The end of 2017 marked the completion of 5 full years of early retirement and world travel.
It’s been a fun ride so far… we’ve traveled a bit, had a few good meals, and taken many naps.
But how effective have these 5 years been in terms of implementing our tax minimization strategies? Are Roth IRA Conversions and Capital Gain Harvesting just fantasies we keep while working, or do they actually produce results in the real world?
Let’s do a financial check-up and see how we are doing.
Spoiler alert: In the years 2013 – 2017, we will have an effective income tax burden of negative $4. (Yes, the IRS paid us $5 in 2015 and we paid $1 in 2016.)
By itself a zero tax burden isn’t that impressive… I hear a Presidential candidate once claimed 47% of all Americans do the same (which is true only if you ignore payroll taxes), so this just makes us average.
But in all other metrics, our results are way off the charts.
Roth IRA Conversions
A Roth IRA conversion is the process of moving $ from a Traditional IRA to a Roth IRA, a taxable event. However, the Standard Deduction gives everybody some amount of 0% tax bracket. If the Roth conversion is smaller than total deductions…. it is tax free.
We have enjoyed these tax free conversions to the sum of $36,511.
2013: $12,028
2014: $5,744
2015: $0
2016: $6,039
2017: $12,700
Total: $36,511
Good news! The Roth conversion from 2013 now meets the 5-year seasoning rule. We can withdraw that $12,028 at any time, tax free and penalty free.
Roth IRA Contributions
Because we’ve earned some income via blogging these past few years, we’ve been able to make normal Roth IRA contributions.
Additionally, business income can be contributed to a Roth solo 401k.
Without this income we could increase the size of our Roth IRA conversions, resulting in the same taxable income and same $0 tax bill. In that regard, earning income hurts our long term battle with the RMD.
In total, we have been able to contribute $82,420 to Roth accounts over the past 5 years. If need be, these contributions can be withdrawn at any time, completely tax free and penalty free. (Roth 401k would first need to be rolled over to a Roth IRA. Source: 2019 Quickbooks Self-Employed Review: What You Need to Know)
2013: $0
2014: $1,846
2015: $29,000
2016: $29,000
2017: $22,574
Total: $82,420 (Roth 401k: $54,000; Roth IRA: $28,420)
The beauty of these Roth accounts is that we’ve paid exactly zero taxes on any of these dollars, and now they will grow tax free forever.
Case in point:
While our contributions and conversions total only $118,931, the actual value of these Roth accounts has grown to more than $150,000. This was easy to figure out, because the value of our Roth accounts before we “retired” was exactly $0.
By the time we reach traditional retirement age, we will potentially have $600k in tax free dollars waiting for us in these Roth accounts, even without another contribution or conversion (assuming 7% annual growth, blah blah blah.)
Capital Gain Harvesting
Since the stock market has been generally headed northward these past 5 years, we have no shortage of capital gains to harvest. Without going into great detail, this basically means to sell a stock that has increased in value and then buy it back with increased basis. This is a taxable event, but with a tax rate of 0% it just functions as a basis reset.
If you want a real world example of harvesting a capital gain, I’ve written a template based on the trades I executed in December 2016. Fill out this form and I’ll email it to you.
Over the last 5 years, I’ve harvested $147,207 in capital gains. If I had done this while working, we would have been taxed 15% or more. Instead, we get to keep that $22,081+ (and future growth thereof) for our own use. This increase in basis is now tax-free forever, and even increases the likelihood of being able to harvest a capital loss in the future if that is beneficial.
2013: $44,197
2014: $46,725
2015: $23,737
2016: $28,800
2017: $3,748
Total: $147,207
Any future growth would still be subject to taxation if/when we sell, but we can always harvest more gains next year.
Self-Employment Taxes
No review of tax optimization would be complete without mentioning Self-Employment taxes. All blog income is self-employment income, which is taxed at 15.3% (or slightly lower since half is deductible.) People who work a W2 job pay a similar tax, with the employee paying half and the employer paying the other half.
So… because we violated the 1st Principle of the Never Pay Taxes Again philosophy (Choose Leisure over Labor) we have to pay this “tax.”
2013: $0
2014: $281
2015: $5,146
2016: $3,965
2017: $7,644
Total: $17,036
Normally a tax is a tax, you pay it and the money is gone forever. But these payroll taxes are a little different… every $64.26 we pay in SE taxes increases the amount of Social Security income we will receive by $0.48 ($0.32 for me and $0.16 for spousal benefit.) Our $17,036 paid to date will give us an extra inflation-adjusted $127.25/month in about 20 years. That’s nothing to sneeze at!
In other words, this is more like a (slightly involuntary) annuity payment than a tax, as all of this money will be returned to us. (For more details, I calculated the ROI here.)
Summary
As every manager forced to read the works of Peter Drucker knows, “What gets measured gets done” and “What gets measured gets improved.”
I don’t know about improved, but in terms of tax minimization we definitely got it done.
In 5 years, we were able to harvest capital gains of $147,207, convert $36,511 of our Traditional IRA to a Roth IRA, and add $82,420 to Roth accounts.
This was all done completely income tax free, and all of these dollars will be tax free forever. Sprinkle in a little SE taxes and corresponding higher Social Security income, and this tax deal is still pretty decent.
Well what do you know! This stuff works!
For more details, here are our complete tax returns for 2013, 2014, 2015, 2016, and 2017.
Have you had success with Roth Conversions and Capital Gain Harvesting?
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Great job. I’m very envious of your tax free lifestyle.
We’re still paying a lot of taxes because Mrs. RB40 still has W2 income. I’m also making income from blogging and pay plenty of SE tax. We’re not doing too well with tax minimization, but that just means we have room to improve. We’ll have to keep working on it.
I’d rather have income and pay taxes than no income at all :)
If I plan to retire early would it be beneficial to wait on all IRA to ROTH IRA conversions? Currently I do that every year as I go, but at some point I’ll be retired and will have little to no income coming in. Currently a high earner with high savings/retirement accounts. No rental income and very little dividend income so I would most likely change that as I get closer to retiring in a few years (currently 39 years old).
If you are doing non-deductible contributions as part of backdoor Roth, then do them now.
If you are making deductible contributions, then yes wait until you have a 0% marginal rate.
There is a great tool you can use to check out when to make IRA to Roth Conversions. And it is my favourite price: free. I-ORP.com. Use the extended calculator. That gizmo is making our conversions much easier as the calculator is taking into account tax minimization over the rest of your life. For those of us older, RMDs will force us into much higher brackets and push much of our Social Security payments into unattractive taxation status. Many folks who try it get surprising results. The author is available to answer questions and check your outcomes if you run into problems. I’m a fanboy, not related in any way to the author
Another Great and Simple post! Thank you!
Question: For the Solo 401(k) contribution, does the self employment company has to make an income? or the individual’s brokerage profit/income/sales proceeds can be contributed to the Solo 401(k) ?.
The reason I ask is, once I get my early retirement, it may take 3-5 years for my corp to make income/profit but I don’t want to miss out on my Solo 401(k) contribution for all those years. Can I sell my stocks and contribute?
Thanks.
Only business profit can be contributed. Earned income, same as other 401ks.
Thanks!
Can’t you contribute $18,500 regardless of business income?
No
I hate you GCC! You are a tax cheat and a scammer!
That’s what I feel like saying out of pure jealousy as a highly paid wage slave with a combined 40+% marginal tax rate..but the reality is you are brilliant and have done great work to make the US tax code work for you. Very, very impressive.
I appreciate both the hate and the love. Thank you :)
I love reading posts like this. I’m leaving work in a couple more months and planning to do something similar – a Roth IRA conversion ladder and a Solo 401(k). Although I have a decent understanding of how I anticipate this will flow, I like hearing more about how the tax side of the equation actually works.
I haven’t done anything with capital gain harvesting, but it’s amazing to hear how effective some of these tax strategies can actually be!
— Jim
First off, all of your tax posts are great! I’ve become significant more tax efficient since reading them. Im curious though, do you plan to withdrawal the $12,028 from your Roth IRA now that’s it’s available to you tax/penalty free and just invest it in your brokerage, or do you plan to let it ride in the Roth? You made a compelling case in an earlier post about avoiding contributing to a Roth because the earning can’t be enjoyed tax free until “retirement” age, whereas you can enjoy all or most of your dividends and capital gains tax free now. This is a slightly different situation, but I believe the opportunity cost is essentially the same.
I don’t plan to withdraw it. Our taxable account is big enough to carry us for life, so having some extra earnings doesn’t help. But the option will always be there.
The value of access to earnings vs contributions is a function of age. People retiring at age 35 need the earnings, people retiring at 55 not as much.
I love your tax posts. I’m impressed that you were able to get Roth contributions done, even as the blog has increased in income.I always assumed you would get to the point where the blog income would be more than the exemptions (maybe that day will still come) but it’s nice to see you continuing to make impressive tax gains.
Prior to the affordable care act, it was such a no brainer to do deductible contributions to a 401k at pretty much any tax bracket. Due to the affordable care act subsidies, it gave me pause, considering whether or not it would be advantageous to take the tax hit now but to have tax free income that’s exempt from the affordable care act. At the 32% tax bracket plus state tax, I think it’s better right now to save on the taxes and invest the additional $6-7k in tax savings in a brokerage account. I still do the back door Roth but every once in a while I go down a healthcare.gov rabbit hole and it makes me think about my 401k.
You start to realize that by the time you get there, all the rules could change! It’s good to plan, but I’d rather save the taxes now and try to figure out what to do later to unwind it.
The blog income was excluded this year, so I can use more of the standard deduction for Roth conversions than in prior years.
The ACA penalties can be pretty severe. At 32% I would still be doing Traditional. Having some pre-tax/post-tax/taxable mix provides some flexibility in optimizing MAGI.
You’re as clever as they come! So cool that you use both the feie and the standard deduction. Thanks for these posts. They’re the most valuable I’ve ever seen in the fire community.
Thanks Nate. I have to give the credit to IRS documentation and TurboTax though.
I could use some help understanding how one knows in a given year whether to do Roth IRA conversions, Roth contributions, and/or capital gains harvesting, or some combination. Is there an order that you approach these, and a maximum amount done in one before moving on to the next one? I’m single so have a lower standard deduction than a married couple. Planning to stop work early next year at age 63, so will have little earned income in 2019 and some tax-free space to do some of these things.
On a related note, I’ve recently done some financial planning and it was recommended that I max out the 12% bracket with Roth conversions to reduce future RMDs and tax on social security. Any thoughts on this? Not sure how to consider this vs doing some capital gains harvesting (and how much to do of which or both)……
Thanks for any help. My understanding of how taxes work is sketchy….
Roth conversions at 0% tax rate mean all future earnings on that conversion are also tax free. This means only standard deduction ($12k single in 2018.)
For cap gain harvesting at 0% you have more opportunity (~40k.) This resets basis to a higher level, but future growth is still taxable. So generally better to prioritize the Roth conversions, but can do both in same year.
With both of these, be aware that it can impact ACA subsidies and may also be taxable by your State. Going abroad for a year or 2 can get around this.
There is an example of doing larger Roth conversions to minimize RMDs and tax on SS in this post.
I am really confused on why you have contributed to a Roth and how you talk so highly of them but in your article: https://www.gocurrycracker.com/roth-sucks/
it seems like a Roth is a poor choice and that you spoke so strongly against it. You even state that contributions to a taxable account should come before a Roth and it is in fact a better place to put your money due to the 0% long term tax rate and qualified dividends as well as being able to spend your earnings anytime and harvest capital losses. Could you please help me understand your reasoning and where you stand with Roth contributions?
A Roth IRA is a tool, with pros & cons. A big con for extreme early retirees is lack of access to the earnings. This value decreases with time – a 55 year old is just a few years away from full unrestricted access whereas a 30 year old has 30 years to go. I’m now 44.5, so I’m on the other side of the hill.
Access to earnings is also less important if you have a sufficiently large brokerage account or other income. We have both.
A brokerage account has similar properties to a Roth (tax free gains and dividends) if total income is below ~$100k. We are pushing above that level. I’ve actually worked towards having less dividend income rather than more, because our dividends are starting to be taxed.
We have an effective tax rate of 0% and are still adding funds to our brokerage account on occasion (we continue to LBYM.) Since we already have retirement funded, putting some funds in a Roth in addition to the brokerage is a good way to build a 3 legged stool (pre-tax/post-tax/taxable.) Having all 3 provides flexibility.
From the post you linked, there is a section titled “When is the Roth a good idea?” I quoted it below. Looking back at it now, I think the reasons I just highlighted match closely.
Ok, that makes sense for your situation you described. Sometimes there is no “one size fits all” method. I completely understand what you mean about flexibility as having a cushion of cash on hand allows me to realize income now or allows me to defer it in order to take advantage of tax credits. I’m at a different point right now being 32 and a little late starting in the game shooting to FIRE around your age. I really like the idea of having a taxable account vs a Roth but it does affect my AGI every year which is important in qualifying for tax credits.
Yeah, it is a series of trade offs. You want enough in a brokerage account but not too much.
When we were accumulating we had zero Roth contributions. I wanted full access to earnings and dividends. At that time there were no AGI limitations (no ACA.)
Now, all income is extra so I’m looking at tax optimization for 10-20 years from now.
So I think I just made a big mistake. Let me explain my current setup. I have been shoving every spare dollar i make into my retirement accounts to reduce my current tax burden. The plan was to save up 600k and retire living off about 24k a year with my house paid off. But i think i somehow got my wires crossed with Mad Fientist and GCC. I kept thinking that i would be able to pull the money out of my traditional IRA and pay 0% tax as a result of capital gains. But now i just realized that i’m gonna have to treat any Roth conversion and IRA withdrawal as regular income. That means I will need 800k to be able to get my conversion ladder going with 24k Roth Conversion and 24k for living expenses all while paying the tax man for the first 5 years, ouch. So much for retiring at 44, now it’s looking more like 46 or 47. Is there any way to avoid paying the tax on this money when i retire?
See the post: Is your 401k too big?
$48k withdrawal will pay about $2.5k to the IRS, MFJ. That’s only 5%. Compared to today’s marginal rates on contribution you come out ahead.
It’s funny you mention “Is your 401k too big?” because I was thinking the same thing. And you hit the nail on the head for the taxes. I’ve read all your posts and I have loved the blog for years. But after rereading the post it would appear the best course of action is to keep maxing out my retirement accounts. If I drop my 401k to the company match and switch to a Vanguard investment account than anything I put in there will be minus the 22% tax bracket for 2018 and beyond. But when I start to convert my 401k in retirement only a small part will be taxed at 22%, most will be in the 12% and 10% brackets. Although, i’m kinda wondering if the growth would be enough to offset the higher tax now. Would tax loss/gain harvesting plus 0% capital gains tax make it a better choice than the tax I would pay on the Roth conversions. Or maybe i’m just overthinking this, lol.
You might be overthinking it. Paying 22% later on withdrawal is the same as paying 22% today. If you pay less on withdrawal, you win.
You also have to look at ACA subsidies and State taxes, if applicable.
Did I miss your 2017 tax return ?
It’s the previous post. ;)
Great post! I just have a quick question: your roth IRA contributions consists of a Roth solo 401k? Are these contributions after-tax? How do you avoid paying taxes on after tax contributions? Thanks.
Roth contributions are always after tax.
Look at our tax returns for the how. 2017 with the FEIE. 2016 without.
AND Roth is tax free forever, so it is a great place to stow money you’ll need later. No tax drag once you put your money in because you already paid taxes on that income.
Maybe better to say it has been subject to taxes. As in our example, the tax rate may be 0%.
What are you using to fund your living expenses? Must be post tax savings accounts? Traditional retirement plans, SocSec are taxable. What is your annual living expense/spending?
Here is our most recent tax return, and our annual spending report.
>Traditional retirement plans, SocSec are taxable.
Yes, but the tax rate may be 0%.
Any fears of these tax benefits going away? As a 23 year old, I am trying to plan my finances in a similar way, so that I can retire early. However, I fear these tax benefits are more likely to go away, than the ROTH tax benefits. Thoughts?
They haven’t gone away during the last 3 pieces of major tax legislation…
Hi there, my family travel alot like yours. I have $400k, want to put in VTSAX, but curious about state taxes. Because we dont live in US, which state tax should we base on? I like to invest in VTSAX, but worry about tax implication.
Love your blogs
If you aren’t a resident of any state, then you would pay only federal taxes.
If you are a US citizen, then investment income is taxed the same as if you were a US resident.
If you are a non-resident alien, then you would have some taxes withheld on dividends. Google US taxes for non resident aliens for more details.
Can you recommend someone in Michigan (Detroit Metro Area) who is a CFP and CPA so I can plan my early retirement tax strategy with them?
Sorry, I don’t know anybody in the US.
Hi Jeremy,
Which shares should I select to harvest tax gains?
I aim to harvest around 40-50k (want to give myself a generous buffer as it’s my first year doing this), and I have the following in my Vanguard taxable account:
– $192,118.92 Unrealized gains from non-covered “various” shares bought before 2012
– $730.49 Unrealized gains from shares bought in 2012, and so on…
It looks like I was buying every quarter around the same amount, so lots of little gains adding up.
Should I sell the uncovered shares or start with the covered ones and try to find the actual prices for the shares I bought before 2012?
Thanks!
Typically what you want to do is sell the shares with the highest basis (long-term gains only.)
This will result in you having the greatest number of shares / market value possible at full basis.
You should definitely find the purchase price for pre-2012 purchases.