The Biggest Financial Surprise in Retirement that I did not Expect before Retirement

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September 11, 2012

One reader recently asked a question, “What was the biggest financial surprise in retirement?” You might guess that my answer might be the high costs of health care. But I had done a lot of research concerning health insurance before I retired, so I knew all the options and costs associated with this expense.

For us the biggest financial surprise in retirement was our tax bill.

We were surprised how much our tax liability dropped when we stopped receiving earned income. In 2010, the last year I received earned income, we paid just shy of $32,000 federal income and payroll taxes and about another $10,000 in state income taxes. I knew our taxes would drop in retirement. I had estimated our tax liability in 2011 would be about $10,000 federal taxes and about $5,000 for state income taxes. I was way off on this estimate.

Our 2011 federal income tax liability was less than $200 and our state income tax was about $3,500. In 2012, because of the purchase of another rental property, we will pay ZERO federal income taxes. Low taxes are one of the benefits of retiring early (i.e., before you start receiving social security and making withdrawals from retirement accounts). But how is it possible to pay zero federal taxes?

There are several reasons zero federal income taxes is possible:

The low interest rate environment is certainly bad for retirees who depend on interest for retirement income. To be sure I would rather have higher interest rates and pay some income taxes, but low rates is the economic environment we are currently in.

But the reason we will pay zero federal income taxes in 2012 is not because we have no income. We still have a couple bank Certificate of Deposits (CDs) that are paying 5.5% and 6% interest, we also have dividend income from stocks, and we have rental income. The reason we will pay no federal income taxes this year is because of the current tax code.

If the current federal tax code stays intact for lower income tax payers (as both major political party candidates are advocating), we will likely not pay any federal income taxes until I reach age 70 when we start receiving social security. Now that we are retired, my wife and I have joined the 47% of the country that pay no federal income taxes. (For the record, I do not think it is good for the country that half of the citizens do not pay any federal income taxes, but that is the way the federal tax laws are currently written).

You are not going to believe this, but in 2012 it would be possible for my wife and me to have over $120,000 in spendable income (and I mean income not spending principle) and still pay zero federal income taxes. In our case we don’t need that much income to live on, but if we did, it would be possible to pay no federal income taxes.

Our zero tax liability is not because we take advantage of sophisticated tax loop holes. We have simply positioned our assets to optimize the current tax code. There are three things we have done to zero out our taxable income.

  1. Own residential real estate,
  2. Own stocks that pay “qualifying” dividend income,
  3. Obtained health insurance policies that allow Health Savings Accounts (HSAs).

These three things along with the two personal exemptions and the standard deduction allow us to pay zero federal income taxes in 2012.

But how would it be possible to have $120,000 in income and pay no federal income taxes? This is possible for people like us who do not have an employer-paid pension but have a lot of long-term capital gains and qualifying stock dividend income.

The 2003 Bush tax bill had a clause in it that, starting in 2008, changed the tax rate on “qualifying” stock dividend and long-term capital gains to 0% for all tax payers that are in the bottom two tax brackets (in 2012 up to $70,700 for a couple filing jointly). But contrary to the way tax breaks are usually capped, the $70,700 income limit is based on a tax payer’s “taxable income” and not their Adjusted Gross Income (AGI). In other words, the 0% tax rate applies to all qualifying stock dividend income and long-term capital gains, after all personal exemptions, standard deductions, and any other income tax exclusions you have are applied.

In our case, we have just over $50,000 of income exclusions. This amount includes the following:

This $50,600 is added to the $70,700 for a total of $121,300 income. So all our stock dividend income and long-term capital gains (from any source) totaling up to $70,700 would be taxed at 0%. We don’t need $70,700 of additional tax-free income, but it does cover all our 2012 dividend income. I plan to use the remaining balance of this $70,700 by realizing any other stock long-term capital gains I have left in 2012 as this tax break may be gone in 2013.

If the tax rates go up for everyone in 2013, the 0% tax break for dividends and long-term capital gains will go away, but the two lowest tax brackets will still have a favored long-term capital gain rate of 10%. If dividends go back to being taxed as regular income, I will have a tax rate of 15% on our stock dividends.  These tax changes are not enough incentive for me to make any adjustments to how our assets are positioned.

However for those tax payers in the over $200,000 income category ($250,000 if married), tax rates will increase enough that I would consider making some changes in my investments. The biggest change is to the stock dividend tax rate. If you are in the highest income tax bracket, your dividend tax rate will increase to 39.6%. But the changes do not end there.

There is also a new tax in the new healthcare law that starts in 2013. This tax adds another 3.8% tax onto all “Investment” income (which includes stock dividends) over $200,000. These two changes add up to a new 43.4% tax rate on investment income. If you live in a state with a top income tax rate of 6%, that puts your dividend income total tax rate at close to 50%. That is significantly higher than the current 21% rate (15% + 6%) you would pay in 2012.

If you have earned income over $200,000 and you also have a $200,000 stock portfolio outside of your retirement accounts with an average dividend yield of 4%, the $8,000 gross income from this portfolio will be only about $4,000 after you pay all taxes. If I were in this situation, I would make an asset change. I would sell the $200,000 stock portfolio (preferably in 2012 before tax rates go up) and purchase a $400,000 rental property with a $200,000 loan. Let’s look at an example of how your income and tax situation changes if you make this move.

I have recommended in past posts that you should try to purchase rental real estate where the gross annual rent is at or above 10% of the purchase price. In our example let’s assume you could only find a property that has a total annual gross rent of 8.4% of the purchase price. The gross annual rent is then $33,600 or $2,800 per month for a $400,000 property.

Let’s also assume the following data for the property:

If the annual property gross rental income is $33,600 and the annual expenses in the above list total $24,020, the net annual rent is $9,580 ($33,600 – $24,020). This is about a 4.8% annual return with just the rental income which will increase over time just like a stock dividend. In addition the first year principle reduction on the loan is $3,226. Adding this amount to the net rent is $12,806 ($9,580 + $3,226) profit in the first year. This is about a 6.4% before tax return on the $200,000 investment.

But we cannot forget the one other financial benefit of investment real estate, which is the depreciation expense. For typical residential properties the building/land value ratio is around 70%/30%. For a $400,000 property 70% of the purchase price would mean a $280,000 building value. Straight line building depreciation is over 27.5 years, so this property would have a $10,182 depreciation ($280,000/27.5 years) expense each year. What does this do to the property income taxes?

The net annual cash flow from the property is $9,580. All investment property expenses are tax deductible except the portion of the monthly loan payment that is principle repayment. So, in our example, the $3,226 principle reduction in year one must be added to the net cash flow before taking the depreciation expense. So the taxable amount is $12,806 ($9,580 + $3,226). Deducting the $10,182 depreciation expense means the net taxable amount from this property is $2,624 ($12,806 – $10,182). Applying the assumed 49.4% tax rate to investment income means this property would have a total tax liability of about $1,296.

The table below summarizes the two investments:

 

$200,000 Stock Portfolio with 4% yield

$400,00 Real Estate Investment with $200,00 mortgage
Net Investment Income

$8,000

$9,580
Income subject to taxation

$8,000

$2,624
Assumed Federal and State  combined tax rate

49.4%

49.4%
Total taxes

$3,952

$1,296
Spendable After-tax cash

$4,048

$8,284
After tax profit (Income & principle reduction)

$4,048

$11,510
After tax return on $200,000 Investment

2.0%

5.8%

 

If you are in the highest federal income tax bracket and in 2013 all the tax rates go back to where they were in 2000, the above asset change is something I would seriously consider doing.

However, I would never change any investment just to save on taxes. But right now I think real estate is actually a better value than stocks. Real estate values have dropped significantly in the past five years and stock prices are nearing their all-time highs. If you do not own any investment real estate, a move like this will also give you some asset diversification. You can keep your stock investments in your retirement accounts.

One last thing to consider; what if the Federal Reserve keeps devaluing the currency through more and more rounds of dollar printing (i.e., Quantitative Easing)? If inflation comes back, owning a hard asset like real estate will help protect your wealth.

If there is no tax reform next year, all sorts of taxes will change and all of them in one form or another will increase your tax liability. To date there has been no talk of any changes to the real estate depreciation expense now available to owners of rental properties. Down the road this may be the only meaningful tax break left to the average person.

I will write one more post next week for this blog, “Retirement Planning Simplified,” summarizing my current thoughts about retirement planning. Then I will take a couple weeks off as we prepare for our trip south to the Bahamas.

In October I will start up a blog chronicling our sailing trip. Perhaps I will call it “Retirement Living Simplified.” For now the new blog will be on this same site. Hope you keep visiting.

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