A blessing and a curse of retirement income
It appears that future of Obamacare remains uncertain. I've decided to take healthcare in retirement, which will provide healthcare until Medicare.
Fortunately and unfortunately, this means electing to receive pension income in retirement.
Until now, as with most other middle class faithfuls, I've been socking diligently away into tax deferred accounts as much as I was able.
First, it provides pretty rock solid asset protection, especially in 401k (ERISA https://en.wikipedia.org/wiki/Employee_ ... curity_Act
), and second, it immediately lowers income and therefore tax.
One of the benefits of retiring early is one's ability to control annual income and tax. In conjunction, Roth conversion ladder would allow transfer of assets from tax deferred accounts such as 401k to tax-free accounts such as Roth IRA at low tax bracket and allow having an annual income without incurring additional tax.
A steady pension income erodes all these benefits. Some flexibility remain if you're married, but it turns into a nightmare if you're single.
Per 2017 tax table, a single individual would have $6350 standard deduction and $4050 personal exemption, so when using standard deduction, first $10,400 of yearly income would be tax free.
This means that for 15% bracket, single individual would pay $5226.25 of tax on $48350 ($37950 (15%) + $10400 (std. deduction + personal exemption) of income. Provided that there is no income for the year, or all income for the year comes from 5+ year old Roth IRA account under basis, $43123.75 of tax deferred funds can be transferred to Roth IRA account on a distribution of $48350 for about $5000 tax - not bad!
Married filing jointly would pay $10452.50 of tax on $96700 ($75900 (15%) + $12700 (std. deduction) + $4050 (personal exemption) + $4050 (personal exemption)) of income. In contrast, a single individual would pay $17313.75 ($5226.25 (15%) + ($96700-$10400)-($37950) (25%)) of tax on $96700 income, almost $7000 more for the same income.
So the rule of thumb is, when there is no income for the year, a single individual would be able distribute roughly about $50,000 and married filing jointly about $100,000, both paying about 10% tax on the distribution, from tax deferred account to tax-free account each year under standard deduction.
However, when single individual doubles the amount of distribution to $100000, the same amount of distribution as married filing jointly each year, single individual pays $17313.75 or almost 3.3x and not $10452.50 or 2x of tax as one would expect. Not good. This means that a single individual would take twice as many years to transfer assets from tax deferred account to tax-free account as married filing jointly while paying the same amount of tax before Required Minimum Distribution (RMD) kicks in at age 70 and 1/2.
Situation become even more dire with addition of pension income. Since pension income is ordinary income that is not earned income, it only reduces the amount of distribution per year while still paying the same amount of tax.
For example, at the earliest retirement, around 350k of deferred savings along with about 31k or yearly gross retirement income is projected (see first graph above). That means only about 17k can be transferred from deferred to tax-free each year while tax ($5226.25 (15%)) is being paid out of retirement income, further reducing net income. Having state income tax would reduce this even further - which is why many Californians move to Nevada after retirement, a state without income tax (and pretty good asset protection laws).
It would take about 20.58 years (350k / 17k) to move all assets to tax-free as single individual while staying in 15% tax bracket. In contrast, it would only take 5.32 years (350k / (96.7k-31k)) for married filing jointly. The price of having same advantage is to pay about 70% more tax each year.
Tax paid by married filing jointly after 5 years: $52262.50
Tax paid by single to convert the same amount as married filing jointly after 5 years: $86568.75
The solution is obvious - get married. It's clearly encouraged by the tax code. It's probably best to stop here for the purposes of retirement. (Tax code also encourages havings kids, with $1000 tax credit for each child and various additional deductions, but the cost of raising kids outweigh tax benefits rather quickly).
But marriage isn't for everybody. The next best step is to find ways to reduce ordinary income. At the risk of increasing chances of an IRS audit, having a legitimate home based small business generating sufficient earned income and operating costs may be the best option.
More thoughts to come.