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Withdrawing Income In Retirement & Taxes

So let’s say you and your partner are retired, you no longer have earned income from wages or a business. The only place you can draw an income from are your investments – in form of capital gains.

There are beneficial tax implications which I’ll review in this post but I’ll also  review some logistics of how to access your retirement money in order to live off of it.


Capital Gains

Well, there isn’t just capital gains but also capital losses. A capital gain isn’t actually realized until a sale occurs, same with a loss.

When the market ate shit in 2008 there was no capital losses unless the investor sold at the bottom of the market and locked in a loss. Conversely, I don’t have a capital gains just because my investments are up 12% this year.

The reason we even have a word like capital gains is for no other reason than for the gov’t to squeeze taxes from it. Selling your home will generate a capital gains. Selling a piece of art that has appreciated in value will have capital gains.


Generating Income From Investments

Let’s say that you and your partner are 45 years old and need $50,000 a year of income, how would you actually do that? Let’s talk logistics.

If you have a financial adviser with power of attorney, they can do this for you but if you prefer to do it yourself, it’s not that complicated.

Taxable Accounts & Retirement Accounts

The IRS says that you should retire at age 59.5, meaning that you must pay a 10% tax penalty if you want to access your retirement accounts sooner. So, you likely won’t be touching your retirement accounts initially and instead going for your taxable private brokerage investments.

For this example, we’re gonna assume that you have most of your investments in taxable accounts such as a private brokerage, savings, CD’s, and money market accounts.

Withdrawing Income From CD’s

CD’s are straightforward. You invest $100k and at the end of the year you’ll have maybe $2,000 in profits. You’ll pay taxes on this as if it was income from wages.

Because you guys as a couple get to subtract personal exemptions and standard or itemized deductions, you probably will have somewhere in the $12,700 range of tax savings alone. See the table below for breakdown of this.

Withdrawing Income From Securities

Let’s say you have $800k that you invested over the years which has grown to $1,000,000, a $200k appreciation in value. Likely from a mix of dividends being reinvested and the individual funds appreciating in value.

Your $1 million portfolio of passive index funds likely had somewhere around 2% of dividends – or $20,000 of income which you can take off the top.

From that $200k of appreciation you can take out $30,000 in order to make up that $50,000 that you need for retirement ($20k from dividends + $30k from sale of appreciated funds).

Oh shit, what about taxes?


Taxes On Capital Gains Income

There are 2 kinds of capital gains, long-term capital gains and short-term capital gains. The former is what the majority of our index funds provide us. The latter is what active stock traders deal with.

Long-term capital gains has to do with holding an investment for at least 12 months so that any profit is taxed at a much lower rate. If you look at the table below, while you get shafted with your income taxes, favorable capital gains taxing is quite sexy.

You can see that a couple can have a taxable income of up to $75,900 and pay $0 in federal taxes.

What if the income was short-term capital gains (investments held for short periods of time)? Simple, it would be taxed at ordinary income tax rates.

Taxes In Retirement

Hopefully you will strategically generate income in retirement mostly from capital gains instead of earned income. Why? Because this can provide you with incredible tax savings. As you saw, income is taxed horribly while capital gains is taxed favorably.

Can you imagine earning nearly $76,000/year or $6,000/month and pay zero in federal taxes? This doesn’t even include any deductions or exemptions which would only raise the amount that you can earn before paying any taxes at all.

Next, let’s discuss state taxes.

State Income Taxes

On the federal level capital gains is taxed minimally. On the state level it’s a different story. California, New York, and Oregon are among the highest taxing states. These aren’t the best places to retire – though if you can afford it, why not.

When you’re retired and you are trying to stretch your dollars from your retirement account, the last thing you want is to pay an additional 10% of taxes on your withdrawals.

Some early retirement enthusiasts complain that the 10% tax penalty is what’s keeping them from accessing their retirement accounts early. When, in fact, they could just move to a zero income tax state, or at least be a resident of that state, and essentially “save” that 10%.

Here is a great list of how much states tax capital gains. It’s not urgent for you to make the move now. But the longer you stay in one location, the harder it will be for you to uproot yourself later.

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