Now that I’m retired, lots of things have changed, of course. One of them I have been expecting is the taxes I will pay.
Not only am I earning about one-third of my former income each year, but I’m not doing it from earned income.
On the tax-paying side, I won’t have a job deducting income taxes for me, so there are implications there as well.
To get a head start on all of this I sent a note to my CPA in December. I asked her about a few of the issues I thought might appear.
In the note I also asked about 529 plans. I covered that issue in What to Do When You Save Too Much for College.
Let’s get the conversation going. Here’s my initial email to her:
Hi, Wendy. I hope this email finds you well.
I have had a couple life issues over the past few months (both good!) and want to get some end-of-the-year direction to make the most of our tax return in the spring.
First of all, I retired in August! I will have a substantial income for 2016 (similar to past years) but in 2017 my income will drop to about $100k. Sources will be my rental units, interest and dividends, and my websites.
Given this, are there any implications for 2016? Probably not, but I’m sure there will be for 2017 (like will I need to make quarterly tax payments?). I’ll need any thoughts on taxes for 2017 before the beginning of the year.
I think that’s it for now. Let me know if you have questions and I’ll get back to you asap.
Thanks,
ESI
She responded:
ESI,
Congratulations on your retirement! 🙂
To answer your questions:
For 2016 I wouldn’t anticipate your tax return being much different than in previous years.
Your refund will probably be less…given you only had one employer and there won’t be excess Soc Sec withholdings. This amounted to $4581 last year.
Otherwise, there shouldn’t be much difference as you’ve always had ample withholding to cover your tax liability.
For 2017 you will need to make quarterly estimated payments. In order to give you a projection for this I will need to know the following:
1. Rental income – can we assume same as last year?
2. Interest and dividends
3. An estimate of income/expenses for your website business
4. An estimate of charitable contributions
I can take a look at this before year end or you can give these to me when we prepare your tax return.
Once I get an idea of estimates needed you can decide if you want to carry forward any portion of your refund to cover those.
Let me know if you have additional questions.
Wendy
My response:
Thanks, Wendy.
Here’s an estimate of what I think I’ll earn in 2017:
1. Rental income should be about the same as 2015 and 2016
2. Website income after expenses of about $5,000
3. Interest around $10,000
4. Dividends around $10,000
I think our charitable contributions will be low in 2017. We contributed $25,000 in mutual funds to a Donor Advised Fund this year so we can deduct it on our taxes for 2016 (as income is high). We will only disperse about $5,000 of that $25k this year, then disperse the rest next year. But since we will have taken the deduction for it all in 2016, there won’t be much (if any) in 2017.
Thanks!
ESI
Then she came back with the good news:
ESI,
I’ve finished the tax projection for 2017…these are estimates only based on the information provided.
Federal tax = $2322 – projection sheet attached. Because you would fall into the 15% tax bracket there is 0% tax on qualified dividends.
There are variables here…
1. Education credits would be available since your income will be under the threshold for phase out.
2. The credit would depend on the amount of basis reported on the 1099-Q issued by the 529/ESA.
3. The maximum amount of credit is $2500/student, per year (maximum 4 years).
4. Depending on amount of the Education credit, your tax would be reduced…possibly to $0.
Colorado tax = approx. $50. The tax would be about $1165 but you get a credit for taxes paid to another state so that would reduce your tax almost nothing.
Michigan tax = approx. $1120
Please let me know if you have any additional questions.
Wendy
My response:
That sounds awesome! After so many years of paying so much in taxes, I like this! 🙂
A couple questions:
1. I have roughly $500k in mutual funds in a brokerage account. I’ve accumulated them over the past 10 years and they have substantial capital gains. Are you saying I could sell them and pay zero in capital gains tax?
2. Can you explain how the education credit works in association with the 529 report?
Thanks!
She responded:
Only if your total income falls within the 15% tax bracket will you be eligible for the 0% capital gains rate.
Once you hit the 25% – 36% brackets, you will pay 15% in capital gains tax. And if/when you fall into the 39% bracket you will pay 20% capital gains tax.
State tax is a flat rate, you will pay this tax on any amount of capital gain.
The money you have contributed to the education account is considered your basis.
The education credit is calculated on the amount of basis used to pay for the education expenses.
Any gains within the account are not included when calculating the credit.
For example:
You contributed $2000 to the account, it has grown to $2500 and you withdraw all of it.
The education credit is calculated on the $2000 contribution (basis).
The credit is called the American Opportunity Credit. You qualify for the full credit if you pay at least $4000 out of pocket (this would be 529 basis….or cash you use).
The credit is split between what’s called a nonrefundable credit and a refundable credit.
The nonrefundable part is $1500 and is entered on line 48. If your tax (line 42) is less than $1500, then this part of the credit is limited to the amount of Line 42.
The refundable part is $1000 and is entered on Line 75.
Wendy
Wow! Lots of good news here! Let me go through some of it:
- As a high income earner, I have paid a fortune in income taxes through the years. Running a report on Quicken shows that I’ve paid over $800k in taxes (federal and state income taxes, Soc Sec tax, Medicare tax) in the past 10 years alone. In case you’re wondering, I have a professional doing my taxes so I know I’m not paying more than I need to. I’m not moaning about paying my fair share and certainly I earned a lot to pay that much. That said, that’s a HUGE amount of money. To now have to pay next to nothing is awesome!!!!
- Because of my high income we were phased out of about every possible deduction/credit there was. Now to have the chance to get one is great!!! It’s about time.
- The capital gains idea was given to me by ESI Money reader Glen in this comment and this one. My thinking is that I can sell most of the $500k or so in my Vanguard brokerage account. It’s mostly in their Total Stock Market Index Fund (Admiral shares). I’m thinking of converting that money into a dividend-generating fund. Right now I earn about $10k in annual dividends from this money or about 2%. If I could get it to 3% that’s another $5k. 4% is an extra $10k. Or I could buy a REIT fund. Or invest in more real estate. Any suggestions for how to turn this money from growth to income? (I have enough growth funds in my retirement accounts).
So overall, GREAT news all the way around! This certainly helps my retirement budget as well since I almost eliminate my largest expense.
I had a reader tell me that expenses in retirement would be far lower than I would expect and I’m starting to see this to be true. More on this topic to come!
photo credit: investmentzen Tax Keyboard Button via photopin (license)
Erik @ The Mastermind Within says
A tax bill of less than $5k??!??!?!?!? That’s amazing. That’s the dream, you work for some years, and then you get to keep your money, no sense to keep giving it to the government!
Do you think financial planners and financial planning, in general, have this baked into their retirement forecasts?
I see this is going to help your retirement budget. Are you going to loosen the purse strings or will you stay the course with your projected income? Looking forward to your thoughts in a future post 🙂
ESI says
I think they consider it, but for high income people who are used to paying a TON in taxes, they are probably underestimating the reductions.
I have a pretty healthy budget as it is, so for now I’ll stick with this:
https://esimoney.com/2016-net-worth-retirement-budget-update/
The Green Swan says
I love how no capital gains tax is paid if in the 15% tax bracket. That’s a game changer! Also good news on the education credit, I didn’t realize that was applicable when using 529 funds. Good to know, and another good write-off.
It has always bothered me when I get phased out of tax credits/deductions. I know I’m making more and I get it, but it seems like they get phased out too low on the income scale.
Full Time Finance says
The tax system favors those who have income and those in a position to structure how they receive income. That includes the ultra wealthy, retired, and self employed. There are probably a few steps next year you can use to drive your tax bill to 0. Now might be a good time to read up on them.
Ben says
I know of an amazing REIT in Seattle that is paying 8% plus a bonus every year. We have been averaging 9.5% a year. It’s a private company that loans to local builders of single family homes in Seattle. They have been around since 2006 I believe and never even had a late payment from a builder. It’s run by a few very smart guys who have been in the building scene for decades. Let me know if you would like more info.
Chadnudj says
At the very least, if you sell but stay in the 15% bracket, you’ll pay no taxes on those taxable account capital gains. You can then re-invest them (keeping in mind the wash sale rule) at a stepped up basis, reducing your capital gains taxes later in life if you need to sell them. Essentially — tax GAINS harvesting.
I’d do that, rather than just focusing on “income” funds — there is no difference economically between your returns via dividends and your returns via capital gains growth.
Gen Y Finance Guy says
I am looking at the complete opposite of your situation. Our income hit another all time high in 2016 and our total tax liability looks like it will jump from about ~$46K from 2015 to ~$89K for 2016.
Maybe I can divert some income your way to go through the tax efficient machine and then you can send it back??? We can split the tax savings 😉
ESI says
LOVE that idea!!! 😉
Paul @ ABL says
As painful & complex as income tax problems are to navigate sometimes, they are absolutely the best type of problems to have! I love the engineering problem you’re optimizing right now.
Looking forward to the 529 post. We live in a no-income-tax state, so we’re free agents in choosing ours and I’ve ignored the state tax benefits. Interested to hear your experience and strategy.
Troy says
The 15% capital gains exclusion in one of several reasons which are often mis-understood on why a traditional IRA is usually a better option than a Roth IRA for individual retirement vehicles.
The general advice is to max out a 401(k) with a match, then straight to a Roth IRA if eligible. But many times a deductible traditional IRA is a better choice, and one of the reasons is what you just learned in retirement…that there is no tax on certain gains even in taxable, (or IRA) accounts.
Ray says
Aren’t distributions from a traditional IRA taxed as regular income whether the monies were contributions, dividends or capital gains within the fund?
So I am not sure how being exempt from capital gains tax will help you with your distributions from a traditional IRA. Perhaps I am missing something?
Apex says
Ray,
You are correct. There are never any capital gains in an IRA, 401-k, or any qualified retirement plan. All distributions are ordinary income. They are not earned income but they are ordinary income, thus there is zero benefit from capital gains exclusions.
There may be reasons why a traditional IRA are better than a Roth but it isn’t because of what is written here about capital gains.
Coopersmith says
Sweet….
Max Your Freedom says
Wow! That’s pretty amazing, I hadn’t factored in tax implications to that level in my calculations for early retirement. Something to look forward to some day. Must have felt like the early retirement equivalent of a promotion!
Royal Blue says
As to suggestions for turning some of your money from growth to income, for stocks I own VYM and for REITs I own VNQ. Both high quality, low fee ETFs with good yields.
We just retired last year and are looking at a similar tax situation as yours for 2017. Not paying federal income taxes on that qualified dividend income and LT cap gains is certainly a great deal. Let’s hope that doesn’t change!
George says
So this is a follow up to your brokerage account question which I remember, because it was something I’ve wondered myself if we ever needed the money in our brokerage account. Trying to see if I understand. So compared to when you were working and making good money, you would have had to pay 15 or more likely 20% on any capital gains. So you had 350K+ of that per your post. So any amount you sold would have incurred that tax because you were still working. But for 2017, you can keep your income in the 15% tax bracket and pay nothing in capital gains but limited in the amount you can sell each year, which you can adjust accordingly each year. And even at a 15% rate, .15* 350K is a lot of money. Okay after typing it out I think I get it. Very cool.
Joe says
This is very interesting – Your CPA says “The credit is called the American Opportunity Credit. You qualify for the full credit if you pay at least $4000 out of pocket (this would be 529 basis….or cash you use).” I never realized and have never seen any examples of coordinating the AOTC with 529 withdrawals that referred to 529 basis. I always thought you would need to spend $4000 cash out of pocket, not including any of the 529 withdrawal. I’ll have to look into that. Maybe you could clarify that in your next post.
This is from the WSJ “Here’s how parents can proceed: Consider carving out $4,000 of expenses that you will not be paying for with a 529 plan. So if tuition costs total $20,000 per year, consider taking a withdrawal of $16,000 from the 529 plan while paying the remaining $4,000 with cash.”
ESI says
I’m unclear on that as well and we’ll be discussing it during tax time. We have this year to figure it out, so I didn’t get into detail with her at this time.
But after researching it after my email exchange, my understanding is similar to what you describe from the WSJ. Perhaps she has something up her sleeve that I don’t know about. We shall see and I’ll keep you updated.
Physician on FIRE says
Great to see that tax bill shrinking, isn’t it? I’ve actually paid about twice what you have over the last decade. It’s a first world problem, no doubt, but I so look forward to dropping a digit or two from the tax bills I face as a wage earner.
Humble brag? Yeah, probably. Whatever…
Cheers!
-PoF
Jenna VanLeeuwen says
You can run the numbers about exactly how much stock you can sell to increase your basis (and would that impact your education credit?) I bet that would end up being worth it.
Joe says
If I were your accountant, I would have told you to front-load any foreseeable 2017 rental expenses into 2016 to try and reduce your 2016 tax bill, since 2017 and later you would have considerably lower tax liability. For example, did you pay the April 2017 property tax payments for the rentals in 2016? Did you move any repairs originally planned for 2017 into 2016? Or make earlier insurance or home warranty payments?
Also, did you do tax loss harvesting? Pull any charitable deductions planned for 2017 into 2016? Prepay property taxes for your primary residence?
Pretty much anything to reduce your 2016 tax bill since all those deductions/expenses may not help you at all in 2017 (won’t know until the end of 2017).
I’m not an accountant but I’ve done my own very complicated taxes for many years. I’m kind of surprised your accountant didn’t mention these.
ESI says
I did all those things on my own (and have for years). Highlights:
1. Always pay winter real estate taxes in December (due in February)
2. Asked my property manager if any big expenses were coming up. No (good news).
3. Donated $50k to a donor advised fund. Will distribute over the next couple years but get tax credit in 2016.
I could have gone a bit overboard (like paying an insurance bill due in October 2017) but chose not to. That creates more hassle having to remember what I paid and didn’t pay. So I try to get everything I can pulled into the current year — as long as it’s within reason.
Good stuff!
Harry says
My research shows that you can claim the American Opportunity Tax Credit and claim tax free distributions (both the principal and earnings portions) from a 529 plan for the same student “as long as the 529 distribution isn’t used for the same eduction expenses for which a credit was claimed.” This language can be found in Senate Report No. 107-30 (PL 107-16) pp. 26-30. So I think you need to come up with 4k of your own cash and cover the rest of the eduction costs with withdrawals from the 529 plan. In addition, if you won’t have enough income to get the full credit, create income by converting part of a regular IRA to a Roth. That creates ordinary income to capture the credit.
MexTex says
Harry, Excellent reseach and information about how to get AOTC even if retired. Plus you have converted $4K of a traditional IRA to a Roth which is great also (killing 2 birds with 1 stone) .
I suggest to also look at the recent (oct/2016) Vanguard paper on 529’s and how to maximize grants and tax savings. (to get to it just google on: Tackling the tuition bill: Managing higher education expenses) 8 pages with a great example. And read other items under college on Vanguard website if someone has not already done it.
livingalmostlarge says
Same here. Question, why do people always say put rollover into a roth IRA? When you make a lot that you don’t qualify it’s not necessarily tax efficient to put money into a roth ira when you are paying 35% or more? Have you found this to be true? Waiting allows you to manage the rollover when you have less income, ie now.
Mike says
Interesting articles, but this person is not retired. Managing web sites and writing, owning rental property is also work unless totally hands off. Seem like he is working part time.