In this video, I'll show you how a couple who is making $125,000 in income before retiring and paying over $20,000 in taxes can generate the same level of income in retirement, but owe $0 in taxes. And they're going to do this without drawing any money from a Roth IRA.

While we're going to look at a specific situation to show how this can be done, the real goal is tax-efficiency in retirement. And so the principles we'll discuss can apply broadly.

3 Retirement Tax Buckets

First, let's talk about the three main tax buckets you'll deal with in retirement.

First, you have your pre-tax accounts. These include your 401(k) and traditional IRAs and withdrawals from these accounts are taxed as ordinary income.

Second, you have your tax-free accounts. This bucket is going to include Roth IRAs, Roth 401(k)s, as well as HSAs if they're used for qualified medical expenses. Withdrawals from these accounts are completely tax-free.

And last, we have taxable investment accounts. These are your regular brokerage accounts. The growth in these accounts is subject to capital gains taxes, and dividends and interest are also taxed in the year they're paid.

Taxes Before Retirement

To show you how to be incredibly tax-efficient with your portfolio in retirement, we're going to look at a couple, Ross and Rachel, who are both age 65.

They make $125,000 per year at their jobs, and they're wanting to retire and maintain the same level of spending they're at currently.

When we put their $125,000 of income into our tax planning software, and we pull up the tax report, we can see that their federal income tax liability is roughly $10,700.

This is income tax only, but because their $125,000 of income currently comes from their jobs, they'll also owe Social Security and Medicare taxes, which are 7.65% of their income. So $125,000 times 7.65% is roughly $9,500.

Add that to their federal income tax, and we get to a total federal tax bill of over $20,000.

They haven't started social security yet, and they have an investment portfolio consisting of a $1 million traditional IRA and $700,000 in a taxable brokerage account. Of that $700,000, $350,000 is their cost basis, and the other $350,000 is a long-term capital gain from the growth on their investments.

Using Tax Brackets For Tax-Efficiency

To understand how Ross and Rachel can generate $125,000 per year in income and pay $0 in taxes, we need to look at tax brackets and use them to our advantage.

So here is our married filing jointly ordinary income tax brackets. $0 to $23,220 is taxed at 10%, which would seemingly throw a wrench in our plans to pay no taxes.

But this is taxable income, and you get to taxable income by taking adjusted gross income minus either the standard deduction or itemized deductions if they're higher.

Well, our standard deduction in 2024 is $29,200. Plus, if you're married and 65 or older, each person gets an additional $1,550 deduction, bringing the total deduction to $32,300.

That means that the first $32,300 of adjusted gross income for Ross and Rachel is going to be tax-free because it'll be wiped away by the standard deduction.

Next, we'll look at the long-term capital gains tax brackets. And we can see that while taxable income is under $94,050, long-term capital gains aren't taxed. There's a 0% bracket.

It's important to emphasize this is for long-term capital gains, which are gains on investments you've held for at least a year. Short-term capital gains are taxed as ordinary income and would be applied to the ordinary income tax brackets we looked at before.

How To Pay $0 Taxes In Retirement

How could we put these pieces together to generate $125,000 of tax-free income for Ross and Rachel?

Well, they could take $32,300 out of their IRA, and that gets wiped away by the standard deduction. Then they could sell $92,700 of investments in their taxable account and withdraw that.

That brings them to $125,000 of income they can use for living expenses. But remember, we said that in the taxable account, 50% of it was cost basis and 50% of it was long-term capital gains.

That means of the $92,700 they pulled out, only half of it, or $46,350, would go on their tax return as a long-term capital gain. The other half is a return of their cost basis so it's not counted as income on their tax return.

This raises some really cool opportunities to make this tax efficient retirement income even better. And we're going to go over those, but first let's put this information into our tax planning software.

So I created a scenario here for when Ross and Rachel are retired, and I added $32,300 of IRA distributions and $46,350 of long-term capital gains. And going back to our tax report, we can see that it's generating a federal income tax liability of $0.

Adding Roth Conversions

Okay, but instead of withdrawing money from their IRA to help fund their living expenses, Ross and Rachel could instead do a Roth conversion of the same amount.

Now this conversion would be taxable income on their tax return, but it gets reduced to $0 by the standard deduction, just like a withdrawal would. And now the future growth on that $32,300 will all be tax-free because it's in a Roth IRA.

They can do this because they have plenty of funds in the taxable account in order to fund their living expenses.

So I changed the $32,300 IRA distribution to a $32,300 Roth conversion. And now we need to sell $125,000 of investments in order to fund their $125,000 income. Of that $125,000, $62,500 is long-term capital gains, and $62,500 is a return of their principal or cost basis. So I added that $62,500 here as well, and we can go back to our tax report and we can see that their tax owed is still $0.

That's because their capital gains fall in that 0% long-term capital gains tax bracket. Now you'll also notice that they have $31,550 of room left in that bracket.

Tax Gain Harvesting

Well, they don't need the income, but we sure would like to use that space to realize their capital gains tax-free.

So what we can do is sell another $63,100 of investments, which would generate another $31,550 of tax-free capital gains. Then we could buy those investments right back.

By selling and immediately repurchasing these investments, they realize the gains at 0% and reset their cost basis higher to the new purchase price.

We look again at their tax report and they had a Roth conversion of $32,300 and they realized $94,050 of long-term capital gains. And they did that all without owing a dime of federal income taxes.

The Impact of Social Security

Once Ross and Rachel start taking Social Security, the tax equation changes.

Whether Social Security benefits are taxed and to what extent depends on a household's total income. This adds another variable and will make planning more important.

Let's go back to our example. We'll assume Ross starts taking Social Security of $1,800 per month, which is $21,600 per year. After adding that Social Security income we can see on the tax report that they owe taxes now.

Now you may think we just need to reduce their Roth conversion by $21,600 and then they'd be fine. And that would take their tax back down to $0.

But they could actually get a little bit extra in there because their Social Security isn't fully taxable. I'm going to take the Roth conversion out and we can go into this tool and it's going to tell us how much additional income they can have before they would start owing taxes.

We can see here before taxes would kick in, it's around $13,000. We could add an additional $13,000 Roth conversion and then go back up to their tax report and see that their tax is back to $0.

Other Factors To Consider

While our example demonstrates a strategy to pay $0 taxes, in some cases it might be more beneficial to pay a small amount of tax in order to enable larger Roth conversions.

That's going to depend on a retiree's current tax rate versus their projected future tax rate, among many other factors.

Also, I should mention that I'm ignoring state taxes in our example. State taxes are going to vary widely among the states, but that's something you'll want to consider in your analysis as well.

I'm also ignoring dividends and interest paid on that taxable account, but those are going to go on the tax return as well. So you need to account for that.

As I demonstrated here, it is possible to generate a lot of income completely tax-free in retirement. By using a combination of Roth conversions and capital gains harvesting, you can create a very tax-efficient retirement plan.

With retirement income, you have a lot of control over your tax situation, which is why planning is so important. If you need help creating a tax efficient retirement plan like we looked at today, reach out to us and we can help. Schedule a free consultation using the link below.