This article has been updated to reflect 2023 tax brackets.
Sam was 48 years old. He had a big corporate job and a six-figure income. He and his wife Liz together earned $270,000, but 30% of it went to taxes every year. They had saved and invested well, and decided to retire to spend more time with their children before all three were out of the house.
When Sam filed his taxes the following year, he couldn’t believe it. He had $80,000 of income to report—mostly from Roth IRA conversions and 401k withdrawals—but his tax bill was zero!
Sam and Liz went from paying $80k in taxes each year to living on more than $80k and paying no taxes at all! Zero federal taxes. Zero state taxes.
Did they have a unique situation or find a secret loophole? Were they doing something illegal?
No. Sam and Liz may not have recognized that they had set themselves up for zero taxes, but what they did could be replicated by many Americans—and potentially others in countries with progressive tax systems—with a little planning.
Let me show you how to pay zero taxes on retirement account withdrawals.
1 Progressive taxes are a retiree’s best friend
The American tax system is progressive, which means that it taxes higher income households at a greater rate and those with lower incomes at a lower rate. The idea is that lower income households cannot afford basic necessities such as food and shelter if they are taxed too highly, so the government looks for revenue from its wealthier citizens instead.
There are some who disagree with this approach as being an unfair redistribution of wealth, but our beliefs about government taxation are not relevant to this discussion. The fact is that all citizens of a country are bound by its tax laws.
“If you can’t do anything about it, don’t worry about it.” – Jeanne Calment
At Pathway to FI, we focus on what we can control. We can use the tax laws to our advantage no matter how they are written.
As a retiree, you are well situated to control your tax destiny. You have some combination of pre- and post-tax retirement accounts, taxable brokerage and savings accounts, real estate, and part-time or small business income. You can choose when to take income from your retirement accounts or business, capital gains from your brokerage account or real estate, and when to use principal to avoid taking further income in a given year. I will discuss this more in section 1.5.
1.1 Tax brackets
The US income tax brackets in 2023 have a large step from 12% to 22% as shown in Table 1. This is the point we will plan around since the 12% bracket reaches income levels that represent a comfortable lifestyle for most people.
They are called marginal tax brackets because each tax rate only applies to the dollars earned within the specific margins in that bracket. For instance, every dollar of taxable income above $22,000 is taxed at a 12% marginal rate until reaching $89,450. The next dollar, $89,451, is taxed at the 22% marginal rate.
“But there is no 0% income tax bracket,” you say. I’ll get to that in a minute.
First, take a look at the long-term capital gains tax brackets, which do have a generous 0% bracket. Table 2 won’t apply directly to your 401k or IRA withdrawal, but is important for overall tax planning, so keep it in mind.
1.2 Standard deduction
The standard deduction is subtracted from your income. The result is called your taxable income, and is what the tax brackets are applied to. This effectively creates a 0% tax bracket, which goes all the way to $27.700 for a married couple for 2023.
You may be able to get a higher deduction by itemizing. But the standard deduction is a high bar to get above without making a large gift—for instance, by bunching multiple years of charity into a single year—or have a really big out of pocket medical expense relative to your income level. Most people take the standard deduction these days.
Standard deductions are not progressive. They apply equally to all income levels.
1.3 Child tax credit
Tax credits are more valuable than tax deductions. Credits reduce the amount that you pay in taxes dollar-for-dollar. Deductions reduce the amount of money that your top tax rate applies to. If your top marginal tax bracket is 12%, a $1,000 deduction is worth $120 in taxes while a $1,000 credit is worth a full $1,000.
The child tax credit is what really pushed Sam and Liz into zero taxes at such a high income level. Two of their three children are already in college, but they are still their dependents. So Sam and Liz were able to claim 3 child tax credits worth $2,000 apiece for a total of $6,000.
The child tax credit is also progressive. It begins to phase out at taxable incomes of $200,000 for single filers and $400,000 for married filing jointly. It’s easy enough for most retirees to stay below these thresholds.
Other popular credits and deductions are listed in this article.
1.4 Income cutoffs for zero federal taxes
Now we can put income tax brackets, the standard deduction, and child tax credits together to see how it’s possible to pay zero federal taxes. I have done this for single filers (Table 4) and married filing jointly (Table 5).
The first thing you might notice when comparing these tables is that it literally pays to be married. The IRS gives a big advantage in the tax code to those households.
A single filer without children cannot practically get to zero taxes. With one child, he or she can earn up to $32,954 in taxable income with a $0 tax bill. Two children bump this up to $49,624 (now we’re getting somewhere!), and 3 children push it to $62,782.
Notice that I have not included columns specifically for 3 children, but the income where someone with 2 children would pay $2,000 in taxes equals the limit where someone with 3 children would still pay zero.
A married couple filing jointly will pay zero federal taxes up to $27,700 of income without children (not shown). They can go up to $47,700 with one child, $65,908 with two, and $82,575 with three.
This last level is where Sam and Liz qualified.
1.5 Tricks to keep taxable income low
Sam and Liz had $80,000 of income from Roth conversions and 401k withdrawals. But they actually had another $2,500 in income to account for.
For the last 3 years, they were able to max out their retirement accounts and put additional savings in a brokerage account. They retired with $100,000 invested in index funds that paid out 2.5% in qualified dividends. This gave them an extra $2,500 of income each year that would be taxed at the 0% capital gains rate.
Referring back to Table 2, long-term capital gains are taxed at 0% up to $89,250 for married filing jointly. After factoring in the standard deduction, a couple can make as much as $116,950 before moving out of the 0% capital gains bracket! And that’s before factoring in child tax credits.
So the limitation for zero taxes here is not capital gains but ordinary income.
Adding the dividends to their $80,000 of ordinary taxable income brought Sam and Liz to $82,500 in tax free income. But it didn’t stop there!
1.5.1 Tax Loss and Tax Gain Harvesting
Sam and Liz did something else smart here. This was a good year for the stock market, and their stock portfolio had grown another $10,000. Earlier in the year, however, the market was down. Sam sold some stock at a $2,500 loss when it was down and bought similar funds with the proceeds. This is called tax loss harvesting, and it reduced their taxable income back to $80,000.
Sam and Liz actually missed another opportunity here. They had owned most of their funds for more than a year, and when the market recovered they could have sold enough for another $4,000 in long-term capital gain, and then bought them right back. They would have owed zero taxes on this move since they would still be below the $82,575 ordinary income limit. This strategy is called tax gain harvesting.
If those stocks happened to go down from there, they could tax loss harvest again, claim a loss in income, and save money on a following year’s taxes even though they may still be at a net profit!
1.5.2 Using principal to keep taxable income low
Furthermore, if Sam and Liz were getting close to the limit where they would start paying taxes in a given year, they could make a smaller Roth IRA conversion and use the principal in their brokerage account (the money they initially put into the account and have already paid taxes on) for their living expenses instead. This is an advantage of having savings in several different places. It gives you more control of your tax rate in retirement.
2 What about state taxes?
Every state has its own tax code, so I will not be going through them exhaustively. You can quickly find the details for your state with an internet search, however.
There are 12 states that do not tax 401k and IRA withdrawals:
- Alaska
- Florida
- Nevada
- New Hampshire
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
- Illinois
- Mississippi
- Pennsylvania
The first 9 states on this list do not tax any form of income.
Taxes should never be the reason that you move. But if you are lucky enough to live in one of these 12 states, or if you want to move there when you retire for other reasons as well, your retirement accounts will go farther there.
Sam and Liz live in Washington state, which has zero income tax of any kind.
This article is a good place to start if you would like to research further for your state and see if it may limit taxes on certain pension or other retirement income.
Summary
Taxes in America favor lower income households, including most retirees. With careful planning, it’s possible to pay little or no taxes on 401k and IRA withdrawals. The zero tax income level can be high enough to live on, particularly for retirees with dependent children.
Each state has its own tax laws, but there are 12 states that do not tax retirement withdrawals.
An example was given of a family who was able to retire early and live on more than $80,000 without paying federal or state taxes.
What does your tax situation look like?
Do you have enough money saved in tax-deferred accounts to take advantage of the lowest tax rates?
Is there a simple adjustment to your plan that could make a big difference on your tax bill?
Contact me directly or on social media via the links on this page if you have questions or comments.
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