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Pay zero tax in retirement...part 3.

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I've continued to study how one might minimize taxes in retirement (Part 1 and Part 2). I'm writing software to model the strategies I've previously laid out and eventually to optimize them. The software isn't as sophisticated as it'll eventually be, but it just provided its first bit of interesting data.

Suppose the following:

  • You retire at 37 years old on Jan 1.
  • You'll die at 100 years old on Dec 31.
  • You're single.
  • You've got $1,144,198.89 (77.37% taxable, 18.15% traditional, and 4.48% roth)
  • You spend $35,000 per year on living expenses.
  • You follow the basic steps I previously described (no fancy optimizations).

Notable results (bugs are possible, I still need to test the software, hopefully this data isn’t errroneous):

  • The first 34 years (without RMDs) are very good to you.
    • You don't pay a single cent in taxes thanks to the 0% capital gains rate!
    • Your balance is now $2,884,664.16 (52.85% taxable, 10.67% traditional, and 36.48% roth).
    • That balance is quite nice to look at, but notice how much the Roth account grew thanks to Roth conversions.
  • Now you're 71 and the next next 30 years (with RMDs) are pretty good to you too.
    • You pay taxes every year.
    • The first 2 years your RMDs are below the standard deduction, but the unqualified dividends from your taxable account push you into taxable territory. You continue to enjoy the 0% capital gains bracket though so no taxes on qualified dividends and you keep Tax Gain Harvesting. You pay less than $500 in tax each year.
    • The next 4 years your RMDs exceed the standard deduction, but you continue to enjoy the benefits of the 0% capital gains bracket. You pay less than $800 in tax each year.
    • Thanks to increasing RMDs and increasing dividends from your taxable account, you're no longer able to take advantage of the 0% capital gains bracket (Tax Gain Harvesting has come to an end after 40 years, not a bad run).
    • The next 2 years your Ordinary Income (RMDs and unqualified dividends) keeps you in the 10% tax bracket.
    • The next 22 years your Ordinary Income (RMDs and unqualified dividends) keeps you in the 12% tax bracket.
      • By the time you're 81 years old your taxable account is a runaway train and you're paying more tax due to qualified dividends than ordinary income (RMDs + unqualified dividends).
  • When everything is said and done:
    • Your portfolio is worth $9,763,150.34 (52.13% taxable, 1.28% traditional, and 46.59% roth), basically the traditional's decrease became the roth's gain.
    • You avoided taxes entirely for the first 34 years.
    • You paid $159,766.00 in taxes during the final  30 years.
      • Taxes started at just $399/year but grew to $12,372/year.
      • Taxes averaged $5,325.53 in those final 30 years.
      • Tax growth was mostly driven by the ever increasing dividends thrown off by the taxable account and not by the fact that the RMDs tended to increase year over year.
    • Since our ordinary taxes eventually bumped into the 12% range, it may be worth experimenting with doing Roth conversions in the 10% bracket in the years when we're leading up to the 12% bracket...that may prevent us from reaching the 12% bracket and that might increase the value of our accounts? This is where a simulation is helpful.
    • 100% of capital gains tax was due to dividends...I'd have to look closer to see if any taxable sales (i.e. the tax gain harvesting) was used to pay bills, but we certainly didn't have to sell taxable shares that would be taxed in order to pay bills.
    • We never had to tap into the Roth Account at all.

A few notes on the particulars of the software (some of which introduce small/negligible inaccuracies) that was used to calculate these results:

  • It uses inflation adjusted dollars (2018 dollars).
  • It pretends RMDs are issued on Jan 1.
  • It pretends that dividends are issued all at once on Jan 1.
    • 1.93% of initial taxable balance are dividends.
    • 83.85% of dividends are qualified.
  • It attempts to Tax Gain Harvest right after those dividends are issued.
  • It assumes living expense will remain constant at $35,000 every year.
  • It pays all of the living expenses for the year right on Jan 1 after Tax Gain Harvesting.
  • It pays the tax bill right on Jan 1 even though it isn't due until April of the following year.
  • It reinvests the surplus in the taxable account right away (on Jan 1).
  • It assumes a steady 5% real return every single year.
  • It models RMDs.
  • It does Roth Conversions every year as long as doing so doesn’t generate any taxes.
  • It assumes the tax code never changes (2018 tax code).
  • It does not include social security or pensions yet.

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...a few additional details after looking through the data more:

  • In those first 40 years, thanks to Tax Gain Harvesting, you were able to erase $735,849 worth of capital gains from our taxable account. That represents $1,827,414.26 worth of sales/income.
  • In those first 34 years, thanks to Roth Conversions, we were able to move $290,164.81 from our Traditional account to our Roth account without paying any tax. This demonstrates the immense value of Traditional investing.
  • RMDs generated very little tax, which once again demonstrates the immense value of Traditional investing.
    • $567,206.40 worth of RMDs were issued.
    • $21,130.83 worth of tax was paid, effective rate is 3.7%
    • Two years RMDs didn't generate any tax thanks to the standard deduction.
    • Fourteen years RMDs pushed us into the 10% bracket.
    • Tweleve years RMDs pushed us barely into the 12% bracket.
  • I'm not breaking news, but that Taxable account is a huge tax drag!
    • By our late 70s (just a few years after we started paying taxes for the first time), most of our yearly tax bill is caused by the dividends being produced.
    • By the end we've paid $108,400 due to qualified dividends and $30,235 due to unqualified dividends...that represents 87% of all the taxes we paid!
    • Obviously the ever increasing dividends are expensive, but they have secondary effects. It lessens our ability to perform Roth conversions, which means our RMDs are larger, which means we pay more tax. It also lessens our ability to Tax Gain Harvest (which didn't hurt us much in this hypothetical run). All of that is to say, the taxable account may (in truth) account for more than 87% of the taxes we paid if you include the secondary effects.

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That was indeed a deep dive. Thanks for outlining the possibilities. You join the ranks of Big Earn and White Coat Investor -if not exceed them - on details, applications and explanations.

I love your idea of the Mega Back Door. I asked in my district if we could contribute more non-deductible money into our 403b account and we can't . It does depend on your employer allowing you to do this, as you probably already know.


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Thanks. I’m trying to find time to improve the software, the two big ones:

1. Model social security and possibly pensions.

2. Instead of just calculating a specific outcome if you follow a specific strategy, I want to determine the best outcome by having the software examine a variety of different strategies (take SS early, go beyond the 0% bracket on Roth conversions, etc).

...I haven’t gotten into the Mega Backdoor Roth. My software models Roth conversions. I personally only fully understand the regular Backdoor Roth, I haven’t had the energy to learn the Mega Backdoor Roth yet (maybe never will).

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