How Income Taxes Work and My $0 Tax Bill

Taxes seem really complicated. So complicated that a reader asked me to write about how they work so here goes.

No, not all CPA’s are tax experts. Though I had to have an understanding of how taxes worked in order to pass the exam, my work has never involved income taxes. But, we’ve always done our own taxes, even when they were complicated by business sales and rental property.

Even if you hire someone to do your taxes, no one cares about your money as much as you do, so you need to be at least a bit knowledgeable about them.

I use Turbotax. I buy it at Costco in late December/early January when it goes on coupon special. I like answering all of their questions and making sure I’m getting it all right. The Federal e-filing is free and the process is super straight forward. There is an extra $20 charge for e-filing the state return but I still do it because it’s just so easy.

I use last year’s software to get an idea how our current year will pan out. I make a copy of last year’s return and replace the numbers with estimates for the current year. With Obamacare subsidies and the 15% bracket limits, earning an additional $1 of income can cost thousands in additional taxes and premium credit paybacks. So being able to play with my current year’s numbers is important. I know last year’s software won’t be completely accurate but it will be close.

Do you really know how much you are paying in federal income taxes? We might know what tax bracket we are in but what does that really mean? And how much should we budget for taxes when planning our retirement?

Let’s start with a quick summary of how taxable income and taxes are calculated in the U.S..

We start by calculating our income. Income includes our wages, interest, dividends, income produced in a business, capital gains, retirement distributions, real estate rentals, and Social Security. Often, our wage income is reported after our employer sponsored retirement plan, flexible spending contributions and health insurance premiums are removed.

We can then subtract certain things from that income to arrive at our Adjusted Gross Income. Common subtractions include contributions to health savings accounts (HSA’s) and IRA’s., student loan interest and sometimes, tuition. Then, there are a number of less common subtractions.

We subtract certain expenses and exemptions to arrive at our Taxable Income.

Exemptions are easy so let’s start with those. An exemption is simply a fixed dollar amount times the number of dependents (you, your spouse any children and, sometimes, parents you support) you are including in your filing. In 2017, the exemption is $4,050 per person. So a family of four has an exemption of $16,200. Current exemption amounts can be found on bankrate.com.

Then we have deductible Schedule A expenses. Common deductions include state taxes, property taxes, home mortgage interest, certain medical expenses, and charitable contributions. If your deductible expenses are low, you can take a standard deduction in lieu of your actual expenses.  In 2017, that standard deduction is $12,700 for married filing joint taxpayers. All standard deduction amounts can be found on Forbes.com. This is an area that was changed a lot with the most recent tax reform. It will be interesting to prepare my 2018 taxes and see the impact on us.

Income – Adjustments to Income = Adjusted Gross Income
Adjusted Gross Income – (Deductible Expenses + Exemptions) = Taxable Income

At higher income levels, certain of these deductions and exemptions are phased out. This means the high income folks don’t receive the benefit of all of their deductions. Additionally, there are some extra taxes that get tacked onto a high earner’s return. The ones we were hit with in our high earning years include the Alternate Minimum Tax, Additional Medicare Tax and Net Investment Income tax.

The tax is then calculated on this taxable income (makes sense right?!).

The income tax is set up so lower earners pay a lower percentage of their income in tax and higher earners pay a higher percentage. These income levels and tax rates are called brackets.

There are brackets for four different filing types: Single, Head of Household (typically single parents), Married Filing Jointly and Married Filing Separately. Here’s the 2017 bracket for Married Filing Jointly which is how Mr. Ms. Liz and I file:

2017 tax brackets

All four brackets can be found on bankrate.com.

I’ve complained, in earlier posts, about the impact of marriage on taxes. How two married people pay much more than two single people. You may think we could just file in the Married Filed Separately bracket. But, the IRS is too smart for that–that filing status comes with so many lost deductions the outcome would be even worse.

What’s nice about these brackets is even a family making $500,000 only pays 10% tax on the first $18,650 they made, 15% on the next $57,000 and so on. So while it looks like those folks are paying 39.6% tax, their effective tax rate is really about 29% on their taxable income. And their effective tax rate is even lower when divided by their total income before adjustments, exemptions and deductions.

Additionally, these high earners often benefit from lower tax rates on their capital gains. Capital gains are created when investments and properties are sold for more than they were purchased. Capital gains are taxed at 15% if your taxable income is above the 15% bracket limits or 0% if you are in the 10% or 15% tax bracket. Yep 0%.

So what does this all mean?

In my high income years, I was paying close to 25% of my taxable income in federal taxes. We were making income well into the 33% tax bracket but our blended rate was 25%. And as a percentage of our true income (what the IRS calls income with retirement contributions and health insurance premiums added back), it was more like 19%.

I paid 9% of my taxable income in federal income taxes the last year I worked. With my mid-year retirement, I had more moderate income.

And for 2017, I expect to pay no federal income tax. And not because we will have no income. I will pay some self employment tax and some state tax but my federal income tax bill will be $0.

First, all of Mr. Ms. Liz’s wages are going to his work retirement plan so those wages effectively go away in the eyes of the IRS. We are converting a portion of his traditional IRA to Roth IRA because we can do so and incur no federal or state tax on $20,000 of income. Add capital gains, dividends and my bit of consulting revenue and our taxable income will be close to $67,000. But we contributed $7,750 (the maximum amount for age 55+) to an HSA and all of my consulting income goes away via IRA contributions. This gets our Adjusted Gross Income down to $55,000. From that, we’ll take the standard deduction and exemptions to get our taxable income down to $31,000. And how much is the tax on $31,000? $0. Because all of that income is capital gains or qualified dividends which are treated just like capital gains. Since our income puts us in the 15% tax bracket, we pay no tax on those capital gains and qualified dividends.

We will have a tax bill from Colorado though it will be minimal. Mr. Ms. Liz’s Roth conversions are exempt up to $20,000 since he is over 59. Unfortunately Colorado does not have free capital gains but with a tax rate under 5% the resulting tax is reasonable.

We are in the sweet spot of early retirement. We do not have to take any distributions from our retirement accounts until we turn 70. We are not yet eligible for Social Security–though Mr. Ms. Liz could claim starting as early as next year. We support ourselves with our non retirement investments which are primarily invested in low cost Vanguard stock index funds. One of the many advantages of these index funds is they are tax efficient. They do not create much taxable income until they are sold.

There have been many unexpected benefits of early retirement. Paying very little in taxes is one of them. So how much should you budget for taxes in your retirement? If your income is similar to ours, not much. You can actually get your income up to almost $100,000 without paying taxes–check out the fabulous work of GoCurryCracker.com to see how.  My retirement budget has about 8% of my investment income for taxes–it’s looking like that’s more than I’ll need.

Generally, you can pay taxes now or pay them later. If you have investments that are worth more than you paid for them, you’ve got a tax bill coming when you sell. A great strategy is to sell your investments with gains to get your taxable income close to (but not over!) the limit of the 15% bracket. As you now know, there is no tax on those gains. You can immediately repurchase those investments and, when you sell them years from now, your gain will be calculated on the new, higher purchase price.

Why didn’t we sell some gainers to get our income higher? We’re on Obamacare subsidized health insurance. The income limits to qualify for those subsidies are around $65,000 for married couples. Yes I know, subsidies for high net worth individuals are absurd but this is how it currently works.

Ok, I have to say it. Taxes are super complicated–consult a real expert (and not all CPA’s, me included, are experts). 

What did I miss? Do you file your own taxes? Why or why not?

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Author: Ms. Liz

A CPA, I retired at 51 and I am helping people create their fantastic futures!

One thought on “How Income Taxes Work and My $0 Tax Bill”

  1. ms. liz, this post rocks! would you mind if i ever added a link to it should i write about the subject? you summed it up so clearly and concisely that to try and regurgitate it in my own words would not do justice. i’ve been reading about this subject for years now but just learned of the exemption for 20k of roth conversion over age 59. it’s very interesting in that we have a little age (5 years) in our house but the opposite way. i was just mentioning on another site how to “customize” your income for the subsidy cliff and the 0% capital gains sweet spot. good work!

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