24 Jul

Early Retirement With Zero Income Taxes

Everyone loves taxes, and now that we’re traveling the world and no longer going to work everyday, what better time to plan for our future income taxes?

After years of working hard at our careers, we were curious to see how much of our previous income we’ve already paid to income taxes. Here is a table showing our income and taxes over the last seven years:

Year Income (AGI) Federal Tax CA State Tax Total Tax Paid Effective Tax Rate
2008 $177,863 $26,290 $11,445 $37,735 21.22%
2009 $158,857 $26,192 $9,713 $35,905 22.60%
2010 $146,863 $23,407 $8,574 $31,981 21.78%
2011 $149,305 $24,775 $8,229 $33,004 22.11%
2012 $207,581 $38,892 $13,507 $52,399 25.24%
2013 $204,718 $38,241 $13,729 $51,970 25.39%
2014 $234,992 $43,428 $16,368 $59,796 25.45%
Total $1,280,179 $221,225 $81,565 $302,790 23.65%

So, we paid more than $300,000 in income taxes over the last seven years – that’s a lot of cat food! This turns out to be an overall effective tax rate of 23.65%.

Note that the first row in the tax table (Year 2008) is for Canadian Income Taxes. Our great adventure of moving from Calgary, Alberta to Oakland, California did not happen until the very end of 2008. With this in mind, the biggest thing that jumps out when looking at these numbers is that in Canada we paid an effective tax rate equal to that of the US. This is not particularly interesting until you consider that Canadian taxes provide the wonderful benefit of Universal Health Care! So where is the extra money in the US going? I can only hazard a guess that it’s related to military spending in the US which apparently represents approximately 28–38% of the entire federal budget. Yikes! I digress.

We were driven to crunch our seemingly boring tax numbers by the desire to outline what our future tax scenarios might look like. If we plan things right, we can actually pay zero income taxes. This is made possible by a combination of living on less, and no longer having Earned Income from a job payroll, which is taxed at a higher rate than our alternative incomes: Capital Gains, Traditional IRA and Roth IRA.


The Basics of Paying No Income Tax

  • States With No Income Tax: If you can, set your domicile to be in a no income tax state! There are seven states that do not have an income tax, and two more that only tax dividend and interest income.
  • Federal Standard Deduction and Personal Exemption Amounts: The Federal Income Tax standard deduction for Married Filing Jointly in 2015 is $12,600. Additionally, the personal exemption rate for 2015 is $4,000 per person. Combined, this means that a married couple will not be charged tax on their first $20,600 of taxable income!
  • Capital Gains Tax: Taxes on capital gains are essentially non-existent. For a couple Married Filing Jointly with an income of less than $73,800, the tax rate on capital gains is 0%. Absurd and almost unbelievable tax laws working to our advantage.
  • Roth IRA Conversion: There are two types of retirement accounts (IRA’s), and the Traditional type cannot directly be withdrawn from until you reach age 59.5 (unless you want to pay a 10% penalty fee). To avoid the 10% fee, the wonderful and legal work-around is to convert a certain amount of your Traditional IRA into a Roth IRA each year. Then, after waiting 5 years, you are allowed to withdrawal this money! Setting up this conversion to occur annually is called a ‘Roth IRA Conversion Ladder’. It is worth noting that Canada does not have an age restriction on their RRSP retirement account withdrawals; it is allowed at any age.

The above items are the four main tools available to us in planning to eliminate our income taxes.

Different Retirement Investment Accounts

The next steps is understanding how different investment accounts are taxed. This helped us determine exactly how to implement the above basics to eliminate income taxes. Currently, our portfolio is broken up into the following accounts:

Name Amount Tax Status
Traditional IRA $315,000 Original contributions were tax deductible (we paid no income taxes), and all future withdrawals will be taxable. Must pay extra 10% penalty if money is withdrawn before age 59.5 (must use 72t or ROTH IRA Conversion Ladder as work-around – see below for more detail). This is comparable to Canadian RRSP accounts.
Roth IRA $80,000 Original contributions were not tax deductible (income tax was already paid), and all future withdrawals on the growth are not taxed. Can only withdrawal the original contributions (not growth) before age 59.5. This is comparable to Canadian Tax-Free Savings Accounts (TFSA).
Taxable Investments $500,000 General savings account with Vanguard. All growth is considered capital gains when withdrawn from the account.
HSA $15,000 Health Savings Account can only be used for qualified health expenses. No tax on contributions or growth.
RRSP (Canada) $95,000 Similar to Traditional IRA except money can be withdrawn at anytime without penalty.
LIRA (Canada) $20,000 A mysterious type of “locked-in” RRSP which cannot easily be accessed before retirement age.

Wow, six different types of investment accounts! Aren’t taxes FUN!?

How can we pay no income taxes on these accounts?

Well, basically any money we pull from our Taxable Investment Account (up to 73k annually) or Roth IRA is not taxed. Our cost of living is well within this 73k annual limit (in fact, it’s probably about half that), so right away, these accounts could sustain us for a long time with zero income taxes due.

Also, it would also be nice to have access to the money in our Traditional IRA on our own terms, instead of waiting until age 59.5. To do this, our next move will be to start a Roth IRA Conversion Ladder. We can convert $20,600 of our Traditional IRA into a Roth IRA every year without paying any taxes. After waiting 5 years, this would allow us to gain access to our Traditional IRA balance without paying any income taxes or early withdrawal fees!

Example – If we require an income of $40,000 for year 2016, this is what we could do to pay no income taxes:

A. Withdraw $40,000 from our Taxable Investments Account (capital gains) – current balance $500,000.
B. Withdraw $40,000 from our existing Roth IRA funds – current balance $80,000.
C. Some combination of the two accounts.

Pretty straight forward, right?

Are we done here? Sadly, no. It actually gets more complex than this! Since the United States still does not yet have a Universal Health Care system, we need to consider how income will affect our health care costs.

Affordable Care Act (ACA) Subsidies with Roth IRA Income

As if figuring out your income taxes was not already difficult enough, we need to add another layer of complexity and consider the tax implications of the Affordable Care Act. The metric that dictates your cost of Health Care Coverage is your Modified Adjusted Gross Income (MAGI). The larger your MAGI, the more expensive your health insurance. However, the magic bullet is that distributions from your Roth IRA do not count towards your MAGI.

Our friend Justin over at Root of Good did a great job digging into the details of ACA subsidies and recommending what he calls the ‘Gold Plated Silver Plan‘. In 2015, for a married couple without kids, this plan would cost us $1,486 for the year and to qualify for it we would require a Modified Adjusted Gross Income (MAGI) of no more than $31,460.

So to achieve this, we’ll need to pay attention to how much of our income is from capital gains (which is counted towards MAGI) vs distributions from our Roth IRA (which are not counted towards MAGI).

As mentioned above, to use money from our Traditional IRA we will be doing a Roth IRA Conversion Ladder each year. Although we cannot access this money for 5 years, the $20,600 that we will be converting tax-free each year from our Traditional IRA into a Roth IRA every year IS COUNTED towards our MAGI.

Example: If we want to live on $40,000 for the year, our income will look like:
$20,600 – Conversion of Traditional IRA to Roth IRA (must wait 5 years for this money)
$10,860 – Capital gains from our Taxable Investment Account
$29,140 – Distributions from our Roth IRA (don’t count towards MAGI).

Success! This delivers us the magical MAGI of $31,460!

Since we’re aiming to live on 3-4% of our portfolio each year (which would be $30,000-$40,000), we will need to pull anywhere between $19,140 – $29,140 from our Roth IRA each year.

In the event that our Roth IRA balance eventually becomes depleted, we’ll instead have to pull money from our Taxable Investments Account. This would give us a higher MAGI and would bump us into a higher-cost health care plan. We’ll need to check the balances each year and adjust our plans accordingly.

For now, this is our plan! Open invitation for anyone to shoot holes all over this. Your recommendations would be helping us out.

Β Other Notes

1. You may have noticed that we already have a decent Roth IRA balance, even though we haven’t yet started doing our Roth IRA Conversion Ladder. Why on earth would we have contributed to a Roth IRA if we were rushing to become financially independent? Yes, this is a good question! Why did we choose to pay an income tax rate of probably 30% on this money, when we could have deferred the tax by using a Traditional IRA and instead end up paying a 0% rate!? The answer my friends, is that these contributions were made before we ever started thinking about becoming financially independent. We sadly expected to work until we were 65, and considering tax rates are currently at historic lows, we thought a Roth IRA made sense since tax rates will probably be higher 35 years from now. So for a short period of time, we essentially implemented a tax strategy that was opposite to our ultimate goals… dang!

2. In the future we can also pull from our Canadian RRSP anytime we want, but it’s a little complex. Canada will do a standard 25% withholding tax because we are currently non-residents, but we should be able to get a refund from the Canada Revenue Agency (CRA) at the end of that tax year by filing Non-Resident Income Taxes (Section 217). We would enter all our world income on the Section 217, and apply the Canadian personal exemption of $22,276 for a married couple. For example, if we had world income of $40,000 and applied the exemption, we would need to pay a 15% Canadian tax rate on the remaining $17,724 (which would be total tax of $2,659). Also, we would need to pay US taxes on the RRSP gains since we left Canada in 2008. Finally, before doing anything we must confirm that the IRS is fully notified of our RRSP accounts over all the previous years (and that the growth taxes were deferred for those years). International taxes are super fun!

  • Looks like a very solid plan, and one that parallels ours closely too. We will end up doing something like $20-25k of Roth IRA conversions each year and sell some taxable investments to cover the first decade of living expenses. The awesome thing about funding early retirement out of taxable investments is that only part of the sales proceeds are taxable income (the gains, namely). So we can raise $40k of living expenses and only have $10-15k worth of gains (which leaves all that room for $20-25k worth of Roth IRA conversion headroom).

    And as for your taxes while working. Holy crappers. +1 on the “where does the money go?” question, and I think you figured out the answer already. Not a fan of huge military spending myself, and glad I’m able to mostly avoid paying for that spending these days.

    Thanks for the mention and for helping me to popularize the phrase “Gold Plated Silver Plans”. It’s one of the huge benefits of the ACA to really make health care affordable to those of low to moderate income (and incidentally helps early retirees too!). Sadly many folks don’t know about the Gold Plated Silver Plan benefits.

    As for your Notes bullet point #1 regarding Roth vs Traditional IRA’s, you likely made too much to contribute anything to a deductible traditional IRA anyway. I can’t recall the exact AGI threshold but it’s somewhere around $110k for married filing jointly to be able to deduct Trad IRA contributions.

    As always, I’m really enjoying the updates. Keep up the good work and have fun down south!

    • Travis

      Thanks Justin!

      Yeah, I think you’re right about us not being eligible for the Traditional IRA since our income was over the limit. Perhaps we contributed to a Roth IRA instead for a couple of the years because of this? It’s also possible I contributed to a Roth 401(k) at one of my jobs as well, and once I quit, I rolled it over into a Roth IRA. Hrmm, I can’t exactly remember!

  • Our Next Life

    Just found your blog! We’re still 2.5 years out from ER, and are thinking about exactly these kinds of questions. We have rental income as well, which complicated things, and makes it tougher to stay under the ACA ceilings, and may limit our ability to do Roth conversions. But you’ve given us a lot of food for thought. Thanks!

    • Travis

      Awesome! You’re welcome, and I’m glad this stuff is helpful!

    • Savard

      A little off topic but what Fund(s) would you recommend for my 1 year old daughter for a Roth IRA at vanguard?

  • Ryland

    Been reading since the start. Real believer in this stuff. Beyond being wonderful for you both, it’s always wonderful for the world. Thank you for sharing all the great info you’ve learned along the way. And showing how much fun you’re having I’m passing on to my friends!

    • Ryland

      *Beyond the financial freedom path being wonderful for you both, it’s also wonderful for the world.

      • Travis

        Thanks Ryland – it’s wonderful from a financial freedom perspective, but I think if everyone reduced their consumption, we’d likely have reduced environmental/climate change issues happening as well!

  • Just found your blog from a comment on LivingaFI! Great tax plan! I’ll definitely be sure to stop back by to hear more about the journey.

    • Travis

      Thanks Fervent!!

  • Mike

    did you account for FICA taxes as well? Not sure if that skews the Canada vs US effective rates. Sadly, there’s the CA SDI too πŸ™ … CA = no es bueno

    • Travis

      Hi Mike! FICA and CA SDI are payroll taxes, which are only paid on employee wages. We’ve had the pleasure of paying these over the years during our working years, but shouldn’t need to pay any more unless we get another salaried job somewhere.

      • Mike

        Hi Travis, I was just referring to your table with your past taxes paid. Hopefully, you won’t ‘need’ a W2 job in the future :). Best, Mike

  • LeRainDrop

    “So where is the extra money in the US going? I can only hazard a guess that it’s related to military spending in the US . . . .” Here ya go — check out the All Federal Spending pie chart for 2015: https://www.nationalpriorities.org/budget-basics/federal-budget-101/spending/ Plus, you already realized that you lived in a very high-tax state.

    • Travis

      Nice breakdown of the 2015 budget – thanks for sharing!

  • easytrader70

    How do you avoid paying taxes on the $20,600 you are intending to convert into your Roth IRA? That would normally become taxable as regular income at the time of conversion, ladder or not, would it not? Did i mis-read something or do you already have some kind of offset for that new earned income each year that you plan to convert over to the Roth?

    • Travis

      The $20,600 comes from the Federal Standard Deduction and Personal Exemption Amounts. Basically, the standard deduction for Married Filing Jointly in 2015 is $12,600. Additionally, the personal exemption rate for 2015 is $4,000 per person. Combined, this means that a married couple will not be charged tax on their first $20,600 of taxable income!

  • Josephine Jing

    How were you able to save so much in your traditional ira account despite the annual contribution limits?

    • Travis

      Hi Josephine – when we quit our jobs, we are able to “rollover” our 401(k) accounts into our Traditional IRA accounts, which explains why the balance is so significant!

  • BikerTy

    So to make sure I understand. If I plan on doing a ROTH conversion ladder, then it’s better to contribute to a non-ROTH retirement account (401k or otherwise) during my working years? I’m currently in the camp of doing everything ROTH.

    • Travis

      BikerTy, you are exactly right! During your higher-income working years, generally speaking it is best to reduce your income taxes by using Traditional 401(k) and Traditional IRA options. Then, once you stop working you can rollover your 401(k) into your IRA and because you’ll then have a lower annual income, you can start your Roth Conversion Ladder by slowly converting your Traditional IRA into a Roth IRA (with makes the money accessible after 5 years)!

      • BikerTy

        Awesome. Thanks Travis! So I have to wait until I stop working/lower my income to start the conversion ladder?

        • Travis

          You’re very welcome! Keep in mind that money you put into a Roth gets taxed up front, whereas Traditional gets taxed later (i.e. when you’re pulling money out, whether it’s at age 65 or when you’re doing the ladder conversion into a Roth IRA). Therefore, it’s best to pile money into a Trad account while you’re still working and your income tax bracket is higher. Hope this helps!

  • David in CND

    Nice work on your savings. I’m a Canadian still living here trying to match your result (hoping to eventually escape the winters of Alberta) I’d love more information on your plan to withdraw your yearly income. Have you changed any of your allocations at all or are you still in the same investment funds that you were in while you were saving? What index investment funds are you in? Do you have cash reserves that you draw from in case the market tanks? Sometimes it’s easier to know what to do when your accumulating your nest egg but more difficult to do the right thing when your starting to spend from it. Your thoughts would be appreciated.
    Another thought, could you guys break down your expenses in living in Costa Rica? Would it be reasonable to live there long term? Could you be comfortable on $2500-3000 a month? Fortunately your US dollars go a lot farther than our struggling CND $$ πŸ™
    As well if you know of any Canadian tax tricks please post them for your Canadian readers.
    Looking forward to your response.

    • Travis

      Hi David! Our portfolio allocation is based on the Core Four Lazy Portfolio as described here: https://www.bogleheads.org/wiki/Lazy_portfolios#Core_four_portfolios

      Whenever we need some money in our checking account, we log into Vanguard and sell some of the funds from our Investment Account and transfer over to our bank account. We don’t really keep much of a cash reserve, just enough for an emergency.

      For living in Costa Rica you could be comfortable living on $2500. We broke down some of our expenses and our thoughts on living there in this post here: http://freedomwithbruno.com/six-months-of-early-retirement/

      Hope that helps!!

      • David in CND

        Thanks for the response. What is your asset allocation? Did you change from 80/20 to 60/40 when stopped working or have you kept it the same. What determines which of the 4 funds you sell or do you just equally distribute from all 4.
        I just wanted to tell you guys that I appreciate going to a site of someone who has ‘retired’ and not been bombarded with ads and pop ups. If your retired you don’t need to make money from your website…thats the whole idea of being retired! I appreciate that you planned out your retirement properly so you don’t need to grasp at every penny that might come your way via advertising but rather have an educational website that you seem to truly enjoy contributing to as a hobby.
        Well done! I wish more ‘retired’ bloggers would follow your example.

        • Travis

          Thanks for the compliments – although most people use Adblockers anyway, I agree that ads on FI websites are generally unpleasant!

          Our asset allocation is 80/20 which has not changed over time, and we expect to keep this for many years into the future. Whenever we sell, we try to sell funds that keep the portfolio balanced, and we also try to rebalance the portfolio every 3-4 months anyways. Hope that helps!!

  • Awesome blog! Just stumbled upon it a few days ago.The tax code is very beneficial to early retirees indeed, quite a sweet spot. High income W2 earners get heavily punished. The key is not having excess expenses in retirement that push you into those higher brackets.

    Congrats on your freedom and thinking outside the box!

    • Travis

      Thank you very much HappyPhilosopher! You’re 100% correct and effectively summarized this entire article in just three short sentences!

      • Haha! Brevity is great…until I sit down and try writing a 1500 word blog post πŸ˜‰

  • Freedom35

    Hey guys, nice article and overview. I’m catching up on your blog and planning ahead for ourselves. Is there a reason you plan to preferentially withdraw from your ROTH before your taxable account? By selectively choosing shares with the highest cost basis in your taxable to sell, couldn’t you minimize capital gains, while allowing your ROTH balance to grow tax free for a bit longer? Am I missing something?

    • Travis

      Yes – you are 100% correct! Right now we could likely easily live off of funds withdrawn from our Taxable Investment Account, and not need to touch our ROTH at all.

      e.g.: We could withdraw $31,460 from our Taxable Investment Account, and likely only need to pay a few thousand dollars in capital gains (since our investments are still so young), this would probably allow us to convert even more into our Roth Ladder.

      A big question mark now, is that since we’re planning on moving to North Carolina (which has a flat income tax of 5.8%), I’ll need to do some additional analysis on how/if we’ll still do the Roth Ladder (Conversion of Traditional IRA to Roth IRA). I’ll have to report back on this.

  • Bruce

    While you are living in the states, do you qualify for food stamps or any other Govt subsidy programs based on your “income”?

    • Amanda

      Hi Bruce, with our net worth we do not qualify for food stamps (nor would we want to take advantage of this program, since we feed ourselves quite well). What we do happily take advantage of is the lower health insurance premiums due to our reduced “income” – this is thanks to the Affordable Care Act (aka Obamacare).

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