Challenger 2 main battle tank by Cpl Ross Fernie RLC - Defence Imagery. Licensed under OGL via Wikimedia Commons.

Go Curry Cracker Going to Battle with the RMD

Over the past few years, taxes have become a bit of a passion obsession.

I had always assumed our tax rate would be lower in retirement, and therefore followed the mainstream advice to max out my 401k each year.  This definitely helped to Turbocharge our Savings, and saved a ton in taxes during the accumulation phase

Then in our first years of early retirement, it became clear just how low our taxes could be.  Infinitesimally low.  Completely non existent.  Zero

Now I’m on a mission to Never Pay Taxes Again, not for any politically or financially motivated reason… but just because we can

Beating the RMD

For an early retiree, a 401k/IRA has 3 life stages:
Accumulation, Conversion, and the RMD

The duration of each stage varies by the individual.  The accumulation phase lasts at least as long as it takes to save a sufficient portfolio, and possibly longer if one decides to continue working after Financial Independence

On the other end, the IRS mandates Required Minimum Distributions in the year you turn Age 70.5 (which is why I was strategically born in the latter half of the year.)

In between is the tax saving nirvana of the Conversion stage

The Conversion Stage

The goal during the conversion stage is to move as large a sum as possible from a Traditional IRA / 401k to a Roth IRA at the lowest possible tax rate.  Just as the Traditional IRA / 401k is the ideal tool for the Accumulation phase, the Roth IRA is the ideal tool for the Conversion stage

Any funds converted will be taxed as ordinary income, but thanks to tax deductions and exemptions, the first $20k +/- is tax free for Married Filing Jointly (MFJ.)  Other deductions or exemptions can increase this further, which I’ll touch on later

We use a Traditional IRA / 401k during the working years because tax deductions combined with tax-deferral and compound interest is an incredibly powerful force for wealth creation.  Just add time, and these accounts are bound to grow to impressive levels.  But if they get “too large” then RMDs will be large, potentially resulting in large tax bills late in life.  Uncle Sam wants his take

If we are able to remove a sufficient amount during the years before the RMD, we can minimize total lifetime taxes.  We pay as little tax as possible during the accumulation phase, and as little tax as possible in the conversion phase, ultimately resulting in the least amount in the RMD stage

Our Traditional 401k / IRA

During my working days, with the exception of the first few years I always contributed the maximum amount to my 401k.  I wasn’t as tax savvy back then, and either wasn’t aware of the option to also contribute to a Traditional IRA or wasn’t eligible.  Similarly, we hadn’t contributed to Roth IRAs, with all additional savings going into our Brokerage account

Our tax-deferred accounts are no beacon of investment success.  The ~6% CAGR “growth” to date isn’t so impressive when considering inflation and employer matching.  Maybe the only positive thing to say is our tax-deferred accounts are a good example that a high savings rate is more important than investment returns for an early retirement

As of Dec 31st, 2014 the value of our tax-deferred accounts was ~$450k

We paid no tax on any of those assets, and my goal is to never do so

How Much to Convert

In 2013 I converted $12,028, and in 2014 I converted $5,744 from our tax-deferred accounts to a Roth.  That seems like the wrong direction to be trending in, so some changes are in order

Because my goal is a 0% tax rate, the size of our annual conversion is limited to the Standard Deduction and our 2 Personal Exemptions minus any ordinary income such as Interest, Short Term Capital Gains, or Non-qualified Dividends

Conversion Amount at 0% Tax Rate = Standard Deduction + 2 x Personal Exemptions – Ordinary Income

In 2014, the standard deduction was $12,400 and personal exemptions were $3,950 for a total of $20,300

Over time, our Deductions and Exemptions will change:

  • 2015:  GCCjr is born.  +1 Personal Exemption (+$3,950 in 2014)
    • Until college graduation +/-
  • Age 65:  Standard Deduction increases (+$1,200/person over Age 65)

I’m also taking steps to reduce Ordinary Income

  • Reduce interest income:  Keep less cash on hand (-$400/year)
  • Sell assets that generate Non-qualified Dividends and replace with index funds (in progress, -$3k/year)
  • 2017:  Private Mortgage balloons out (-$6k/year)

The combination of these factors will allow us to increase our Conversions by ~$13k/year and still pay no tax

With these changes, and assuming 7% annual growth our efforts to beat the RMD look like this

Required Minimum Distribution, Roth IRA Conversion Ladder, Pipeline

Convert Maximum at 0% Tax Rate (Assumes 7% annual growth)

Because we are only able to withdraw about 3-4%/year while still paying 0% tax, and the portfolio is growing by 7%, the portfolio continues to grow at an increasing rate.  That is, until Age 70.5 when the RMD starts requiring large withdrawals.  In this round of GCC vs the RMD, the RMD is the victor

Even in this scenario, however, we never surpass the top edge of the 15% tax bracket (thin red line), highlighting the value of choosing a Traditional 401k/IRA over a Roth during our working years

A Compromise?

Not ready to admit defeat, I looked into other options.  Maybe a compromise was in order

What if instead of paying 0% tax, I was willing to at least concede the 10% tax bracket?  Using 2014 dollars, this would allow conversion of an additional $18,150 per year, at a cost of $1,815 in tax.  Paying tax now at 10% and avoiding the 15% tax bracket later is better, right?

Max 10%

Convert Maximum at 10% Tax Rate (Assumes 7% annual growth)

But this isn’t quite right either.  I avoid the 15% tax bracket, but the 401k/IRA is depleted too quickly.  We pay tax in the near term at only 10%, but we lose all of those future years of 0% tax opportunity

So the right answer is probably to fill the 10% Tax Bracket a small amount.  But how much of this bracket would be ideal?  Use 10% of it and increase our total Conversion by $1,815?  20%?  30%? More?

And what about the rate of return?  The stock market isn’t going to just go up 7% per year.  It might average that over the long term, but it will be chaotic and random, up some years and down others

And since future dollars are worth much less than today’s dollars, it might be better to pay more later rather than a little now

Net Present Value (NPV) of All Future Taxes

Enter the Net Present Value.  This chart plots the Value of all future taxes in today’s dollars for investment returns ranging from 5% to 9%.

This is based on using only part of the 10% Tax Bracket, incrementing in steps of 10%.  Since the size of the 10% Tax Bracket (in 2014) is $18,150, each 10% step represents increasing the size of our annual conversion by $1,850 which would result in a tax bill of $185

If we use 0% of the 10% tax bracket, the results are the same as in the 1st chart, growing faster than we can withdraw the funds.  If we use 100% of the 10% tax bracket, the results are as in the 2nd chart, depleting the 401k too quickly

Net Present Value of Future Taxes

Net Present Value of Future Taxes (to Age 100)

A couple data points to clarify what this graph represents, using 2014 dollars

The purple line represents an annual growth rate of 7%, the same as in the first 2 charts.  The minimum point on that line is at the 30% point.

If growth is a little higher at 8% (the blue line) then it would be better to convert more each year in order to minimize the value of total future taxes paid (minimum value at 50%)

Key Takeaways from the NPV Graph

This is a lot of data to process in a short period of time, so let me highlight a few things that can be pertained from the NPV graph

If return rates are low (5-6% per year) then there is no need to convert more quickly.  The minimum NPV is actually at 0%

At the 7% growth rate, the NPV is roughly the same if we choose to use 0% or 30% of the 10% Tax Bracket

The worst case value of all future taxes in 2014 dollars is less than $35k.  That means I could basically write a check for $35k now and that would cover our tax load for life (If only the IRS would accept such an offer)

Increasing the size of the annual conversion by 20% of the 10% Tax Bracket (~$3,600) is roughly equivalent to increasing investment returns by 1%

If investment returns are low, we win (pay no tax.)
If investment returns are high, we win (can make large charitable donations late in life)

Increasing the Rate of Conversion

$3,600 is not a lot of change per year to effectively gain a 1% return.  Taxes are a heavy load on a portfolio

Can we do anything to try to gain additional tax free conversion space?  I can think of 3 things (or 4, if you count business expenses)

  1. Roth IRA Horse Race
    I first learned of this idea from the Mad Fientist.  Done correctly, the Roth IRA Horse Race can increase the effective size of each year’s Roth IRA Conversion, in both up and down years.  We can do 2 (or more) Roth IRA conversions in one year with different investments, and whichever one grows less can be recharacterized (meaning it never really happened, wink wink)
  2. Harvest Capital Losses
    Each year, up to $3k in capital loss can be used to offset ordinary income.  Greater losses must be carried over to future years.  I could either harvest gains each year, or harvest a large loss and use it over the next few years.  I have 2 investments from long ago that pay non-qualified dividends and have an unrealized loss of $30k, so selling would have double benefit.  (These losses are first offset against capital gains, so this would need to be balanced against Harvesting Capital Gains)
  3. Harvest Taxes Paid on Foreign Investments
    Any assets that invest Internationally will typically have taxes paid in the host countries.  We hold the VEU ETF, and in 2014 paid $480 in foreign tax.  The IRS will provide a credit against foreign tax paid on your US tax bill, so we could increase the size of our annual Conversion to harvest foreign taxes paid.  Because this is a credit, we could effectively convert an additional $4,800 in the 10% tax bracket using this as an offset

Note:  Neither Harvesting Capital Losses nor Harvesting Taxes Paid on Foreign Investments can be done in an IRA.  These are 2 of the reasons I prefer a Brokerage Account to a Roth IRA

Through the above techniques, if on average I can increase our annual conversion amount by an additional $5k (possible from the Foreign Tax Credit alone) I can improve our tax situation further.

In this case, we are best off NOT paying any taxes now.  RMDs could possibly result in us paying some tax at the 10% rate when we are 80, but only if the market only goes up.  At this rate, we might even beat the Social Security tax torpedo too


Convert Maximum Using All Tools at Our Disposal (Assumes 7% annual growth)


The quest to Never Pay Taxes Again has inspired me to leave no stone unturned.

I outlined why the Traditional IRA / 401k is the ideal tool for the Accumulation phase, and the Roth IRA is the ideal tool of the Conversion phase

We explored all of our options for increasing deductions, replacing ordinary income with tax-friendly income, and increasing our tax space via credits, harvested losses, and recharacterized investments

The best Net Present Value of all future taxes is to continue to pay no tax now, and take advantage of multiple decades of tax free income and growth

The result is what I hope is the world’s longest Roth IRA Conversion pipeline, resulting in a lifetime of tax minimization and maximized wealth

See All of Your Accounts in One Place

Track your net worth, asset allocation, and portfolio performance with free financial tools from Personal Capital

Are You Ready to Battle the RMD?




Retire Early.

Travel the World.

Let's do this.

Powered by ConvertKit

You have Successfully Subscribed!