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.

 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!