Tax Planning for Retirement, Part 3: What Is Taxable Income? A Reminder

By Johnny Roland, CFP®, EA

This blog post is the final one in the three-part tax series I started in June:

  1. The Golden Decade of Tax Planning Opportunity
  2. Understanding Taxation During Retirement
  3. What Is Taxable Income? A Reminder

In Part 3, I will close the series by discussing common misunderstandings that clients have about income and taxes after retirement. I want to focus on these three points:

  • Taxes are calculated on your total income.
  • The more income you make, the higher your taxes go.
  • Long-term capital gains are taxed at a lower 15% rate.

So let’s start with how much of your income gets taxed. You are not taxed on your total income. You are taxed on your “taxable income.” For those of you unfamiliar with IRS Form 1040, you will find your taxable income on Page 2, Line 43. As you can see, the next line, 44, shows the taxes that are due on that taxable income.

ASP-8-22-17a.png

“Taxable income” on Line 43 is an IRS definition and much narrower than the concept of taxable income that I explained in Part 2. Lots of income types are potentially taxable, like Social Security, pensions, IRA distributions, interest income, and rental income. But it is only that final number on Line 43 that is used to calculate your income tax. Let’s ignore the alternative minimum tax (AMT) and tax credits for now, or I will end up writing a book rather than a blog post. What I do want you to remember is that each type of income may also get its own special tax treatment even though it is included in the “taxable income” total. Good examples are pension income, Social Security income, qualified dividends, and long-term capital gain.

This brings us to the topic of taxation of long-term capital gain (LTCG). Most people know that long-term capital gains get their own tax rate of 15%. But there are two other rates: (1) 0% if your taxable income falls below the 25% tax bracket, and (2) 20% if your taxable income falls in the highest, or 39.6%, tax bracket.

What I want to illustrate is the opportunity to get a 0% tax rate on your LTCG income. And this is where many people have a faulty understanding. Look at the chart below illustrating a married couple who had $75,300 of taxable income in 2016 with no LTCG income. Let’s assume that 2016 was their second year of retirement, they are both 65, and our tax planning strategy for them is to rely on taking money out of their taxable trust account for the next five years until they turn 70. In that year, they will start drawing Social Security and will start taking required minimum distributions (RMDs) from their tax-deferred retirement accounts.

As you can see, they are bumping right up against the limit of the 15% tax bracket. Remember, tax rates are incremental. You do not pay 15% on the entire $75,300. You pay 15% on only that portion of taxable income between $18,551 and $75,300, i.e., $56,750. Let’s assume in this scenario that the couple had no LTCG income.

ASP-8-22-17b.png

Now, what if we decided to sell mutual funds in their trust account to generate income for their current retirement while they wait for Social Security and RMDs? And let’s also assume that we generated $25,000 of LTCG when we made those sales—LTCG income that now becomes part of their $75,300 in taxable income for 2016.

Since their total taxable income, including the LTCG income, is below the 25% tax bracket, the $25,000 of LTCG income gets a 0% tax rate applied! The picture below shows you the result. Since they do not have to pay any income tax on the $25,000 of LTCG income, their average tax rate falls to 9%!

ASP-8-22-17c.png

This is a beautiful example of how the higher your income goes, the lower your average tax rate may fall. Key points to remember?

  • LTCG gets included in the total taxable income number to determine which tax bracket you are in—and that then determines whether LTCG gets taxed at 0%, 15%, or 20%. The charts above don’t even show the 39.6% tax bracket—for a married couple, it would mean having taxable income over $466,951.
  • You can control the timing of when you sell assets to generate LTCG. So some pre-planning could pay off in great tax savings.
  • You need to generate the LTCG income in a taxable account. Selling assets in a retirement account is not a “taxable event”—see Part 2 of this series.

I hope you have enjoyed this “trilogy” on taxes in retirement. I always get excited when clients want to retire early—it gives Aspire a chance to help them creatively plan for a five-, 10-, or even 15-year period during which we can help them reduce income taxes over their lifetime by structuring their assets, their types of accounts, and their income. I will close this series with the standard disclaimer that you encounter with almost anything related to taxes: “Please consult with your tax advisor.”