Recently I received an email from one of the big brokerage firms, titled “Savvy Year-End Tax Strategies.” It contained much advice, such as “Consider contributing as much as you can to a 401(k)” and “Be careful when selling highly appreciated assets, such as stocks, land, fine art, precious metals, or antiques.” This might be considered good advice by some, but I just call it, “Boring!”
Benjamin Franklin once wrote that nothing is certain except death and taxes. I beg to differ. I personally expect to never pay taxes again, legally and respectfully.
Perhaps you would like to do the same?
Never Pay Taxes Again
There are many reasons to not pay taxes. Some may have political, moral, or philosophical reasons for doing so. Maybe you don’t want to pay for wars, for example. But the one that is strongest for me is also the most straight forward: If you don’t need to pay taxes, you don’t need to save as much
Let’s use an example to make this clear. A typical middle class family man in the United States goes out for dinner with his wife at one of the nation’s many fine fast food establishments, paying $20 for a couple super sized mechanically separated chicken sandwiches, oily, starchy, and salty side dishes, insulin-bomb sodas, and artificially flavored and colored desserts. Ignoring the long term health costs of such a decision, how much does Joe Average pay for this meal? $20? More like $33.50
Joe Average paid for his meal with after tax dollars. Assuming a 25% marginal tax rate, social security and medicare taxes (both individual and employer), Joe had to earn $33.50 in order to have a $20 bill in his wallet to pay for that meal, paying $13.50 in tax before even walking into the restaurant. Including a 10% sales tax already included in the $20 total check, $15.50 was paid in tax. If they drove to the restaurant, they even paid tax on gas
For the same $33.50 in food spending (there is no sales tax on groceries in Washington State), we enjoyed a couple organic salads, grass-fed steaks, a side of vegetables with garlic and bacon, a couple glasses of wine, and had $10 left over. Not paying taxes has its rewards.
So how do we eliminate taxes? All we need to do is follow 4 simple rules:
- Choose leisure over labor
- Live well for less
- Leverage Roth IRA Conversions
- Harvest Capital Losses AND Capital Gains
Choose Leisure Over Labor
The tax laws in the US target people who work for a living. If you get a paycheck, the US government classifies that paycheck as Earned Income, with special taxes just for you. This is one part of the reason that Warren Buffet says his secretary pays more tax than he does. Social Security and Medicare taxes are only applied to Earned Income, 15.3% tax in total for most people.
The only way to avoid paying these taxes is to not work. Now leisure comes with an added bonus. I intend to never have earned income again, completely eliminating this tax
Live Well For Less
The more a person or family spends a year, the more likely they will be required to pay income taxes, due to the graduated tax brackets that exist in the US and many other countries. Using the 2012 tax rules, a married couple can earn up to $19,500 a year without paying tax. This is because the government allows us a standard deduction for a married couple of $11,900 and an exemption of $3,800 per person. Other deductions can be applied, such as the $17,000 for 401k contributions, raising the untaxed income level to $36,500. (That advice from the big brokerage firm hit the spot on this one.) Normally the deductions are increased every year with inflation or some arbitrary level decided by Congress
Once income and spending exceeds this level, taxes must be paid. Unless…
Unless that income comes from qualified dividends or long term capital gains. In this case, a married couple can have $19,500 a year in income AND $70,700 in investment income, TAX FREE (if that isn’t a strong signal to not work, I don’t know what is.)
If spending is kept below these levels (and thus incomes) then there will be no taxes
But wait, there’s more
Leverage Roth IRA Conversions
If we follow normal tax advice during our working days, we will retire early with a 401k or IRA or two. Except under special rules, this money can’t be spent until we turn 59.5, upon which it is taxed. But there is a way to avoid this, by converting it to a Roth IRA. Withdrawals from a Roth IRA are tax free for life.
Once we’ve chosen leisure over work, we can convert our 401ks and IRAs to a Roth IRA, a small amount each year. Any dollars converted to a Roth are considered income, but we can earn up to $19,500 a year and pay no tax. This is why we always contributed to Traditional IRAs while working, and never to a Roth (which seems to be a big controversy.)
Other income sources can contribute to this $19,500 limit, such as interest on bonds, rental income, short term capital gains, and earned income. Some deductions can also be made, such as capital losses and HSA contributions (a common option for people buying health insurance through the new government exchanges under the ACA.)
Harvest Capital Losses AND Capital Gains
Harvesting Capital Losses is a common practice. If you sold a stock for less than what you paid for it, you’ve had a capital loss. This loss can be used to offset capital gains and, if it is big enough, even up to $3,000 per year of Earned Income. There is a special rule for Wash Sales that needs to be watched out for, but the Mad Fientist wrote a great article about harvesting capital losses that can guide us.
For stocks that have gone up in value, normally taxes must be paid on the gains. But… not if those gains are less than $70,700 (again, 2012 values) AND our earned income and taxable interest is sufficiently low that it is taxed at the 10% or 15% marginal rate.
In our own case, if we assume that our $36k a year spending comes from Qualified Dividends and Long Term Capital Gains, then we have an extra $34,700 in tax free capital gains to play with. Why not sell some extra stock, locking in that $34,700 gain, and immediately buy it back to raise our basis.
For example, let’s say we bought some of the VTI ETF over 1-year ago for $50,000, and it is now worth $84,700. It must be over 1 year ago in order to be considered a Long Term Capital Gain, an important time frame. Short Term Capital Gains are taxed at the normal marginal rate. Our basis in the stock is $50,000, with a $34,700 long term gain. When we sell it, we will pay NO TAX since we are keeping our total investment income below $70,700 (which also includes our qualified dividend income.) When we buy the VTI ETF back, our basis is now $84,700. The gain is locked in tax free, forever.
For even more detail, I’ve written a Tax Gain Harvesting Template, with a step-by-step example of how we harvest capital gains. Enter your info here and I’ll email it to you.
Do you want to Never Pay Taxes Again?
Following these 4 simple rules, it is possible for any US Resident. Maybe following these guidelines will help you retire earlier and live better.
A key part of our tax optimization is being able to quickly and efficiently view our full financial and tax picture. Personal Capital is a great FREE online financial management tool. Give it a try
One item to be careful of is new with the Affordable Care Act. It is possible for an early retiree to get massive health insurance subsidies, as long as income is less than 400% of the Federal Poverty Level ($62,040 in 2013.) At our $36k per year spending level, we qualify for several thousand dollars of assistance. Being aware of this threshold is important when deciding size of a ROTH IRA Conversion or Capital Gain Harvest.
Read an in depth review in our post on the Affordable Care Act and its tax implications
A special note:
Taxes are used for many useful and good purposes for the collective good, such as building roads, the filming of Sesame Street, and helping the disadvantaged. Isn’t it part of our moral obligation to help pay for these things?
I believe this is true, although it isn’t necessary to pay it annually. The taxes we paid during our working years were many, disproportionate to our use of roads (we bike and walk instead of drive) or our viewing of Sesame Street (we don’t own or watch TV.)
When it comes to helping others, there are many ways to help. The government helps in some ways, but other organizations do as well, more so even. Those organizations are very receptive to donations of both time and money. I encourage the giving of both.
As an added bonus, donations of cash or capital assets are tax deductible 🙂 And the donation of appreciated assets eliminates all capital gains taxes for both parties. Win win. If this sounds intriguing, check out a post by Jim Collins about making the most of your donations, How to Give Like a Billionaire