How Middle Income Retirees can have $100k in retirement income and pay no Federal Income Taxes
Since it is now officially tax season, I thought I would post a commentary on retirees and taxes (Beware, this post contains a lot of numbers and calculations).
This post is particularly aimed at middle income retirees which I am defining as people having between $75k to $125k of retirement income in 2025. Because of the way our tax laws have been written, it is actually fairly easy to have $100k in retirement income and not pay any federal income taxes.
Compared to people who are still working, retirees have more flexibility about where they can take their income from. One caveat, though; if you have a large employer pension it is much more difficult to pay zero federal taxes. If you do not have a large pension, there are a few ways a retiree can pay zero taxes with $100k in funds to spend. The easiest way is to have most of your 401(k) or IRA funds in tax-free Roth-type accounts versus tax-deferred accounts. But that would be too easy. In a future post, I will discuss how and why savers should try to get as many funds as possible into Roth-type accounts. But, in this commentary, I will describe the most common way a retiree can pay zero taxes without using Roth funds.
I am going to use a fictitious couple, named Bob and Betty Planner, to illustrate this ZERO-tax approach. Bob and Betty Planner are a typical middle class couple that worked hard and were successful in their careers. And they were also diligent about saving money for retirement. Bob worked his way up to be the manager at a local Home Depot store and Betty was a nurse at the local hospital.
After 40 years of raising two children and diligently saving money, together, they managed to save the following financial assets:
-$300k in a taxable stock brokerage account,
-$800k in their combined traditional IRAs,
-$100k in their combined Roth IRAs,
-$100k in Federal I-bonds; these funds are dedicated for emergencies only. (NOTE: The interest from I-bonds is not taxable until you cash out the bonds).
-$200k, that Betty recently inherited from her parents, is currently invested in several short duration bank CDs at an average interest rate of 3%.
So Bob and Betty Planner’s financial assets total $1.5 million. Currently, in 2025, they both are turning age 65 and both are recently retired. They have also both just started their social security benefits with combined benefits of $5,500 per month or $66,000 per year.
So the Planner’s have $66,000 in Social Security benefits guaranteed income as a starting point. Their other income that they must report every year is any interest or dividend income that is not in a tax-deferred account. They have $6k interest from their $200k saving account (3% CD interest rate) and they have dividend income from their $300k taxable stock brokerage account.
We will make two assumptions about the Planner’s $300k taxable stock brokerage account. First, after 15-20 years, all these stocks have appreciated in value by 100%. In other words, these assets are 50% long-term capital gains and 50% cost basis. Second, the average dividend yield from the stocks in this account is 3%. So the taxable brokerage account generates $9k in total dividend income per year.
Combine the $6k in CD interest income and the $9k of dividend income with their total social security benefits and the Planner’s have $81k income that they must report on their tax return, regardless if they do not make any other distributions from their retirement accounts. If Bob and Betty did not need any more annual funds than the $$81k for living expenses in 2025, what would their taxes look like? Would they pay any Federal taxes on this amount? To determine this, there are two major items of the Federal tax law that requires us to make a simple calculation.
We first need to determine what the Planner’s 2025 standard deduction will be. In 2025, the Federal standard deduction has been raised to $30k per married couple. Anyone age 65 or older gets an extra deduction of $1,600. So, Bob and Betty will get an extra $3,200 added to their $30k standard deduction giving them a total of $33,200 for tax year 2025.
The other major item is we need to determine how much of their social security benefits would be taxable. To do this we need to calculate what the federal gov’t calls the tax payer’s “Provisional Income.” Provisional income (PI) is defined as all non-social security income (including income from tax-free bonds) added to 50% of the total social security benefits. In the Planner’s case, $48k is their total PI ($66k/2 + $15k = $48k). For married couples, to determine the taxable amount of social security, the way the calculation works is if your total PI is under $32k, then none of your social security benefits are taxed. Any part of the PI over $32k, but under $44k, 50% of the your social security benefit is taxable. For any amount of the PI over $44k, 85% of this portion of the benefit is taxed.
For future reference, here is a link to a site with a calculator to easily determine how much of your social security benefit will be taxable:
https://www.covisum.com/resources/taxable-social-security-calculator
So, in Bob and Betty’s case, their PI is $48k. This means the first $32k of their social security benefit will not be taxed. However, for the amount from $32k to $44k, 50% will be taxed, or $6k. And the $4k amount over the $44k threshold will 85% taxed or $3.4k. So, if the planner’s decided they only needed $81k to live on in 2025, the amount of income that is included on their tax return is $9,400 of their social security benefit and the $15k of non-social security income, totaling $24.4k of income. This $24.4k amount is, obviously, lower than the Planner’s $33,200 standard deduction. So, they would owe no Federal taxes if they only needed $81k to live on in 2025.
But the Planner’s want to spend $100k to live their desired retirement life. So they need to withdraw another $19k from their assets to add to the $81k of reportable income from social security, interest, and dividend income. With a $1.5 million portfolio, withdrawing the additional $19k will not be a problem. But what account should they withdraw this additional $19k from? The specific accounts the Planner’s withdraw these funds from will determine if the Planner’s pay any Federal income taxes in 2025.
Before continuing, I need to briefly discuss another section of the federal tax code that greatly benefits middle income taxpayers. That is the lower tax rates on investment income; that is, stock qualified dividends and Long-Term Capital Gains (LTCGs). These lower tax rates are 0%, 15%, and 20% depending on how much you have in total taxable income. However, in 2025, the 0% tax bracket for dividends and LTCGs income, for a couple filing jointly, goes up to $96,700. So the Planner’s will not pay any taxes on their dividends or LTCGs income unless their taxable income in 2025 is greater than $96,700.
To obtain the additional $19k of funds, the Planner’s will take $6k from their taxable Traditional IRA in order to be sure they “use up” the entire $33,200 standard deduction. However, to avoid owing any Federal income taxes, the Planner’s will take the remaining $13k needed from their $300k taxable brokerage account. This is so they can take advantage of the Federal tax law’s favorable LTCG tax rates. The sale of $13k of stock from this taxable account means only the gain ($6,500) is taxable at the lower LTCG rates (the other $6,500 is just the return of principle).
The table below shows the different types and amount of income the Planner’s will take from each account to have $100k of funds to spend and be sure they will not owe any Federal income taxes in 2025.
INCOME TYPE INCOME AMOUNT
Social Security = $66,000
Interest Income = $6,000
Dividend Income = $9,000 (taxable at LTCG rates)
Traditional IRA = $6,000
Taxable stock sale = $13,000 (only $6.5k is taxable at LTCG rates)
Total funds = $100,000
How does the Planner’s 2025 Federal tax return process the above income data?
First, the social security PI data is calculated as $60,500. This figure means that only $20,025 of the Planner’s social security benefits are taxable. Adding in the $27,500 of non-social security income to the $20,025 provides a gross taxable income of $47,525.
Gross Income = $47,525
Less the Stand. Ded. = ($33,200)
Net taxable Income = $14,325
However, since the $14,325 taxable income for Bob and Betty Planner is less than $96,700, this means their investment income of $9,000 dividends and $6,500 LTCGs is taxed at the 0% tax rate. As such, they get to also exclude this taxable investment income totaling $15,500 from the total net income. Since these two items together are larger than the $14,325 net taxable income, the $14,325 of net taxable income shown above is zeroed out. This is how Bob and Betty Planner, a typical successful middle income retired couple, can easily pay zero Federal income taxes while having $100k of funds available for spending. It is just a matter of having the right type assets in the correct type of accounts.
Bob and Betty Planner could use this approach to pay zero Federal income taxes for several years; at least until they must start taking their Required Minimum Distributions (RMDs) from their tax deferred retirement funds such as 401(k)s and IRAs. But is this approach of paying ZERO federal taxes at the Planner’s current ages of 65, the best overall tax move for them? I would argue, for most retirees who have a fairly large traditional 401(k) or IRA balance, the answer is no!
I mentioned at the beginning of this post that savers should try to get as many funds as possible into tax-free Roth-type accounts. I will even go so far as to say, I think all future retirees should have a goal of getting most (or all) of their retirement funds into tax-free Roth-type accounts by the time they reach their early 70s. However, to reach this goal means that, not only will Bob and Betty Planner be paying taxes at their current age of 65, they will be paying more taxes than is necessary over the next few years. I will explain in the next post why this is the case, and why, for most retired couples, this is a better way to lower their overall lifetime tax bill.
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