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My Income Taxes: 2014

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Are taxes going to be your single biggest financial concern in retirement? A ravenous velociraptor stalking your financial security? Many pundits say so. Or, are taxes just another expense, and by no means your largest one?

Despite their scary reputation, I don’t worry about taxes much. I laid out the reasons why — my political and financial analysis of tax rates for middle-income retirees — in an article last year. That post was a bit controversial. Seems it’s not politically correct to be ambivalent about taxes!

Politics notwithstanding, if you’re able to live on less than about $6,000/month or $72,000/year in retirement — as more than 70% of my readers expect to do — then income taxes are unlikely to be a deciding factor in your finances. The U.S. Census Bureau reports, as of 2012, that the median household income was a bit over $51,000 — taxes will be even less of a factor at that level. Below I’ll show why, with examples from our own tax return.

(If you are wealthier, or have unique financial circumstances, then you may pay more in taxes and may need some tax planning to reach your objectives. But I’m going to focus on the common cases for this post.)

Do-It-Yourself Tax Prep

A few weeks ago, in late March, I completed my tax returns for the 2013 tax year. I’m usually early out of the gate in most financial matters, but I’ve tended to leave taxes until late March/early April in recent years. That’s because of the ever-present possibility of receiving an updated 1099 for my investments that would require filing a revised return. Completing tax returns is one of my least favorite annual rites — so I take care not to have to repeat the process!

As has been the case for many years, I used TurboTax Home and Business to prepare my federal and state returns. Every year I reluctantly plod through the somewhat arduous “interview” where TurboTax asks me questions about my tax situation. And I’m once again brought face-to-face with our grotesquely complex tax code and its 1,001 favors for every imaginable interest group. You would think that, as an engineer, I’d prefer to work through the efficient “forms” view, focusing only on the data that I need to enter. But, though I always resolve to try that, most years I cave in and perform the interview, fearful that I’ll miss some new wrinkle in the tax code otherwise.

The root of the problem is that, doing taxes only once a year, I never quite feel confident enough in my mastery of tax law to go it alone with the forms. That’s despite having done my own taxes all but a couple of my approximately 30+ adult earning years. I even keep extensive notes on how to do our taxes, and I update those every year. When mid-April arrives and my taxes are complete, I’m usually feeling highly confident about my ability to navigate the tax code. But by the time the next year rolls around, the keen edge has worn off, and I again gratefully accept TurboTax’s handholding. So why not pay a pro? Because every time I’ve used a tax preparer in the past, I’ve wound up doing just as much work — collecting all the information so they can punch it into their computer, then reviewing the results.

I spend as little time on taxes as humanly possible, though it still feels like too much. Our tax situation has always been relatively simple, and I work to keep it that way. When the choice is between complexity or paying a bit more in taxes, I’ll pay. Shocking to some, I’ll forego modest deductions because the paperwork just isn’t worth my time. For example, I generally never took the home office deduction — even back when the rules were much looser, because the paperwork implications, including depreciation recapture when you sell, were grim. I preferred to invest those hours I would spend understanding and applying tax law to building my business instead.

I always e-file my federal and state returns, using electronic funds transfer for refunds/payments. Even with all that automation and my laser focus on simplicity, it takes me at least a solid 8 hours of work, sometimes more, spread out over several days, to prepare my taxes.

Ugh! But you have your own horror stories. Let’s focus on the bottom line next….

Taxes on Your First $70K

If your lifestyle requires under about $70K in income, and you don’t have any special financial considerations, then here is how your federal income taxes will play out:

For this past tax year — 2013 — the standard deduction for a married couple filing jointly was $12,200, and the personal exemption was $3,900 each. So that makes exactly $20,000 of income, for a couple, which is not taxed at all. You get $20K tax free. That’s enough for baseline food and shelter right there. You can live a frugal RV lifestyle in the U.S. without paying taxes. Though, understandably, most of us want more comfort than that.

Factoring in that first $20K of tax-free income and the two lowest tax brackets of 10% and 15%, retirees with annual incomes of $72,000 — covering a plush $6,000/month in expenses — might expect to pay a maximum of about $575/month in federal taxes, or an effective tax rate of about 9.6%, worst case.

But there are a number of other factors such as itemized deductions, favorable capital gains treatment, and withdrawing from after-tax accounts for some of your income that are likely to reduce that tax bite further, possibly much further.

Consider that any qualified dividends or long-term capital gains that fall into the 15% tax bracket, or below, will not even be taxed! That’s right, there is a 0% long term capital gain tax rate for the first two tax brackets.

An even bigger factor for many early retirees, and anybody with a Roth account, is that you may have substantial after-tax assets to live on. These are savings where you’ve already paid the taxes. So withdrawals, other than new gains in taxable accounts, will be tax free. (Because our own investments are split almost evenly between pre- and post-tax accounts, we could conceivably go for years declaring very little taxable income.)

Unexpected Bonuses

For better or worse, the underlying structure of the U.S. tax code — standard deductions, personal exemptions, and tax brackets — favors those who operate around the median income. And, there are many other goodies in the tax code for middle and lower income earners, some of which I’m still discovering.

With a generous software engineering salary during my working years, I grew accustomed to paying handily into government coffers without much expectation of benefits in return. That high salary moved us well out of range of the grab bag of tax deductions and credits created to benefit those with lower income or higher expenses.

Now, suddenly, having rejoined the middle class, I’m reaping surprise benefits. This year, in particular, we received a couple of unexpected bonuses from the tax code:

The first gift we received this year was thanks to the modest part-time income from this blog. I’m “working” again, but not making too much. So, for the first time in many years, I was able to make a small deductible IRA contribution, that further reduced our taxes. Not a big deal, but a nice benefit for any retiree working part time: You can tax shelter some income, if you wish.

That first benefit led to another surprise: We qualified for the Retirement Savings Contribution Credit. We’re already financially independent, but thanks in part to our modest income in retirement, and the fact that we aren’t needing to take distributions from our retirement plans yet, the government wants to reward us for saving more towards our retirement.

Bottom Line: Our Effective Tax Rate

Opinions will differ about whether we’re all getting our money’s worth from the taxes we pay, but the fact is, in our middle-income range, taxes do not take a large percentage of our income:

When all is said and done, our effective federal gross tax rate (total tax divided by adjusted gross income) for my first two full years of retirement has been just 4.1% each year. When I add in our state taxes, that rate rises to around 6%. Not trivial, but not our largest expense, by a long shot. We spend more than that every month on transportation, food, health care, shelter, or travel, for example.

I’m OK with that effective rate. And I expect it could go even lower in the coming years. That’s because Caroline retired only last year, so we won’t have her taxable income going forward. And I expect us to get savvier about tax planning for living off our mixture of taxable and tax-sheltered investments, plus part-time income, as the years pass.

And, if I’m wrong, and our effective tax rate does go up? If that happens, the most likely cause will be that we are doing better than expected — earning more income. And we can deal with that.

Our Retirement Lifestyle

My conclusion, reached not through political machination but via real-world experience, is this: “If you have to worry about taxes, it’s probably because you’re doing well.”

That’s right. It’s one of those problems that most of the human beings in the world would love to have.

Meanwhile, we enjoy our middle-income retirement lifestyle. We live in a modest two bedroom rental, and drive modest, older vehicles. Other than that, we live like kings. We keep our own schedule. We eat excellent food. We travel when and where we want. We own nice things: With our recent change in location, we splurged on new clothes, bikes, and outdoor gear, and we can’t even see the impact on our net worth.

So that is what a retirement lifestyle in the lower tax brackets can look like. Given quite a bit of flexibility to control our income from various taxable and tax-free sources, I expect the story to be the same or better in future years. And if, instead, our taxes or tax rates go up, it will most likely be because we are even more financially comfortable.

Life is good. I have no complaints. Even with that velociraptor on the loose….

Comments

  1. Darrow-
    I agree 100% with you. While we could debate tax policy endlessly, the reality is that for me taxes in retirement will not be a factor especially if I balance spending between taxable accounts and withdrawals from IRA’s until I reach age 65 and qualify for Medicare.

  2. I think I’ve mastered the ultimate in simplicity for our tax situation. Our combined pension/SS income, after deductions, is under the amount at the top of the 15% marginal rate. So, during the year, I convert from the traditional IRA accounts to a Roth IRA. I figure (roughly) how much I can convert and still be in the 15% bracket. Then I convert a bit more. During the year, I have our withholding set to withhold the amount of taxes that are due at the top of the 15% bracket.

    In March, or so, when I file, I recharacterize just enough of the aroth IRA to keep us just under the top amount of the 15% bracket. That way I maximinze the conversion and still keep us in the 15% bracket.

    I plan to do this for another 5 years when my husband will have to start taking RMD’s.

  3. Another timely gem, Darrow. Your effective tax rate is indeed “manageable”. I’m curious if you’re doing any kind or Roth IRA conversion ladder converting from a traditional IRA to get your tax rate even lower in the future? I’d say you’re first two full years of retirement have been both a personal and financial success.

    • Hi Jon, and thanks. Roth IRA conversions are high on my list to explore, but I was waiting until my wife fully retired, so we would have no wage income filling up the lower tax brackets. I’d say I’m very interested in the prospect, but not totally convinced of the merits for me just yet. I always hesitate to pay any expenses/taxes in the present based on what I “think” will happen in the future.

  4. Darrow- As you know, it’s even a little better if you can go into retirement with all your debt/mortgage paid off and keep your living expenses at a very reasonable $40K per year. For 2014, there’s no tax on the married couple with 2 exemptions with $20,300 in income and you pay a federal 10% rate on the next $18,150. That means you can make roughly make $38,450 and pay an annual rate of $1815 or $150 a month. Having no debt/mortgage is one of the biggest “double benefits”, but many financial pundits keep pushing the “you can make more in the market” without regard to the investment income you need for debt in retirement and the additional taxes you will pay on that income just to pay on that debt.
    -Keep up the good work, Ed

    • Hi Ed, good to hear from you. Thanks for the example. Interesting angle: needing taxable income to pay off debt. I loathe debt — even when it supposedly makes financial “sense.” So I’m convinced!

  5. pastafarian says:

    This post and your original “Why I Don’t Fret About Taxes,” are two of my favorites. I do our taxes in the same manner, no creative or aggressive deductions. In retirement we expect to be in the 25% and possibly the 28% marginal bracket (according to TaxCaster) depending on RMDs and age 70 SS. Throw in 6-7% state, for good measure. I have been extremely fortunate…lucky. Me whining about taxes would be the moral equivalent of talking with my mouth full of food. Convincing my spouse that we’ll be fine in terms of the cost health insurance before age 65, is a work in progress.

    • Hi pastafarian, thanks for the comment. And you’re even up in the tax brackets where people tend to get grumpy about things. I hope your generosity of spirit will come back to you in the form of health insurance, as needed. Thanks again for reading!

  6. As a single looking at retirement soon, I have calculated my taxes (state & fed) to average out to about 13-15% with AGI no greater than the top of the 15% bracket less standard deductions. I also have a mix of taxable and tax deferred investments. I will have some actual income and I will be able to pull any extra I might need from investments. What I am wondering about is how do you get yours so low? Can I assume that you live on much less than the maximum 15% bracket amount available for a couple (i.e. $72,000 plus standard deductions)?

    A side note, I also loathe debt even if it makes some financial sense. Thanks for your post.

    • Thanks CT. That’s right, we do live on much less than $72K + standard deductions/exemptions, typically. More importantly, our taxable income number can be considerably less than our cost of living in early retirement, because we can pull living expenses from taxable accounts — where the principal was already taxed. Lastly, we’ve lived in low-tax states, so they don’t add much to our obligations.

  7. Thanks for a good read Darrow. I enjoyed your book also. I too use TT and I am such a nerd that I actually like doing it. Upon my retirement at age 51 in 2008 I rolled my 457 account into an IRA. Every year since I have converted just enough into a Roth to keep me in the 15% bracket. It is almost done and it is nice to have the taxes out of the way.

    • Hi Mark, thanks for that. I ought to enjoy running a big tax calculator like TurboTax, but the thrill is gone, for some reason. Thanks for sharing your Roth conversion strategy. Many smart people vouch for this approach.

  8. Always happy to see your next post as info is very timely for us. I missed the opportunity for Roth conversion for 2013 as I thought I had until April 15 like the other IRA contribution rules. We are currently 75% taxable in retirement accounts so need to work on changing it. Is Santa Fe all you hoped it would be?

  9. You are so right about the general over-concern about income taxes in retirement. When I was preparing to retire, I had difficulty calculating withholding on pensions and Social Security, so I erred on the side of caution. Between my wife and I, we have three small pensions and two Social Security benefits. As bad as its reputation may be as a place to retire, New York does exempt the first $20,000 in pension income from state tax and it doesn’t tax SS benefits. My first mistake was forgetting that the exemption is $20,000 per person — not per couple. That was the first unexpected windfall when I filed my first return in retirement. The other came with Social Security and its arcane formula for figuring out if and how much federal tax you will pay on your benefits. I had them withhold 15 percent, which was slightly higher than our effective tax rate when we were both working, but I thought 10 percent (the next lowest available withholding rate) would be too low. Based on the windfall we got back at the end of that first tax year, I stopped all withholding on my wife’s smaller benefit and cut mine back to 10 percent. Our after-tax income jumped by nearly $300 a month, and after three years in retirement we’re within a few dollars (plus or minus) of breaking even every April 15.

    • Very interesting. Thanks for the detailed comment John. Nothing like getting some numbers from the real world to illustrate the point. The complexity of our tax code breeds fear and doubt, and that might be the real issue. Thanks again for sharing your experience.

  10. William St. Clair says:

    Darrow–
    A fine article. … I know that I would happily pay a percent or two more if I could get someone to fix a few bridges and roads around here.
    William