Zero tax in the future!

[KTP]

After finishing our 2011 tax return where we paid almost $40,000 in federal tax, I decided to investigate what our tax might look like in 4 years when we partially early retire and travel the country doing odd jobs. The results (using the 2011 tax software of course) were suprising.

I had our assets hypothetically producing the following:

$3000 of regular taxable interest
$8000 of qualified dividends
$30000 of long term capital gains

In addition, I assumed we would each work a part time job during the year to earn:
$5000 W2 income for me
$5000 W2 income for DW

I had us contribute all of this income to a Roth IRA.
I also converted an additional $10,000 of taxable traditional IRA money to a Roth, reported as regular income.

I selected $4000 to go into an HSA to cover out of pocket medical expenses.

So our total income is $61,000 with $20,000 of that going directly into a Roth IRA, leaving us with $41,000 (including the HSA money). I figure we may need an additional $5,000 to $10,000 for our traveling lifestyle, which would come from a $200,000 already taxed cash reserve I have now.

Here is the total tax we would owe (I had zero withheld from our W2 income):

edit: ok, I can't seem to get the attachment to display...but the totals were 61,000 income with zero tax due.

[KTP]

I should mention that I first tried to get the $2000 saver's credit, but had so many problems trying to make it work that I gave up.

First problem is the credit has an extremely sharp cutoff, going from $2000 if you make $34,000 down to $400 if you make just $2500 more in income ($36,500). Can you say ouch!?!

The second problem is you can't get the saver's credit if you have other distributions from a retirement account, including Roth conversions. Since we are able to convert at least $10,000 from a taxable IRA to a Roth with no tax due, this was another reason to nix trying to qualify for the savers credit.

The final problem is that the saver's credit is non-refundable, meaning you can't get it if you have a zero tax liability. The HSA credit is already helping to reduce our liability to zero, so even if we reduced income and did not have a IRA distribution we would still only get a few hundred dollars at most from the saver's credit.

Ah well, such is life.

[KTP]

The current plan is to partially early retire in 4 years with assets of around $1.3 million divided up as:

$500,000 401K (will be rolled over into an IRA)
$100,000 IRA
$100,000 Roths
$400,000 taxable (invested in dividend paying stocks)
$200,000 cash (invested in very short term bonds, ibonds and CD ladder)

At the end of 10 years of doing odd jobs in hopefully every state but Hawaii, I hope to have things look like the following:

$500,000 rollover IRA
$500,000 Roths
$400,000 taxable
$200,000 cash

We would at this point be age 55 and 56 with assets of $1.6 million and maybe ready to settle down somewhere.

[MonkeyMama]

In general, if you only have investment income, and little to no earned income or ordinary income, you won't pay much in taxes. SO you will probably see some benefits in that regard. {Plus, significantly lower income just equals significantly less tax}.

BUT, there is a big but there. You are forecasting things based on current tax code, which changes very drastically decade to decade, and changes much in many little ways, year to year. So, though I think it is safe to assume that your tax rate will be pretty low under this scenario, I would not assume it to be $0 for the next decade or so.

For example? The capital gains rate is 0% right now for the lower tax brackets. This is no doubt while you are coming up with a $0 tax. BUT, this tax break expires at the end of this year. So I wouldn't get too excited about that.

[KTP]

Well, not being able to see the future, I can only base my plans on current tax law. They could extend the zero capital gains tax for the very low bracket and raise it for people making more (it seems popular right now to raise taxes on people making more than $250K). The US could default on debts in the next 10 years. We could have a major world war. I could have a stroke next year.

Lots of things *could* happen. Basing decisions on the current state of affairs is the best you can do.

[MonkeyMama]

Well, not being able to see the future, I can only base my plans on current tax law. They could extend the zero capital gains tax for the very low bracket and raise it for people making more (it seems popular right now to raise taxes on people making more than $250K). The US could default on debts in the next 10 years. We could have a major world war. I could have a stroke next year.

Lots of things *could* happen. Basing decisions on the current state of affairs is the best you can do.

Um, it is 100% certain the tax code will change. That is very different than planning for some random event that may or may not ever happen.

They could extend the 0% capital gains rate, or they could obliterate it. I think it would be wise to be prepared for either scenario, especially since there is nothing set in stone with the 0% rate. It will expire unless legislative action is taken.

Are you saying that you aren't going to at all plan for a scenario where you could pay taxes? Because of some very temporary provisions in the tax code that mean "no taxes"?

[KTP]

Um, it is 100% certain the tax code will change. That is very different than planning for some random event that may or may not ever happen.

They could extend the 0% capital gains rate, or they could obliterate it. I think it would be wise to be prepared for either scenario, especially since there is nothing set in stone with the 0% rate. It will expire unless legislative action is taken.

Are you saying that you aren't going to at all plan for a scenario where you could pay taxes? Because of some very temporary provisions in the tax code that mean "no taxes"?

Eh, I would probably arrange things a bit differently if the tax code changes drastically. For example, if they eliminate the 0% long term cap gains rate for very low income earners, then I would probably skew more toward high dividend stocks (if those rates stay low) or I would reduce the amount I convert to a Roth from the traditional IRA and use the savers credit to reduce overall tax (in my current calcs I am missing the entire $2000 savers credit because I have elected to convert $10,000 of a traditional IRA with zero basis into a Roth each year).

So yeah, I can be flexible with tax code changes.