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Author: Pappys Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35392  
Subject: I Bond Tax issues Date: 3/23/2006 7:55 PM
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I am interested in I bonds and Tips and have read I think every post.

But, I must be missing something.
Sooner or later you are going to use the proceeds of say your I Bonds.

EX fixed 1% + average inflation 4% = 5%

Now 5% - (Fed tax 20% bracket) 1% = 4% which is equal to inflation.

You preserved your capital thats all and in some cases by changing
your tax bracket or the fixed rate or inflation you lose some of
your capital.

I know I have left out some of the steps such as tax protection until
used but I can't see where that will change things much.

As I will admit this is my first attempt to understand fixed income
investments as I have been in stocks/mutual funds. Which after some close scrutiny may not be much better Ha!

Pappys
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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15893 of 35392
Subject: Re: I Bond Tax issues Date: 3/23/2006 9:08 PM
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But, I must be missing something.
Sooner or later you are going to use the proceeds of say your I Bonds.

EX fixed 1% + average inflation 4% = 5%

Now 5% - (Fed tax 20% bracket) 1% = 4% which is equal to inflation.

You preserved your capital thats all and in some cases by changing
your tax bracket or the fixed rate or inflation you lose some of
your capital.


In many cases, it is even worse than that. For example, what if inflation shoots up to 9% for a few years? Then you have 9+1 - 20% = 8%, or a loss relative to inflation. But this isn't a good example since inflation won't remain at 9% for 30 years!

But how about a much more realisitic scenario. Democrats get elected around the time you need to cash in your I-bonds and they raise tax rates to 33%., so now you have 4+1 - 33% = 3.35%, also a loss compared to inflation.


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Author: whyohwhyoh Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15894 of 35392
Subject: Re: I Bond Tax issues Date: 3/23/2006 11:43 PM
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I know I have left out some of the steps such as tax protection until
used but I can't see where that will change things much.


Roths provide some tax protection.

Here is an example showing no taxes paid on I-bond gains and TODAY's tax system (subject to change in the future):

Let's say I retire with $1,000,000 and plan on withdrawing $40k the first year.

Assume my assets are:
$250k Roth
$250k Traditional IRA
$150k High yielding dividend stocks in Taxable Account
$250k Fixed instruments CD's
$100k I-bonds - Assume principal is $80k (you bought them 5 years ago)
___________________________________

INCOME:
$13k income from CD's
$6k dividend income
$9k wihdrawn from Roth IRA
$4k Sale of stock in taxable account ($1.8k taxable)
$8k from I-bonds ($1.6k taxable income)

Married so first $16.4k is tax free from standard decuctions.
$6k dividend is taxed at 5% since I will be in lowest tax bracket.

Gross taxable non dividend income is 13+1.6+1.8 = $16.4k

So only pay tax on dividend income at 5%=$300

So total taxes on $40k gross income is $300.

--
whyohwhyoh

By the way, netting $39,700 before retirement probably takes about $70k annual income (due to savings, SS tax, FICA, income taxes). Too lazy to work out details.












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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15895 of 35392
Subject: Re: I Bond Tax issues Date: 3/23/2006 11:45 PM
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In taxable accounts, including US Savings Bonds with tax delay advantages, your return after taxes may not keep your original buying power after inflation—it certainly won't by much. Of course, it's not clear with tax-deferred accounts, either (401ks, Traditional IRAs, etc.), but at least there you are deferring income as well as earnings, and stocks don't get an advantage, like they do in taxable accounts.

When we compare different "fixed-income" options, the question is which looks best after taxes and inflation. If you really want a chance to significantly beat inflation after taxes, you need to go for stocks or high risk bond picking/trading (or maybe real estate), and there you also have a chance of big losses.

I look at taxes as part of my expenses, so when I say I want to earn at least 2% above inflation on fixed income to survive with a 3% initial withdrawal rate in retirement, the 3% initial withdrawal rate includes taxes and I am assuming taxes will grow at the inflation rate (which is probably an overestimate).

When we compare TIPS and I-bonds after taxes, the issue is whether the tax delay and the possibility of being in a lower tax bracket at cash in makes up for a lower fixed rate for I-bonds (currently the answer is no). But there's nothing in this comparison that suggests either will mean your principal will keep pace with inflation after taxes.

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Author: Pappys Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15896 of 35392
Subject: Re: I Bond Tax issues Date: 3/24/2006 10:00 AM
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OK, Lots of good points to consider.

I have been investing mostly since 98 but I seem to be learning something new each day. When I thought I already had it figured out. Ha
Whyohwhyoh thanks for the good examples it brought to light how important those standard deductions will be on retirement pay. Right now I am lucky to be making good money and so I had'nt thought that through well enough. Your examples did. I am looking to park some cash from my 401K and some on the retail side in fixed income. I do appreciate all of your post.

Pappys

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15897 of 35392
Subject: Re: I Bond Tax issues Date: 3/24/2006 11:08 AM
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Pappys,

If you aren't familiar with this from previous discussions, here is a useful calculator/graphs on the issue of initial withdrawal rates (i.e., in retirement) and the return you need above inflation to maintain an inflation adjusted withdrawal for a number of years:

http://www.gummy-stuff.org/to_zero_explain.htm

(The calculator doesn't work with Safari for the Mac, but does with Explorer).

Taxes need to be included on the expense side, which is hard to project, and, of course, in this case we are dealing with inflation to your actual expenses, not CPI-U adjustments—I just allow for a generous margin for error (e.g., if in principal you can get about 40 years at a 3% initial withdrawal rate and 1% above inflation, you figure in reality a 2.5% initial withdrawal rate would be safer).

There is a lot of guesswork projecting your future assets and expenses, but I find this kind of do it yourself planning is much more useful than all the planning calculators, and you can do a range of calculations. For many, it is very sobering, because they discover they are on a path where they will need large stock allocations and historical stock market returns (or analogous returns) to get the returns above inflation needed to sustain a high initial withdrawal rate (e.g., 6%). For those of us managing to save enough to hit a low initial withdrawal rate, the calculations can be reassuring (e.g., I'm seriously thinking about getting a new computer, though I could hold off another year or two, because the planned obsolescence, like not being able to ugrade Safari, is getting annoying enough to warrant a new model, and the fact is I can easily afford it, according to my retirement planning calculations).

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15900 of 35392
Subject: Re: I Bond Tax issues Date: 3/24/2006 1:18 PM
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One issue that nobody has mentioned yet is the effect of non-reportability of I-Bond income on deductions. I-Bond interest is not reportable, and not taxed, until you cash in the I-Bond (which can be up to 30 years).

If you retire early, you may have to buy private health insurance (this is our situation). Medical expenses (including health insurance plus any medical expenses) are only deductible, if they exceed 7% of income.

I-Bond income is not reported. This lowers the threshold of deductibility of medical expenses.

Others have spoken about buying I-Bonds in IRAs. My understanding is that the only entities that can buy I-Bonds are individuals and trusts, not IRAs. The I-Bond is a way of turning non-IRA money into the equivalent of IRA money.

As Loki said, TIPS are yielding more than I-Bonds, over inflation. There are a few subtle differences between these two investments.

TIPS interest, plus the inflation-adjusted increase in the principal of the TIPS, are reported and taxed, each year. That is, you pay tax on an increase in principal, before the TIPS is cashed in. This tax has to be paid from a separate source. Once the TIPS matures (or you sell it), you will receive the increase in the principal, in hand...however, this increase must be paid for all along -- possibly from the interest that is periodically paid from the TIPS. I believe that this increase is treated as a capital gain.

If you need the cash from the TIPS, you can sell it, on the secondary market. However, if interest rates have risen, you will get less for the TIPS than you paid for it. However, the principal of I-Bonds is guraranteed: you always get paid the par value, when you cash an I-Bond, even if interest rates have gone up. (That guarantee of principal is also true of CDs.) If you buy a TIPS, you must either decide to hold to maturity, or take the chance that interest rates will be stable/decline.

The question is: given the prevailing interest rates, the prevailing risk premia, and your particular circumstances, which fixed-income investments are better for you?

You might want to look at this historical chart, of nominal and real interest rates. Context is always useful.
http://www.martincapital.com/chart-pgs/CH_mmnry.HTM

Wendy


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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15901 of 35392
Subject: Re: I Bond Tax issues Date: 3/24/2006 3:54 PM
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I-Bond interest is not reportable, and not taxed, until you cash in the I-Bond (which can be up to 30 years).

...unless you elect to report and be taxed on the phantom income on all your savings bonds, as long as you hold any.

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Author: Pappys Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15902 of 35392
Subject: Re: I Bond Tax issues Date: 3/24/2006 5:15 PM
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Lokicious said:


"Taxes need to be included on the expense side, which is hard to project, and, of course, in this case we are dealing with inflation to your actual expenses, not CPI-U adjustments—I just allow for a generous margin for error (e.g., if in principal you can get about 40 years at a 3% initial withdrawal rate and 1% above inflation, you figure in reality a 2.5% initial withdrawal rate would be safer)."


Your statement about inflation to actual expenses is a new concept for me. I have just been thinking about protecting the whole nest egg from inflation based on the CPI-U. It will indeed depend on where the expenses are coming from and what part of the country you live in.

Pappys

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15906 of 35392
Subject: Re: I Bond Tax issues Date: 3/25/2006 9:53 AM
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"Your statement about inflation to actual expenses is a new concept for me. I have just been thinking about protecting the whole nest egg from inflation based on the CPI-U. It will indeed depend on where the expenses are coming from and what part of the country you live in."

Pappys,

There are folks on this board who will lay into you any time you neglectfully use "inflation" as a synonym for "CPI-U." It gets annoying, but they are correct. The CPI-U is a poor approximation for inflation as experienced by each of us in our own way, and when we use CPI-U adjusted vehicles (TIPS, I-bonds), the extent to which they protect our buying power is going to vary.

It isn't just regional differences, or urban versus rural (the U in CPI-U is for "urban"). More important are our lifestyles, including age considerations. People like my wife and myself, who use about 200 gallons of gas a year, including travel, are going to be much less affected by changes in gas prices than people with a couple of gas guzzlers, long commutes, and soccer mom duties, who might use 5000 gallons or more. On the other hand, people like us who don't buy the latest technologies as soon as they exist, lose out on the deflationary component in the CPI-U that comes from the fact that we can now get a new computer that is much better than 2-years ago, even though we don't need anything better than the computers of 5 years ago.

And, as best I understand, CPI-U does not take into account changes in benefits: that we now pay for a portion of Health plan, plus co-pays, when all was free a few years back, is not "inflation": it's just higher costs. I was just reading a piece in the Times about caring for elderly parents (something many ofus have dealt with or will soon be) and there are a lot of issues around aging that are not factored into CPI-U. I get furious with the "get-away-with-saying-anything" finance shock troops (get headlines without being dismissed as an idiot) who say things like elderly people will have lower expenses, based on some simplistic reading of historical statistics. I'm watching my neighbor (right out my study window), now in his mid-70s, whose daughter and son-in-law have taken over most of the yard work, and I have to assume many of us, who want to stay in our homes, will have considerably higher expenses by having to hire someone to do stuff we now do ourselves. How much it costs to have someone mow the lawn may not go up more than inflation, but paying someone to mow the lawn when you don't now is definitely inflation as you experience it.

I don't know how to factor all this in, but my basic response is, if formal calculations say I can afford a certain initial withdrawal rate with a certain return above inflation, I need to lower the initial withdrawal rate or get a better return, so I have a good margin for error.


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Author: Pappys Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15907 of 35392
Subject: Re: I Bond Tax issues Date: 3/25/2006 11:18 AM
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Lokicious,

Thanks for setting me straight and I concur about the other factors
not computed into the CPI-U.

Now can anyone recommend a book about fixed income and bond investing in particular.

Pappys

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Author: vickifool Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15909 of 35392
Subject: Re: I Bond Tax issues Date: 3/25/2006 12:07 PM
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I don't know how to factor all this in, but my basic response is, if formal calculations say I can afford a certain initial withdrawal rate with a certain return above inflation, I need to lower the initial withdrawal rate or get a better return, so I have a good margin for error.

I agree.

On the other hand,
I was at a Retirement Planning Seminar recently, and many of the attendees came away feeling fear and disempowerment. You can't predict inflation, so the best you can do is buy an annuity?

As far as I could tell, the investment advisor giving the seminar had never heard of I-bond or TIPS. Or maybe they weren't mentioned because of the lack of commission. ;-)

I don't think things are that hopeless. We can estimate a range. We can give ourselves a margin for error like you are doing. We can follow a multiple bucket approach (One bucket of money for basics, one bucket for extras depending on return vs. personal inflation, etc.) We can find ways to cut expenses.

(For example, my bedridden 91-year-old aunt just moved from a 1 bedroom to a studio to try not to outlive her money. She didn't want to, but hospice took such good care of her 18 months ago that she regained enough lucidity and strength that they decided she wasn't going to die within their required 6 months.)

Vickifool



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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15917 of 35392
Subject: Re: I Bond Tax issues Date: 3/25/2006 7:38 PM
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"I don't think things are that hopeless. We can estimate a range. We can give ourselves a margin for error like you are doing. We can follow a multiple bucket approach (One bucket of money for basics, one bucket for extras depending on return vs. personal inflation, etc.) We can find ways to cut expenses."

Vicki,

Absolutely. What I like about the year-to-zero calculations (using a range) is I think they give us a realistic sense of what we need to do. In my case, they are at this point reassuring, which doesn't mean I'm going to run out and buy a Hummer, but I can remind myself, when it makes sense to spend money, even if not absolutely necessary, I don't have to act like my late father-in-law, who wouldn't spend money when it would have made his life much easier (and his wife's). I think for others, a wake up call is a good idea, but a good financial planner (not to be confused with an investment advisor) can then help figure out the most realistic approach to survival, so the fright doesn't generate a sense of hopelessness.


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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15921 of 35392
Subject: Re: I Bond Tax issues Date: 3/25/2006 10:28 PM
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There are folks on this board who will lay into you any time you neglectfully use "inflation" as a synonym for "CPI-U." It gets annoying, but they are correct. The CPI-U is a poor approximation for inflation as experienced by each of us in our own way, and when we use CPI-U adjusted vehicles (TIPS, I-bonds), the extent to which they protect our buying power is going to vary.

And it's going to vary a lot! Any number that is calculated as an average is not going to "fit" everyone, or even the majority of folks. The CPI-U, flawed as it is, encompasses people from every walk of [urban] life, from the 22 year old college graduate who just upgraded her i-Pod (and saved $48 compared to the previous model of similar capability) to the 45 year old who just purchased a new carpet (up by $13) for the household, to the 70 year old who purchased their monthly prescriptions (at an increase of $7).

It isn't just regional differences, or urban versus rural (the U in CPI-U is for "urban"). More important are our lifestyles, including age considerations. People like my wife and myself, who use about 200 gallons of gas a year, including travel, are going to be much less affected by changes in gas prices than people with a couple of gas guzzlers, long commutes, and soccer mom duties, who might use 5000 gallons or more. On the other hand, people like us who don't buy the latest technologies as soon as they exist, lose out on the deflationary component in the CPI-U that comes from the fact that we can now get a new computer that is much better than 2-years ago, even though we don't need anything better than the computers of 5 years ago.

Since the CPI-U is a relative measure, perhaps that guzzler family may be better off than you, since if they cut their gasoline usage by 10%, they save $1300/year, but if you save 10%, you save about $52 :-) Relatively, that is ...

Besides, by not purchasing the latest computer, you still capture that deflation eventually when you purchase your next 5 year old computer.

And, as best I understand, CPI-U does not take into account changes in benefits: that we now pay for a portion of Health plan, plus co-pays, when all was free a few years back, is not "inflation": it's just higher costs. I was just reading a piece in the Times about caring for elderly parents (something many ofus have dealt with or will soon be) and there are a lot of issues around aging that are not factored into CPI-U. I get furious with the "get-away-with-saying-anything" finance shock troops (get headlines without being dismissed as an idiot) who say things like elderly people will have lower expenses, based on some simplistic reading of historical statistics. I'm watching my neighbor (right out my study window), now in his mid-70s, whose daughter and son-in-law have taken over most of the yard work, and I have to assume many of us, who want to stay in our homes, will have considerably higher expenses by having to hire someone to do stuff we now do ourselves. How much it costs to have someone mow the lawn may not go up more than inflation, but paying someone to mow the lawn when you don't now is definitely inflation as you experience it.

But what about all the older folks that move from a 4 bedroom home to a 1 or 2 bedroom condo? Do we count the reduction of their costs (taxes, energy, maintenance, etc) as deflation?

I don't know how to factor all this in, but my basic response is, if formal calculations say I can afford a certain initial withdrawal rate with a certain return above inflation, I need to lower the initial withdrawal rate or get a better return, so I have a good margin for error.

The only way to know is to calculate it yourself and that calculation will by necessity will include many guesses.

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Author: 2old4bs Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15977 of 35392
Subject: Re: I Bond Tax issues Date: 3/28/2006 4:58 PM
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I am looking to park some cash from my 401K and some on the retail side in fixed income.

Some folks (like me) invest in I-Bonds because we're in high marginal tax brackets in high tax localities (NYC for example). One of the advantages of I-Bonds is that the income isn't subject to state or local taxes.

I also estimate that I'll have a much lower marginal tax rate when I cash them in than I currently have, and I don't have to claim the income until then.

If the 2 things above weren't true, I don't think I-Bonds would be as lucrative for me.

2old
(currently at a 40% marginal tax rate)


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Author: kentm401 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15997 of 35392
Subject: Re: I Bond Tax issues Date: 3/29/2006 3:31 PM
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Hope you're not brushing up against the AMT "issue"?

High marginal rate payers with tax-exempt interest often do, imv

KBM ("taxes R us")


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Author: BEC Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15998 of 35392
Subject: Re: I Bond Tax issues Date: 3/30/2006 7:23 AM
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I Bond interest is not tax-exemt but tax deferred. I'm not sure
AMT applies

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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15999 of 35392
Subject: Re: I Bond Tax issues Date: 3/30/2006 9:11 AM
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Some folks (like me) invest in I-Bonds because we're in high marginal tax brackets in high tax localities (NYC for example). One of the advantages of I-Bonds is that the income isn't subject to state or local taxes.

I also estimate that I'll have a much lower marginal tax rate when I cash them in than I currently have, and I don't have to claim the income until then.


I also estimate that when I will cash in my I-bonds, I will be in a lower marginal tax bracket, but my certainty in that estimation is dwindling.

Did you make that estimation mainly based on the fact that you will be leaving highly-taxed NY (NYC), or did you assume a lower Federal tax bracket as well? Also, did you account for the fact that some (or most) of your social security benefit will become taxable, thereby raising your effective marginal rate dramatically? And, if we are prognosticating, it seems to me that it is very likely that, in the future, social security benefits will become even more taxed for those with even moderate levels of other income (tax free, tax deferred, or other).

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Author: 2old4bs Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 16125 of 35392
Subject: Re: I Bond Tax issues Date: 4/4/2006 1:45 PM
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Did you make that estimation mainly based on the fact that you will be leaving highly-taxed NY (NYC), or did you assume a lower Federal tax bracket as well?

I have assumed a lower Federal tax bracket--I estimate I'll be going from ~ 28% marginal federal rate to ~ 15% marginal rate.

Also, did you account for the fact that some (or most) of your social security benefit will become taxable, thereby raising your effective marginal rate dramatically?

At the level of income I'm estimating most of my SS benefit will NOT be taxable.

Here are the basic assumptions in today's dollars: I need $50K per year (which includes my estimated 15% federal tax liability). Approximately $19K of that nut will come from my SS benefits. That leaves $31K to be supplied from my nest egg. According to Yahoo that's $2K at 25%, $22K at 15%, and $7K at 10%, so I'm using an average of 15%.

http://taxes.yahoo.com/rates.html

I currently live on $55K net, with $12K/annum mortgage paid out of that, so the $50K number isn't unreasonable.

2old



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Author: 2old4bs Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 16127 of 35392
Subject: Re: I Bond Tax issues Date: 4/4/2006 1:54 PM
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Hope you're not brushing up against the AMT "issue"?

Ha! I think the last time I calculated it, at my current income level, I'd need $50K in cap gains/unearned income to trigger the AMT--I should be so lucky! I won't be cashing in those bonds until I'm retired anyway. At that time, I'll make sure I never cash in enough to trigger the AMT, which won't be hard since about 40% of my income will be from a 401k, taxed at ordinary rates.

2old





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