The Bensons sold a whopping $109,000 worth of mutual funds that had doubled. Their cost basis being $54,500 meant a long-term capital gain of $54,500. Still no tax. Why? If you have a taxable income of $74,900 or less in 2015, your long-term capital gains and qualified dividends have a 0% tax rate. If you get lazy or goof up and end up with $75,000 in taxable income, don’t worry, you haven’t fallen off a cliff. You won’t owe 15% on all of your capital gains and qualified dividends, you’ll just owe on the portion that exceeds the limit. If you exceed the limit by $100, you owe $15 in taxes.
In the first 2 examples, we assumed the kids were long gone. Not in college, not dependents. But what it that weren’t the case? What if they were in college, considered dependents, and the Bensons paid $4000 out of pocket towards their education?
The American Opportunity Tax Credit (available to married couples with MAGI under $160,000) will match the first $2000 paid toward tuition with a $2000 tax credit (that’s free money, folks) and provide an additional $500 credit for the next $2000. In this case, the Bensons can take a lot more from the 457(b) or do some Roth conversions from the 401(k), provided it is rolled over to a traditional IRA first.
Rather than increasing the 457(b) withdrawal, they could have maintained it at $18,000 and converted $32,000 of traditional IRA (previously 401(k)) money to a Roth IRA. What is the advantage of doing this? Reducing required mandatory distributions (RMDs) which will be enforced at age 70.5, thereby avoiding future taxable income.
What if the Bensons still had children in junior high when they retired? Say Hello to the child tax credit of $1000 per child. The children must live at home, be under 17 years of age, and taxable income (MAGI) must remain below $110,000 for the married joint filers. Easy enough.
The child tax credit only applies to taxes due, so the Bensons either took more from the 457(b) or did some Roth conversions in December to get their “taxes due” as close to $2000 as possible. Since you most likely will not have the ability to adjust your 457(b) income on an annual basis, it is probably best to use Roth conversions to keep taxable income flexible during early retirement.
Note that in 2 of these examples, the Bensons had spending money exceeding 4% of their nest egg of $3.3 million (= $132,000). It might be OK for them to do so in a year with good market returns, particularly if they are planning on using a variable withdrawal strategy. The point of this exercise is not to show much they can spend each year without depleting their nest egg, it is to show how much money can be made available without paying federal income tax in early retirement.