Is it possible to pay no income tax in retirement?
My wife and I are both 60 years old. We have taxable investments valued at $900,000, 401k and IRAs valued at $1,200,000, and a Roth valued at $23,000. We would like to retire in about 8 years. A co-worker said he heard that it is possible to pay no income tax in retirement, even on Social Security benefits. With my situation how is that possible?
More likely than not, it is not possible. Typically, the only way you would be exempt from paying federal income taxes in a given year is if your total income for the year does not exceed your standard deduction plus exemptions (or itemized deductions). For a married couple filing jointly over the age of 65 in 2016, you would be required to pay some amount in taxes if your adjusted gross income exceeded ~$23,000. Additionally, for married couples filing a joint return once your modified adjusted gross income plus 1/2 of your social security benefits is greater than $44,000, then up to 85% of your social security benefit will be subject to ordinary income tax.
Depending on how tax efficient your investments are in your brokerage account, it’s possible you wouldn’t have enough realized gain in a given tax year to exceed your standard deduction plus exemptions (or itemized deductions).
The wrinkle here is that once you turn age 70 ½, you are required to begin taking distributions from your traditional retirement accounts, like 401(k)s or IRAs. Given the fact that you are planning or retiring in about 8 years at age 68, you would be required to begin withdrawing funds from your non Roth accounts about 2 ½ years into your retirement. The entire amount of that withdrawal is considered ordinary income and is subject to federal income tax. Assuming no further growth of the ~$1.2M, hopefully not the case, your first RMD would be about $44K, which when coupled with your social security benefits, would almost certainly generate an income tax burden for you.
If you are concerned about taxes in retirement, you may want to consider taking advantage of tactical Roth conversions during the next 8 years. Please feel free to contact me directly if this is something you would like more information about.
If you find out, please let all of us know! LOL
The IRS considers any "increase in wealth" as income broadly defined which will be taxed. So, it is pretty hard to escape that broad definition. I suppose you could own a investment portfolio of all municipal bonds in a state that has no tax, and hold until they mature. Although you would have tax on the potential capital gains, it would be fairly negligible (assuming you buy them at par). But say for instance you received SSI benefits, your annual income would have to be less than $32,000 (married filing joint) in order to not have any of your SSI benefits taxed. So the short answer is that this is probably not possible.
A more effective strategy would be to draw down your asset base in a more tax-efficient manner. That is to say, since ordinary income rates are currently the highest, seek to live off long-term capital gains (taxed at lower rates) and/or cash reserves first. Based on your progress, you may or may not need all of your RMDs at 70 1/2, so you may consider holding tax-free investments in your IRAs and distributing those to taxable accounts and/or donating your RMD to charity. So suffice to say, you should focus on tax efficiency vs. tax "avoidance".
I hope this helps!
As John Wayne famously said, "not hardly." With the value of your Retirement Accounts exclusive of your Roth, you will be forced to take MRDs (minimum required distributions) at age 70 1/2. Those distributions will be taxable. With good tax planning, though, you can minimize the tax hit.
One way you can do this by actively harvesting tax losses in your taxable accounts before year end, every year on stocks that have losses. Even if you love the stock, you can always buy the same stock/investment back after 31 days and recognize the loss to offset gains in the current year and carry forward any net loss. If you do this consistently, you will pay far less tax on capital gains in your taxable accounts. The only reason not do this is if you think that stock/investment can go up at least 15% (lowest tax bracket L-T capital gains) within 31 days.
Advisors many times don't like to broach this subject because losses are never appealing. In reality, you have the loss the moment it went down, not when you recognize it for tax purposes. A good manager knows the only difference between a realized loss and an unrealized loss is for tax purposes.
With your net worth, you should focus on individual stocks in your taxable accounts and not mutual funds. This is because you have no control over distributions which are taxable. You also hear the old adage, "never spend the principal." But principal is not taxable, earnings are. Sometimes, it is better to spend the principal in order to minimize the taxes. You can do this by selectively selling a specific position when needing money in your taxable accounts.
Along these same lines, you would want to place the income producing investments inside the retirement accounts so you don't have income tax as they pay out the interest. Many will tell you that you want to place the higher growth assets (growth stocks) inside your retirement account. I disagree. First of all, many times you will not know which stocks will be the "breakout" stock in advance, but more importantly, you have just turned capital gains into income when you take distributions.
Then the other thing you can do is to coordinate with your tax advisor how and when to take monies out of your retirement accounts to minimize the tax burden. I know this isn't exactly what you wanted to hear, but the good news is that you have done well. It is worse to not have to pay the taxes because you don't have the asset base. But a combination of tax planning and investment strategies can help you keep more of what you have worked for.
You will hear stories of using products like life insurance and then borrow against the cash value in order to avoid taxes. Then your heirs will inherit the net benefit when you expire. But when you actually examine the cost, the numbers just don't come out as well, even if you avoid paying some tax. That may be what your co-worker is talking about. You may want to ask him about the specifics of the strategy he/she is referring to.
If you need any more guidance or would like to pick my brain for tax or investment strategies, feel free to reach out to me, but this should give you plenty to think about.
Best of luck, Dan Stewart CFA®
Yes, it is possible to pay no income tax in retirement, at least for a while. In your case, once you turn 70 ½, you will pay tax on the required minimum distributions from your IRA. But in the two- year window between your retirement at age 68 and age 70 ½, you may be able to completely avoid the payment of tax.
To accomplish this, you would temporarily allocate your taxable account into securities that do not produce current taxable income. This could be accomplished through the purchase of a fee-only deferred annuity with the majority of the taxable account. A smaller portion could be invested into tax free municipal bonds. As long as the amount in municipal bonds is kept fairly small, your social security will be tax free under current law. You would live on the municipal bond principal and interest and the Roth IRA for those two years.
Anyway, this is a long way off, and the tax rules will change between now and then, but yes, under current law it is possible.
That depends on you, for a while. Once you make it to age 70 1/2, it won't be possible. But before that, if your provisional income is less than $32,000, you might be able to pull it off. Here's a definition from Google:
"Provisional income is a measure used by the IRS to determine whether or not recipients of Social Security are required to pay taxes on their benefits. Provisional income is calculated by adding up a recipient's gross income, tax-free interest*, and 50% of Social Security benefits."
*Tax-free interest applies to Municipal bonds and some US savings bonds, not Roth IRA.