For us, going back home (to the United States) means enrolling in an ACA health insurance policy and potentially stepping into the clutches of a State tax authority (e.g. California.)
Does this mean we will Never Pay Taxes Again?
Maybe.
Taxes
The United States taxes its citizens on worldwide income, irregardless of where they live, so we have been working with that system throughout our “retirement.” (Quite effectively, I must say.)
With the addition of California State taxes and the effective tax rates of the ACA, we would now be juggling 3 unique tax systems. That seems a tad more difficult than working with just 1, but is the real situation of many early retirees in the US.
I’m a visual thinker so I made some charts of how these 3 tax system overlap.
At the Federal level, there are different tax rates for different income types. Our discretionary income is largely from Long Term Capital Gains, which are tax free below an AGI of ~$100k and 15% above (Blue line in chart.)
Conversely, California taxes all income types equally, with marginal tax rates up to 13.3%. Fortunately, rates only go as high as 8% in our income range of interest (Purple line in chart.)
Federal and California Tax Brackets
Additionally, we have the ACA. I previously explored the financial implications of the ACA in great depth. If any of the following is unclear, please check that background info.
Cliff Notes: As income increases towards 300% FPL, ACA subsidies decrease at a rate of 15%, and then at 9% up to 400% FPL. Smaller subsides mean higher premiums. For Silver Plans Only, CSR (cost sharing reduction) phaseouts result in higher deductibles and co-pays, which will increase costs at time of care. The subsidy cliff (the complete elimination of subsidies) occurs at 400% FPL plus $1, resulting in a massive premium increase ($7,700 in this case.) The cliff gets worse over time, doubling to ~$15,000 for a 60 year old me.
ACA Tax for a Family of 3 (dollar amounts different for other family sizes, but shape the same)
These 3 distinct tax systems overlap as shown in the Marginal Tax Rate chart below, which is simply the sum of the marginal tax rates from Federal, California, and ACA.
Sum of Federal, California, & ACA tax systems. CSR/Subsidy Cliff Impulses not to scale.
How I interpret this chart: For most of the income range from ~$30k to $200k, qualified dividends and long term capital gains will be taxed at more than 15%. The 6-8% tax rate from 83k / 400% FPL to ~100k is lower, yes, but that is small consolation for going over the ACA subsidy cliff ($7,700 cost!)
Going Back to Cali
In a previous post, I ended with the following scenario – We are living large in California, with:
- Taxable income of $40,000/year from dividends & interest
- $70,000/year cost of living ($ sourced tax-free from stock sold at basis, Roth IRA contributions, & seasoned Roth conversions.)
- Free health insurance
- Zero tax burden across Federal and State combined
It sounds nice, but… this position is quite fragile.
With the overhead of the ACA and CA taxes, we would no longer be able to harvest capital gains tax free. Over time our ability to sell stock at full basis would disappear… 10 years of 5% capital growth means 40% of every sale becomes a gain. That’s the way it is with long-term capital gains over the long term. (Tax free Roth IRA conversions would also be a thing of the past.)
And if we really needed a large lump sum, say to buy a Tesla X or a nice boat, then we would most certainly go over the ACA subsidy cliff. There’s nothing like adding an extra $7,700 to every major purchase.
This doesn’t sound good.
Actual Tax Burden
From the idilic case of zero tax burden, each additional dollar of investment income will result in an increased cost of living in the form of taxes and higher insurance premiums.
In the following chart, I look at our effective tax rates and additional tax paid across all 3 tax systems as we increase taxable capital gains above our base income of $40,000.
Some noteworthy data points:
- Effective tax rates for income <400% FPL are never less than 16.9%
- Going off the subsidy cliff is painful (+$7,700 in tax, tax rate jumps to ~33%. Or infinite, depending on how you look at it.)
- Harvesting more capital gains to average subsidy cliff over greater income drops tax rate to 25.5% at ~$100k (when Federal tax will start to apply.)
- Additional capital gains ($100k+) will be taxed at 23%+.
Harvesting Massive Capital Gains
In any typical year where we wanted more capital gains without going over the ACA subsidy cliff, we would be paying a minimum of 17% in tax.
In any year where we fell off the subsidy cliff, we would be paying tax rates of 23%+ at best.
There is simply no way around this for a California resident.
But maybe we can minimize the damage… what if we harvested massive amounts of capital gains before returning to the US? (Or for that matter, before entering any residential tax system country which taxes worldwide income.)
Over the past 5 years we have harvested over $147,000 in capital gains, completely tax free. From this already stepped up basis, we could harvest an additional $200k-$400k of capital gains over the next 2 years (enough to keep us below the NIIT (net investment income tax) of 3.8%.) This would mean $500k-$1KK of stock at basis.
This would all be taxed at 15%. Is paying 15% tax today better than paying 17-23% tax later?
The downside is we lose any interim (potential) gain or dividend income on the tax paid.
The upside is the fragile scenario of $40k annual income with no tax burden and free health insurance becomes much more robust (for at least another 5-10 years? Time erodes all things.)
The risk is the ACA tax system is replaced by a system with no income dependency (as in the latest Repeal & Replace efforts – unlikely for next 4-6 years.)
Summary
Moving back to the US/California has major tax implications, putting us firmly into the crosshairs of 3 tax systems: Federal, State, and ACA.
In any year where we needed/wanted to tap into capital gains we would pay a tax rate of 17%+. In years where we wanted to tap deeply into gains, we would pay 23%+ largely due to the ACA subsidy cliff. This gets worse over time as insurance premiums increase with age (doubling as I reach age 60.)
But in most years our total income would be less than 400% FPL, in which case the highest amount we would pay for tax and health insurance would be <$6,000/year (<$500/month.) (Roughly $2k to California and $3-4k in health insurance premiums.) Additionally, we could have ~$2,000 in annual expenses in “medium usage” health care expenses, based on estimates by Covered CA. This could be much higher in years with expensive health issues (an accident or a major illness.)
While the marginal rates are somewhat high, the effective tax rate is fairly reasonable at less than 10% ($6k / $80k.) Plus we get health insurance with that.
To minimize the potential for going over the ACA subsidy cliff, I could choose to pay 15% tax today by harvesting Massive Amounts of Capital Gains. This would result in significant tax payments but result in lower future tax burden and significantly greater flexibility. This assumes a lower overall marginal rate ends up being the better deal.
The income at which your long term capital gain rate changes differs from:
https://www.investopedia.com/articles/personal-finance/101515/comparing-longterm-vs-shortterm-capital-gain-tax-rates.asp
Aus: Half (50% discount) of capital gain added to taxable income and taxed at entity’s tax rates.
Add the $24k standard deduction
Aus:
Capital gain for couple $USA 100,000 = $A 139,000
50% discount = $A 139,000 * 50% / 2 = $A 34,750 taxable income each individual.
Income tax: 2 * $A 2,562.28 = $A 5,124.56
Good hospital insurance couple: $A 3,400.00
Total tax + insurance: $A 8,524.56 = $USA 6,137.68
Net: $A 139,000 – $A 8,524.58 = $A 130,475.44 = $USA 93,942.32
$USA 80,000 gain = $A 111,111; Total tax + ins = $A 5,938.44 = $USA 4,275.68
$USA 200,000 gain = $A 277,778; Total tax + ins = $A 31,723.17 = $USA 22,840.68
Interesting comparison, thanks!
What is / is not a tax: USA Self-Employment Contributions Act (SECA) / Aus Superannuation Guarantee both contribute a portion / (100% – 15% tax) to an individual’s retirement fund. Above Aus numbers do not include ‘super’ contributions as there is no employer self or otherwise and thus no mandatory requirement.
USA, Exempt Income: ‘The Social Security tax only applies to your earned income, such as wages, bonuses and self-employment income. All of your unearned income, like capital gains, interest and dividends, are exempt from the Social Security tax, regardless of how much income you have.’
https://finance.zacks.com/much-social-security-tax-pay-2748.html
Presumably then your calculations do not include Social Security or FICA charges. The Aus numbers include 2% of taxable income MediCare levy but not Superannuation Guarantee (~USA SS).
Correct. No social security taxes.
That’s a difficult question. Partly it’s about trying to predict what might happen to tax rates in the future… a completely impossible task. Nobody knows how taxes might change in the future. That 17% today could become 25% or 16% for all we know.
Although you mentioned missing out on dividends, etc if you took those gains, wouldn’t you reinvest that spare cash at a higher basis?
Gotta pay tax on a massive harvest. That 15% is gone.
Yes, of course. I’m asking what your plans would be for *the remaining* cash in the interim. Presumably you wouldn’t spend it all right away.
“This would mean $500k-$1KK of stock at basis.”
The goal is to raise basis, not alter our asset allocation. So it just goes back into the portfolio.
Guess it begs the question – why in God’s name would you go to a state like CA when there are so many fiscally responsible states to move to?
It meets our quality of life criteria.
There is more to life than money :)
I agree. I’m not completely opposed to taxes as long as public services are up to par. Here in Oklahoma there isn’t much of a tax burden but the public services like schools, police, and fire are severely lacking. Don’t look at it as a tax, look at it as a “manditory donation” to your community. Haha! California is a nice place to live.
This X10. Not retired but self employed. Moved from TX – CO years ago and wouldnt move back under most circumstances. Would consider a move to CA tho. Taxes take many forms; I look at lower quality of life as a tax that everyone has to pay. “Spends less money != Fiscally responsible”; TX skimps on many services at the state level, which just pushes those services and the attendant taxes down to the local level.
Yes, please explain why in the world you’re going to CA when there are so many nice income-tax free states out there like TX, FL, etc…?
Because California is awesome and those other places aren’t? (ymmv)
(Those States have ACA also)
CA’s revenue comes from income tax. While there are property taxes, the tax rate as a percentage of asset value is lower than many other states. Because of something called Prop 13, the effective tax rate on property is not only more or less fixed at a specific dollar amount at time of purchase, but as a percentage of property value it decreases dramatically over time (we have a rental that pays 0.37%/year in property taxes).
Often, states with lower or no income tax collect much of their revenue from property taxes. It is not uncommon to see property taxes at 2-2.5% of asset value. Every state collects money somehow, some just collect it in different ways than others.
Yes, that’s true, but 1% of 1 million is still bigger than 2.5% of 350k, not even factoring in the differences in income taxes on top of that.
Dave, we were always told that same nonsense when we lived in NY. But then we moved to a state with no income tax and very low property taxes, and realized it was all a lie propagated by fiscally irresponsible politicians. So we were able to retire early by our move, and save boatloads of $ every year that goes by.
My wife and I thought the same thing until we really dug into public service quality. Here in Oklahoma the public services stink. Schools, police, fire all severely underfunded. Terrible roads and overall infrastructure. Id move back to up state NY anyday to get my public services back. While those taxes were higher, our schools had actual desks, sports programs other than football, and nice learning tech. I’d rather pay a bit of taxes and get a good service anyday. I know politicians are crooked but not all of our tax money is lining dirty pockets. It’s a tough call though, I hear ya. No one wants to pay taxes.
Chuck – I’m not saying that you individually won’t save money if there isn’t tax revenue of any kind in your state. I’m saying, agreeing with Jeff, that if you want infrastructure, education, and services in your state then the state needs to collect revenue.
As citizens we need to find an acceptable trade-off between what we get and how much we pay for it. Some programs are not wise, but not wise is not the same as corrupt or lies or abuse. I agree that some money is wasted by politicians, but waste/fraud/abuse is much less than many claim for political purposes. All that said, I’m also not opposed to minimizing taxes as an individual. I think we should each pay the minimum of what we owe, but when we owe it, we should pay it.
Dave, we are in agreement on paying taxes that are required. But I still have to call out those who feel NY, as an example, is superior to a state like TN where our taxes are now substantially less, because of the perception that NY and other states like it have better infrastructure, education and services than those who have much lower taxes. Everyone who comes down to visit us here in TN from NY marvels at the quality of the road systems here, versus the pothole-infested roads and interstates in NY. We have quality universities such as Vanderbilt and UT that can compete with anyone, and our high schools and lower grades are earning higher and higher marks every year on the national level. Even in a small town like ours the medical care is exceptional, while if anything really serious comes up Nashville has become one of the best centers in the country for medicine, along with superior hospitals in Knoxville and Chattanooga.
I stand by my comments since I have lived for long periods of time in NY and now in the South, versus those who follow standard arguments used by high tax states spokespeople. The North and West have nothing over the South except for high taxes. These taxes are due to profligate politicians in those states, welfare systems that are out of control, rampant illegal immigration straining all services, and waste and abuse. Those insolvent states need to take a serious look at how states like TN can run a surplus every year and still be places people actually want to move to.
Chuck. Fair enough. I have no experience with NY or TN, but I do in the Southwest and currently live in CA which was the state being discussed. The only caveat I’d put on what you’ve said is that some states receive much more in federal aid than they pay in federal taxes. These states are subsidized by the higher tax states to make up the shortfall between what they need to maintain their services and the taxes they collect. It is not unusual for low tax states to be low tax in part because of they are dependent on this federal welfare. Many of those same states like to talk of the out of control spending, illegal immigration, welfare, waste, fraud, and abuse, etc of the higher tax states while being completely dependent on welfare themselves. The worst offender is South Carolina who receives $7.87 in federal spending for every $1 they pay in federal tax. Part (but only part) of why taxes are higher in states like NY is because they are effectively subsiding other states who can’t or won’t pay their own bills.
https://www.theatlantic.com/business/archive/2014/05/which-states-are-givers-and-which-are-takers/361668/
Dave, while there is some truth to what you say about states receiving more than they pay in federal taxes, “some” is the operative word. When blue states accuse the South of this, they are looking at total Federal outlays and somehow thinking that is a largesse that is being paid for by states like CA where you reside. In reality the South has an outsized share of military bases which are very large in costs, resulting in large Federal outlays. Also the South is huge with retirees, hence an outsized amount of Social Security and Medicare monies flowing to these states. Since entitlement programs and the military consume the absolute largest amount of Federal revenues, why wouldn’t the South receive more than the North and West in aggregate?
Chuck, not sure about the military bases claim. Doesn’t seem to match this: http://www.militarybases.us/by-state/
Might be more of an urban myth than fact. For example, CA has far and away more military bases than any other state, so by your reasoning CA should be getting the most money from the federal government and would be incorrectly classified on the “federal welfare” chart as getting an inordinate amount of federal funds vs what is paid in taxes. This is not the case.
You are completely correct on the retirees and Social Security/Medicare. Based only on stereotypes of New Yorkers moving to Florida to retire (thank you Seinfeld!), I’d definitely concede that many people move to warmer climates as they get older. I’m not completely confident on the tax aspects of this, but 30 seconds of generic searching (https://www.forbes.com/sites/davidrae/2018/04/03/social-security-medicare-changes-2018/#3960e756640b) seems to say the following: Social security is federally taxable once you reach a minimum threshold, so if the retiree has retirement account income, pension, etc they would be paying federal taxes on income. They wouldn’t be paying state income on the SS income, but they would on the other income. Same with Medicare benefits (or maybe the premium just goes up?). So even if federal funds flow into the South for this, if those citizens had other sources of income they would have to pay federal income tax. If my flimsy understanding of all of that works, then it is a bit of a moot point just dismissing the money flow as going to retirees so it shouldn’t be counted. Especially given this money is then spent in the state, so any sales tax from direct purchases would stay local as well as pushing money into the economy that would otherwise not be there and therefore subject to state income tax, etc indirectly as it is paid out in wages later on, etc. I’m sure that if Florida felt like the retirees were an expense and damaging to the state’s income/budget, they would not be so welcoming to retirees. To some extent this is a side discussion, if those states still require federal funds to make their budgets work, then they are still on federal welfare.
As to your final point/question, I would submit that the same article pointed out the large percentage of the population in the South (and a few other places, so not an absolute by any stretch) on federally funded food stamps. The justifications for the money flowing southward can’t all be about retirees and the military when so many are below the poverty line and therefore have no money to pay taxes to state or federal, although there are some who fit the former categories and also require food stamps.
I’m guessing we’re at an impasse, so I’ll step away and leave you with the last word. I’ve enjoyed our back and forth. Have a Happy Thanksgiving!
Same here, Dave. A very Happy Thanksgiving to you and yours as well, my friend.
Federal tax revenue by state
https://en.m.wikipedia.org/wiki/Federal_tax_revenue_by_state
Lowly Minnesota with a million less people than Tennessee sends far more tax dollars to DC.
I think an additional factor that weighs in on your question is the likelihood of the move (quantified as a percent chance of actually swallowing the Californian anchor). Then from there you should be able to plug it into a future-value equation and get a reasonable sense of the answer to your question, given that your assumptions hold.
Indeed, very much so.
Great analysis and love the charts.
Makes me glad I’m old and past having to worry about the ACA. :)
My guess is that tax rates will be stable for a while. Pols are not going to want to raise them, but the appetite for more decreases has dried up.
Health care is the real wild card in the next decade or so.
How are those RMDs treating you?
I like the charts, very nice. This is a tough question. Pay now or pay later. I’d probably pay some now and some later. Life is uncertain. You might move to CA and then leave the country for a few years later. Who knows?
Yeah, balance is good. How much is enough to harvest now vs later… TBD.
We are California residents and have been retired 8 years and using the ACA since 2014. My husband is now 62 and I’m 59. I’ve found that you can read and read the “technical” lines on the tax chart for the ACA, but the reality is different. First, the rates are based on the “Second Lowest Cost Silver Plan”. We almost always choose something cheaper, often Bronze, but we look at it every year. I have played around with the Covered CA website and it doesn’t appear to be as straight-forward as the law and tax lines read. There is a lot of variation in zip codes and ages.
At our age, the subsidy can be as high as $20,000, so the cliff is more serious. We sure would like to do Roth Conversions, but it does not make sense because we are open to moving when we hit 70.5. It is a tough call as we have a ton of net worth in IRAs and are frugal now, but will be quite high income later.
Why wait until age 70.5 to move?
The individual mandate repeal changes things in a couple ways.
One – ACA will get more expensive.
Two – If you decide to take a year where you draw heavily to buy a Tesla or whatever, you can opt out of ACA and go a year without healthcare (aside from the insurance you have from established wealth).
ACA gets more expensive, but below 400% FPL this just means subsidies get larger.
Health insurance is mostly wealth insurance. It prevents the $1 million bill from derailing everything. I wouldn’t view established wealth as a shield against the US health system.
What about relocating? Many countries let you access their national healthcare systems once you establish residency. I know you’re going the other way but it’s something I’ve been thinking on lately.
What software are you using to create your charts?
Excel
Brilliant, as usual.
I realize that you are renters for life, and that this may be less appealing with the SALT deduction limits, but as owners you could have a lower income for the same QOL, making ACA subsidies etc easier.
Curious as to your thoughts….
Yeah, imputed rent means we would need to source less cash. I figured we would spend $12k less per year if we paid cash for a house.
I’d rather pay 17% on the $12k than get lower long term growth on $750k.
I’m confused by the two seemingly contradicting statements:
1) Effective tax rates for income <400% FPL are never less than 16.9%
2) While the marginal rates are somewhat high, the effective tax rate is fairly reasonable at less than 10% ($6k / $80k.)
The former is the marginal rate. It is better to pay 15% than 17%.
The latter is the effective rate.
Both sentence are talking about effective tax rates. I’m trying to understand it, not saying you did something wrong.
1) Effective tax rates for income <400% FPL are never less than 16.9%.
2) the effective tax rate is fairly reasonable at less than 10% ($6k / $80k.)
If the effective tax rate is never less than 16.9%, then how come it is less than 10% at 80k (which is below 400% FPL)?
Probably poor phrasing on my part.
From a base of $40k, rates are 16.9%+.
But to make myself feel better, the rate on total income of $80k is <10%.
So moral of the story is stay below 80k. Roth conversion is a little tougher, even in a low cost state. Are there significant advantages that could keep income lower for someone that owns a business? Like a travel blog, travel consultant(if you plan on traveling a lot) or even a booth at a flea market(if you just want to buy some cheap junk while traveling)? While not trying too hard to make money. I know after 5 years you have to show a profit. Home office, milage, travel costs, meals, etc wouldn’t count toward income?(is that MAGI?)
Below $80k for a family of 3 (400% FPL) is key.
Business profit/loss shows up in MAGI, so losses could reduce total income.
I liked the idea of San Miguel de Allande in Mexico, but you must have a pretty big reason for wanting to move back to CA despite it negatively affecting your income stream. Perhaps it has to do with having kids and extended families in CA.. NOMB but good luck!
Mostly we just talked about the idea of California so I crunched the numbers. It’s pretty interesting, and really not that expensive.
The kid part for sure changes things. We more or less expected to slow down as school age approached, we just weren’t sure where.
Not that expensive, what part of Cali? Looks like main concern is the costly health insurance and tax rate.. Did you consider Portland as many in Cali love that area, probably mostly those in the northern half as a similar climate?
Expensive is relative. I shared a budget here.
I’ve looked at Portland before mostly as a comparison to our home in Seattle.
Income taxes in OR are 2.5x that of CA for our income target ($700/month vs $250/month.) With the ACA, below 400% FPL we would pay exactly the same amount for health insurance in every State (chart from earlier years for CA vs WA vs OR ACA subsidies.) Avg rent for a 2 bedroom in Portland is 12% higher than Sacramento. Umbrella budget is substantially higher. Conclusion: OR is more expensive than CA.
Sunscreen budget might cancel out the umbrella budget, but yes, Oregon is crazy expensive for anyone who works or has money. All their mad taxes go to bailing out folks in the poorer, more rural areas, and now Portland is so popular that the COL has far outpaced more moderate areas in CA, so it’s a lose- lose financially, although Sac can’t match the walkability and transit options of Portland.
Back when Portland was cheap it was a different story and people fled CA to FIRE in Oregon. I think now the migration will reverse.
Moved from Cali last year and getting ready to be financially independent this January. I looked at all the rental prices in areas with good public schools somewhat near the ocean in Central Coast and was unable to find anything lower than $3,000/month. If they were lower than that they were on a major road, next door to an E.R. or other quality of life affecting factor.
Totally depends on what your return expectations are, and when you expect to harvest.
23% less 15%, or 17% less 15% is a 2%-8% difference between now and later. That’s the hurdle rate, applied to every year between the 15% “now” and 17-23% “later”. If you think you can beat that hurdle rate, then you pay later. If you can’t, then pay now.
What about dividend growth? 40k will grow every year.
Dividends will increase over time, but so will the FPL.
Great article, thanks for doing the math. I left California a couple of years ago for a variety of reasons, but I can see coming back at some point.
My specific situation is kind of different though. I wasn’t diligent in putting money away into tax-advantaged accounts, but I did have a windfall recently, which means that my IRA is only 7% of the total liquid assets. I’m currently thinking of just putting the majority of assets into VTI/VXUS and some bonds, and next year when I can be sure of being in the lower income bracket start the IRA->Roth IRA conversion, while living on dividends/interest and sales of a bit of stock. Obviously, I’ll have to wait to do any capital gains harvesting until a year or more from now.
Any particular advice in this situation?
Seems like a reasonable approach. Enjoy!