2020 was our 8th full year of this thing we do. It’s been an incredible ride – we’ve traveled, adventured, and procreated, with the best yet to come.
We’ve also done a fair amount of tax optimization, paying little tax each year while taking steps to minimize future taxes.
Do these optimization efforts actually work? Let’s find out.
These past 8 years I’ve worked to minimize our current and future tax burdens, legally and respectfully. Roth conversions, Capital Gain Harvesting, zero-tax Roth contributions, and geographic arbitrage (Foreign Earned Income) are all part of the tax optimization arsenal.
We’ve paid a small amount of tax on occasion, sure, but it helps to look at total tax burden as a matter of perspective.
Even with incomes of $100,000+ per year, our income tax bills have been fairly reasonable:
2013: $0 on $91,752
2014: $0 on $95,654
2015: -$5 on $102,663
2016: $1 on $101,519
2017: $0 on $109,140
2018: $1,187 on $136,866
2019: $10,288 on $206,113
2020: $0 on $143,290
Total: $11,471on $986,997 (1.1% effective tax rate)
Not bad for nearly $1 million in taxable income.
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 $53,934.
2013: $12,028
2014: $5,744
2015: $0
2016: $6,039
2017: $12,700
2018: $0
2019: $0
2020: $17,423
Total: $53,934
Good news! The Roth conversions from 2013 & 2014 now meet the 5-year seasoning rule. (2015 also, but $0.) We can withdraw that $17,772 at any time, tax free and penalty free (but we won’t.) Still, always nice to have the option.
Foreign Earned Income
Because we enjoy life in places outside the United States we are able to claim the Foreign Earned Income Exclusion, paying zero US income tax on any earned income we happen to make.
2017: $45,700 of foreign earned income saving $5,926 in tax
2018: $57,775 of foreign earned income saving $6,552 in tax
2019: $52,480 of foreign earned income saving $5,909 in tax
2020: $32,166 of foreign earned income saving $3,466 in tax.
Total foreign earned income: $188,121
Total tax: $0
Total tax savings: $21,853
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 (US income only.) Additionally, business income can be contributed to a Roth solo 401k (even while using the FEIE.)
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 $126,025 to Roth accounts over the past 7 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.)
2013: $0
2014: $1,846
2015: $29,000
2016: $29,000
2017: $22,574
2018: $24,285
2019: $19,320
2020: $19,848
Total: $145,873
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.
It’s interesting because the value of our Roth accounts before we “retired” was exactly $0.
Capital Gain Harvesting
Since the stock market has been generally headed northward these past 7 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 actual trades I executed. Fill out this form and I’ll email it to you.
Over the last 8 years, I’ve harvested $327,394 in long-term capital gains.
$228,530 of this was done completely tax-free. If I had done this while working, we would have been taxed 15% or more with a tax bill of $34k+. Instead, we get to keep that money (and future growth thereof) for our own use.
The remaining $98,864 was taxed at 15%. This was done intentionally to avoid paying 18-22% later (or worse, paying $12,000 extra for going over the ACA subsidy cliff.)
With the elimination of the subsidy cliff for 2021 (and possibly going forward), I think this is an example of being too smart for my own good – I should have just let it all ride.
With this higher basis, I’ve also increased the likelihood of being able to harvest a capital loss in the future if that is beneficial. This did happen in 2020 when I sold some of our bonds for a small loss in order to buy stock at a deep discount during the covid plunge.
2013: $44,197
2014: $46,725
2015: $23,737
2016: $28,800
2017: $3,748
2018: $25,850
2019: $101,259
2020: $53,078
Total: $327,394
Any future growth would still be subject to taxation if/when we sell, but we can always harvest more gains next year. But by having higher basis we will show a smaller capital gain if/when we do decide to sell.
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
2018: $9,663
2019: $7,979
2020: $4,891
Total: $39,569
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 $39,569 paid to date will give us an extra inflation-adjusted $296/month in about 16 years. That’s nothing to sneeze at!
In other words, this is more like a (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
In 8 years, we were able to harvest capital gains of $327,394, convert $53,934 of our Traditional IRA to a Roth IRA, and add $145,873 to Roth accounts. We’ve also earned $188,121 of tax-free foreign income.
This was all done nearly income tax-free (1.1% effective tax rate), and growth on Roth IRAs will be tax-free forever. Sprinkle in a little SE taxes and corresponding higher Social Security income, and this tax deal is still pretty sweet.
Well, what do you know! This stuff works!
For more details, here are our complete tax returns for the past 7 years: 2013, 2014, 2015, 2016, 2017, 2018, 2019, & 2020.
Have you had success with early retirement tax optimization?
See All of Your Accounts in One Place
Track your net worth, spending, asset allocation, and portfolio performance with free financial tools from Personal Capital.
WOW! What a great post. Head spinning but enjoying the learning…
In the post, you noted, “Because we’ve earned some income via blogging these past few years, we’ve been able to make normal Roth IRA contributions (U.S. income only.) Additionally, business income can be contributed to a Roth solo 401k (even while using the FEIE.)” I was under the impression that ALL income earned overseas is part of the FEIE and this could not be separated out. Can you expand on this a bit more to help readers understand this process? Kind regards…
Income earned while on US soil is US income, even if you live outside the US – an example is on our 2017 tax return when we spent 33 days in the US.
If you elect to claim the foreign earned income exclusion, then yes, its all or nothing. But each individual can make the election for themselves – I choose to claim it, my wife does not. Also both kids earn some income and choose not to use the FEIE.
No tax bill in Taiwan on income/capital gains?
Correct
Amazing! You guys are very lucky to be in Taiwan where you don’t have to deal with two countries tax systems! It’s a lot tricker to create a tax optimization strategy when your country of residence (outside the US) has their own income/capital gains tax brackets too. I’m in the process of FIREing and trying to figure out the tax side of things for optimal withdrawals has been my nemesis these past few years! If anyyyyone has experience as a dual US Canadian citizen I’d love to connect!
It is a bit lucky. But also planned.
If you are a resident of a high(er) tax country and wish to remain there, there aren’t any tax reduction options. You can carry forward/back the foreign tax credit for a few years.
Like you we’re looking forward to welcoming child no. 2. Looking for more info on how this can help lower tax burden
Child tax credit and Dependent care credit for mid-high income households. EITC for low.
Great post, Jeremy. One bummer is that if you are a U.S.-based FIRE and taking advantage of Affordable Care Act subsidies, many of these strategies — such as capital gain harvesting, Roth conversions, etc. — push your AGI up such that you no longer qualify for Affordable Care Act subsidies and even fall over the ACA subsidy cliff. So it really reduces one’s ability to leverage these strategies. Do you agree? Do you see any way around this other than spending a few years outside the U.S.?
Yes, the ACA is an additional tax. There is no subsidy cliff in 2021, but for prior years you would have to keep AGI below 400% FPL and do the math to see if doing Roth conversions and gain harvests would still be warranted with a higher tax rate. For most people, they won’t.
I recommend at least a year abroad to kickstart your (early) retirement.
Makes sense, and thanks for your response.
Just an FYI… “We have enjoyed these tax-free conversions to the sum of $36,511.” The sum should be $53,934.
I love your tax optimization posts!
Right you are, thank you. Fixed it
I look forward to your tax related posts. We just started our Roth conversions last year and are trying to get as much transferred over while staying within our tax bracket. My husband is self employed so it is always an adventure to keep one step ahead of the game. I appreciate the strategies you lay out for your readers
Jeremy, you say:
“ Summary
In 8 years, we were able to harvest capital gains of $327,394, convert $53,934 of our Traditional IRA to a Roth IRA…”.
Why do you dedicate so much more of your 0% tax bracket / tax deduction to capital gains than converting traditional IRAs to Roth IRAs? Is the tax treatment different or is this personal preference?
Thanks for the great article!
I prioritize Roth conversions (explained here, Roth Conversions vs Capital Gain Harvesting) but the 0% tax bracket for capital gains is 5x the size that it is for Roth conversions (~24k, the standard deduction only)
Thanks for the great update. Last year was our first year of early retirement. Using your blog as a guide, we paid $0 in federal taxes on $81,000 of income! I played it a bit too conservative trying to avoid the ACA subsidy cliff or I would have realized even more capital gains. With no cliff in 2021 and 2022, I should be able to increase our income some and still pay $0 in federal tax. Thanks so much for all your help!
You felt it was OK to pay higher ACA premiums? What about State taxes?
Sorry – should have clarified. We have a family of four, so our $81,000 income was well under 400% of FPL. I could have realized even more capital gains and still been under 400% – missed opportunity. And, unfortunately, yes, we live in a state with state income taxes, so we did have to pay those.
Below 400% FPL you still pay a 10-15% “tax” in the form of higher ACA premiums
See: Obamacare Optimization in Early Retirement
Wow – that made my head hurt! :-) But seriously, I put a bit more information in a question on the forum. Thanks again for your help.
Hi Jeremy, I have a question about Roth conversions. Did you rollover ALL of your 401K to traditional IRA first? Or “partial” rollover from 401K to traditional is allowed?
I guess it depends on the brokerage firm? Thanks.
I rolled over a 401k from my first job out of college, still using that for Roth conversions. I left my most recent 401k at the company as they have great funds with lower ers than I can get elsewhere.
Could you please explain in more detail how converting money from a traditional IRA to a Roth IRA can be done tax free and how the standard deduction amount relates to that. It almost seems like you might be saying that if the amount converted in a single year is less than your standard deduction (approx. $12k in my case), the conversion is tax free. But since I can’t find corroboration of that in other resources – plus it doesn’t sound right to me – I doubt that’s what you mean. So I’d appreciate some more detail on that if you will. Thank you!
That’s what I mean
Great post! Love your work!
Question about your Roth contributions.
Isn’t there a limit on how much you can contribute to a Roth IRA every year? It is $6,500 for year 2023, so I’m confused how you were able to contribute higher amounts?
Thanks for shedding light on this.
There is a contribution limit. This is per person.
There is no conversion limit.
As a business owner, you can also have a Roth 401k with its own (higher) contribution limit.