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My Retirement Income Taxes: 2016

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On April Fool’s Day I completed and filed my returns for the 2015 tax year. Normally I’m proactive about financial matters. But, for taxes, I wait until a few weeks before the mid-April deadline. That reduces the chances that a late-breaking 1099 will force me to file an amended return. Taxes are my least favorite annual financial rite, and I don’t want to do them more than once!

This year required less than a day to complete my federal and state returns. That might be a personal record. Writing this blog has made me more comfortable with the labyrinthine U.S. tax code. I short-cut much of the tedious TurboTax interview, using “explore on my own” instead. That saved some time. And my ongoing efforts to simplify our investments and record-keeping are also paying off.

Let’s review a few details of my tax situation, past and present, for insights about your taxes in retirement…

Looking Back to 2014

My last article on our income taxes was two years ago. I didn’t write about income taxes last year, because there wasn’t much of note:

We had higher than average capital gains due to my mistake in liquidating part of a balanced fund during the short-term gain window, and due to clearing out another long-held, specialized fund holding.

In resolving a family estate we generated some major itemized deductions that won’t repeat. And, for the first time in memory, our medical expenses were high enough to receive a deduction on Schedule A.

These factors largely cancelled each other out, and we ultimately paid very little in taxes for 2014. Our combined state and federal effective tax rate (total tax divided by adjusted gross income) was just 3.9%.

2015 Income and Deductions

Now, for tax year 2015, our situation looks more “normal”:

Our taxable income was very low, especially when you subtract the modest income from this blog. We were generally living off of cash I had set aside in previous years. And that cash had already been taxed.

There were very few transactions in our investment accounts, and no sales. That’s right, we didn’t sell a single share in 2015. That reduced our income, and our taxes. Though, we still had some taxable dividends and capital gains distributions.

For the first time, we collected on my wife’s pension as a public school teacher. It’s a small sum, about $100/month, owing to her shortened career and cashing out along the way. The monthly checks are more a novelty than a financial factor in our lives. But, I was chagrined to learn that even this small amount is fully taxable. After their difficult, underpaid careers, I would think we could cut our school teachers a tax break!

Once again, thanks to our high health insurance premiums, and the realities of caring for ourselves in the back half of our 50’s, our medical expenses — at over $14K — were high enough to generate an itemized deduction. I expect this will be a fact of life, going forward.

(Several readers have written to suggest we should be deducting our health insurance on the front of Form 1040 as a “self-employed health insurance deduction.” But that doesn’t work for us: The IRS says the health insurance policy has to be in “my name or the business name.” But it’s my wife’s policy — her retirement benefit. I’m also uncomfortable describing myself as “self-employed.” I’m retired, with a part-time business on the side. The business doesn’t support us, or even come close.)

IRA Contribution

While Caroline’s career is done, I have a new one, of sorts. The modest income from this blog means I’m “working” again. So, I made a deductible IRA contribution that further reduced our taxes this year. That’s a nice benefit for any early retiree who is working part-time to keep in mind: You can still tax shelter some job income.

I added that contribution into an existing Traditional IRA. I considered starting a Roth, but I still can’t stomach giving up the definite tax savings now for a possible savings, if current rules hold constant, 20 years from now. However, that opinion of mine is in transition: My current model of our financial future shows our tax rates going up significantly in our 70’s due to Required Minimum Distributions and Social Security benefits. So I’ll be revisiting this issue sooner than later….

How did I invest that IRA contribution? When I look at the asset classes in our current portfolio now, I don’t see lots of good choices. But my recent research has driven home the value of stocks, even in conservative retirement portfolios. And, in a world of possibly overpriced assets, international stocks continue to lag. So I simply added to our position in Vanguard’s Total International Stock Index Fund (VTIAX).

Thanks to that IRA contribution, we also qualified for the Retirement Savings Contribution Credit. Because of our relatively low income in retirement, and because we don’t need to take distributions from our retirement accounts yet, the government rewards us for saving still more towards our retirement.

Low Effective Tax Rates

When all the calculations were done for our tax return this year, we paid tax at only a 10% marginal rate. Our effective rate looks high at 8.2%. But that is really due to the 15.3% bite of self-employment tax on my modest blogging income, which represented almost half of our taxable income last year.

That business income is “gravy” on our retirement, and shouldn’t figure into your realistic assessment of tax rates for middle-income retirees. Take it out, and our effective state and federal tax rate is a mere 1.3%.

Why did we pay so little?

First, the standard deduction and personal exemptions mean we get at least $20K in tax-free income every year. Second, because about half of our net worth is in taxable accounts, in many years we can live primarily off money that has already been taxed. Third, because we are in a low tax bracket (10% or 15%) the capital gains and qualified dividends we do receive are not taxed at all (0% rate). Finally, we can get another deduction by making an IRA contribution with income from my small part-time business, and then taking the Retirement Savings Contribution Credit.

Perspective

Our lifestyle is comfortable, though not luxurious by most standards. We watch our budget very carefully, but we do live well in retirement:

We inhabit a safe and prosperous country with adequate infrastructure and an unparalleled national park system. We rent a comfortable two-bedroom town-home in one of the most desirable getaway spots in the country. We dine out regularly and have the best fresh foods at home. We drive nice vehicles and travel when and where we want. We get all the modern health care we need, from first-rate providers.

How much did we pay on our taxable income for this retirement lifestyle last year? I keep my investments simple, run a part-time business on the side, and do my own taxes. There are no complex schemes for sheltering income here. If you take out that small business, which is a bonus for our retirement, we paid in total state and federal taxes about what we do for eating out in a typical month!

Sure, there are issues with taxation in this country. I loathe the complexity of our bizarre tax code. And political debates over who should get how much of the pie will probably never end. But, given what I get for what I pay in early retirement, I have no complaints.

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