Dividends, Income, And The 'T' Word (taxes, an example of self-directed retirement planning)

Ron Katalinich @ SeekingAlpha writes: 2014 will be my first full year of retirement. My years of investing are ready to provide all the income I need to fund the future. In the spirit of the Dividends & Income forum I decided to poke around my tax bill due April 15, 2015.

The "T" in the title does stand for taxes. Having received the "gold watch" after 30 years with the same company, I decided I will do two things for myself while in retirement; manage my own investing and do my own taxes. The only qualifier is that it must be simple and I, not the IRS, retain as much of it as possible.

With this in mind let's look at a working plan to retirement:

Pulling out my last paycheck stub from August 31st last year, I looked at federal withholdings, state withholdings, SS withholdings, Medicare withholdings, 401K deposits and so on and so forth. I was an OINK; One Income No Kids and saw a significant portion of the pay go everywhere else. Fast forward to 2014 and see what the plan is:

1. First we answered that famous question "How much do you need in retirement?" 15 years of check stub analysis determined that it will take anywhere from $5000-6000 per month to live very comfortably as we wish. But thanks to the company raising my health insurance premium to $1673 per month I will explain our needed income based on $6000/mo.

2. Asset review to fund the income:

· While not included in the creation of monthly income, real estate sales gave us a cash emergency fund to pay for toys. The home sales were small in size and exempt from taxes. I could pay the bills for 1.5 years. We currently have no mortgage.

· My 401K is now a simple IRA. It is 70% of the portfolio used in funding(Monthly 7% from me and a 6% match deposits for 30 years)

· Remember OINK?, that gave us the chance to create a smaller 25% portfolio nest egg spread across mutual funds. The largest is a totally tax exempt muni paying monthly interest payments. (Some of it's size is from an inheritance which may be in everyone future if you retire in your 60s)

· And lastly 5% are in ROTHs. We ran to them years ago but stopped funding due to apathy and or stupidity.

Without naming names the investments are spread across Large-Cap Dividend Champions, CEFs, BDCs, Taxed and Tax Exempt bond funds. Overall we are 55% equity and 45% fixed income.

· I worked for a utility that offered a "retirement plan". My Cash Balance sits with the company. It will continue to increase at a small rate (3%) based on some smoke and mirrors calculation for up to another 10 years at which time IRS rules say I'll have to roll it over. If I wait that long it will increase my income producing portfolio by 40%.

· Lastly is Social Security…. I'll take it at age 66 (I'm 60). At that time my wife will also receive the spouse 50% benefit. The total will reduce the portfolio stress by as much as 50%. This will extend the life of everything by 20 more years.

It's interesting to realize that the annual total of $72,000 is more "take home" pay than I received in a lot of the years while I worked. But what is more interesting is that it represents the "just for us" money. Nothing is added nothing is set aside. When tax time comes, line 1 is all zeros and this puts us in the lowest of the IRS income tax brackets!!

On to the tax stuff: The 2014 federal taxes (filing joint) are: (Source: IRS website)

• 10% on taxable income from $0 to $18,150, plus
• 15% on taxable income over $18,150 to $73,800, plus
• 25% on taxable income over $73,800 to $148,850, plus
• 28% on taxable income over $148,850 to $226,850, plus
• 33% on taxable income over $226,850 to $405,100, plus
• 35% on taxable income over $405,100 to $457,600, plus
• 39.6% on taxable income over $457,600.

I use to be in the 25% bracket and brought home almost $72K but now my new job pays the same but it's different!

Monthly IRA distributions of $5000/mo. times 12 = $60,000
Cash deposits from bond fund $1000/mo. times 12 = $12,000
Total = $72,000

The simple IRAs distributions will be $5000 per month. Had I been smarter, all this could have been ROTH money, but its too late now. Every dollar withdrawn is a dollar taxed not to mention you cannot take a distribution without the required 10% minimum withholding so the bank deposit will be $4500.

From the non-sheltered accounts the $1000 per month is 80% tax exempt by investing in state issued municipal bonds. The makeup of the rest of those funds will be subject to taxes. So for the math let's add $2400 in taxed income to the $60K.

Fast forward to tax season and fill in the blanks. Out of our $72,000 it becomes an AGI of only $62,400, the benefit of the muni monies. On page two of the 1040 form AGI is reduced using the Standard Deduction and our two exemptions for a lowly taxable income of $42,100. If you figure the income tax on the AGI, the amount due is $5408 or an effective tax rate of 8.7% (Tax/AGI)

The IRS withholding rule on distribution takes out too much tax triggering new car fever or that spring trip using the refund. But wait it gets better.

If you read other articles in this forum many investors not only use DG investing but also value investing for the maximum total return. These folks can get their gains for free under this scenario.

When it comes time to figure your tax, if your employed and have a salary much higher than my example here, you just use the tax table and call it a day. Under this scenario if you have had gains listed on Schedule D you do not use the tax tables. A worksheet is used to determine what portion of line 43 is free of tax. For my situation, ALL gains are removed from the taxable income. Thus a larger portion of the $72,000 can come from selling that stock you sweated over and finally rose the 50% you were hoping for. SELL! and don't fear the tax!

If we say the extra $2400 as part of the AGI was all capital gains, the tax on the original $62,400 decreases to $5048 which is a 6.7% decrease i.e. keep the $2400 it was just cash all along.

So back to the beginning of this article, what to do to minimize taxes?

• I believe that most of America is not setup in ROTH IRAs or ROTH 401Ks. So for the simple IRAs where a dollar out is a dollar taxed you might as well invest for the maximum possible return up to the limit of eating Rolaids and aspirins. If your timeline is many years then stuff the ROTH IRAs with everything you can afford.
• For mutual funds held outside IRAs consider tax exempt bonds. I KNOW returns can never match a good DG company, but they areinvisible to the tax tables. This allows MORE INCOME generationnot subject to income tax.
• You all can stop talking about those fabulous total returns, cash out and take the gain. With a little math plan on taking profit up to the 15% tax bracket limit reported on line 43 of the 1040 form. Cash the check and spend it....... its free of charge.

DISCLOSURE: I have not mentioned one stock or fund by name. In reading the articles here at SA, I am convinced you all are much smarter than I in deciding what's the right investment. What we all have in common though is the tax law. What I hope to share is a simple method to maximize the Income part and minimize the Tax part of retirement.