Cash flow is kind of important, in (early) retirement as in life. No cash flow, no nuthin’ – can’t pay the bills, can’t buy the things, can’t do the stuff.
A couple common cash flow challenges in early retirement involve:
- wanting to spend retirement account income before age 59.5 (you have the funds, it’s just locked in tax-deferred accounts)
- contributing to tax-deferred accounts when you have little to no cash on hand (but have earned income)
I like to get around these challenges with a little legal money laundering.
Legal Money Laundering
Spending retirement account income early
Money laundering as I understand it involves moving money you can’t legally touch into that which you can.
For example, the IRS says the money in your 401k / IRA is locked up until age 59 1/2.
But what if I want/need to get access to some of those funds early? I can’t do so without some significant consequences (10% penalty) or a serious commitment (72t.)
Alas, I do need access – I recently shared how our actual cost of living is ~$25k higher than our income.
If I could only tap into the $25,000 in dividends we are receiving each year in our retirement accounts… we could be completely cash flow neutral. (What are the odds?)
And in fact I can. I just generate my own dividend in our taxable brokerage account.
Example:
We receive $25,000 in dividends in a retirement account. This is auto-reinvested in additional shares. For simplicity let’s assume we get 1,000 new shares of $X at $25 each.
To spend those dividends I just sell 1,000 shares of $X in the brokerage account.
I now have $25,000 in cash and the exact same number of shares as we did pre-dividend.
As a bonus – we will pay fewer taxes on the stock sale than we would have had we received the dividend directly in the taxable account. Win win.
Contributing to Retirement Accounts with Minimal Cash
Being cash flow neutral is nice – by laundering our retirement account dividends we are able to fully cover our cost of living with income from our portfolio and part-time hobbies.
But I also want to make some additional retirement account contributions and we are spending 100% of our income!
I want to make retirement account contributions this year but only have about $500 in our checking account. (I intentionally keep the amount of cash on hand low – it yields poorly and doesn’t respond well to inflation.)
What to do?
Example:
2022
Earned income: ~$40,000 via blogging
Cash on hand: ~$0 or close enough
Roth solo-401k contribution: $20,500
Employer solo-401k contribution: ~$7,400 (Traditional, deductible)
After-tax non-Roth solo-401k contribution: ~$1,800
His/Her Roth IRAs: $12,000
Total retirement contributions: $41,700 (more than we earned! You have to love IRS math.)
To get these funds I sell $41,700 worth of stock, move it into the retirement accounts, and then buy $41,700 worth of stock.
In a year like 2022 where the market is down I am able to realize a capital loss in the process for a nice tax deduction, possibly offsetting any tax burden from the first example above. (Thanks to prior years’ capital gain harvests.)
All future growth on the Roth contributions will also be tax-free.
IMPORTANT: Avoid wash sale rule violations. This is critical with retirement accounts because we can eliminate the capital loss deduction for all time. The retirement account stock purchase needs to be a different, non-substantially similar, stock than we sold in the brokerage account.
For the math on solo-401k contributions and how we can contribute more than we earned, see: Solo 401(k) Contribution Calculator
Shift Portfolio Towards Tax-Free
Early retirees often (but not always) have a significant percentage of their portfolio in a brokerage account. When you save large sums of money over a short period of time, retirement account contribution limits push excess savings into taxable accounts.
Both of the examples shift funds from taxable into Roth accounts, thereby moving the portfolio ratio of Taxable / Pre-Tax / Post-tax towards post-tax/Roth/tax-free.
When we left our jobs ~20 years ago we were roughly 75/25/0 but most recently we were at 63/29/8. That growing Roth percentage will help significantly with tax minimization later in life.
Special note:
A lot of people self-restrict retirement spending to income – side hustles, pensions, dividends, interest, etc… I am doing this in both of the examples above.
This is unnecessary unless you have very ambitious inheritance plans, although I understand the appeal. Spending principal is a normal and natural part of retirement (some even go to other extremes, see: Book Review: Die with Zero.)
Spend less than 4%, spending principal is fine. It’s ok to sell some more stock.
Summary
Cash flow is king in retirement. A little legal money laundering helps keep the cash flowing smoothly, allowing you to:
- Spend retirement account dividends before age 59.5.
- Contribute to retirement accounts even when you have minimal cash.
- Contribute more than you earn to retirement accounts.
As a bonus, these efforts will shift the portfolio in a way that helps to minimize future taxes.
May your cash be clean, accessible, and tax-friendly.
Have you legally laundered your money?
Love it!! And fairly straightforward too where even I can follow it ;)
Ha!
Welcome back to blogging good sir.
Sorry, I found this one confusing (but would love to know more!). Could you expound on the method for withdrawing dividends from a pre-tax account like a 401k? How does this get reported on a tax form? Anything different to do on the brokerage side?
If I get $1 in dividends in a retirement account I sell $1 of stock in my brokerage account
That stock sale is reported on schedule D
So to be clear, I just need to ensure that I have the same fund getting dividends in my retirement account that I have in my brokerage account, correct?
You can for simplicity. But a dollar is a dollar, there is no requirement that the funds be the same.
The sell a dollar in a taxable account to account for a tax-sheltered dividend dollar construct is kind of fun. Will remember!
PS that solo 401k calculator is handy and made me aware of some additional contributions I didn’t know about. Keep up the nerdiness!
I didn’t like any of the calculators that google pointed me at so I wrote my own. Now it is slowly working its way up the google links
The sleight-of-hand does help me sleep easier at night
You said that “As a bonus – we will pay fewer taxes on the stock sale than we would have had we received the dividend directly in the taxable account.”
Can you explain how/why you’ll pay fewer taxes?
Does it mean I should always choose to reinvest dividends in taxable account and sell shares when I need cash?
If we get a $1,000 dividend in a taxable account, 100% of it is part of our gross income and all of it is taxable.
If I sell $1,000 worth of stock, a portion is a return of my original investment. Only the gain is income/taxable. If the stock doubled since we bought it, only half of the sale is a gain.
Lower income = lower taxes
In both cases the federal tax rate will probably be 0%, but we will pay lower state taxes and ACA premiums in the latter case.
Thanks for the clarification.
Do you mean that reinvesting dividends in a taxable account, from say VTSAX, are not taxed in the same way as if I took the dividends as cash?
In your taxable account, dividends are taxed whether they are reinvested or not.
For the same amount of cash, long-term capital gains are taxed less than qualified dividends because only the gain is taxed.
Isn’t this just drawing down on your taxable brokerage accounts, and leaving your 401k to continue to accumulate? Is the magic that you’re matching the amounts?
It is. If the gimmick helps somebody be at ease spending more than their income then it worked.
I don’t get it…
I was confused but the answer to DanO’s comment clarified it…this is more of a psychological trick than a financial one. I do think that people have a hard time drawing down from retirement accounts and if this way of thinking helps than that is great. I have a related question. My husband is 58 and I am 54…we both have IRAs and his will be accessible in November 2023. We will begin to take 4% at that point…can we calculate that on OUR combined balance although I can’t touch mine for 5 years? I think this is similar to your “gimmick”…we are spending money from the total of our joint balances although part of it is inaccessible. We have the exact same allocation in both IRAS.
Yes, you can think of all of your accounts as just one big wallet that you share. Money is fungible. If you have 7 accounts that add up to $1 million, for example, 4% of that is $40k. You just draw down the ones you have legal access to first.
This psychological trick is based on a conversation I had with an aspiring early retiree awhile back – they wanted to live off dividends “for peace of mind” but had most of their savings in retirement accounts. This way of thinking helped.
I’m sorry to say that this is one of the worst articles I’ve ever read from you. First, there is nothing novel here. The title is click bait and the article is very low effort. Selling stock in your brokerage is not ‘accessing retirement funds early’. I wish I had something nice to say as I’ve followed your blog for years but felt I had to provide you some feedback on this one, even if negative.
Sorry to disappoint you.
On the flip side I love this article. Money / spending is a lot of psychology! Great way to thinking about your spending and your articles always give me a lot to think about.
Thanks for the thought-provoking post as usual. I’m wondering what your end-game plan is for your pre-tax accounts. Are you trying to thread the needle over time and get most of it out 0%? I guess that could be achievable since you have such a large amount of taxable accounts with the much more generous 0% LTCG rate brackets.
As for me, I have mostly pre-tax with a side of roth. So I think that I probably need to come up with my own ‘acceptable’ tax rate that I’m comfortable with and go that route. The earned income 0% zone (standard deduction + misc. credits/deductions) seems too small. I’m actually wondering if I should diversify some of my future savings to taxable accounts at this point (at no higher than the 12% bracket of course; also I live in an income tax-free state). It almost seems like a sin but I have such a different situation than you. I wonder if I need to adjust strategy.
Are you doing Roth conversions?
At some point your 401k / pre-tax accounts are too big to pay 0%, see: Is Your 401k Too Big.
To contribute to retirement accounts (or not) is always a question of tax rate. If you save 22% now to pay 12% later, then it is better to contribute. If the opposite, then don’t (or contribute to Roths.) The challenge is figuring out what tax rate you will pay later, but we can make an educated guess based on account size.
Our pre-tax accounts are too big to pay 0% forever so we have been doing Roth conversions and will continue to do so. Filling the 10% or 12% tax brackets now is better than paying 22% later.
Currently still working and accumulating (age 33). 1 income, married + 2 very young kids. Hoping to retire at 49, but life happens, so I understand that may not happen.
I make about $122K/year. I figure about $13K of that is in the 22% bracket, so that’s a no-brainer to defer in 401k. I have access to a spousal IRA and wife is eligible for traditional because she does not have an employer plan, of course. If I defer enough income in a 401k, I can squeak into traditional ira deductibility limits myself also. So I have the potential to defer up to $32.5K (1*401k + 2*IRA); that’s also about what my free cash flow would allow.
I stay up late wondering if I should use some of that money (after deferring $13K), to pay some taxes at 12% now, to build up taxable accounts to take advantage of the 0% LTCG bracket in the future. Currently have about $200K in pre-tax and $100K in roth (I consider the contributions here as my emergency fund).
My biggest worries are the scheduled increase of the brackets for 2026 (12% becoming 15%) combined with the slow-creep of stealth inflation. The 2017 tax law permanently changed the bracket adjustment methodology to chained-CPI which tends to come in about 0.25% lower than unchained CPI. It’s small in a given year but could be significant in longer time horizons.
I understand that there’s no way to perfectly optimize this without knowing all the future variables (job safety, lifespan, tax changes, asset performance, etc.). But I appreciate the opportunity to think out loud here.
One day I’m convinced that I should pay taxes now and build a taxable account in the 12%, and then plan to defer this segment of income again in 2026 when(if) the bracket reverts to 15%…. But then I get philosophical and think I should maximize/leverage the government’s willingness to subsidize the risk-taking inherent in investing. Since future returns are unknown, I could view it as the government kind of loaning me money to invest for retirement. If I win big and future returns are as good as the past, maybe I should be okay with paying more taxes. If future returns are mediocre, then I get to share that disappointment with the government.
I think my longer timeline (not that early of a retirement compared to you guys) complicates certain things in a way because there’s like 16 years for tax changes and ACA changes to happen. Oh well! Sorry for writing a novel here. Hope all is well.
I am happy to think out loud with you.
Generally speaking the closer to traditional retirement ages you plan to stop working, the less important it is to have funds in taxable accounts. You don’t have that many years to get to age 59.5 so unrestricted access isn’t as critical. Thus the following is different out loud thinking than if you planned to retire at age 35.
For your free cash flow, what you are doing now requires the least amount of money. You get ~$3,000 in tax savings by making the $13k 401k contribution. You put this (and another $3k) into your wife’s IRA, saving you another ~$700. Finally you max out the 401k and contribute to your Trad IRA for an additional ~$1,600 in tax savings. Thus you only need ~$27k in cash flow to have $32.5k in contributions (plus employer match.)
You could instead pay some tax at 12% now and contribute to a Roth or save in a taxable brokerage account. For $6k in savings you would need to pay $720 in tax for total cash required of $6,720.
If you invest in a brokerage account you will get taxable dividends each year. If your work income rises (likely) you will be paying 15% tax on dividends. Current yield on SP500 is about 1.5%. A 15% tax on that is equivalent to a load of 0.225%, or about 4-5x what you pay on a Vanguard index fund. Small, but not zero over the next 16+ years.
Also as income rises you will contribute more to Traditional retirement accounts because you are strongly in the 22%+ bracket. The likelihood is high that you will max out Traditional accounts and still have funds left to invest, and the only option available to you is a brokerage account.
A common and good approach is this – fill Traditional accounts in 22%+ brackets. Fill Roths with brackets <= 12%. Rest goes in brokerage.What this means is you will contribute more to Roths early in career, more to Traditional in mid-late career, and late in career funds will end up in brokerage because you have no other choice.Now you have a nice mix of pre-tax/post-tax/taxable account that you can use to fine tune your adjusted gross income on taxes.When it comes time to withdraw funds at age 50, assuming tax and health insurance law stays the same, you probably have a marginal tax rate of 15% minimum due to ACA premium subsidies. 15% is higher than 12%, so math says paying tax now is better. The counter argument is that it probably isn't worth worrying about a 3% difference in marginal tax rates 20 years in advance.As with most things there is no right answer.
Thanks, Jeremy. I appreciate you running my scenario through your mental model.
I spend way too much time thinking about 3% stuff when I would get a bigger bang for the buck researching/doing home maintenance projects (as opposed to paying someone). I probably enjoy thinking about this stuff more than fixing my lawnmower though, haha.
Same
Although I just paid a guy to replace a few windows because I didn’t want to climb up a 28 foot ladder
edit: we rented a 32 ft ladder
This is exactly what I needed. The way you reframed the problem of not being able to access retirement account dividends by just selling an equal value of stock from a brokerage account is brilliant. I’m probably not alone in being apprehensive about selling stock to pay the bills, wanting instead to just live off dividends (at least now while I’m still young). This article has shattered a mental block I’ve had. Thank you very much.
I have to agree with the disappointed poster. This isn’t money laundering. You’re selling equities you already have in a taxable brokerage account to spend before you can access your retirement account. This article should be titled If You Need More Money than You Have Coming In, Sell Stock You Already Own in Taxable.
I too have experienced disappointment
Hey Jeremy! Belated welcome back to the USA.
For early retirees, is there a way to still contribute to IRA or Roth IRA without earned income, or is this only possible because of your blog income?
Earned income is required
I spend a lot of time managing my own finances. Could I create an LLC and pay myself as a financial solo employee off the dividends from my brokerage account, then direct those funds through a solo 401k?
No
Great info! I’ve always monthly DCA’d my Roth contribution but this post gave me an idea on how to defund a taxable account with a high expense ratio (had it for years). I will sell $7K in that taxable account then contribute $7K in my Roth IRA (VTSAX). Since I’m front loading the Roth, I’ll DCA $583 (normal Roth monthly) to a taxable index fund. Gotta have a fat taxable account to live on when I spit hot FIRE in a few years.
I can’t figure out what brokerage to use for a solo 401k. I have one at Fidelity, but I can’t figure out if they have a Roth option, and also if I can roll my tax deferred contributions into my Roth IRA (which is at Vanguard).
I have a moderately large work 401k to roll over, and I have not figured out whether to roll it into my Fidelity solo 401k and whether I can add a Roth 401k option to that, or whether I need to open another brokerage account somewhere.
So confusing to me…any thoughts? I’m sure you have a post on this, but I can’t seem to find it.
I do not have a post on this. The Finance Buff has a lot of articles about Roth solo-401ks and is a good resource. When I opened my solo-401k only Etrade and Vanguard offered Roth accounts, and Vanguard was more expensive (no admiral funds) so I went with Etrade. Now (I believe) all of the main providers offer Roth type accounts. If you look in the Fidelity plan trust agreement it details the Roth features (“Designated Roth Contributions”) … or call them, their phone support is actually half way decent (disclaimer: I have not talked to them about Roth solo-401k.)
Thanks!
Seems like it’s mostly OK to roll my work, non-Roth 410k into a rollover IRA post Secure 2.0. My rollover IRA is not so huge that I will likely be doing Roth conversions, and frankly doing a Roth conversion from a rollover 401k seems like an enormous PITA. A rollover IRA is OK for rollovers?
If I plan on earning self-employment income, though, it seems like I should open a solo 401k with Roth option for future earnings so I can do the employee and employer contributions and also contribute to a Roth IRA. Alas, the Secure 2.0 SEP IRA with Roth option caps self-employment income at 20% and you can’t do a SEP Roth and a Roth IRA additionally, so I’d better stick with the solo 401k.
Am I on target?
There isn’t really anything with the name rollover IRA. It’s just an IRA. Yes, it is ok for rollovers.
I chose to NOT rollover my old work 401k because it has the cheapest index funds anywhere, but if plan choices or fees were not good I would have moved it.
Why do you say doing a Roth conversion is a pain? Move funds from IRA to Roth IRA. Pay taxes on the conversion. Done.
All of my Roth conversions have been done from an old rollover IRA (from my first post-college job.)
I haven’t read any of the SECURE Act 2.0 stuff beyond basic headlines. Prior to that legislation I believe solo-401k was always the superior choice. I can’t think of a reason to choose anything else.
Thank you. Very helpful.
When I had rolled over an old 401k to IRA from Vanguard, Vanguard actually did title it as a “Rollover IRA”. But you could still make additional traditional contributions to it, so I don’t know that it’s a distinction with a difference.
Yeah that is just a label. You could call it “dish soap” or “chartreuse” or whatever, but it is still just a Traditional IRA.
Hi Jeremy, Thank you for this post. Even if this is a psychological sleight of hand, having permission to spend retirement account dividends this way seems empowering.
I discovered you via Jackie Cummings Koski’s great F.I.R.E. for Dummies, which actually is higher level in some respects than the title suggests.
Here’s my question: we are still working and are in the 22% tax bracket. I max out my work (W2) 401k traditional pretax contribution.
Via my side gig, I also have a solo 401k and have been maxing out my after-tax contributions (up to compensation) and immediately rolling to Roth via mega backdoor.
Since my wife contributes materially to my side biz by doing my books and IT, and she doesn’t have a retirement plan at work, she contributes pre-tax to the solo 401k and we take that deduction to total income MFJ.
Then, my wife and I have both been maxing out front door/backdoor Roth contributions (depending on a given year’s income), plus funding our taxable account.
This approach has netted a 41/22/36 tax deferred/taxable/tax exempt mix for our funds about 2 years out from retirement, which should give us cash flow flexibility as we go on ACA while doing Roth conversions post FIRE in the 12% bracket.
I am wondering now though if we should make traditional IRA contributions instead of Roth while we’re in the 22% bracket for our remaining work years and then convert those to Roth after we FIRE.
What’s stopped me in the past has been the pro rata rule and doing backdoors when needed. My understanding is you need to have a $0 trad IRA balance before doing the roll to the Roth to not trigger the rule.
As a work around, could we each make traditional IRA contributions for the deduction now, and then roll the entire balance to our solo 401k pretax accounts, before making my own after-tax contribution to the solo 401k and then rolling that to Roth via the mega backdoor?
Would this keep us clear of the pro rata rule?
The pro-rata rule applies when you have both pre-tax and after-tax funds in Traditional IRAs and you convert some funds to Roth.
A 401k is not a Traditional IRA so anything you do inside the 401k is not subject to the pro-rata rule.
If in the future you wanted to do a backdoor Roth (not Mega, not 401k related) pro-rate rule applies. In that case, yes, you could roll existing Trad IRAs to the solo-401k (assuming plan docs allow.)
All that said… 2 years away from retirement, with large existing portfolio, what you do with $15k+/- is probably irrelevant in the long term. Having more than 1/3 of assets in Roth already is way more than enough.
fwiw, in addition to permission to spend retirement account dividends I also give permission to spend more than dividends (up to 4% of total portfolio value)
by selling stock.
Thanks, Jeremy! We have a home in the Sac area that we’re planning on moving back to post FIRE. Perhaps I’ll see you on the bike trail or snowboarding on the hill!