Optimizing retirement tax

Optimizing Your Retirement Tax Strategy – Bump Zones 2

Recently I completed my first post on the topic of taxation. This is an area I have previously avoided – faced with over 2,600 pages of the tax code I felt much like Will Durant at the start of his epic The Lessons Of History – “only a fool would try to compress a hundred centuries into a hundred pages of hazardous conclusions. We proceed.”

So I chose to look at a very small section of the code and in part 1 I gave a very natural extension to Michael Kitces’s work on capital gains “Bump Zones”. If you’re not familiar with these then I suggest you start with part 1 or the original Kitces article as a primer and then proceed here.

I was pretty pleased with the first post, but this area gets more interesting…

Bump Zones

Bump Zones are combinations of income and capital gains that produce unexpectedly high marginal income tax rates. Since the taxation of capital gains takes place after income Michael Kitces observed that an additional dollar of income can “crowd out” the lower marginal rates and force capital gains into higher brackets.

For example in the chart below you can see that a taxable income of $60,000 and long term capital gains of $20,000 can result in marginal income tax rates of 27% (married filing jointly). Bear in mind that this is occurs when the marginal income tax rate alone without LTCG is only 12%. So it’s really a significant bump!

Marginal tax rates

Effective Tax Rates

Marginal rates are useful, but they are like derivatives in calculus in that they tell you about the instantaneous change. Sometimes it’s more useful to look at the underlying function. In the case of tax rates this is the effective rate. The effective tax rate is the single equivalent tax rate that would apply to all the taxable income.

Note that I’m working here with taxable income and taking my effective rate as a percentage of the taxable income. You could take an effective rate as a percentage of gross income. I’m not sure what’s more typical. Also I’m only considering Federal taxes – but my blog, my rules…

If you plot out the effective tax rates for taxable income with no long-term capital gains you get the following (married filing jointly).

Tax optimization

The weird kinks at $19,400 and $78,950 occurs where your income is high enough to enter the 12% and 22% marginal income tax brackets respectively. At these points your effective rate accelerates.

In this article – Optimizing Taxes will mean reducing your effective tax rate

We not only have a tax system where the rich pay more, but we have a progressive tax system where the rich pay proportionally more. This means that the above chart of effective rates increases with income. It’s then pretty trivial to reduce, or optimize, your effective tax rate. Simply reduce your income and your effective rate will decrease. Preferably to zero!

So that’s clearly not very helpful. But stick with it, as things will get interesting when we add capital gains…

In the above chart I’ve noted that if you are earning above $78,950 and can reduce your income then you get quite a lot of bang for your buck in terms of optimizing your taxes until you hit the lower marginal rate at which point reducing your income has a bit of a meh impact.

Note that if you have regular paid employment then I completely appreciate that you might have no flexibility to reduce your income, but when taking an income from savings (either pre or post tax) then you might have considerable freedom. In other words pre-retirement you may have little to no flexibility, but post-retirement you can have considerably more flexibility. 

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Optimizing Taxes With Capital Gains

Let’s now look at the effective rates for a couple with $30,000 long term capital gains. I’ve plotted the effective rate below along with the chart we saw above. 

Optimizing taxes

The situation has changed quite considerably. The threshold, or kink, is no longer at $78,950 but has moved lower. This impacts the curvature of the effective rate and so for incomes above $78k optimizing is a bit meh, but the curvature increases below $78k making it more and more valuable to reduce your income if you are interested in tax optimization.

I know what you’re thinking – that’s pretty cool right? But these are two isolated examples, let’s see the whole glorious picture.

I’m ahead of you…

Effective Tax Rates for Income and LTCG

The chart below shows combinations of taxable income up to $130k and LTCG up to $100k. You can see that effective rates range from 0% to 15.1% for these income levels. A 0% effective rate is achievable by using solely capital gains to fill the marginal 0% bracket up to $78,750 for married filing jointly. 

Optimizing retirement taxes
Effective Tax Rates (on taxable income)
You might expect that with capital gains having lower marginal rates than regular income that optimization could be achieved simply by either reducing income or moving from income to capital gains, but the picture is rather more complex than that. For each income level in the chart above I have highlighted and bolded the LTCG that optimizes a given income level. That’s the diagonal strip of cells.

If we look at the bump zone for an income level of $40k we see that the edge of the bump zone is a LTCG of $40k.

Optimizing tax rates

If you keep income constant at $40k and reduce capital gains you move down the highlighted column in the chart above. This moves through the bump zone with a high marginal rate of 27%. In this zone LTCG attracts a 15% marginal rate so reducing it will optimize your effective rate. The optimal point is when you emerge from the bump zone at $40k and LTCG attract a 0% marginal rate.

As you continue to reduce LTCG below $40k you now enter a strange dynamic. You are peeling off LTCG where you are currently paying 0% marginal rate. So reducing your LTCG at this point will not reduce your tax bill. You therefore end up paying the same dollars of tax on a reducing total income. Thus increasing your effective rate.

The following summary should help (watch out for the reversed x-axis!). Here we keep taxable income constant at $40k and play with the level of LTCG to find the minimum effective tax rate. 

Optimizing retirement tax

Optimizing Further

Phew! That was pretty fun, but I think we can dial it up and make it funner – right? Depending on our income and LTCG there are essentially two regions where we optimize differently. In both regions we reduce income to optimize (remember progressive taxes…) but in one region we should increase LTCG and the other region we decrease LTCG. The barrier between the regions is the line of optimal income/LTCG combinations. The following chart shows the effective rates and the two different regions with the applicable method to optimize your tax.
Optimizing tax rates

Bonus!

We’re not quite done yet. There is a neat geometrical way to visualize this (and I bet you were just thinking “this is great, but I just wish there was a neat geometrical way to visualize this…”). The effective tax rates are like heights on a map where equal effective rates are contour lines. You can see this below where I’ve provided a 3D plot.

Optimizing tax rates

The kink running along the surface corresponds to the optimal LTCG for a given income level. In terms of optimizing your tax the goal is to move down the slope – i.e. reduce your effective rate. The kink is bit like a river running down the hill and if you were to pour water on the surface it would first move into the river and then down the hill. The path that water would take down the hill is the path you should take for your optimal tax strategy. Get it?

Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my day job I advise corporate America on investment and retirement strategies. I am a qualified actuary, a registered investment adviser and have a PhD in mathematics and I reserve the right to include the occasional math post.

15 thoughts on “Optimizing Your Retirement Tax Strategy – Bump Zones 2”

  1. Great article once again. The fly in the ointment is you probably won’t be able to control your income very well. If you take SS and you’d be a fool not to, it tends to grow with inflation at least. In my case our SS is 44,800/yr of which 85% is taxable so my taxable income is 38080. I also get an RMD from a small 500K TIRA of 18,328 bringing my taxable up to 56328. Because of inflation and the RMD schedule my income automatically grows. The 78,750 foray into 22% actually occurs at about 103K if you take the married filing jointly standard write off into account. So I have a trough from 56328 up to 103K I can slowly fill and still remain in the 0% cap gain region. If you risk the TIRA using the “tangent portfolio” It’s growth will will be slow steady pretty much recession and SOR resistant. The TIRA SS combo provides 57% of my income with quite predictable growth The variable then becomes capital gains. I can add more income simply by selling some stock up to the top of the bracket with a quite predictable tax. The growth is such that I should stay in the 12% (0% cap gain) for a long time. I can add a little money from a Roth account without screwing up the underlying tax structure.

    1. actuary on FIRE

      It becomes quite a juggling act!
      I completely take on board the flexibility of one’s income. On one extreme you have Go Curry Cracker with a huge amount of flexibility to get a 0% tax bill, to you that has a pretty fixed income stream with little flexibility. I will be in an even more constrained position with social security and various DB pensions.

  2. This is very timely as I have been trying to figure out the optimal amounts to do Roth conversions for the next decade.

    1. I recently completed a series on how to allocate funds pre-retirement in order to control taxes post retirement. It’s called parsing cash flow parts 1-4

  3. Something I’m chewing on as I approach RE: interaction with ACA (“Obamacare”) subsidies. Which then introduces family size as a variable. And then the actuary in me thinks about HSMs (health sharing ministries) and how that’s probably a healthier pool of risks. Decisions decisions.

    1. actuary on FIRE

      Wow you’re the third person recently who has mentioned ACA subsidies. I need to look into this.
      “The Actuary in me”. We all have an actuary inside us fighting to get out!

  4. AOF,

    Is there a way you can share the spreadsheet used to create the bump zone tables or maybe include it the yet to be released advanced FI spreadsheet course on udemy or possibly a third course that takes into consideration tax implications?

    I completed the kickass FI spreadsheet for beginners course this afternoon and am adjusting my own cashflow modeling spreadsheet that i have been using for a few years based on some of the information you presented. My spreadsheet, probably like your own actual spreadsheet, is more complicated.

    The timing and amount of federal income taxes, not to mention state income taxes, can have huge impacts on cashflow modeling. As of right now, I am recreating the LTCG and NIIT calculations in my spreadsheet but I haven’t entered in how the LTCG affects to the ordinary income tax rates. The formulas and inputs you use are probably a lot more efficient than the way I am doing it.

    1. actuary on FIRE

      Chris – email me and I’ll get you a copy. I’m definitely thinking of doing a course on optimizing tax in the spendown phase. That’s *the* issue in FIRE as far as I’m concerned at the moment.

      Thanks for doing the course. I have a mixture of students ranging from excel beginners to folks like you who are fine-tuning their own spreadsheet.

      1. Taxes can be a huge issue once someone has achieved FIRE. My wife and fatFIREd a little more than three years ago. Our current and future income streams are more complicated than living off just the dividends from our passive index ETFs. I sent you an email. TIA.

  5. Great 2-part series, AOF! Was considering expounding on the Kitces bump zones but it looks like someone already did the work 🙂

    An often overlooked mechanic for the early retiree to manage earned income is margin loans. While typically touted as an instrument of tax minimization for the ultra wealthy – CEOs use their equity positions in the businesses they champion as collateral – the principal is transferrable and easy to implement for the average Joe and Jane.

    I have a writeup on it at https://spintwig.com/fire-taxes/ It even has fancy-schmancy waterfall charts. AoF, you can also get in on the chart glamour by using google sheets. That’s how I created the ones in the post. No Kitces staff needed.

    On an unrelated note, have you considered doing a series on data from the Insurance Information Institute? Part of my FIRE budget and strategy includes risk management by either self insuring or purchasing insurance. I’d be very interested in seeing an analysis on the frequency, severity and outliers of liability and physical damage claims for auto and homeowners/renters insurance.

    1. actuary on FIRE

      Thanks for visiting! I shall have to look into margin loans – sounds intriguing.
      I shall also look into self-insuring. It’s been a while since I did insurance exams, so I will have to dust that off!

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