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Can a Retiree Really Pay No Taxes on $100,000 in Income?

So here’s a hypothetical scenario: a retired couple, married, both age 66, needs $100,000 per year of income. They both expect to live a long time, so they’ve decided to delay their Social Security benefits until age 70, when their combined benefits will reach $65,000. Their portfolio is pretty simple: $600,000 in a 401(k) plan and $600,000 of low-basis stock in their personal account (stock they’ve owned for many years). That’s it. No money in Roths and no bonds, just a 401(k) and their personal brokerage account.

So how do they take a $100,000 income from these two taxable accounts and potentially pay no federal income tax? Let’s take a look.

The first thing they’ll do is take $27,000 out of their 401(k). But wait, isn’t any money that comes out of a 401(k) taxable at ordinary income rates? Yes. But in this case, that ordinary income tax rate is 0%. Why? Because for a married couple age 65 or older, the first $27,000 of income is offset by the standard deduction. So that money comes out tax-free.

But that still leaves us with $73,000 of income that the couple will still need for the year. How could THAT possibly come out tax-free, especially when they don’t have a Roth IRA?

Here’s how.

They turn to the $600,000 of low-basis stocks in their personal, taxable brokerage account, and they sell $73,000 of those stocks. How is THAT tax-free? Because a married couple filing jointly with a taxable income of no more than $78,750, including the capital gain, is in the 12% marginal income tax bracket. They only took out $73,000. Remember that they’re selling stock, which is (in this case) taxed at long-term capital gains rates. And in the 12% marginal income tax bracket, the long-term capital gains tax rate is 0%. 

So there it is: $27,000 comes out of the 401(k) tax-free, and $73,000 comes out of the brokerage account, also tax-free. They’ve got their $100,000 of income from two taxable accounts, and no federal taxes have been paid on any of it.

So what does all of this mean to you? First, it demonstrates the importance of tax management. If our hypothetical couple had taken any more than $27,000 from their 401(k), that money would have been taxable. By stopping at the standard deduction amount, it was all tax-free. And by taking no other income except what they sold from their personal brokerage account, they were able to stay in the 12% marginal bracket, thus taking advantage of the 0% capital gains rate.

It also shows how it’s helpful to have different silos of money with different tax treatments. Having a combination of pre-tax, tax-deferred, and tax-free money potentially gives you some really good planning options.

And finally, it shows that you don’t have to limit yourself to a 4% withdrawal rate in every situation. Our couple was able to take out a little more than 8% from their portfolio for the first four years because they knew they would have Social Security coming in at age 70, when their withdrawal rate would go back down to somewhere around 4–5%.

It’s about strategy, and it’s about planning. It’s what we do every single day.

Information presented should not be considered specific tax, legal, or investment advice. You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

Case studies are hypothetical, are for illustrative purposes only, are not guaranteed and subject to potential federal and state law amendments. There is no guarantee that you will achieve the results discussed.

Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy (including the investments purchased and/or investment strategies devised by LCG) will be either suitable or profitable for a client's or prospective client's portfolio, thus, investments may result in a loss of principal. Accordingly, no client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from LCG or from any other investment professional.

The information provided is based on current laws, which are subject to change at any time. Lucia Capital Group is not affiliated with or endorsed by the Social Security Administration or any government agency.

Social Security rules can be complex. For more information about Social Security benefits, visit the SSA website at www.ssa.gov, or call (800) 772-1213 to speak with an SSA representative.

This information is for educational purposes only and no tax payer shall use it for unlawful tax reporting.

Rates of return are hypothetical, are for illustrative purposes only, are not guaranteed, and do not represent the performance of any one investment. There is no guarantee that you will achieve the results illustrated or that the investment strategy will meet its stated objectives.

Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.

It is important to keep in mind that investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. Interest may be subject to the alternative minimum tax. Treasury securities are backed by full faith and credit of the U. S. Government but are subject to inflation risk.

Rick Plum is a registered representative of, and offers securities through, Lucia Securities, LLC, a registered broker/dealer, member FINRA/SIPC. Advisory services offered through Lucia Capital Group, a registered investment advisor, and an affiliate of Lucia Securities, LLC. Registration with the SEC does not imply a certain level of skill or training.

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