Tax Decisions in Early Retirement

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Picking Your Tax Rate in Early Retirement


How do you estimate and plan for your taxes in early retirement?   While working, we were trained to understand the simple graduated tax scale.  The first so many dollars were free due to the standard deduction, followed by 10%, 12%, 22%, and 24% tax rates.  Capital Gains are taxed at either 0% or 15% depending on other income.  Taxes were withheld, so instead of estimated payments the employer took care of these during payroll.    Taxes can’t be ignored, for virtually everyone, they will be in the top five in lifetime expenses, right there with the cost of housing, transportation, food, and healthcare.  

Sloppy surf beats the office

Now that we’re early retired, the tax calculation has changed.   Most of the income sources are voluntary. For us, I’ve talked about Roth IRA conversions as part of our financial plan.   We didn’t enter early retirement with much in our Roth accounts, so we’ve been converting a portion of our accounts each year to create the Roth IRA conversion ladder.

 Enter the Healthcare Tax Credit

The Affordable Care Act provides tax credits for individuals purchasing insurance off the healthcare exchange.   These tax credits are sometimes referred to as subsidies*, since if elected, they can be advanced against healthcare premiums then settled up at year end.  We’ve always elected to pay the full cost of insurance (on a rewards credit) then receive a tax credit at year end if eligible.

There used to be a “cliff” on these tax credits, where once income exceeded a dollar threshold, the entire tax credit evaporated.   That was changed in 2021 and the legislation is currently extended through 2025. The credit now slowly phases out, meaning for each dollar earned there’s an effective tax that’s equal to the taxes owed + lost credit.  

The illustration below is a rough outline of the incremental tax rate for each $10,000 in income earned starting at $50,000 going up to $120,000.   This accounts for the 12% rate plus the amount of health insurance tax credit that is phased out.   This pushes our tax rate to almost 28% for every dollar earned over $50,000 down to a low of just over 20% between $110,000 and $120,000. 

This is based on Married Filing Jointly and a family size of two at Age 41.  You can use the Kaiser Family Foundation’s calculator if you want to figure out the credit amounts for your age and family size.  In our scenario, the credit phases out completely right around the 22% tax rate.  The federal tax liability for us essentially goes from 0% around $50,000, 28% between $50,000 and $80,000 in income, down to 20.5% from $80,000 to $120,000, then back up to 22% above $120,000 in income.  

What Are Our Considerations?

One of the great things about a FIREy financial situation is being able to choose how/when to realize income.   Outside of some dividends paid, capital gains when we liquidate stocks, and a pesky residual from a deferred compensation plan, all income is voluntary.   Some considerations I am debating:

Should we pause Roth IRA conversions or continue to pursue them?   There are benefits to getting assets into the Roth IRA, including the conversion ladder, eliminating future exposure to Required Minimum Distributions, and other embedded taxes for high income retirees utilizing Medicare and social security.    

Does it make sense to pursue a high / low strategy?   Alternating years between realizing $50,000 in income and a much higher amount would have benefits, fully utilizing the tax credits every other year and utilizing the safe harbor provision for estimated tax payments.   Having a $200,000 income year and a $50,000 income year will produce a lower tax burden over those two years than recording $125,000 in AGI for two consecutive years.    

Do we accelerate Roth IRA conversions to use health care tax credits later?  Health insurance will get mathematically more expensive due to age based pricing, plus health insurance continues to increase in price faster than the pace of inflation.   Our premiums have increased 26% since 2021 for our Bronze plan.  There doesn’t seem to be any help on the horizon related to these costs. 

Does harvesting capital gains make sense?   Even if they are realized at the 0% federal rate, the lost credit creates a 16% or so effective tax rate between $50,000 and $80,000.   The healthcare tax credit phaseouts means that $50,000 to $80,000 income range is the most punitive marginal tax rate until a couple exceeds $250,000 (22% federal + 3.8% Net Investment Income Tax)

In 2022 and 2023, we converted significant amounts to get well above the 12% bracket.  With the ever increasing cost of healthcare and the tax credits available, it may make sense to modify strategies. 


Final Thoughts and Resources

Taxes are one of the top five lifetime expenses for individuals and families.  The United State tax code, as it’s currently written, gives multiple preferences to how and when to realize income, with the healthcare tax credits being one of the biggest factors for retirees and self employed individuals under the age of 65. Other tax implications and penalties can occur in traditional retirement if someone has too much income as the code is currently written.   If we knew exactly what tax rates / tax policy would be in the future, there would be simple and mathematical answers.   Instead we are working in the world of probabilities including investment returns, inflation, and future tax rates.   All of these decisions have tradeoffs and each person has to work through this decision and figure out what is best for their situation.


Resources:

2024 Contributions and Tax Limits from 7 Saturdays Financial

*Occasionally the internet police will argue that someone worth X dollars shouldn’t take an income based tax credit, such as the one offered on health insurance.   That’s a perfectly reasonable opinion, but if you are a resident of the United States, that opinion is best voiced towards your member of congress and two Senators.  I have a laundry list of things I don’t agree with in the tax code, but I also won’t spend my time on the internet insulting people for paying the amount of tax they owe based on the IRS calculations.  

3 Replies to “Tax Decisions in Early Retirement”

  1. Yes taxes are one of the top 5 expenses for a family and many people don’t truly understand the negative impact they have on wealth building. Same for stock broker fees, they eat away at your wealth building prowess as well, and people just go along and pay them! Happy New Year!

  2. It seems that if the “temporary cliff fix” has an end date, you should wait to do the lower years until after the cliff fix is gone.

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