Income Tax Analysis

Your Comprehensive Written Retirement Income Plan Section 2: Income Tax Analysis

Estate Planning Guidance for Those Without Heirs

In three previous articles, we discussed all the details of the very first step in creating a comprehensive written retirement income plan: the Retirement Income Projection. If you didn’t get a chance to read it yet, you can start here. Now, we move on to the second step in your planning, which is the all-important Income Tax Analysis.

Why are we continuing to discuss this topic? Because having a comprehensive written retirement income plan is just that important!

Reviewing What We’ve Done So Far

Now let’s get down to it. You may remember the hypothetical couple we’ve been using to illustrate the principles we’re discussing – Bob and Carol. So, here we are having taken them through all three components of Step 1, the Retirement Income Projection. They loved their new plan up to this point:

  1. They increased their gross annual income from $78,000 up to $138,000.
  2. They reduced their potential risk from a stock market crash similar to the 2008 crash from -49.4% to -9.4%.
  3. They reduced their recovery gain needed from +97.5% to +10.3%.
  4. They reduced their annual fee percentage from 3.08% to 1.07%.
  5. They reduced their annual fees from $49,218 to $17,150.
  6. They are projected to save $640,360 in fees over the next 20 years.

But, even with all these potential benefits, Bob and Carol were still freaked out about the potential income taxes they thought they would have to pay. An income tax analysis must be performed to eliminate their fears of paying too much income taxes.


SEE ALSO: Why Should Retirees Avoid Volatility?


The first step of their income tax analysis is to determine how much of their total gross income is going to be reportable on their income tax return as a “taxable income source.” In this case, 85% of their $54,000 Social Security benefits are taxable, the full $24,000 pension is taxable, and their worst fears looked like they came true as all $60,000 of their IRA distribution would also be considered taxable income. Their new plan brought in $138,000 of gross annual income with $129,900 being potentially subjected to income taxes.

Reducing Bob and Carol’s Taxes

The good news is that Bob and Carol do not have to pay income taxes on the $129,900 because they will get to reduce this number by the higher of their total itemized deductions or their standard deduction. Bob and Carol don’t owe anything on their home, so they don’t itemize their deductions anymore. They  will claim their $24,000 standard deduction, which will leave them with a $105,900 taxable income. The $105,900 of taxable income will create combined federal and California state income taxes of $20,267.

By dividing the $20,267 of total federal and state income taxes into their $138,000 of gross income, you arrive at their combined federal and California state effective income tax rate of 15%. This means they will only pay a total of 15% combined federal and state income taxes on their $138,000 of total gross income:

  • 11% in federal income taxes
  • 4% in California state income taxes
  • 15% in combined federal and California state income taxes

Bob and Carol were overjoyed to learn this is actually how the income tax rates work and that they won’t be getting killed with income taxes simply because they want to use their assets to produce income. Would you be worried about paying 15% in combined federal and California state income taxes on $138,000 of gross income? Your individual state income taxes could be lower or higher if you live outside California.


SEE ALSO: Answer These Three Questions to Know What You Really Want Out of Retirement


The Final Steps

The last two steps in the income tax analysis are to determine what is Bob and Carol’s net after income tax monthly income amount and then to determine how much extra money they have on a monthly basis they can save after paying their anticipated monthly expenses. Their monthly gross income of $11,500 ($138,000 annual income divided by 12 months) is reduced by $1,689 which is the amount of monthly income tax withholding they need to break even with taxes at the end of the year, resulting in their net after-tax monthly income of $9,811.

Bob and Carol have a $7,500 monthly budget, which covers their current monthly living costs as well as $21,600 per year for travel. After subtracting the $7,500 of funds needed per month from the monthly net after-tax income of $9,811, they still have $2,311 extra they can save in the bank every month. What can Bob and Carol do with the extra $2,311 per month? Remember, they have already budgeted for $21,600 in travel, but they could spend more on travel if they liked, or they could save the money for future use.

If Bob and Carol want to buy a new car that will cost $50,000 in 24 months, can they save $2,311 every month and then pay cash for the car? Yes, they can and then they won’t have to worry about a car payment!

Should Bob and Carol increase their income by $60,000 per year if they are going to be in a 15% effective income tax bracket if they can increase their travel budget by $21,600 per year, and still have $2,311 extra to save every month? Based on their previously established goals and objectives, yes, they should.

Remember, their plan is designed to provide them income this month, income next month, income every month this year, income every month next year, and income every month for the rest of their lives, so they don’t have to worry about running out of money. And if they don’t have to worry about running out of money, Bob and Carol will be willing to use their assets to create income to improve their quality of life in retirement.

Check back next time for a discussion of Step 3 in preparing your comprehensive written retirement income plan! In the meantime, check out our blog and radio show for more valuable content!

Peak Financial Freedom Group
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Roseville, CA 95661

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