Use The Lower Brackets To Retire Tax Free

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Includes: DVY, VNQ, XLU
by: The Market Flash

In this highly politicized season of ours, you may have heard that roughly half the people in the U.S. pay no Federal Income taxes at all. Regardless of the political merits of this situation, you can use the tax code in the United States to your advantage when you retire. For most of your working life you have little choice but to report your income and pay your taxes. Retirement is a time in life when you can make conscious choices about how much money will be reported in certain years. The point of this article is to show you how to plan your retirement so that you can use the tax code to give you income in your retirement that is largely free of taxation. The focus will be on how to use Social Security and your IRA to create a retirement income stream that uses up all the lower tax brackets and minimizes your taxes. In addition, we'll take a look at options for managing an IRA as an income-generating vehicle.

So let's look at some tax scenarios that reveal how the tax rate schedules could benefit you in retirement. Below are some charts that show the Federal and California taxes paid on various levels of income, at $10,000 increments. These tables were drawn up by modeling the various scenarios with a commonly used personal income tax preparation software package for the 2011 tax year. The tax assumptions for Joint Filers are a couple with no itemized deductions, no dependents, and no other taxable income-reducing deductions or credits. The Social Security income was assumed to have been earned by one person. The tax situation for a Single Filer is shown below that, again assuming no deductions or credits. The main point the author wants you to notice from this table is that a couple can make up to $44,000 in a high-tax state and pay almost no income taxes at all, and not pay much tax at the $54,000 level.

Tax Scenarios for Joint Filers

IRA
Withdrawal

Social
Security
Income

Gross
Income

Federal Tax

CA Tax

$10000

$24000

$34000

$0

$0

$20000

$24000

$44000

$101

$0

$30000

$24000

$54000

$1603

$100

$40000

$24000

$64000

$4224

$300

$50000

$24000

$74000

$6864

$656

Tax Scenarios for Single Filers

IRA
Withdrawal

Social
Security
Income

Gross
Income

Federal Tax

CA Tax

$10000

$24000

$34000

$51

$0

$20000

$24000

$44000

$1679

$149

$30000

$24000

$54000

$4349

$526

$40000

$24000

$64000

$8706

$1102

The mix of Social Security income and IRA income withdrawal does not matter, but the typical person can only modify their IRA withdrawal. To relate this tax chart to your personal situation: If you itemize deductions then you can increase your IRA withdrawal by roughly the amount of your itemized deductions and still pay no extra tax. If you still declare dependents you can take more IRA withdrawals and still pay no extra tax. If you live in lower income tax state than California (and most states are) you are probably better off than what this chart shows. A single person can make up to $34k and pay very little income tax. To use the tax code to your advantage, you need to proactively plan your retirement so that your earned income from a job stops at the end of a tax year and Social Security and IRA withdrawals come in right behind it to generate all the income that low brackets allow.

An Income-Generating IRA Portfolio

Now I'm going to take this exercise one step further. Assume a retired couple is willing to pay the taxes for the $54k income level (Taxes=$1603 Fed + $100 State). Further assume the couple does not want to withdraw principal from their IRA.

Let's take a look at a dividend stock portfolio that will generate the $30k annual IRA withdrawal that creates income for the lowest bracket for Joint Filers. This is a dividend-generating portfolio that is diversified across financials, utilities, energy and technology. The Principal column in the table is the dollar amount of the stock you would buy. The Yearly Dividend Income column in the table is the dividends you would get from buying that amount of stock. If you want some more diversification and were willing to give up some yield the following Dividend ETFs would make the portfolio more diversified: SPDR Utilities [(NYSEARCA:XLU) 3.9%], Vanguard REIT [(NYSEARCA:VNQ) 3.4%] and IShares Select Dividend [(NYSEARCA:DVY) 3.4%]. If your investing style tends toward actively managing your portfolio for capital gains, then you would use capital gains to supply your $30k IRA withdrawal. From a tax standpoint it doesn't matter whether your IRA withdrawals came from dividends or capital gains or original principal, and they will count the same way on your return. Dividend yields shown in the table below were taken from Yahoo Finance ® slightly before this article was published and will not be accurate going forward. Here is a $600k portfolio that will generate the $30k a year:

Stock

Symbol

Dividend
Rate

Principal

Yearly
Dividend
Income

Wells Fargo

WFC

2.90%

$75000

$2175

Westpac Bank

WBK

7.80%

$75000

$5850

Intel Corp

INTC

3.10%

$75000

$2325

KLA-Tencor

KLAC

2.80%

$75000

$2100

Verizon Comm

VZ

4.90%

$75000

$3675

San Juan Trust

SJT

5.60%

$75000

$4200

Atlantic Power

AT

8.40%

$75000

$6300

Duke Energy

DUK

4.60%

$75000

$3450

Total

$600000

$30075

This arrangement also has the benefit that it works in perpetuity (you will always have this income) as long as the status quo holds. If the tax law changes, Social Security gets into trouble, the stock market crashes, and or one of these companies goes broke or stops paying their dividend then the perpetuity statement would not hold. Dividend stocks aren't the worst inflation protection you can buy either. Good companies have pricing power in times of inflation and can increase their dividends when there is inflation. So for our hypothetical Joint Filer couple, $24k of Social Security Income adds to $30k of IRA withdrawal to give them $54k, minus only $1.7k taxes of spendable cash, to live on each year.

Are My Retirements Savings on Target?

A question may now be coming up in some readers' minds. Will I have the nest egg I need to use up the low tax brackets and hopefully more? To tell whether you are on track for your retirement nest egg I'm going to give you an Excel ® formula that will help you figure it out. The Future Value (FV) formula in Excel works as follows:

=FV(0.06,10,12000,250000)

This formula is a depiction of someone who is going to make the IRA level used as an example in this article. The person will have $605,881 at retirement, assuming the following: He or she has $250,000 now and or his or her company is contributing $12,000 a year to their 401k/IRA until retirement. Retirement is in 10 years. You can use fractional periods (10.5, 10 years 6 months) if you like. Finally, .06 (6% annual) is shown as the compound interest rate, which can be higher or lower depending on how well you invest, for the same period. Copy this formula into a spreadsheet cell and you can modify the numbers for your personal situation. This formula is complex and small changes in the inputs can make huge differences in the output, so check your results against another source if making decisions. Google "Web Retirement Calculators" if you want some web retirement calculators to check your results. The compounding shown in this Excel formula is yearly, while some calculators compound daily or monthly.

The U.S. Federal and State income tax structures effectively exempt half of the population from paying income tax. Hopefully this article has shown you how to use that fact to your advantage when you retire. Plan your retirement date toward the end of the year to make that clean cut from earned income to retirement income. Some of you may need more income than what is provided by the lower brackets to retire. You could have a comfortable retirement by lowering your required expenses, or if you have the retirement assets, increasing the withdrawals from your retirement assets. These scenarios and their tax implications will be discussed in a future article.

Disclosure: I am long WFC, WBK, INTC, KLAC, VZ, AT, DUK, DVY.

Disclaimer: This article is intended to be solely informational and does not represent a recommendation to buy or sell any security. The information in the article is believed to be accurate but you are advised to do your own research and exercise your own due diligence before taking any action that affects your financial future.