Optimal Income Thresholds Post ERE

[akratic]

The puzzle I'd like to solve is for someone with control over their income in the US, what specific incomes are optimal from a taxation perspective in 2013?

We've been talking lately in my journal about what I should have done in 2013 from a tax perspective, and I've learned some very helpful things, and I thought I'd 1) share them more broadly here and 2) hope to learn even more from you all.

Credit the good parts of this post to helpful posters in my journal like chipmunk, and credit the mistakes to me.

So:

let taxable income = wages + interest + conversions

where

wages = salaries, tips, and net self employment income

interest = taxable dividends and interest

conversions = if you convert traditional ira into roth ira then you pay income taxes on the amount converted

Also for a single filer, we have:
- $3.9k personal exemption
- $6.1k standard deduction
=> $10k total standard deduction

Now what things can we say:

1) wages should be ~= $5,500.

You can only contribute new money to a Roth IRA if you earn money that tax year. There doesn't seem to be any tax benefit to earning more than $5.5k that fits inside a yearly IRA contribution though.

2) taxable income should be <= $17,750

The primary reason is the Retirement Savings Contributions Credit

A single filer that earns $17,750 or less and contributes at least $2,000 to an IRA gets a $1,000 tax credit!

So starting with $17,750 of taxable income, we subtract the $10,000 standard deduction and pay 10% taxes on the remaining $7,750, or $750 total in taxes. But we have a $1,000 tax credit! Tax owed can't go negative ($750 - $1000), so it becomes *zero*.

(PS: as soon as income exceeds $17,750, this credit drops from $1k/yr to only $400/yr, and then it drops again at another threshold later.)

3) conversions should be $17,750 - wages - interest

This is just algebra on the original formula once we know the optimal taxable income from 2). Given that any conversions you do at this income level are free, you might as well do the conversion and save yourself some taxes in 50 years or so as well.

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Takeaways:

a) post ERE it's good to still have a small source of earned income so that you can keep sliding $5.5k into IRAs each year. This can be a part-time job or a small self employed income, etc.

b) after ERE you can actually convert a fairly healthy amount per year into Roth (based on formula 3), seemingly without paying any taxes at all on the conversion, which in my mind means that for people the accumulation phase Traditional > Roth. Basically choose Traditional while accumulating to get a tax benefit, and then post ERE change about $10k/yr of it ($17.75k - wages - taxable interest) to Roth *for free*.

===

Questions:

any mistakes in the above analysis? any further room for further improvement? any other awesome* tax credits?

* (am I the only one who tries to use the word "awesome" whenever applicable on this forum just to get under jacob's skin?! )

I'll pre-emptively point out a nuance I glanced over above, which is that it's actually adjusted gross income, or AGI, that you need to get <= $17,750 above, but I can't seem to find many useful adjustments.

PS: Also lets avoid the optimal income == infinity or optimal income == $0 answers

[jacob]

Just to be sure,

gross income (wage, dividends, interest, business, ..) - adjustments (student loan interest, moving expense, HSA, SE tax adj) = adjusted gross income (AGI) - itemized/standard deductions (schedule A or a fixed number for single, married, household) - exemptions (number of people * some amount) - non-refundable credits (savers credit, child tax credit, education) = taxable income (this is where the tax brackets are applied)

So not only is the game to have the right type of income, it's also in taking the available deductions and credits.

For your example, if you're putting money into a retirement account while keeping your income "low" (not even that low) there's also the saver's credit. This will change your numbers upwards.

http://www.irs.gov/Retirement-Plans/Pla ... -Credit%29

In terms of interest, you can also start considering which bonds are specifically tax-exempt for your particular state.

Oh yeah, and if you get married, you can make even better combinations, e.g. spousal IRA.

I'd really recommend downloading form 1040 and just looking through it line by line to see what kind of money is available for "selective shoppers".

[akratic]

I don't think you're allowed to use the word "also" when linking to the same tax credit I discussed.

But yeah that thing is awesome, the more posts about it the better.

[jacob]

Yeah, obviously I rarely read whatever I'm commenting on

But, eh, there's also the health savings account deduction (if you have a HDHP that allows for HSAs) on line 25 (you can earn about three grand more) and the earned income credit on line 64a (an extra form worth a few hundred bucks). If you never spend your HSA it will turn into an IRA at age 59.5, so it's a bit like getting a $8500 annual IRA contribution instead.

Note that deductions and credits are different. Credits are way better than deductions since they are below the line---they work directly on the taxes you pay rather than the AGI your taxes are determined by, e.g. if your marginal rate is 10% a $100 credit is worth a $1000 deduction.

[Ego]

a) post ERE it's good to still have a small source of earned income so that you can keep sliding $5.5k into IRAs each year. This can be a part-time job or a small self employed income, etc.

Self-employment tax. This one always catches those who start a small business and fail to make adequate quarterly payments. For self-employment income earned in 2013, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security and 2.9% for Medicare. On the plus side, you can deduct the cost of health insurance.

[Tyler9000]

One more data point -- it is highly beneficial to make at least $15,302 in MAGI as an individual to qualify for ACA subsidies (especially if you live in a state that has not expanded Medicaid).

[jennypenny]

What about bunching income and deductions into alternate years to optimize even further? Deferring income and paying 2x expenses like real estate taxes. Would that allow someone to pay less in taxes but make more overall?

At that level of income, bunching medical and dental expenses would also be beneficial.

[workathome]

Self-employed also lets you deduct things like tools. Like if you do carpentry part-time, those tools add up. Or if you make a profit blogging, you can look at computer, internet access, smart phone, etc.

Since many post-ERE are looking at making a living off investments, I wonder how you claim "investing" as a business (or if it's worthwhile to do so?) and deduct appropriate expenses (e.g. books, magazine subscriptions, computer, internet access)?

[chipmunk]

While not really an optimal income threshold, the preferential treatment of qualified dividends and long term capital gains should be considered. This can be as simple as keeping things that pay a lot of ordinary dividends or interest (BDCs, REITs, bonds, bond funds) in an IRA and things that pay qualified dividends (stock in C corporations, stock index funds) in a taxable account.

Currently, the 0% rate on qualified dividends and long term capital gains extends up to the top of the 15% bracket. So (using 2014 limits), it is possible for an individual to have $47,050 in tax-free passive income ($3950 personal exemption + $6200 standard deduction + $36,900 to the top of the 15% bracket). For a couple this amount is $94,100 in tax-free passive income (2*$3950 personal exemption + $12,400 standard deduction + $73,800 to the top of the 15% bracket).

That's a lot of tax-free income.

[JohnnyH]

This thread is great, awesome I dare say , basically highlighting my retirement plans... The 5.5k wages for Roth and 17.75k retirement credit are new info to me. Thanks, Akratic!

I'm probably going to sit on long term capital gains until I can fully convert standard IRA and 401 to Roth... I want my massive Roth to be my ultimate middle finger to the stupid US tax code.

[ohcanada]

I like chipmunks plan - awesome!

[Seneca]

Great thread, and Fantastic post Chipmunk!

[chipmunk]

I want my massive Roth to be my ultimate middle finger to the stupid US tax code.

Unless the tax code changes and all Roth distributions are somehow taxable in the future...

None of this is written in stone.

[LiquidSapphire]

I wanted to mention that Solo 401(k) and Solo Roth 401(k)s are options for legally sheltering income for tax purposes, also SEP IRAs, SIMPLE IRAs, etc. I have a Solo 401(k) and will likely open the Solo Roth 401(k) as well just to have it. I would have to research/think about the implications but at least with the Solo 401(k) you can dump $17500 + 25% of profit into it and you can still get your ACA subsidies, etc. So possibly there is more flexibility in the ceiling than the $17k or $18k figure thrown around so far.

I am still working with my accountant on my tax situation but hope to see how it all shakes out this year so I can optimize 2014. I'll try to remember to come back and update once I get an idea on what she comes up with.

[jacob]

What's the difference in terms of forms, conditions, etc. between the solo401k and the sep ira?

[robby152]

https://investor.vanguard.com/what-we-o ... Link=facet

I did solo401k with my S corp, and it is super easy. For me it is up to 100% of wages up to 17K employee wage deferral limit + 25% of w2 income via the S corp up to the combined 51K limit. So I can do 34K via company contributions and 17K via employer contributions.

[jacob]

It mentions extra reporting required. What does that entail?

[robby152]

If you have over 250K in the plan, file form 5500. I don't yet, so I do nothing.

Here is the form http://www.dol.gov/ebsa/pdf/2013-5500-SF.pdf

It is the 'short form' version since it is only a solo plan. Once I get to 250K I will probably call vanguard and ask for guidance. They were very helpful in the set up.

[LiquidSapphire]

@jacob -

The forms aren't so bad. There are many of them but Vanguard has basically a standard template. You have to print out 40 pages or so as "the plan document", and sign about 5 places and fill out a couple forms (phone customer support was very helpful on terms I did not understand). Fumbling through it all took maybe 2 hours, maybe a smarter person could do it in one, I don't know. Once it is set up it is practically maintenance free. I actually ended up overcontributing for 2013 and I just had to fill out a one page form to get that undone and mail it in. Not a big deal. No extra forms to do since I have less than $250K in there. One small gotcha is you have to have an EIN on file with the IRS. It's free to get one so no big deal.

I recommend Vanguard for ease of use for Voyager+ clients (makes it fee free) but NOT for Permanent Portfolio holders, Dividend stock pickers, or anyone who uses anything other than Vanguard Index Funds, because that is basically all they will allow you to hold. (Yes ALLOW - you cannot buy IAU for instance no matter what fee you are willing to pay). For sub $20K of my NW it's fine but if I get into 6 figures that would annoy me. I think this year I will open a Solo Roth 401K with Fidelity and see how that goes. My accountant indicates you can have as many Solo 401ks, of different types, as you want, so long as you respect the total account contribution limitations as set forth by the IRS.

I can't speak to the SEP IRA having never had one, but the Solo 401K allows for a much higher initial contribution (you can put in 100% of the first $17500 you earn, PLUS 25% of your profit of your "company") and so I went with that.

So far I have no other magical tax strategies other than those previously mentioned. You still have to pay SE tax on funds you put into the 401K BUT you do get the advantages as if you were using a traditional 401k in that you do not have to pay capital gains taxes if you sell winners, can do Roth conversions, or if you start with a Roth, don't even have to pay taxes once you take out the money.

[SimpleLife]

Good info, thanks for putting it together.