Cliff’s Notes: Never Pay Taxes

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In my experience a great blog post is much more than an idea.

It is more like a seed pod that is dropped into fertile soil. It germinates and sprouts and expands in all directions in the readers mind, transforming him much as a piece of ground is enriched by the presence of a growing tree.

There are so many good blog posts, but not so many great ones.

In the field of personal-finance I would say that have read only three great ones so far.

The first of course was Mr. Money Mustaches powerful post on the Shockingly Simple Math Of Early Retirement.

I’ve written about this ad nauseum  because the post was so transformative in my own life. How powerful that simple chart.

The second was the Mad Fientist’s excellent post on The Triple Value Of Money. This was fundamental because it quantified the oft underestimated power of saving and investing money as opposed to spending it now..

Which brings me to today’s post.

Today’s post was written by Jeremy and Winnie of Go Curry Cracker.

From what I can gather, this is a couple very much after my own heart.

First of all, they’re self-proclaimed foodies. And they choose to waste their money where I choose to waste mine. And you know what? They’re already traveling the world at a young age, fully retired, following their bliss. So scoreboard. It is possible.

Secondly, they love travel ,and are currently slow voyaging through developing countries as a form of geographic arbitrage. This is an obvious area of overlap for the value obsessed travel hacking aspect of my blog.

And finally, they are an international marriage who make good use of their complementary skills. Jeremy is an excellent writer, and Winnie shoots incredible photographs of their travels. I see obvious parallels to the wonderful international marriage that I fell into. Synergy.

But enough blabbering, onto the post…

This is a post about the tax advantages of being an early retiree.

Please read this before continuing… Never Pay Taxes Again

chicago_02_12_2012

Behold the sweet symphony of Go Curry Cracker

Welcome back. Pretty great,huh?

I see this article as a symphony in five movements so let’s break it down.

Movement 1: Why You Should Care About Taxes.

If using after-tax money to buy things is like using a deflated currency, (a premise well proven in the triple value post) then using tax-free money is like using inflated dollars. Think of it like earning money in a first world country and then buying an item in a Third World country. Same item lower price.

There is then some foreshadowing of the subsequent four movements…

Movement 2: Choose Leisure Over Work.

Because the early retiree chooses not to have any earned income, he is able to take advantage of a predictable quirk in the tax code.

There is an important distinction between earned income (the way you probably make money now, by means of a paycheck,), and investment income (long-term capital gains, and dividend income.)

This distinction is hugely advantageous to hedge fund billionaires(duh,) trust fund babies (duh,) evil right wing petrochemical trust fund fascists (duh,)  and early retirees (who knew?)

Charles_David_Koch

Who let in the riff raff?

You see, investment income is not taxed at all until you get to the 15% tax bracket for taxable income. ($70,700 in 2012, or $73,800 in 2014.)

This means in that 2014 you can have up to $94,100  of retirement income, ($20,300 in earned income + $73,800 him investment income) tax-free.

Movement 3: Live Well For Less.

Once you earn more than a certain threshold, your money starts being taxed. The threshold is determined by the standard deductions which anyone can claim. In 2012, at the time the article was written, the threshold was $19,500. Now in 2014 the threshold is $20,300 for a married couple.

This threshold is sort of a nonissue, at face falue, for an early retired couple as they presumably have no earned income. (But keep reading.)

Movement 4: Leverage Roth Ira Conversions.

The Roth IRA conversion involves converting a (Traditional) IRA into an (After tax) Roth IRA.

You can withdraw money from a Roth IRA any time five years after the conversion tax free.

This is very useful to an early retiree.

Importantly, the amount that you convert is counted as ordinary income.

So as an early retiree, if you have no earned income, you can currently convert up to $20,300 from an IRA to a Roth IRA per year tax free.

I actually see this as an extension of the sweet music played during Movement 2.

By choosing leisure, and having a nice long retirement, You open up a huge loophole that allows you to turn your traditional IRA account into the ultimate savings vehicle. Pretax money is put in and it grows tax-free.  It is converted into a Roth IRA (tax-free) where it then grows some more. It is eventually pulled out (tax-free.)  Taxes are completely avoided at every step  in the chain.(Cha-ching).

Importantly this also allows you to access your 401(k)/IRA money five years after initiating early retirement.

Movement 5. Harvest Capital Gains And Capital Losses.

The mechanics of harvesting capital gains and capital losses are well explained here, and here.

In many ways this is the ultimate heads I win, tails you lose scenario.

For tax loss harvesting, if your taxable stocks go down, you sell them. You can then use the amount lost to counteract future capital gains or ordinary income, thereby avoiding taxes.

For tax gain harvesting, If your taxable stocks go up, you can sell them and buy them again so that their current value is reset at their higher current level (their so called “basis” is changed.) This allows you to take bigger capital losses in the future when the stock’s value goes down.

This selling at an increased value would ordinarily be taxed as a capital gain, but won’t in this instance unless the amount gained (in addition to other investment income) exceeds The $94,100/year threshold mentioned above.

To my way of thinking this is an extension of Movement 3: Live Well On Less. By being disciplined in your spending you open up a huge reservoir of value to make your non-tax sheltered investing very tax efficient.

Movement 6: Grand Finale.

There is then an lively discussion on the ethics of taxation.

It’s an interesting take, but you already know my take on this.

When voting we should vote for the fairest system possible. (This post actually illustrates nicely the intrinsic unfairness of our current tax system. And I’m all for it changing for the fairer.)

But when doing your own finances we should act as rational economic actors and take advantage of every loophole there is. Otherwise we’re leaving money (and by extension freedom) on the table.  And let’s face it, we’re smarter than that.

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8 Responses to “Cliff’s Notes: Never Pay Taxes”

  1. Syed February 19, 2014 at 9:16 am #

    Very interesting post. I’m used to the standard contribute to my 401k and forget it so all this tax loss/gain harvesting stuff is a little over my head. But I am intrigued and will learn more.

    • Miles Dividend MD February 21, 2014 at 5:38 pm #

      Syed, tax loss harvesting and tax gain harvesting are really useful ways to make your taxable accounts more tax efficient.

      But taxable accounts can rarely be more tax efficient than tax sheltered investments.

      So this is really a strategy to be aware of after you have maxed out your 401K/backdoor Roth IRA/HSA savings for the year.(which you very well may do if you are pursuing early-retirement and have a high enough income.)

      Alexi

  2. Jeremy @ Go Curry Cracker! February 20, 2014 at 7:52 pm #

    Wow, thanks for that incredible intro!

    I am glad to hear that the Never Pay Taxes Again has been valuable. The system definitely is kind to an early retiree. Fortunately, it also rewards saving and investing over consumption

    Cheers

    Jeremy

  3. Miles Dividend M.D. February 20, 2014 at 11:27 pm #

    Jeremy,

    Thanks for checking the blog out. And thank you for your incredible post. Definitely a classic.

    Safe travels,

    Alexi

  4. Mike October 26, 2014 at 9:29 am #

    Question: So I’ve spent this morning looking at the numbers on this, and it seems that the maximum 401k balance that makes sense in an early retiree scenario under the conversion ladder strategy is around 500k (using the 4% rule). In other words, the most you can get tax free from the traditional IRA to your pocket via a Roth conversion is 20,300, 25 times that is $507,500. Once you have that amount, additional 401k savings don’t add to your annual income, right? So at that point would you be better off shifting the bulk of your savings (other than what you need to contribute to get a match) to taxable accounts instead, in order to maximize the long term capital gains / dividend part of the equation?

    Thanks for taking a look at this.

    • Miles Dividend M.D. October 26, 2014 at 7:52 pm #

      Great point Mike.

      A couple of points.

      1. Your 25X calculation assumes early retirement at age 40 I’m guessing? If you retire at age 30 would you use 35X?
      2. If you can save 500K in your 401K at a young age this implies a high tax bracket. In such an instance you are almost always better of lowering your taxable income as much as possible by contributing a maximum amount to your 401K each year. After all your tax liability will never be higher.
      3.The only time when contributing to taxable accounts are preferable to me, is in the case of a person who makes is in the 15% bracket or less, since he does not have to pay capital gains/dividends anyway. Short of that I always prefer tax sheltered accounts.

      AZ

      • Mike October 27, 2014 at 5:17 am #

        25x is based solely on the 4% rule. And assume 28% tax bracket. This is for a notional retirement around age 45, at which point on our current path we would have around 500k in tax sheltered accounts and about the same in taxable accounts with no mortgage. Granted, there are a number of assumptions baked in, but I’m comfortable with them. At any rate, the precise numbers aren’t as important as the overall decision; do I boost 401k contributions at the expense of paying down the mortgage and adding to the taxable stash, or just keep putting in the minimum to get a match. You’re post has certainly made me go back and dig into the numbers more deeply. y life spent out of a giant, glass-enclosed coffin :)

      • Mike October 27, 2014 at 5:19 am #

        25x is based solely on the 4% rule. And assume 28% tax bracket. This is for a notional retirement around age 45, at which point on our current path we would have around 500k in tax sheltered accounts and about the same in taxable accounts with no mortgage. Granted, there are a number of assumptions baked in, but I’m comfortable with them. At any rate, the precise numbers aren’t as important as the overall decision; do I boost 401k contributions at the expense of paying down the mortgage and adding to the taxable stash, or just keep putting in the minimum to get a match.

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