UnThreaded | Threaded | Whole Thread (37) | Ignore Thread Prev | Next
Author: ptsurmr Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 740897  
Subject: Taxes projections for Early Retirement Date: 4/9/2000 2:52 AM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 13
Taxes and Early Retirement

Let's take a look at taxes and how they impact the early retiree. This is a large subject area, and one that will have unique characteristics for each of us. It is my hope that there are sufficient similarities between us so that our analysis will benefit each other. I invite you to extend and evaluate alternate scenarios, and to provide corrections/clarifications to this post.

Of all my expenses, taxes will see the most change with early retirement (health care may be another big change for many. I will leave this for a separate thread.

It has been relatively easy for me to project how most of my current expense categories will change when I leave the working world. Taxes are the one expense area that I have left without rigorous study (I did perform a thumbnail study in post http://boards.fool.com/Message.asp?id=1380025000920029 ). That is, until tonight.

The reason I have neglected an absolutely rigorous study of the tax consequences is because I really dislike doing (and paying) taxes! Whenever it came time for me to figure taxes into my projections, I just “guessed” at a rate (BTW, 15% was my guess). I have, however, harbored deep doubts as to the accuracy of my guess. Mostly I worried that my 15% guess was too low. I think this doubt comes from the vast difference in this rate vs. what I currently pay (an obscenely large percentage, IMHO).

I won't bore you with the precise details of my own situation, but I will provide a couple of examples as a point of reference. Note that neither of these examples includes the taking of SEPPs from an IRA, drawing a pension, social security, etc. I invite others to make contributions to this thread that include pensions, SEPPs, etc., starting from day 1 of early retirement.

The couples in the examples below will live off the interest from their Cash and annual sales of their equities. The draw from their tax deferred accounts, pensions, etc. will occur a “long” time in the future (20+ years). The analysis of the tax consequences for this future period is not included in this post (it is very likely to change, given the propensity of the tax laws to be continually revised). I chose this set of assumptions since it closely reflects my own situation (the dollar amounts differ, but the source of withdrawals is similar). Your mileage may vary (I would love to see analysis for your situation, if it differs).

Furthermore, I assume “worst case” for itemized deductions – that there are none. No mortgage deductions, no medical deductions, etc. The only deductions included are the “standard” deductions and exemptions (e.g. for dependents, including self). All tax calculations were derived using Kiplinger TaxCut 1999 Federal and CA State).

The examples use a retirement date of January 1, 1999 with a $1,000,000 portfolio. Portfolio is divided with 83% ($830,000) in equities and 17% ($170,000) in Cash (Bonds, MMAs or CDs). Both examples use 4% withdrawal rate ($40,000 per year) and figure that the Cash portion of the portfolio earns 7% taxable interest (current 2 1/2 year CD rates are ~7.25% APY). I calculate state income taxes at the California rate (which is one of the highest in the country, from what I understand).

Example 1:
John and Jane Smith are married and have 1 child, John Jr. They have just retired early, and the equity portion of their portfolio has 50% unrealized capital gains (i.e. they have a cost “basis” of $415,000 in their $830,000 equity portfolio). What will their annual tax burden be (federal and state)?
Annual interest earned on cash portion of portfolio: 170,000 * .07 = $11,900.00
Sale of equities required for balance of $40,000 draw: $40,000 – $11,900 = $28,100
Taxable Long Term Capital Gains (50% cost basis): $28,100 * .50 = $14,050
Adjusted Gross Income (AGI): $11,900 + $14,050 = $25,950
Total Federal Tax: $550
Total CA State Tax: $0 (yes, $0!)
Total Federal and State Tax for the Year: $550
Percent of annual withdrawal that taxes represent: $550 / $40,000 = 1.3%


Example 2
John and Jane Brown are married with no dependents. They have just retired early, and the equity portion of their portfolio has 80% unrealized capital gains (i.e. they have a cost “basis” of $166,000 in their $830,000 equity portfolio. They are happy to have a “5 bagger” portfolio). What will their annual tax burden be (federal and state)?
Annual interest earned on cash portion of portfolio: 170,000 * .07 = $11,900.00
Sale of equities required for balance of $40,000 draw: $40,000 – $11,900 = $28,100
Taxable Long Term Capital Gains (20% cost basis): $28,100 * 80 = $22,480
Adjusted Gross Income (AGI): $11,900 + $22,480 = $34,380
Total Federal Tax: $2168
Total CA State Tax: $412
Total Federal and State Tax for the Year: $2580
Percent of annual withdrawal that taxes represent: $2580 / $40,000 = 6.5%


To put this in perspective, take a look at the following table (based upon the research above, I will have to update this table with tax rates below 5%!)

Annual after tax income per $100,000 portfolio value for various withdrawal rate
and income tax rate (combined federal and state) assumptions

Tax Rate

5.00% 7.50% 10.00% 12.50% 15.00% 17.50%
------------------------------------------------------------
Withdrawal 3.50% | $3,325.00 $3,237.50 $3,150.00 $3,062.50 $2,975.00 $2,887.50
Rate 4.00% | $3,800.00 $3,700.00 $3,600.00 $3,500.00 $3,400.00 $3,300.00
4.50% | $4,275.00 $4,162.50 $4,050.00 $3,937.50 $3,825.00 $3,712.50
5.00% | $4,750.00 $4,625.00 $4,500.00 $4,375.00 $4,250.00 $4,125.00
5.50% | $5,225.00 $5,087.50 $4,950.00 $4,812.50 $4,675.00 $4,537.50
6.00% | $5,700.00 $5,550.00 $5,400.00 $5,250.00 $5,100.00 $4,950.00

For a million-dollar portfolio at a 4% withdrawal rate and a 15% tax rate, I would be left with $34,000 after taxes for expenses. If I use the more accurate 5% tax rate assumption, I will have $38,000 left after taxes, a difference of $4,000. Another way to look at this is that if I need $34,000 for after tax expenses, and I yield 5% to taxes rather than 15%, I will not need $1,000,000 to retire, but rather $894,736.84. This is a difference of over $100,000! It certainly means my early retirement date is moved forward..

Now it is important to keep in mind that, over time, the percentage of unrealized capital gains in the equity portfolio will continue (hopefully) to grow. This will have the effect of raising the taxable income of the early retiree (and thus the total tax due). It will however be a “gradual” process. For example, someone starting with an equity portfolio having 50% unrealized capital gains (50% cost basis) and achieving an annual 10% appreciation will have the following approximate cost basis after (7 years) 25%, (14 years) 12.5%, (21 years) 6.25%, etc. This process may be optimized further by selling losers to offset winners, and/or selling equities with higher cost basis earlier (thus postponing taxes on equities with lower cost basis into the future).

Well, these figures really opened my eyes, in a positive way. Here I thought my 15% “guess” may be too low (I have seen others estimate their post-retirement rate at 20% or more, making me feel even less comfortable with my estimate). This is no longer the case. I can now make an informed, very accurate projection about my tax burden after retirement. I encourage you to do the same analysis for your situation ('tis the season, and you may be pleasantly surprised).

PtSurMr

Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Print the post  
UnThreaded | Threaded | Whole Thread (37) | Ignore Thread Prev | Next

Announcements

Post of the Day:
Berkshire Hathaway

Burger King's Play Not For Taxes?
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Community Home
Speak Your Mind, Start Your Blog, Rate Your Stocks

Community Team Fools - who are those TMF's?
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and "#1 Media Company to Work For" (BusinessInsider 2011)! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.
Advertisement