Retire Early And Pay Zero Income Taxes…Forever

You've done it!

You stumbled across GoGreenDollar after clicking on a post shared by a friend on Facebook and, after reading the articles on the site, realized that you are the master of your own financial future. This revelation inspired you to begin your journey towards financial independence and early retirement.

You applied the proper techniques and were able to erase your debt for good. You used your savings rate to calculate your retirement number and date. You withdrew the money that had been slowly wasting away in your savings account and used it to open an investment account. You started investing in your 401k at work.  You took advantage of the many other great investment accounts that were available to you. You implemented a simple yet effective investment strategy to grow your money.

You followed all the recommendations and checked all the boxes. It wasn’t an easy journey, but you never wavered, and now you're on the verge of being able to retire early.

What if, after you've resigned from your job, you could spend $100,000, or more, each year and owe zero federal income taxes? Pretty sweet deal, right?

In early retirement, there is a high likelihood that the majority of your income will come from long-term capital gains (i.e. profit on an investment held for more than 1 year), qualified dividends, and retirement account distributions. Luckily, the IRS treats income from these sources much differently, and more favorably, than it does income earned from an employer. The key to avoiding income taxes in early retirement is to strategically take advantage of the favorable tax treatment of these sources of income.

The tax rate you pay on long-term capital gains (LTCGs) and qualified dividends (QDs) depends on the tax bracket you fall into (with a little overlap).

Long-Term Capital Gains & Qualified Dividend Tax Rates

Comparing these rates with the normal income tax rates, you can see that, generally, anyone in the 12% tax bracket or lower, will have a long-term capital gain and qualified dividend tax rate of 0%.

2018 Tax Brackets

Based on these figures, a single person could have up to $38,600 in long-term capital gains and qualified dividend income and owe zero income taxes. For a married couple, the amount would be $77,200. This is before any deductions or credits are applied.

If we add in just the standard deduction ($12,000 for individuals; $24,000 for married couples filing jointly), these amounts increase to $50,600 and $101,200 respectively!

Let’s take it a step further.

Remember, a “capital gain” only includes the growth portion of your investment.  The amount spent to purchase the investment (i.e. the “cost basis”) is not part of your capital gain and thus it is not counted as income. I’ll use an example to illustrate.

5 years ago, while they were still working, Stewie and his wife Meg used their taxable investment account to purchased 1,000 shares of ABC stock for $100 per share. They believed the company had great long-term growth potential and also liked the fact that it yielded a 1.0% dividend each year. The total cost basis for their purchase was $100,000 (i.e. 1,000 shares x $100).

In the time since, ABC has performed very well and the stock price has risen significantly. Today, one share of ABC stock sells for $200 and still yields a 1.0% dividend.

Assuming Stewie and Meg are retired at this point, how many shares of ABC could they sell before owing income taxes?

Answer: 992 shares

They could sell almost every share, generating an income of around $200,000 and still, they would owe exactly $0 in taxes.  Let’s crunch the numbers.

Taxable Income Calculations
Qualified Dividends = $200 x 1.0% x 1,000 shares = $2,000
Long-Term Capital Gains = 992 shares x $200 - (992 x $100) cost basis = $99,200
Tax Deductions = $24,000 standard deduction
Total Taxable Income = $2,000 + $99,200 - $24,000 = $77,200

With a total taxable income of just $77,200, Stewie and Meg fall just below the top of the 12% tax bracket. Since all of the money came from qualified dividends and long-term capital gains, it will be taxed at 0%!

Total Spending money = $2,000 dividends + $198,400 stock sales = $200,400

They have over $200,000 in spending money, yet owe exactly $0 in federal income taxes!

Another potential source of tax-free income in early retirement is retirement account distributions.

All contributions to a Roth investment account can be withdrawn at any time, tax-free (the gains are not available until age 59.5).

If Stewie and Meg both maxed out their Roth 401(k) ($18,500 each) and Roth IRA ($5,500 each) contributions each year for 10 years, with 7% growth per year, they would have approximately $693,093 in their combined accounts. Assuming they rolled over their Roth 401(k) balances into their Roth IRAs after retiring, they would have $480,000 (i.e. their total contributions) available to withdraw, completely tax-free.

So what about non-Roth retirement accounts?

Although withdrawals from 401(k), 403(b), and 457 investment accounts are usually subject to income taxes (and early withdrawal penalties in the cases of 401(k)s and 403(b)s), it is possible to leverage deductions and credits to avoid paying taxes even on these accounts.

Circumventing taxes on withdrawals from these pre-tax accounts is especially valuable because the original contributions were made on a tax-deferred basis. Since these accounts are designed so that any taxes are delayed until the funds are withdrawn, being able to make tax-free withdrawals presents the rare opportunity to generate income that will never been taxed!

There is a limit to tax-free withdrawals for pre-tax retirement accounts, however. In order to keep your taxes at zero, the maximum you can withdraw each year must be less than or equal to the total of your tax deductions and credits. For example, Stewie and Meg would be able to withdraw a maximum of $24,000 per year without paying taxes since they use the standard deduction. Every dollar above this amount would be subject to income taxes.

Note: I realized I haven’t spent much time addressing the early withdrawal penalties associated with 401(k) and 403(b) accounts. That’s because you can easily avoid these penalties in early retirement by utilizing one of the simple techniques we've previously discussed (e.g. SEPP, Roth Conversion Ladder, etc).

If you’ve been following our monthly financial updates, you know that approximately 51% of our portfolio is held in 401(k)s and approximately 4% is held in IRAs. For this example, let’s assume the other 45% of our portfolio is invested in a taxable account (in reality it’s about 33% with the remaining 12% held across other investments and cash).

Assumptions
All investments are long-term and have grown by 100% (i.e. cost basis is half of each investment)
Yearly Living Expenses = $50,000
Total Portfolio = $1,250,000
401(k) Balance = $1,250,000 x 51% = $637,500
Roth IRA Balance = $1,250,000 x 4% = $50,000
Taxable Account Balance = $1,250,000 x 45% = $562,500
Yearly Qualified Dividends (1%) = $562,500 x 1% = $5,625

With yearly expenses of $50,000 and a total portfolio of $1,250,000, we’ve reached financial independence! After resigning from our corporate jobs we immediately rollover our 401(k)s to traditional IRAs. We plan to create Roth Conversion Ladders to slowly move all of these funds over to our Roth IRA accounts.

Using the assumptions above, how can we avoid paying income taxes?

Here's an example of how we might withdraw from our accounts.

Account Withdrawals

Our total income is $74,000, but how much of that is taxable? Let’s step through each source of income.

Since the actual capital gain is only half of our taxable account withdrawal (the other half being the cost basis, as stated in the assumptions above), we can subtract $21,250 from the total.

Taxable Income = $74,000 - $21,250 = $52,750

Roth IRA contribution withdrawals are always tax-free so we can subtract $1,875 from the total.

Taxable Income = $52,750 - $1,875 = $50,875

Any distributions from a traditional IRA (including conversions) are considered taxable income, but we can apply our $24,000 standard deduction to negate the impact.

Taxable Income = $50,875 - $24,000 = $26,875

After making all of the adjustments, we are left with $26,875 as our final taxable income. If you've been following along, you know that the source of this income is long-term capital gains ($21,250) and qualified dividends ($5,625). As we've learned, at this income level, the tax rate for these two sources is 0%.  Our final tax bill is $0.

Final Tax Bill = $26,875 x 0% = $0

Note: Moving forward with this hypothetical scenario, we would continue to build our Roth Conversion Ladder by making traditional to Roth IRA conversions each year. Our taxable account would remain our main source of income in the initial years, but once the Roth Conversion Ladder was fully formed we would begin splitting our withdrawals between our Roth and taxable accounts more proportionately.

Get a head start on your journey toward achieving financial independence by analyzing and tracking your income, expenses, investment performance, and overall net worth with the free online wealth management tool Personal Capital.

We use Personal Capital regularly to analyze our investment fees, track our investments, and project our net worth. We also periodically review our progress toward retirement with their retirement planning calculator.

If you’d rather do things on your own, become a subscriber today and you’ll receive our Free Financial Planning Dashboard. This tool allows you to enter your income and expenses to create a detailed budget. You can use it to track your spending habits over time or just to get an idea of where your money is going each month.  Take a look at the automatically generated charts and you may discover you have a little more cash to invest than you thought.

If you’re interested in detailed instructions on how to budget, save, pay off debt, and invest, check out The 6 Phases of Building Wealth. This book provides step-by-step instructions for working through each “Phase” in the process of achieving Financial Freedom. If you're just starting out, the information in this book will provide you with an invaluable resource. You can pick up the digital version for only $2.99 on Amazon.

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