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How it is Possible to have $100,000 in income and Pay $0 Federal Income Taxes

It may not seem feasible for a retiree to have $100,000 in spendable income and pay zero federal income taxes, but at least for tax year 2012 it is possible. It requires no special tax shelters and just takes advantage of a few ordinary tax laws. In this post I will provide a scenario that illustrates how this can be done.

This scenario may not apply to some people because it requires accumulating significant assets outside of your tax-deferred retirement accounts. But for many couples nearing retirement, this situation is very realistic. Although tax laws are always changing, I think the example provided below can also benefit those in the middle of their working lives as it can provide guidance in what to look for when accumulating and positioning retirement assets.

Although the below scenario is similar to our own tax situation, it is not our exact tax situation as we live on a lot less than $100,000 per year, and we will pay a small amount of federal income tax in 2011 and 2012. However, we do use every tax deduction discussed below.

So how can a retired couple have $100,000 in spendable income and pay zero federal income taxes? I make assumptions in this example that optimize the different income types at the levels that zero out the federal income tax liability. But these assumptions are not unrealistic.

Here is the scenario:

• A husband and wife are both 60 years old, no longer working, and file their taxes as “Married filing jointly.”
• They do not have an employer paid pension or health care benefits,
• They are not yet collecting any social security benefits nor making any withdrawals from any “tax-deferred” retirement accounts.
• They have $200,000 in bond/CD fixed income assets outside of their retirement accounts averaging 3% interest.
• They have a $400,000 stock portfolio outside of their retirement accounts that is yielding an average of 4%.
• This same $400,000 stock portfolio has $75,000 in Long Term Capital Gains (LTCGs) that can be harvested at any time.
• They own two residential investment properties that each generates a net $21,000 per year in spendable income.

Let’s summarize this couple’s 2012 income:

Table 1: Total Spendable Income

If one has this much income how is it possible to pay zero federal income taxes? There are 5 parts of the IRS tax code that, when combined, can significantly lower your federal income taxes. They are:

1. The High Deductible Health Care Plan (HDHCP) that allows you to deduct a certain amount to pay for your out of pocket health care expenses tax free.
2. Real property improvement depreciation expense.
3. Take full advantage of the 10% and 15% tax bracket’s 0% tax rate on LTCGs and qualifying dividends.
4. Take the “Married filing jointly” standard deduction.
5. Take 2 personal exemptions.

Before I go on to explain how the tax in this example is calculated, let me explain one important tax distinction. There are generally two ways to reduce your taxes; income exclusions and tax deductions. Most people are aware of tax deductions such as interest payments on your home loan, state taxes paid, or charitable contributions. Tax deductions generally require you to spend money to get the tax break. This is not my preferred way to reduce taxes. My preferred method to reduce taxes is through income exclusions. An income exclusion tax break usually does not require you to spend money in order to reduce your taxable income. Items 1, 2, and 3 in the above list are examples of income exclusions.

The High Deductible Health Care Plan (HDHCP) Deduction

For a variety of reasons I think the introduction of HDHCPs are one of the best health care innovations in many years. For the first time in my life I am asking doctors’ offices/clinics how much they charge and I am shopping around for prescription drugs. For anyone younger than 65 and does not have employer paid health care, the HDHCP is the best way to go. First of all the higher deductible allows for lower monthly premiums. I am in my mid 50s and my HDHCP premium is currently $300 per month with a $2,700 annual deductible. The deductible is a comprehensive deductible that includes all medical expenses including doctor’s visits, prescription drugs, and hospitalization.

But the beauty of these HDHCPs is they allow each person to set up a special “Health Savings Account (HSA). In 2012 up to $3,100 per year can be deposited into these HSAs and you take a tax deduction for this amount. The reason I call this tax break an “income exclusion” is because you can take the deduction even if you spend nothing that year on your medical care. That’s right, the $3,100 contribution and tax deduction can be made whether or not you have any health care expenses that year. Another benefit of these HSAs is, when you do take funds out of an HSA, the funds are not taxable. That means you get a tax deduction when making a contribution and withdrawals are tax free as long as the funds are used for medical care purposes. This is better than a Roth IRA.

But the thing I like best about these HSAs is you can pay your health care expenses with your other money (i.e., not using any HSA funds) and roll over all the funds in your HSA to the next year. The next year you can make another $3,100 contribution and then roll over the account again. This can be done forever. It essentially becomes another retirement account. At age 65 you can withdraw funds from your HSA and spend the money on anything. However if the withdrawn funds are not used for medical expenses, they are taxed just like any other traditional IRA withdrawal.

Back to the tax deduction, if you get a qualifying HDHCP you can deduct $3,100 from your taxes each year whether you spend the money on medical care or not. If you are over 55 years old, the IRS allows you to contribute another $1,000 to your HSA. So if you and your spouse are both over 55, you can deduct $8,200 from your taxable income without paying out any money out-of-pocket. You just transfer $8,200 to your HSA.

Real Property Improvement Depreciation Expense

I discussed all the financial benefits of owning investment real estate in this previous post. One of these benefits is a tax break from depreciation of the investment property’s improvements. In our example, this couple bought two investment properties a decade earlier and they each now provide $21,000 in income totaling $42,000 spendable income per year. But the great thing about real estate depreciation is that it’s a non-cash expense against the net property income.

Let’s assume the 2 rental properties were each purchased for $400,000, and that each property’s improvements are assessed to be about $290,000. IRS straight line depreciation for real property improvements requires each property’s $290,000 to be depreciated over 27.5 years. This means each property can deduct $10,550 ($290,000/27.5 years) from the properties net income. So each properties “taxable” income is only entered as $10,450 on your tax return. This means that the $42,000 total annual spendable income is taxed as only $20,900 (i.e., $42,000 is reduced by $21,100 for the non-cash depreciation expense = $20,900 taxable income).

Without getting too far into the tax code, it is important to note that the HDHCP deduction and the real estate depreciation expense amounts are what are informally referred to as “above the line” deductions. This means that these deductions lower the tax payer’s Adjusted Gross Income (AGI). This is important as many tax breaks are reduced the higher your AGI is.

At this point the AGI is calculated as follows:

Table 2: AGI Calculation

The 10% and 15% tax Bracket’s 0% Tax Rate on LTCGs and Qualified Dividend

Since this couple’s AGI is at or below the top of the 15% tax bracket, which is $70,700 for 2012, this means that due to the little known tax break I discussed in my last post all LTCGs and qualifying dividends are taxed at 0%. Therefore the $16,000 qualifying dividends and $36,000 LTCGs listed in Table 1 above are taxed at 0%. This results in $18,700 taxable income remaining ($70,700 – $16,000 – $36,000 = $18,700).

But there are still a couple more deductions left to be taken. In 2012 the “Married filing jointly” standard deduction is $11,900. The personal exemption in 2012 is $3,800 which totals $7,600 for a couple. Adding the $11,900 standard deduction to the $7,600 in personal exemptions totals $19,500 which offsets the entire remaining $18,700 taxable income. Additionally, since this couple has no earned income, they pay no payroll taxes. Therefore, this couple will pay zero federal taxes in 2012.

Table 3 below summarizes this 2012 tax analysis:

Table 3: Summary of Tax Deductions

I have presented this example assuming $18,700 in interest income and part of the net rental income was completely offset by the $19,500 total for 2 exemptions and the standard deduction for a married couple. However if another taxpayer, instead of having interest and real estate income, had $18,700 in pension income or an $18,700 taxable IRA withdrawal, the bottom line tax liability would still be zero. In the example you will get the same zero federal tax bill as long as there is no more than $18,700 of regular income.

One last comment, this whole exercise might seem to indicate that saving money in employer 401(k) or IRA accounts is a bad idea. This is not the case. Contributing funds to all types of retirement accounts is very important. But in making these retirement account contributions, it is important to maintain what is called “tax diversification” of your retirement assets. Basically this means that you should not make all your retirement account contributions to “tax-deferred” retirement accounts. I will discuss this strategy in more detail in a future post.

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