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Alright, let's do an exercise together. Joe Taxpayer is single, with no dependents and no deductions. Joe has zero earned income, spending his days playing video games in the basement of his house, which he inherited (tax-free) from his mother. Joe's rich uncle, Uncle Joe, bequeathed to Joe $5M. Joe invests his money with Fidelity, in a taxable account, 100% in an index fund. Being a good index fund, it's turnover is nearly zero. let's say that it outright is zero. Joe makes no changes to his account - he makes no trades, redemptions, exchanges, rebalancing or withdrawals.
Joe's annual statement from Fidelity shows an income of $85K from dividends. Let's assume (not strictly true!) that these are all qualifying long-term dividends.
To summarize: Joe has $85K of qualifying dividends in 2018. That's his only income, and his only taxable activity in 2018. And just to re-emphasize: Joe is SINGLE.
What is Joe's 2018 federal income tax bill?
Pretty ridiculous example given that the entire discussion started around FIRE, not some dude that got left a house and 5 million dollars. Why not make it 25 million to further prove your point? But the amount of taxable income for a single filer on $85k would be $33,525 at 15% or around $5k in federal taxes.If instead that was a couple MFJ they'd have $0 in federal income taxes.
If you can completely retire extremely early with $85k/year income...you’ve probably done remarkably well and I doubt you’d be bothered by $5k worth of income tax. Heck, if you want to “spend down” to avoid taxes, give about $30k/year to parents or something.
Another option is to “just” live on $50k/year and pay whatever taxes you have to pay.
Pretty ridiculous example given that the entire discussion started around FIRE, not some dude that got left a house and 5 million dollars. Why not make it 25 million to further prove your point? But the amount of taxable income for a single filer on $85k would be $33,525 at 15% or around $5k in federal taxes.If instead that was a couple MFJ they'd have $0 in federal income taxes.
I injected a ridiculous backstory to add dramatic flair to the discussion. But the tax-code doesn't care if dividends are from an account filled with earnings from one's own labors, from inheritance, lottery winnings or a lemonade stand. There's the account, it's taxable, and gains on that account incur taxes.
Now suppose that Joe is the FIRE type, but doesn't want to spend-down his portfolio. Somehow Joe needs to earn $5K, just to cover his federal tax bill. But in reality he needs to gross about $10K, assuming that he's a private consultant. Why? Because he pays 15% in self-employment tax, 15% in straight-up income tax, and another 15% effective tax dollar-for-dollar in that his earnings push a portion of his portfolio-gains out of the 0% bracket. That's close to 50% tax-rate... not counting state/local.
If Joe actually needs $10K to cover his living-expenses, he needs to earn $30K. Why? Because he's going to pay 50% on his earnings, and still needs $5K to cover the aforementioned tax on dividends. Joe's effective tax rate in "retirement" is therefore 67%... in federal taxes alone.
Now suppose that Joe also needs to pay $5K in property tax on his paid-off house. He needs to earn an additional $10K pre-tax... for a total of $40K, and an effective (not marginal!) tax rate of 75%.
On the other hand, had Joe stayed working at his cushy computer-job, earning $150K, taxes on his portfolio would have been nearly the same. He'd be paying straight-FICA and Medicare taxes instead of self-employment tax, and his income is over the SS cap, so not all of it is taxed. His gross tax bill is of course higher, than it would have been as a retiree... but his total percentage tax is a lot lower.
Again, the point here isn't that wah-wah-wah, taxes are too high, etc. Rather, the point is that expenses in retirement - assuming EARLY retirement - can be much higher than foreseen... especially taxes.
Quote:
Originally Posted by eddiehaskell
If you can completely retire extremely early with $85k/year income...you’ve probably done remarkably well and I doubt you’d be bothered by $5k worth of income tax. Heck, if you want to “spend down” to avoid taxes, give about $30k/year to parents or something.
You're assuming that that $85K in dividends is withdrawn and used to cover living-expenses. I'm assuming that it gets automatically reinvested to grow the portfolio.
My whole premise is that we NEVER touch our portfolios... not in sickness, not in health, not in penury, not in wealth, not overtly, not in stealth. Joe has $5M, but he doesn't touch it. It's his holy cow. Joe works part-time simply to keep his portfolio inviolate. The more money that Joe has, the more expensive that gets! This is the part that's totally absent in financial-planning advice, be it from the television/radio gurus or brokerage firms or anyone else.
I injected a ridiculous backstory to add dramatic flair to the discussion. But the tax-code doesn't care if dividends are from an account filled with earnings from one's own labors, from inheritance, lottery winnings or a lemonade stand. There's the account, it's taxable, and gains on that account incur taxes.
Now suppose that Joe is the FIRE type, but doesn't want to spend-down his portfolio. Somehow Joe needs to earn $5K, just to cover his federal tax bill. But in reality he needs to gross about $10K, assuming that he's a private consultant. Why? Because he pays 15% in self-employment tax, 15% in straight-up income tax, and another 15% effective tax dollar-for-dollar in that his earnings push a portion of his portfolio-gains out of the 0% bracket. That's close to 50% tax-rate... not counting state/local.
If Joe actually needs $10K to cover his living-expenses, he needs to earn $30K. Why? Because he's going to pay 50% on his earnings, and still needs $5K to cover the aforementioned tax on dividends. Joe's effective tax rate in "retirement" is therefore 67%... in federal taxes alone.
Now suppose that Joe also needs to pay $5K in property tax on his paid-off house. He needs to earn an additional $10K pre-tax... for a total of $40K, and an effective (not marginal!) tax rate of 75%.
On the other hand, had Joe stayed working at his cushy computer-job, earning $150K, taxes on his portfolio would have been nearly the same. He'd be paying straight-FICA and Medicare taxes instead of self-employment tax, and his income is over the SS cap, so not all of it is taxed. His gross tax bill is of course higher, than it would have been as a retiree... but his total percentage tax is a lot lower.
Again, the point here isn't that wah-wah-wah, taxes are too high, etc. Rather, the point is that expenses in retirement - assuming EARLY retirement - can be much higher than foreseen... especially taxes.
You're assuming that that $85K in dividends is withdrawn and used to cover living-expenses. I'm assuming that it gets automatically reinvested to grow the portfolio.
My whole premise is that we NEVER touch our portfolios... not in sickness, not in health, not in penury, not in wealth, not overtly, not in stealth. Joe has $5M, but he doesn't touch it. It's his holy cow. Joe works part-time simply to keep his portfolio inviolate. The more money that Joe has, the more expensive that gets! This is the part that's totally absent in financial-planning advice, be it from the television/radio gurus or brokerage firms or anyone else.
Or he could take $5k of the $85k in dividends to pay his taxes $10k for his living expenses and re-invest the other $70k. Why are you assuming a person with $85k/yr of dividend income can’t afford to pay a $5k tax bill? It's clearly impossible to retire early if you don't use anything from your portfolio to live off of, I don't know why you are even arguing about that. If that's the case you could literally have 50 million dollars and you'd need to work harder than if you had 1 million to pay the taxes on your dividends.
If your assumption is that he never ever touches the money he can just donate it to charity each year and he never pays a dime in taxes at all.
Last edited by mizzourah2006; 12-13-2018 at 05:03 PM..
If you play your cards right, healthcare is almost free for those that are asset rich and income poor. That knocks out the biggest hurdle to retiring early.
Take me for example - around $20k income, home paid off and a subsidized “silver” healthcare plan. My nest egg is continually compounded and added to...never “spent down”.
Yup.
It’s amazing how the benefits snowball once you get expenses down. I live on 30k a year or so, but that’s with a 9k property tax bill on a 1M+ home. I just did my year end maneuvering which will put my 2018 AGI just under 12k. So no income taxes either. Part of this maneuvering included selling 10k worth of equities this year, to fill up the 12k tax bracket, but will offset next years expenses (property taxes due in February).
I get medi-cal completely free. And btw, when I signed up for medi-cal years ago, the county sent me a packet essentially saying “here’s what other low income programs you might qualify for”. I have a net worth in the multiple millions, so I only qualified for one other program....subsidized energy costs. My total energy costs (electric and gas) where about $500 for 2018 in a 2500 sq ft home (just one person, and a mild Bay Area climate).
I can’t think of anywhere in the US I couldn’t live on 30k a year, providing the home is paid off. Maybe Hawaii?
...It’s amazing how the benefits snowball once you get expenses down. I live on 30k a year or so, but that’s with a 9k property tax bill on a 1M+ home. ...
I get medi-cal completely free. And btw, when I signed up for medi-cal years ago, the county sent me a packet essentially saying “here’s what other low income programs you might qualify for”. I have a net worth in the multiple millions, ...
If memory serves, this discussion came up in a thread on healthcare options for high-net-worth early-retirees. And if memory serves, in your example, the bulk of your net-worth is in tax-favored accounts (IRA, Roth IRA, 401K, etc.), plus your primary residence. Were your holdings overwhelmingly in plain-Jane taxable accounts, but otherwise the same amount, your options would have been starkly different.
A couple of considerations come to mind. First, one might attain a large portfolio by being a good investor, enjoying a high rate of return. Then, large annual contributions are not necessary. Second, maybe one has been doing this for decades. Here again large contributions aren't necessary, and neither is a prodigious annual rate of return. But we presume that for an early retiree, likely neither of these is true. The portfolio grew because of a decade or so, of very high salary-earnings, which fanatically were plowed into savings. This means that the principal account is probably NOT say a 401K. Our FIRE-candidate maybe has $5M, but $4M are in a taxable account, and only $1M in a 401K. So, when it comes to ACA qualification and calculation of MAGI (modified AGI, not three wise men...), dividends (even if in tax-exempt bonds!) from the taxable account count.
Or our candidate has 1.5-2 million accumulated over 15-20 years over half of which is in Roth IRAs and 401ks and be retired by 40-45. I could easily imagine a couple putting ~$45k/yr away in 401ks after factoring in matches. You do that for 15 years at a 6% CAGR you’re over a million. Add in maxing out Roth’s and you’re approaching $1.4 million in tax advantaged accounts alone. FIRE isn’t only for 30 year olds.
If you accumulated your assets quickly (which is the case by definition, in early retirement), you did so largely outside of tax-favored plans, such as Roth IRA. This renders your portfolio [mostly] taxable. Even if you invest in index funds, with low turnover and thus low capital gains, you still get taxed on dividends - even in years when your portfolio declines. If you have a large portfolio invested in typical stock index funds, dividends alone will blow past the ACA income limits for a single person.
If you invest in tax-free bonds, you reduce your tax-bill, but your "modified" AGI has to include interest on those bonds. Again you've blown past the ACA income limits.
The only way to be "asset rich and income poor", for tax purposes or ACA purposes, is if your assets aren't generating income... which is the classic scenario of cutting off one's nose, to spite one's face.
As a consummately frugal person, you can most likely do just fine on $20K/year, or perhaps even $10K/year, to cover your living-expenses... food, housing, transportation, travel, even insurance and entertainment. Great! But what if you also have a $20K/year federal income tax bill (in addition to FICA on any earnings - or even worse, self-employment tax? Plus property tax on the house.). And you can't escape those federal income taxes, even if you move to a retirement-community in Mexico, or go live on a pirate-barge anchored off of the coast of Somalia.
We’ve had this discussion before, and you always overlook individual non dividend paying stocks and low dividend ETFs.
For example, SCHB historically pays between 1.00 and 1.25$ per share annually. At the current price of $63, a million dollars invested would produce from 16K - 19K depending on the exact dividend. Several other schwab ETFs do the same, while providing diversification and the growth potential of equities. Keeping these type of investments in the taxable accounts can easily keep you under the ACA limits.
And your premise regarding taxable versus non taxable assets for early retirees is suspect too. I retired at 42 with most of my assets in retirement vehicles. Granted, I worked in Silicon Valley, and was likely to invest that “trivial” amount in the likes of PSFT, AAPL, etc. perhaps I’m an outlier in that regard.
Perhaps I'm garbling my message here. Yes, of course one can live tolerably well on $24K/year. This may require some compromises, but nothing untoward - barring some calamity, such as failing health.
But taxes are charged on progress with one's portfolio! Unless you're going to use your portfolio to pay its taxes - which, I declare, is a form of spending! - you have to earn additional money to cover the costs of the taxes on your portfolio.
This means that the richer one becomes, the higher one's tax bill... and the more one needs to earn, just to cover this tax bill, even if one spends a totality of zero on oneself, and make zero trades or withdrawals.
Illustrative example: you hold $5M in a taxable account, invested 100% in the S&P 500. I picked $5M because that's the amount frequently recommended for FIRE purposes. That $5M is going to produce $85K in dividends annually, assuming a 1.7% dividend rate, which is evidently typical for US large-caps. Subtract the standard deduction etc., and the remainder is still going to be well above the ACA subsidy-threshold. And yes, the first $36K or whatnot are taxed at 0% dividend-rate, but the remainder is taxed at 15%.
Now if you work part-time just to cover the federal income taxes on those dividends, your labor will be taxed at 15% SEP, plus 15% federal income tax, plus every dollar thus earned shifts a dollar out of the $36K 0% capital gain/dividend tax bracket... into the 15% bracket. So, effectively your income tax rate on every earned dollar - not MARGINAL rate, but actual rate - is at least 45%! And this is not including state/local income taxes. Or property taxes.
Am I making sense here? To reiterate, the asset-rich income-poor frugal FIRE-type of person needs to budget for taxes, as being the overwhelmingly dominant cost of living - not rent, not food, not even healthcare, but taxes. Yes, taxes are the price for living in a civilized society. I'm not saying that taxes are "evil" - just that they're expensive... and that in contemplating a looming early-retirement, we fail to appreciate just how expensive taxes can be!
If you drive your expenses low enough, you don’t need $5M to retire. I live in one of the most desirable places in the world. I haven’t spent more than 40k a year in a long time. Given the 4% rule, that’s 1M investable assets, right?
The key is driving your expenses down. It took me way too long to realize that. For those of you young enough, think about it. I’m not saying a family of 4 can do it. No way in hell I would have retired that early with kids. Too many variables. But with a paid off house, no medical expenses (I’m 57, so getting close to Medicare) and no debt, a million in investable assets should be fine for most.
Clearly having too much money isn’t really a problem with early retirement. The hardest part may be reducing expenses for those that just freely spend (perhaps on a lot of frivolous stuff). Living on $20-30k may be a different world for those accustomed to living on $80k (probably with nice stuff but payments on a lot of it).
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