Hello everyone! Ready to learn how you’ll never pay taxes again? Last week I went into detail on tax-efficient investments to help us identify where and what type of taxes are hiding in our investment portfolios. For Lucy and I, it amounts to an estimated $100,000 in taxes hiding in our retirement accounts right now (only to grow to more by the time we retire). Since we now have a sense of our underlying tax liabilities, we can go about determining how to avoid paying those taxes by taking advantage of nuances in the tax code.
What nuances you ask? Well the key tax codes to take advantage of for early retirees are tax-free retirement account conversions / rollovers (from 401k to IRAs), withdrawals of contributions (not the earnings, just the initial contribution amounts) to Roth IRAs which can be done tax-free and penalty-free, and the 0% capital gains tax on investments when we’re in the 15% income tax bracket and lower. These are all rules in the tax code today and if used correctly it can allow all of us as early retirees to never pay taxes again!
Where there is a will, there is a way! It’s there for you, it is there for all of us, now we just need to find ways to execute and take advantage. Below I will be walking through my personal scenario as an example and hopefully you will be able to adapt it to your individual situation.
So, what are we waiting for, let’s dig in!
The Key Account for Early Retirees
Last week I outlined how the Roth IRA is gold. Tax has already been paid on the contributions and they grow tax free forever! Contributions can be pulled out at anytime tax- and penalty-free, no need to wait until you are 59 1/2! There are other great benefits to the Roth IRA as well such as there being no mandatory withdrawals (which there are for Traditional IRAs at age 70 1/2) and Roth IRAs are well suited to pass onto heirs as they will never have to pay taxes on withdrawals either. Awesome, huh!?
So given how ideal the Roth IRA is for early retirees, the focus of my early retirement is getting as much of my money into the Roth IRA tax efficiently. This will be the epicenter of my successful early retirement!
And while the Roth IRA is the epicenter of my early retirement plan, my retirement strategy as a whole revolves around three key “loopholes” in the tax code: 1) conversions, 2) tax- and penalty-free withdrawals of contributions to Roth IRAs, and 3) 0% capital gains tax when in the 15% income tax bracket or lower. So let’s dive into each!
Upon retirement you can elect to convert the investments held in employer sponsored retirement accounts like a 401k into an IRA. If you have a Roth 401(k), than you can roll that over directly into a Roth IRA (with no tax consequences). If you have a Traditional 401(k) you can choose to roll that into a Traditional IRA (no income tax at the time of conversion, but it will still be a “tax” event upon ultimate withdrawal), or convert the Traditional 401(k) into a Roth IRA (a “tax” event at time of conversion, but will not require any further taxes upon withdrawal from the Roth IRA).
Since my wife and I have some investments in both Traditional 401ks and Roth 401ks, upon retirement we will roll them over into their respective IRA account and therefore incur no immediate tax consequences on either conversion. The majority of our funds are in Traditional 401(k)s though, so those assets will be key in how we eventually roll them from the Traditional IRA into a Roth IRA. That conversion would be a taxable event. Those funds hadn’t been taxed ever before, so they would be subject to full income tax upon conversion.
Granted, in retirement we won’t really have any other taxable income. So the income from a Traditional IRA to Roth IRA conversion will basically be it. The point will be to only roll so much so that we stay within the 15% tax bracket so capital gains are still 0%. For a married couple filing jointly like ourselves, that upper limit of taxable income is $75,900 in 2017.
But the other key to remember is even in retirement we’ll have our normal standard deduction, exemptions and credits thereby lowering our taxable income. The standard deduction for 2017 is $12,700 for married filing jointly and since we are now a family of four we have $16,200 in personal exemptions to claim ($4,050 per individual). Why is this key to remember? Because if you are like us and have other funds to live on for the initial years of early retirement (our taxable brokerage account in particular), then you can rollover funds from your Traditional IRA to Roth IRA slower and drag it out over many years since income up to $28,900 is all tax free (the combo of deduction and exemptions).
My plan…rolling over solely $28,900 tax free every year. And that’s a big idea! I can probably even rollover more in any given year with other credits available to me such as the Child Tax Credit. That is how I can and will get money from my Traditional 401k with taxes still payable as I outlined last week to my Traditional IRA and from there to my Roth IRA without paying any tax at all!
This is probably where I should explain a couple key details that make this work. First, when doing a Traditional IRA to Roth IRA conversion, there is what’s known as the 5-Year Rule which states that those conversion amounts cannot be withdrawn from the Roth IRA tax- and penalty-free for five years. Not a huge deal, but that means you will need alternative resources to live on in those years (which we have via our taxable brokerage account).
Secondly, the entire amount of the conversion can then be withdrawn at anytime, even the portion that would be considered “earnings”. No need to wait until age 59 1/2. Why? Because at the time of conversion, that is a taxable event making the entire amount considered “after tax” contributions to the Roth IRA, just like your normal after tax contributions to the Roth IRA (even though we won’t actual pay tax because we’ll rollover amounts within our deductions and exemptions). Then, “after tax” the conversion will look and feel just like you’re normal contributions to Roth IRA accounts. Albeit, you have to wait for five years per the rule above.
The Roth 401k conversion to a Roth IRA is much more simple and easy. Since the Roth 401k is already after-tax investments, a conversion to a Roth IRA is basically a non-event. Those funds are then perfectly in the mix of the epicenter of early retirement…the Roth IRA! No additional tax is due at conversion or withdrawal!
2. Tax- and Penalty-Free Withdrawals from Roth IRAs
The next big piece of the early retirement tax strategy is the aforementioned tax- and penalty-free withdrawals from Roth IRAs. Withdrawing the regular contributions to a Roth IRA is allowed tax- and penalty-free at any time and any age. The reason is because those contributions have already been taxed. However after you withdraw all of your contributed amount, the remaining portion which is considered the earnings in your account will be subject to tax.
This is not the case for Traditional IRAs. Contributions to Traditional IRAs are done before tax and therefore cannot be withdrawn tax-free.
So in my case, by the time Lucy and I retire in 5 or so years, we will have contributed the max to our Roth IRA for about 15 years each, or 30 years worth of contributions combined. While the max contribution over time has changed, this will amount to over $150,000 in contributions that we could tap at any time without tax or penalties.
We of course wouldn’t want to as this is the epicenter of our retirement, but it is there if needed such as while we’re waiting out the 5-year rule on our conversions. More on that in a bit.
3. 0% Capital Gains Tax
Lastly, we have the federal capital gains tax which is set at 0% so long as we are inside of the 15% income tax bracket ($75,900 in 2017). So long as our taxable income (which in retirement will be the amount we convert from our Traditional IRA to our Roth IRA and dividends from our taxable account if over and above our deductions and exemptions) is below that threshold, we can and will take advantage of the 0% long term capital gains tax by selling our highly appreciated assets in our taxable brokerage account.
When we are in this tax bracket, we can start selling our investments simply to reset the basis and wipe-out our previously identified hidden tax. Once we sell those investments (our low cost index funds), we can then immediately turnaround and buy back the same funds the next day in order to keep them growing into the future.
You may say we have to wait to re-buy or worry about a “wash sale”, but those are rules put in place regarding tax lost harvesting. In this case, we’d actually be creating income that is taxable (although we won’t actually pay tax because of the 0% capital gains tax rate…but that part is irrelevant) so the government doesn’t care if we buy back the same or “substantially equivalent” investments. Said differently, a wash sale is only a concern of the government when we’re trying to avoid tax by tax loss harvesting.
Now that we went over each of the three main tax rules individually that Lucy and I will be taking advantage of in early retirement, let me explain the playbook.
Step 1: Enter early retirement and rollover Roth and Traditional 401ks to their respective Roth and Traditional IRAs (no tax event). Our 401(k)s total around $500,000 today.
Step 2: Begin slowly rolling over Traditional IRA assets into the Roth IRA (tax event, but not taxable as long as only so much is rolled over to stay within my tax deduction and exemptions). This conversion will total around $28,900 per year (or more if we have other tax deductions or credits available to us).
Rolling this over slowly means I will need more assets in my taxable brokerage account to live on. Not only will I have to wait 5-years before I can withdraw them, but one year of conversion won’t equate to one year worth of spending. The benefit of rolling them slowly is that I can milk more and more tax savings (ideally pay no tax at all!) though.
I have about $275,000 in taxable investments today and that will continue to grow. Hopefully it will double by the time we retire and cover 10+ years worth of expenses.
Step 3: As I’m rolling over assets in Step 2, I will be living on my taxable brokerage account. I will begin selling the assets that have high embedded capital gains. Since I’ll be within the 15% income tax bracket though, no federal capital gains tax will actually be charged. I will begin the process of wiping out these tax liabilities. With a portion of the sold funds I will live on the proceeds, the other amount I will sell and then turnaround and reinvest to reset the funds tax basis.
Once I have successfully rolled over all my Traditional IRA assets in Step 2 (which will take more than a decade), I will have also reset my tax basis in my taxable brokerage account and eventually used up those assets to cover my living expenses. At that time the only assets I will have left is the Roth IRA.
Step 4: At this stage I will probably be age 45-50. With only my Roth IRA at this point (and perhaps some assets still in my Traditional IRA still being rolled over) I will begin to withdraw my original contributions tax- and penalty-free. And remember, this would be the original $150,000 of contributions to the Roth IRA that my wife and I will have contributed prior to retirement as well as the entire amount of the rolled Traditional IRA conversions. So the vast majority of the Roth IRA will be available to withdraw and sufficient to cover our living expenses until age 59 1/2 at which point we could access the “earnings” portion tax- and penalty-free.
As a wrap to all these heavy concepts, let me sum up my plan. As you know from last week’s post on tax-efficient investments, I have a decent chunk of money in my taxable investment account and that will continue to grow at a decent pace until retirement. I will be living on those funds, and the value of my small business if I choose to liquidate to my brothers, during the initial years in retirement which will give me time to execute on the rollovers and let the 5-Year Rule take effect.
Since our annual living expenses will be in the range of $50,000 to $70,000 I will need plenty of years worth held in taxable accounts and initial Roth IRA contributions (which can be accessed already tax- and penalty-free) since the rollovers to Roth IRAs to the tune of $28,900 will be coming slower than funds flowing out. So I will need to wait well past the 5-Year Rule to sustainable access those funds, more like 10 years or so.
Also, at the same time I will be taking advantage of being in the 15% tax bracket by triggering my capital gains which would be tax free at that bracket.
There is a lot to take in here, but these tax strategies are available to us all. Although only early retirees can fully take advantage of them to never pay taxes again! As a disclosure, I am not a tax professional. So when trying to adapt this strategies to your situation, be sure to use the help of a certified tax professional.
If you are looking for more great case studies to model your early retirement tax strategies on, be sure to follow the ChooseFI podcast. It is a new podcast that just started in 2017 and is a perfect resource for folks pursuing the road less traveled, financial independence! They have introduced these same tax strategies and are beginning to take real-life case studies from listeners to provide early retirement recommendations / solutions. Be sure to follow along!
Thanks for taking a look!
The Green Swan