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I recently listened to a financial podcast where the guest was promoting the idea of a tax-free retirement. At first, I scoffed. Cynic that I am.
I suspected retirement income strategies funded with large cash value life insurance policies, complicated tax schemes, and/or living an extreme minimalist lifestyle in a van down by the river.
The whole idea of retiring with an income low enough to avoid paying tax seems paradoxical. In retirement you still have bills to pay and if you have the resources to retire comfortably, you will likely have a taxable income, therefore taxes. Plus, most retirees have Social Security, Required Minimum Distributions, and even pensions which can make it super difficult to achieve an income low enough to avoid taxes.
Most people are doing well if they can get their taxable income to the lowest marginal tax brackets. Generally, that’s the goal: minimizing taxes.
The guest was a 20-something content creator who discloses that she is not licensed, has no financial education, doesn’t work directly with real life clients and is committed to a minimalist, no-frill lifestyle that makes living on a conservative budget a lot easier.
So, you can understand my cynicism.
Then I started thinking, “Is a tax-free retirement” possible? What if there really was a legal, ethical way to live tax-free in retirement?
Surprisingly, a tax-free retirement may not be so farfetched.
The amount of income tax you pay is generally based on what is called your taxable income. According to the Tax Foundation, taxable income is “the amount of your income subject to tax after deductions and exemptions.” On your 2022 1040, this number is found on line 15.
If you want a tax-free retirement, line 15 needs to get to $0. Tax credits could eliminate your tax on a certain amount of taxable income, but let’s keep it simple and assume the goal is to get to $0 on line 15.
How to get to $0
Most retired people live off a combination of savings, interest, dividend and capital gains income, Social Security and maybe pension income.
Your taxable income, and how it is calculated, will be different than your neighbor’s. For this exercise, let’s assume you are a 65-year old married couple filing your taxes jointly. You do not receive wage or 1099 income (the biggest driver of taxable income). Social Security income is being deferred to age 70 (probably a good idea anyway), and you do not have a pension.
For the tax year 2022, the standard deduction for a married couple filing jointly (MFJ) is $25,900. Since you and your spouse are age 65 or older you may take an additional $2,800 each making your total standard deduction $31,500.
Everyone qualifies for a standard deduction on their tax return. If your itemized deductions exceed the standard deduction amount, you may itemize and claim a larger deduction.
$31,500 is nice, but it’s not much to live on in retirement. Food, transportation and healthcare together would eat that up and then some.
How can we generate additional income without tax?
Dividends and Capital Gains
For people in the 10% and 12% tax brackets, dividend income and capital gains are tax free. To be more accurate, it’s taxed at 0%. Capital gains and dividends are taxed at 15% for people in the higher tax brackets (even up to 20% or more if your income is high enough).
The 2022 12% tax bracket for married couples filing jointly is $83,550. Combined with your standard deduction amount and additional deduction for being over 65, you could have an income of up to $115,050 with no taxable income.
To achieve a tax-free retirement, you would need to keep your taxable income in the 12% tax bracket or lower.
Ideally, you could take up to $31,500 in annual distributions from a taxable IRA or retirement plan. Since your standard deduction is $31,500, this income would effectively be tax-free.
Earning $83,550 of additional dividend income or capital gains would make for a reasonable total income in retirement. However, earning that much in dividends or capital gains isn’t easy.
Assuming a 3% dividend rate, this means you would need about $2.7 million in a dividend income producing portfolio. To receive the tax break on dividend and capital gains income, this money would need to be in a traditional brokerage account, not your IRA or retirement plan at work. Distributions from retirement accounts count towards your taxable income and are taxed at ordinary tax rates which are higher than the tax rates on dividends and capital gains.
Roth. Roth. Roth.
Roth accounts offer a key benefit to your tax-free retirement, here is why: Qualified distributions from Roth Conversions, Roth IRAs, and Roth 401(k)s are tax free. This means that your Roth IRA will provide a source of tax-free income in retirement – above and beyond what you might earn in dividends or take from your taxable retirement accounts.
For some people, an income of $115,000 just isn’t enough. If you need a higher income, distributions from the Roth IRA can be taken, tax-free, to supplement your dividend and other income.
Here’s an example: You need $12,000 of monthly after tax income in retirement or $144k per year. Using the standard deduction, you may take $31,500 from your traditional 401(k) or retirement plan tax-free. If you have $83,500 of dividend income that brings your taxable income as high as possible without triggering a tax bill.
You are still short $29,000 per year. Your Roth IRA could fund the difference – tax free.
Here’s another: Lets’ say your plan is working perfectly. You are taking tax-free distributions of $31,500 from your traditional IRA and supplementing that with tax-free dividend income or capital gains. Then you discover you need new windows for your house, or a new roof, or your car just died, or… fill in the blank. The Roth account can be your best source for tax free money for those times in retirement when you need some extra (tax-free) cash.
One more reason you need a Roth account as part of your tax-free retirement plan: tax laws change. Our country is over $31 trillion in debt. That number grows by more than a trillion dollars a year and doesn’t count the unfunded liabilities of Medicare and Social Security.
The current tax brackets will expire after the year 2025. What tax rates will be after 2025 we do not know. Taxation of dividends and capital gains could also change. Theoretically, so could the tax-status of Roth accounts, but that seems less likely. Roth accounts allow the government to tax your income when they need the money the most – right now!
Why not Roth everything?
As great as Roth accounts are, they probably won’t be enough to fund your entire retirement. The IRS forbids Roth IRA contributions for married couples with an adjusted gross income over $214,000 (2022).
Roth 401(k)s don’t have income limits, but many workplace retirement plans don’t allow for Roth contributions.
Also, a Roth might not always be your best tax strategy. Sure, they provide tax free income in retirement, but Roth accounts are funded with after-tax dollars. If you are in a high tax bracket now and expect to be in a low bracket like 12% in retirement, you may be better off taking the tax deduction allowed on contributions to traditional 401(k)s and other workplace retirement plans today and making taxable distributions in the future.
Pack your bags and move?
Some people suggest moving from high income tax states like Minnesota to states with no income tax like Florida. With a top tax bracket of 9.8%, this strategy appeals many Minnesotans with high incomes. To be at the top tax bracket in MN, however, your taxable income needs to exceed $284,210. Most retirees will fall into the lower brackets.
Considering that most of your retirement income may not be taxable at all due to the standard deduction and favorable tax treatment of dividends, capital gains and Roth accounts, the marginal amount of tax you may save by moving in retirement could be negligible. Adding in the additional costs related to moving, establishing new relationships with doctors and other professionals, leaving friends and family to create new social connections elsewhere can make the move-to-another-state option less appealing.
Even if you do avoid state income taxes, you still must pay your Federal income tax.
This isn’t to suggest that you shouldn’t move from a high tax state to one that is more tax friendly. Other considerations certainly come in to play: weather, future estate taxes, lifestyle, etc. Do your homework and consider all your options before making a major move.
Not your father’s tax strategy
In fairness to the podcast guest who initially suggested a tax-free retirement was achievable, I have to agree. If you plan it right and make certain life choices, a tax-free retirement can be achievable.
Older people may have more money in traditional IRAs and other retirement plans. The tax-deferred nature of these plans means that every dollar that comes out of them adds to your taxable income making a tax-free retirement more challenging.
Younger people may have an advantage. Early in a person’s career, incomes tend to be lower possibly making Roth retirement plans better vehicles for retirement savings.
Since a young person has time on their side, contributing to Roth retirement plans when you are young gives them more time to grow tax free – lots more time. An extra decade of growth can double your tax-free income in retirement.
Young people at lower tax brackets should consider contributing to their traditional 401(k) up to the level of the company match, then direct any extra income towards paying down debt and funding their Roth accounts.
Likewise, living conservatively and having modest income needs goes a long way towards making the goal of a tax-free retirement more achievable. If a person can avoid some of the trappings of lifestyle creep like a second home, expensive vehicles and continually accumulating more and more stuff, they can create a lifestyle that doesn’t require a high income, and one that is much more sustainable.
Is paying a little tax all that bad?
To be clear, I am not opposed to paying taxes. Taxes are a necessary part of belonging to a modern, functioning society. Like most people, I want to pay my share within the existing tax rules, but I also want to be smart about it.
The scenarios outlined above are best-case, perfect scenarios. Wouldn’t we all like to have a $2.7 million dividend portfolio and fat Roth IRA as a backup?
If your math comes up a little different, odds are you will still pay relatively little tax assuming you have planned ahead and done everything you reasonably can to manage your taxable income in retirement. This is because you will still benefit from the standard deduction and paying relatively low marginal tax rates of 10% and 12% on income that exceeds those brackets.
Other considerations to keep in mind: Social Security is taxable. How much tax you pay depends on your income and where you live (some states don’t tax Social Security income). Even if you delay your Social Security benefits to age 70, eventually Social Security income will be included in your total annual income.
Traditional retirement plans like 401(k) and IRA accounts will eventually be taxed as well. People aged 73 and older must take a Required Minimum Distribution (RMD) from these plans adding to your taxable income for the year. If you have a large retirement plan balance, your future RMD could push you well beyond the limits of the tax-free retirement income.
Is a tax-free retirement possible? Yes, but a low-tax retirement income is much more likely. The best way to achieve these goals depends on a lot of variables. Eventually, Social Security, retirement plan RMDs, pensions and other income sources could combine to make your tax goals more challenging.
A tax-free retirement is a big, but worthy goal. Working with a financial advisor and tax professional who knows your goals and understands long-term tax planning can help you get there.
Royal Alliance Associates does not offer tax or legal advice.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.