How to Pay Zero Income Taxes in Retirement With Mixed IRAs

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How about another mental exercise on taxes? I usually enjoy Christine Benz’s articles on Morningstar, and When Taxes Collide With Your Asset Allocation was no exception. She presents the following scenario:

Let’s say a 65-year-old woman is prepping her portfolio for retirement. Her assets are ultra-streamlined, with a $500,000 Roth IRA account containing stocks and $500,000 in a traditional IRA portfolio consisting of bonds.

Is her asset allocation:
a) 50% bonds and 50% stocks
b) Heavier on stocks than bonds
c) Both of the above statements are true.

The basic premise of the article is that because she has to pay taxes on withdrawals from her Traditional IRA accounts at ordinary income tax rates, while not owing any taxes on her Roth IRA accounts, the woman effectively has more exposure to stocks than bonds. I agree that taxes are an important facet to consider.

However, Benz makes a quick assumption that her federal income tax rate is 25%. Here we meet the difference between marginal and effective overall tax rates, as well as the difference between gross and taxable income, in our progressive tax system. While the woman’s marginal tax rate may be 25%, unless she has a lot of outside income, her effective tax rate on those bond withdrawals would be much less. In fact, my wife and I would like to pay zero taxes in retirement with a similar portfolio.

How? Let’s say we are a couple both age 65 as in the example, which is over 59.5 we can start taking withdrawals without penalty. We have no pensions to rely upon. Like above, we have $500,000 in Roth IRA and $500,000 in Traditional IRA. With 401k plan rollovers and regular IRA contributions, this is not unrealistic. With a 4% withdrawal rate that is $40,000 a year, let’s say $20,000 from both.

What taxes do we owe? The $20,000 Roth IRA withdrawal is tax free. Now onto the $20,000 Traditional IRA withdrawal. Well, since this isn’t earned income, you won’t have to pay any payroll taxes like Social Security and Medicare taxes. For 2012, the standard deduction for a married filing joint couple is $11,900 plus $1,150 per person for being 65+ and the personal exemption is $3,800 per person. That adds up to $21,800. That’s more than $20,000, so our taxable income is zero! In fact, the first $17,400 of taxable income is taxed at the 10% bracket, so your total withdrawals could total up to $39,200 and still owe an overall percentage less than 5%.

As always, there are things that could skew the math. You might have a pension. There’s also the possibility of state income taxes, although if we take California the effective tax rate would less than 1%. Finally, Social Security benefits could create a greater tax liability, although it might be wise if you’re healthy to defer Social Security until age 70 to maximize the payout of what is effectively an inflation-adjusted lifetime annuity.

When you contribute to a Traditional IRA, you take the tax break upfront and pay taxes later. When you contribute to a Roth IRA, you pay taxes now and take withdrawals tax-free after age 59.5. Keep in mind this example when choosing as by carefully mixing the two, your effective tax rate in retirement may be lower than you think.

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  1. Assuming you have some control over your contributions now, and are at a higher marginal tax rate, wouldn’t you be better off in pushing more into the traditional IRA/401k side of things?

    While the concept of paying “no taxes” on your distributions is neat, I would rather pay 15% tax on my distributions when I take them than 28% on my contributions today. (Plus state)

    In other words, I think ending up with a 50/50 roth/traditional balance like that is foolish planning on the contribution side if you are paying 28% tax today and no tax on distribution. Clearly there are other factors involved as well (income limits, the ability to put “more” cash into Roth since it is post tax, RMD, etc), but if your income is going to be significantly less at distribution then shouldn’t you be funding a traditional IRA/401k?

  2. This is an excellent observation, one that I have tried to explain to people several times. Very well done.

  3. Yes, you always want to be in a position to take advantage of the very bottom brackets each year. I’m making sure I have a mix of Roth and traditional IRA money available. Even if you don’t need to withdraw the money on a given year, you can do a Roth IRA conversion to capture the tax break from the exemtptions and deductions that you would otherwise lose.

  4. Where did you see the first $17,400 is tax free? Pretty sure that is wrong. The lowest bracket is 10% ($0-$17,400) for joint.

    • He didn’t say the first $17,400 is tax free. He was showing that with the 2012 MFJ standard deduction and personal exemptions your taxable income distributed from your traditional IRA can reach $39,200 and you will have a federal effective tax rate of approximately 5 %. The math in his example works like this:

      Total Income from year: $59,200
      Less ROTH distribution: ($20,000)
      AGI (Adjusted Gross Income): 39,200
      Less 2012 MFJ standard deduction + Personal exemption (65+): ($21,800)
      Subtracting this gets us to our taxable income,
      Taxable Income: 17,400
      Tax brackets: ($0-$17,400 – 10%)
      Tax owed: 1,740

      So, our marginal tax rate (the highest progressive tax rate we were taxed at) is 10%. Because we were only in one tax bracket, our effective tax rate is (Tax owed/Taxable Income) going to match our marginal at 10%. HOWEVER, your total income from the year was $59,200, so over all like he showed, our federal tax on our almost 60K of income for the year is only 2% way below his listed 5% (1,740/59,200=2%).
      Even at only 60 the math works out well below his listed 5%:

      Total Income from year: $59,200
      Less ROTH distribution: ($20,000)
      AGI (Adjusted Gross Income): 39,200
      Less 2012 MFJ standard deduction + Personal exemption: ($14,200)
      Taxable Income: 25,000
      Tax brackets: ($0-$17,400 – 10%)
      ($17,401-$70,700 – 15%)

      Tax owed: 2,880
      Marginal tax rate: 15% (highest bracket)
      Effective tax rate: 11% (Total Tax Owed/Taxable Income)
      Overall: 4% (Total Tax Owed/Total Income)

      I hope this helps! It is an important topic.

  5. AdirondackJack says

    “In fact, the first $17,400 of taxable income is taxed at the 0% bracket . . .”

    Is this just for folks that are 65+? Or is it for unearned income (capital gains)?

    This is a great concept. I made the decision about ten years ago to keep by traditional and Roth IRAs about even in value so I coule effectively “manipulate” my income in retirement. But, also because I fear that at some point in the future the US could institute a federal value added tax (sales tax, consumption tax, etc.) rather than raising income tax rates, in which case I would get taxed at both ends with regards to my Roth IRA.

  6. Good luck with that. From what I remember, you’re likely 30 years away from those ages. Look back 30 years and see people believed then and compare to how it’s working out for them now. I don’t doubt you’ll be doing better than a lot of people, but applying today’s tax laws to something so far in the future is just an exercise. AdirondackJack is absolutely right about new VAT and other costs. Even the latest CAFE standards are going to save us a $1/gallon on fuel cost for our cars right? I guess the roads will just self-repair with per gallon taxes where they are today… oh, no, actually, I bet your costs don’t go down a penny (however, the portion of your cost going towards actual fuel will lower) as tax rates rise (or a per mile driven tax is added via on-board mileage tracking. There is no doubt the government will use it’s taxing authority to get the money it needs, and as long as you play by the rules and do what you’re supposed to, you won’t get a deal or bailout, you’ll just get the bill.

  7. DoctorPepper says

    “Where did you see the first $17,400 is tax free? Pretty sure that is wrong. The lowest bracket is 10% ($0-$17,400) for joint.”

    Hal, the standard deduction excludes some of your income from being taxed. As the article explained, “For 2012, the standard deduction for a married filing joint couple is $11,900 plus $1,150 per person for being 65+ and the personal exemption is $3,800 per person. That adds up to $21,800.”

  8. Using your example, you could receive up to $10,200 of Social Security and still not pay taxes. Of course, most people would have other taxable money outside their retirement accounts (interest, dividends, capital gains, part time job, etc).

    Your example does a good job of showing the benefits of having a Roth IRA and being able to play with the distributions to avoid paying taxes.

  9. Because I will be forced at 59.5 to take money out of the traditional ira and I plan on working until 75 or so and because my salary is in the top 2%, I believe it is best to pay the taxes now because federal tax will be higher in the future. If I felt taxes would be less in the future, I would do all traditional, instead I’ve rothed everything.

    • American Fool says

      If we had that much income, we’d likely do the same thing. Since cash flow is our biggest concern, we contribute to the regular 401k and less to the Roth. The twist is that we might have been better off contributing more to the Roth, as principal withdrawls can be made from a Roth after 5 years, and it might have served better than a 529 to save for college. I’d be interested knowing if anyone has used that strategy.

  10. This could work, but you have to take into account that you’ve already paid the taxes on the Roth, so it’s not really tax-free. I’d much rather pay the taxes later than now (ie use a Traditional IRA instead of a Roth, unless you’re in a very low tax bracket now). If you pay taxes now, you lose the 30 years of compound interest you could have earned on the money.

  11. I am not as smart as everyone here, so that means i get to ask the dumb questions.

    If this is the case, why wouldn’t you just have 100% of your assets in Roth IRAs so that all income in retirement is tax-free?

  12. @Udo: If you do the math, you will find that if your marginal tax rate does not change, there is no difference in the end result between the Roth and traditional. You will be left with the same amount after taxes whether you pay them now or later. Roth has additional benefits, like no required minimum distibutions and easier to leave to your heirs.

    Since none of us can predict what will happen to tax laws, or even our own personal tax situation, I think hedging our bets with both types of IRAs is the way to go. It seems many financial advisors are very narrow-minded in recommending one to the exclusion of the other.

  13. Also, what about RMD (required minimum distributions) on the 401(k) and what if you don’t want to work until you’re old?

  14. Ack, I read the income bracket table wrong, it is 10% for the first bracket of taxable income. Thanks for the correction. I blame sleep deprivation! There would still be no income tax for the given example, but the first $17,400 above the $21,800 would be taxed at 10%. You could still have total withdrawals (gross income) of up to $39,200 and still owe an overall percentage less than 5%.

  15. @Brian – I’m not saying 50/50, but it should be tailored to your situation. But yes, perhaps more people should have Traditional IRAs if they plan on having a nice, moderate spending retirement. The problem is that people use things like 85% replacement rate and if the household earns $100k now they assume they’ll need $85k later. I don’t link my income with expenses in that way. My house will be paid off, so my needs in retirement should be much less.

    @S.B. – Good advice about taking advantage of Roth conversions when your tax bracket is low.

    @Hal – You are correct!

    @Scott – Tax rates will change, but you should still take advantage of tax breaks when you can, and with mixed IRAs you’ll always have more flexibility. Also, the tax rates on lower incomes will change a lot less than the tax rates on high incomes due to sheer numbers. Look back over the last 30 years and compare marginal rates.

    @Dr Pepper – Actually Hal was right, it was 10% and not 0%. The first $21,800 won’t be taxed, the next $17,400 would be taxed at 10%. So the first $40k would be taxed overall at less than 5%, not nearly as much as a 25% marginal rate.

  16. @Pat – Thanks for running the numbers on Social Security, I was too lazy to do that. 🙂 Agreed, especially if you retire early that will most likely have you earning dividends and income from a taxable brokerage account.

    @Jim – Yes that might work better for you.

    @Udo – I get the argument that you want to pay taxes later, but remember that multiplication is commutative (3×5 = 5×3). Taking 25% out in the beginning or the end is the same, and compounding happens either way.

    @Claudia – WIth a Roth, you contribute with after-tax money (no tax break upfront) and then get tax-free withdrawals. With a Traditional, you get your tax break upfront and then get taxed upon withdrawal. You could put it all in Roths, but if you tax rate is high upfront and low upon withdrawal, you kind of wasted the tax break when it wasn’t the most beneficial.

    @Jeff – Good points!

    @Someguy – If you can wait until RMDs at age 70, maybe you don’t need the money that bad. 🙂 If you want to retire early, you can tap into IRAs without penalty using rule 72(t).

  17. This example works well because you withdraw only a small amount (compared to the entire portfolio) to fund your living expense for the year. But how would this work if you plan to cash out of your Traditional IRA or Taxable accounts and buy an annuity? Any ideas to get out of a huge tax bill?

  18. AdirondackJack says


    Couldn’t you just purchase the annuity in your Traditional IRA?

  19. @John – I don’t know all the details, but it appears that AdironkackJack is correct that you can buy an annuity with your Trad IRA funds and preserve the tax-deferred status. WSJ article:

    To preserve the tax deferral when using IRA assets to buy a fixed immediate annuity, you have two choices: The first is to withdraw money from the account and roll it over within 60 days to an individual retirement annuity (usually referred to as an annuity in an IRA). The other is to do a “direct rollover” or “trustee-to-trustee rollover” in which you move the assets straight from your IRA to the annuity.

  20. Someguy, Also as far as RMD’s they aren’t going to push you into a higher tax bracket unless you have a LOT of money in the IRAs/401ks. At age 70.5 they start at about 4%. Thats about the $20k the example talks about pulling out of the $500k IRA.

  21. Christine Benz is mistaken.

    DUCY? It’s pretty obvious.

  22. Mickey Blue Eyes says

    I think it is shameful for you 1%-ers to try to hide your income from the 99%-ers that you stole it from. You need to pay your fair share to us whom you have exploited. #OccupyMyMoneyBlog

  23. @MBE – I can’t tell if you’re joking or not, but if you think saving up such a similar sum of money over the course of working 45 years is only for the 1% then your anger is misplaced.

  24. Michael Rohr says

    Any chance you will update this article for the new tax law? Thanks.

  25. Hi, just checking to see if this methodology changed at all with the new tax code. It seems that the IRS would catch on to this loop hole at some point. Essentially you tax shelter part of the traditional IRA as well by creating a low MAGI that isn’t reflective of your true income for that year.

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