Sources of taxable income in retirement

Finance hacking enthusiasts spend a vast amount of time minimizing the taxes they pay and shielding income and assets from taxation in the future. These techniques range from the commonsensical (max out IRA contributions each year) to the unhinged (name your favorite front-door/back-door/side-door/trap-door IRA strategy).

How deep you decide to go into the weeds of managing your tax liability is up to you. But you’re exceedingly unlikely to make the right decision if you don’t have a grasp of what your tax liability is, in fact, likely to be, and it appears to me that many tax minimization antics are predicated on a grossly exaggerated idea of the tax code’s actual burden.

With that in mind, I want to break down three sources of taxable income in retirement and indicate what tax rate each source is likely to incur.

Earned income

There’s no rule that says you have to stop working once you retire, and in fact it appears to me that most retirees of the finance hacking genus continue to earn income, whether it’s through real estate management, blogging, or some other activity. This earned income is taxed at the normal income tax rates, which is to say the first $10,350 in earned income ($20,700 for married folks) is untaxed. After that, you’ll pay a modest 10% or 15% marginal income tax rate on additional income until your earned income reaches mid-to-high 5 figures.

Capital gains and dividends

Long-term capital gains and dividends are taxed at preferential tax rates and it’s absolutely essential to keep in mind that these are marginal tax rates, just like the ones I discussed last week. As this post clearly explains, you don’t need to worry about triggering a higher tax rate on your long term capital gains by “accidentally” having too much earned income or too many realized capital gains: the high tax rates are only applied to additional dollars on the margin, so the lowest preferential rates will still apply to every dollar of capital gains that’s eligible for them.

The categories of earned income and capital gains interact in an important way. Look at the two categories in conjunction: a single person can earn $10,350 in earned income to “fill up” their standard deduction and personal exemption, then an additional $37,650 in realized long-term capital gains and qualified dividends at the preferential 0% tax rate. And if they earn more income or realize more long term capital gains than that, only the marginal dollar is taxed at higher rates — the first $48,000 is still tax-free.

The terror of triggering higher tax rates appears to me to be based on the misconception that the higher rate applies to one’s entire income. That’s just not so.

Social Security

If your only source of income in retirement is Social Security (and Roth retirement savings accounts) then you’ll never owe income taxes in retirement. However, under certain circumstances part of your Social Security benefits is added to your taxable income before calculating the income tax you owe:

• if your AGI plus nontaxable interest (e.g. from municipal bonds) plus 50% of your Social Security benefit is between $25,000 and $34,000, you may have to add 50% of your Social Security benefit to your taxable income;
• if it’s above $34,000, you may have to add 85% of your Social Security benefit to your taxable income.

Avoiding the tax on Social Security benefits is one reason folks are so eager to put as many of their retirement assets as possible into Roth accounts, withdrawals from which don’t trigger the tax on Social Security benefits. And indeed, if you have earned income and taxable capital gains and Social Security income, you’re more likely to owe some tax on your Social Security benefits.

However, it’s worth taking a look at the case of someone with just Social Security benefits and taxable capital gains. In this case, if your taxable long term capital gains plus half your Social Security benefit requires you to report half your Social Security benefit as taxable income on Form 1040, line 20b, the federal income tax will apply first to that amount, meaning you’ll owe no federal income tax on up to $20,700 in Social Security benefits, and then no long term capital gains taxes on the same $37,650 in long-term capital gains we calculated above.

In other words, even if your Social Security benefit is taxable, you still might not owe any taxes on it.

Conclusion

There are a lot of common sense strategies, and some esoteric strategies, for maximizing the assets available to you to fund retirement, whether you decide to retire early, late, or right on time, and my intention isn’t to say “tax planning doesn’t matter.” Tax planning can matter.

However, if you don’t have at least a preliminary grasp on what you’re likely to actually owe in taxes, then you are vanishingly unlikely to make smart decisions about how to invest, where to invest, and most importantly, how much time to spend researching your options!