal to the $77,200 limit of the 0% tax bracket for Qualified Income. However, our couple wants to prepare for future tax years that may require them to increase spending and potentially push them beyond the 0% tax brackets that they're currently enjoying. They know that in those circumstances they could always utilize their Roth IRA for tax-free income, but they'd like to give themselves another option because utilizing the Roth account should be a last resort.

With this in mind, our couple decides to make use of the remaining room in the 0% tax bracket by Tax Gain Harvesting. Currently their Taxable Income is $35,500, which means they can realize another $41,700 of Capital Gains and still remain below the $77,200 limit of the 0% bracket. Therefore, our couple decides to sell $83,400 from their Taxable Account and immediately reinvest that money in a similar fund. As of this moment, our couple's tax situation is as follows:

  • Ordinary Income = $24,000
  • Qualified Income = $77,200 (13k + 22.5k + 41.7k)
  • Standard Deduction = $24,000
  • Taxable Income = $77,200

 As you can probably calculate on your own, our couple will not owe a single penny in taxes despite $167,400 worth of transactions throughout the year:

  • $24,000 was converted from a Traditional IRA to a Roth IRA
  • $15,000 of dividends from the Taxable Account was used to pay the bills.
  • $45,000 was withdrawn from the Taxable Account to pay the bills.
  • $83,400 was exchanged within the Taxable Account to eliminate capital gains tied to the Taxable Account.

 

I think you've got it figured out--nice job! I've used the 0% cap gains rate and Tax Gain Harvesting to do rebalancing out of some "legacy" funds in our taxable account. Because we have pensions, social security and RMDs, we're in the 12% income tax bracket, 6% effective rate.

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I second what krow said. Thank for the info!

2018 was the first year for my RMD and I paid 16% tax rate on $100,000 income (SS, pension, two tiny businesses, and RMD). It is the most taxes I have ever paid in my entire life. My donations or my business losses did not put a dent in my tax bill. 

I am thinking about converting some of my IRA to a Roth, but I will pay even more taxes now to pay less taxes later with the rates go back up in 2025, or 26. 

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7 hours ago, krow36 said:

I've used the 0% cap gains rate and Tax Gain Harvesting to do rebalancing out of some "legacy" funds in our taxable account. Because we have pensions, social security and RMDs, we're in the 12% income tax bracket, 6% effective rate.

That’s a great way to get rid of inappropriate investments that have racked up large gains!

A 6% effective tax rate is very workable! I suppose these pensions are going to limit a lot of educators.

5 hours ago, sschullo said:

2018 was the first year for my RMD and I paid 16% tax rate on $100,000 income (SS, pension, two tiny businesses, and RMD). It is the most taxes I have ever paid in my entire life. My donations or my business losses did not put a dent in my tax bill. 

I am thinking about converting some of my IRA to a Roth, but I will pay even more taxes now to pay less taxes later with the rates go back up in 2025, or 26. 

That’s a pretty healthy income . Oddly enough, I hope not to join you in that 😀.

Who knows what’ll happen with this tax code. I’m not as knowledgeable on the Republican rewrite as I’d like to be, but I’m under the impression that the tax cuts for businesses are permanent and the tax cuts for individuals are set to expire sometime within ten years of when the legislation began?

Speaking selfishly, I’m not terribly worried about the tax code, but health care has me quite concerned. It would be a relief to join the rest of the industrialized world before I get too much older!

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13 hours ago, EdLaFave said:

 

That’s a pretty healthy income. Oddly enough, I hope not to join you in that 😀.

I live in a wonderful state and region, but it is not cheap. Where I live is where I am willing to pay more, and California is that place. I am so fortunate I can live here.

$100,000 was my taxable income. Donations and other losses were not more than my personal deduction so my tax man just took the personal deduction.  

Speaking selfishly, I’m not terribly worried about the tax code, but health care has me quite concerned. It would be a relief to join the rest of the industrialized world before I get too much older!

The tax code is also the least of my worries. I resist all of the doom and gloom predictions by the media and some financial advisers to convert IRAs to Roths. They know NOTHING about the future. 

 

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On 4/14/2019 at 11:15 AM, EdLaFave said:

I've been studying how to minimize or eliminate taxation in retirement. To more deeply understand what I'm teaching myself, I've done a write up that could be used to teach others. For anybody willing to dig into a wall of text, I invite you to correct any inaccuracies you find and to add additional helpful information.

 

Cal Newport wrote a book called Deep Work. I just borrowed it yesterday from one of the many wonderful libraries in my area. From what I've read so far (and heard him say on his recent podcast interview) we all have period's of time during the day that is better suited for deep work. Mine is in the morning so I'll be reading your post then. Thanks in advance for sharing, Ed.

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