A few weeks ago I completed and filed my returns for the 2017 tax year. Once again, without much attention to the matter, I paid very little in taxes. And, once again, despite what many financial professionals will tell you, I didn’t find taxes threatening my retirement lifestyle…
I’m proactive about most financial matters. But, I tend to wait and do my taxes in early April. That reduces the odds that I’ll be forced to file an amended return due to a late-breaking 1099. Filing tax returns is just about my least favorite financial task, and I sure don’t want to spend any more time on them than necessary!
Again this year I needed only about a day to complete my federal and state returns. Over the decades, I’ve gotten more comfortable with the labyrinthine U.S. tax code. I avoid large sections now and short-cut much of the tedious TurboTax interview. My ongoing efforts to streamline our investments and reduce our annual paperwork also continue to pay off.
Let’s look over my tax return now for insights about paying your taxes in retirement. Just keep in mind that your situation and your financial priorities could well be different from mine…
Looking Back to 2016
My most recent article on our income taxes was posted more than two years ago. I didn’t write about our income taxes last year, because there wasn’t a great deal of note for tax year 2016. But here are the highlights:
This blog business did relatively well due to the publication of my second book — the best received of all my efforts so far.
Once again in 2016 we were able to itemize deductions on Schedule A, mostly thanks to very high medical expenses, which look likely to be a feature of our retirement for most years going forward. Our overall medical expenses in 2016 including health insurance premiums were over $19K.
The vast majority of the tax we paid in 2016 was self-employment tax for the blog business. We were in the 15% marginal tax bracket and paid no tax on our long-term capital gains. Our combined state and federal effective tax rate was 9.4%. However, if you subtract out the business income and tax, the effective rate was a mere 3.5%.
Note: I’m computing effective tax rates here as total tax paid divided by adjusted gross income. I occasionally see effective tax computed as total tax divided by taxable income, but that makes less sense to me, as taxable income already has some arbitrary expenses like the standard deduction and exemptions subtracted out.
For tax year 2017, our overall tax situation was similar, though there was a greater income contribution from capital gains and less from blog income.
With no more books to publish in my foreseeable future, in 2017, blogging income was back in a “normal” range. (For those under the impression that all blogs are money trees, understand that this blog has typically been at least a 20-hour/week “job,” and netted at best around $2K/month. And that’s after years of unpaid work to build an audience.)
We had the usual taxable dividends — approximately $15K — and capital gains distributions from our investments. Additionally, I was a more “active” trader this past year than most. Though, for me, that still means only a handful of transactions over the course of the year. I sold some long-term holdings in VXUS and GLD to add to our cash cushion for living expenses. Those sales generated sizable long-term capital gains. The presence of those capital gains, which will be consumed over multiple years, has a misleading impact on our annual gross income number. But we were not taxed on them since we are in the lower two tax brackets.
I also sold some of our digital currency holdings at handsome profits. These were short-term gains, unfortunately, so they were taxed at our ordinary income rate. (I’m choosing not to write more about this activity, since I don’t think digital currencies are appropriate for most people, especially retirees. But, if you want a few more thoughts, see my articles on alternative investments for savvy retirees.)
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 $15K — were high enough to generate an itemized deduction. That, along with our gifts to charity allowed us to benefit from taking itemized deductions on Schedule A. Next year, however, with the new TCJA tax law and its $24K standard deduction for joint filers, I’m expecting we’ll no longer be filling out Schedule A most years.
(In the past, 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. This business doesn’t support us, or even come close.)
The modest income from this blog means we can make IRA contributions for the past year. This time around, we made the maximum contribution of $6,500 to my wife’s IRA, and that further reduced our taxes owed. It’s a nice benefit for any early retiree who is working part-time to remember: You can still tax shelter some of that job income. We didn’t make a contribution to my IRA, though we could have contributed another $6,500, because we don’t know for sure what our tax situation will be like later in retirement — whether it makes more sense to avoid taxes now or later. So we split the difference.
We made that contribution to an existing Traditional IRA. Why not a Roth? We don’t have an existing Roth account, because our income was too high in our working years to start one. At this point I just can’t stomach creating another account to manage plus giving up the definite tax savings now for a possible savings, if current law holds constant, many years from now. At any rate, we have substantial taxable investments, which already give us a pool of money we can draw from with no or minimal tax consequences when needed.
How did we invest that IRA contribution? I’ve been downsizing our current portfolio to be simpler and simpler to manage, and I’m not about to gum it up with new kinds of holdings. So we just added to my wife’s Vanguard Wellesley Income (VWINX) — one of our go-to balanced funds.
Roth Conversion, Not
Those who believe that early retirement or financial independence are reliant on hacking the tax code will be mortified that I have once again declined to do a Roth conversion this year. But the truth of my early retirement is that I’m still not personally convinced the hassle of a conversion is necessary for our long run financial health.
Many people take it as an article of faith that you should do everything possible to reduce taxes. But you can achieve and maintain financial independence without needing to take advantage of every possible tax angle.
For a Roth conversion, the decision isn’t always that simple. For me, the issue hinges on trading off my time this year and every year to come for the possibility of a tax benefit more than a decade from now. And I’m just not convinced that we can predict tax rates that far into the future. What I do know is that I don’t value spending my limited time today on creating a separate account to hold the conversion, deciding what investments it should hold, managing those investments, dealing with the complexity around the nondeductible contributions in my Traditional IRA, and — until recently — navigating the law around recharacterizing conversions.
Lastly, the fact that we do have significant income from dividends and a side business, reduces the potential benefit of a conversion anyway. As Chris wrote here recently, “When you have a spouse working, or otherwise earn income with semi-retirement, you fill up lower tax brackets with earned income. This limits or eliminates the effectiveness of Roth IRA conversions.”
Am I arguing that you should not take on the tasks to potentially save money from a Roth conversion? No! Don’t get me wrong. If you enjoy that kind of overhead or think it’s worth your time, by all means go for it. Depending on your situation, retirement modeling often shows that Roth conversions will save you some money in later years, primarily if your tax rates are elevated due to taking Required Minimum Distributions (RMDs). But, for me, it boils down to time spent today on tasks I don’t enjoy for a distant reward that I don’t need and that may never materialize.
Low Effective Tax Rates
When all the numbers were crunched for our tax return this year, we paid tax at a 15% marginal rate — the second lowest. That means our last dollar of income was taxed at 15%.
However, our state plus federal effective tax rate was only 4.6%. And, take out the 15.3% bite of self-employment tax on my modest blogging income, which represented about one-fourth of our gross income last year, and the effective rate drops to just 1.8%.
That business income is superfluous to our financial independence, and shouldn’t figure into your realistic assessment of tax rates for middle-income retirees.
Why did we pay so little?
First, the standard deduction and personal exemptions mean we get more than $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 long-term capital gains and qualified dividends we do receive are not taxed at all (0% rate).
Though we don’t live in a big house or drive fancy cars or do much international travel, the rest of our retirement lifestyle is frankly pretty luxurious. Yes, we watch our budget, but we live quite well in retirement:
This past year we spent freely on food, clothing, recreation, travel, and contributions. It was a blow-out spending year, by our standards. Yet, because our income was constrained, we still wound up in the second lowest tax bracket.
We rent a comfortable two-bedroom townhome in one of the most desirable vacation spots in the country. We eat the finest foods at home and dine out regularly. We travel when and where we want. We get the modern health care we need, from first-rate providers. And, we inhabit a safe and prosperous country with adequate infrastructure and an unparalleled national park system.
How much did we pay in total state and federal income taxes for this retirement lifestyle last year? About $260/month. And that’s without any particular effort toward sheltering income. Given what I get for what I pay in my retirement, I have no complaints.
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