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.
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.)
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.
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.
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.
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.”
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.)
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!
Have you had success with early retirement tax optimization?
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