I don’t hate tax. I just hate overpaying it.
I’m not going to get philosophical about US Tax system here since this is a How-to. Tax optimization strategy tend to get complicated depending on one’s circumstances at a given time.
My goal is to walk through our experience in this area and hope that you can leverage the information. You get to crunch your own number at the end and see if one or more strategies applies to your unique situation.
We pay good amount of money to our CPA team annually, but what I value the most is the financial teaching that they generously give during our sessions (well… the hourly rate still applies). But great things always come with a price.
Our saving strategy
Here’s how we optimize the money we save annually. On the next sections, we will go through each strategy in more details.
- 401k – maximize company matching: $18,500 contribution + $9,250 company match
- HSA – maximize for family: $4,400 contribution + $2,500 company distribution
- Backdoor Traditional IRA to Roth IRA – $5,500 (alohaJim) + $5,500 (missRandom)
- Mega backdoor (after tax) 401k to Roth IRA – $27,500
- ESPP (Employee Stock Purchase Plan) – $25,000 + $2,500 (10% employee discount)
- 5-year Roth IRA conversion ladder – will start doing this in the initial phase of early retirement
Adding #1 to #4: $73,150. This is what we save annually in tax-optimized strategy (given that our tentative FIRE date is in 2025).
At this point, we still need to sell #5 right away for living expense since missRandom stays at home with our little one. But in the near future, we hope to not have to touch #5 as well to bring the number closer to our annual saving goal of $90k.
Retire By saving strategy
Here’s a good rule of thumb for optimized saving. Everyone is unique, so the priority order may vary.
- If your company offers 401k match, maximize it to the match limit.
- Maximize Roth IRA (for you and your spouse)
- Contribute to any employee stock purchase plan, assuming it’s at a discounted rate (you can sell immediately at vesting to cash out the discount)
- Fully fund HSA
- Max out remaining 401k to the limit that year (e.g $18,500 for 2018)
- If your spouse 401k (if you have that option), maximize it
- Cash to buy investment in discount (for the opportunists)
- Backdoor / Mega backdoor Roth IRA
- Depending on your circumstances, ESA or 529 for college saving (but there’s an alternative to accomplish this through Roth IRA)
- Roth IRA conversion ladder (a strategy to gradually withdraw money from Roth IRA before age 59 1/2, penalty and tax free/optimized)
- Money coming in: Pre-tax
- Growth: Tax free
- Money coming out: Ordinary income tax (+ 10% penalty if withdrawn prior to age 59 1/2)
If your workplace offers company matching of 401k, take it on a heartbeat (to the match limit)! This is free money. Let’s say your company gives 50% match on up to 6% contribution. Even if you withdraw that money right away, you still come ahead after penalties and tax. This is like getting 50% return right away. Factoring in the 10% penalty (on early withdrawal) and let’s say 25% marginal tax, you’ll still be ahead by 15%.
There are tons of information on what 401k is out there, but in short, you contribute money before tax and let it grows tax deferred. At qualified withdrawal period (age 59.5), you will pay ordinary income on the amount you withdraw. The premise is, you should hopefully be in lower tax bracket when you are in withdrawal phase since you don’t need to withdraw as much (you have many other streams of incomes if you do this right).
Consider this comparison of investing money on tax-deferred vehicle (like 401k) and after-tax vehicle. This assumes 8% rate of return annually for someone in the 25% marginal tax rate.
On left side, you contribute $18,500 each year. On the right side, your cousin contributes $13,875 each year (after taking the 25% tax on the $18,500).
After 20 years, there’s a $228k difference between the two. Obviously because you contributed more money each year than your cousin. But your cousin already paid the ordinary tax and only need to pay capital gain tax (15%) on the gains. Whereas, you still need to worry about paying ordinary tax at withdrawal phase.
Let’s crunch some numbers to compare during withdrawal period:
- For simplicity, let’s say the portfolio stops appreciating after year 20 and you live somewhere with no state tax (like WA)
- If let’s say your cousin cashes out, he/she needs to pay $61k of capital gain on the $408k gain. This leaves $625k in pocket after tax
- If you are married and can manage to retire within the 12% tax bracket. E.g. withdraw $75k per year, pay $9k tax ($66k after tax)
- Your money will still outlast your cousin’s money by ~25%. This is significant.
2018 Federal Tax Bracket
|Rate||Individuals||Married Filing Jointly|
|12%||$9,526 to $38,700||$19,051 to $77,400|
|22%||38,701 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$165,001 to $315,000|
|32%||$157,501 to $200,000||$315,001 to $400,000|
Health Saving Account (HSA)
- Money coming in: Pre-tax
- Growth: Tax free
- Money coming out:
- Tax free for medical related expenses
- Ordinary income tax after age 65 for non-medical withdrawal
- +20% penalty if you withdraw prior to age 65
HSA is a pretax saving vehicle that let your money grows tax free. Distribution for medical-related expense is tax free. For non-medical expense, there is a 20% penalty if you withdraw the money before age 65.
The penalty is waived after you turn 65. However, you still have to pay ordinary income tax on non-medical withdrawal. For example, if you contribute $5,000 to an HSA account this year and your marginal tax rate is 25%, you already save $1,250 on your tax bill this year. You don’t have to pay any tax either if you reimburse yourself for healthcare expenses, such as deductibles, copay, prescription, medical supplies (e.g. bandaids), and other medical expense not covered by your insurance. Please refer to IRS publication 502 for the list of qualified medical expenses.
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Just like any other tax-deferred investment vehicle, the power of HSA is in the tax-free growth during your wealth accumulation phase. As you can see in the illustration above, tax plays a significant factor on the speed your money growth.During your early retirement period (before 65), you will have tax-free money to fund your health-related expense.
You will likely have medical-related expense throughout your life. Might as well pay it using pretax money.
Backdoor Roth IRA
- Money coming in: Post-tax
- Growth: Tax free
- Money coming out: Tax free (+ 10% penalty on the earnings if withdrawn prior to age 59 1/2)
- But when utilized properly, 5-year Roth IRA conversion ladder can get you your money penalty and tax free (on the principal). There’s a strategy to optimize tax on earnings as well.
First, check the Roth IRA contribution limit on IRS website. For 2018, if you are single and your MAGI is over $135,000, you cannot contribute to Roth IRA. For married couple filling jointly, the MAGI limit is $199,000.
If you can contribute directly to Roth IRA, do it to the max each year ($5,500 if you are below 50. $6,500 otherwise).
But if your MAGI is over the limit, you can do something’s called Backdoor Roth IRA. Here’s how it works:
- You contribute $5,500 (after tax money) to traditional IRA (open one if you don’t have already)
- Wait until the money is available (usually within a couple of days)
- Rollover the money to a Roth IRA
- Report this event on your next tax return (form 8606)
Physician on fire has an excellent article on step-by-step instruction on how to do this in Vanguard. I will write the steps to do this on Fidelity on our next iteration.
You and your spouse can contribute $5,500 each to make $11,000 total each year. If you haven’t done this last year, you can sneak in another $11,000 for last year’s contribution (for a total of $22,000), as long as you do this before mid April.
Over time, the tax saving on this strategy will save you hundreds of thousands of dollars. Let’s say you invest $11,000 each year with 8% interest over 12 years. This will give you $225,448 in your Roth IRA account.
Mega backdoor Roth IRA
As you can see, there are a lot of tax saving benefits of sheltering your investment in a Roth IRA account. Considering that the investment growth and and qualified withdrawal are tax free, this can make a huge difference in the end game.
Let’s say the equity inside your Roth IRA is a rental property (yes, you are not limited to stocks, mutual funds, and bonds when you self-direct your Roth IRA). If your cost basis is $100k and that property appreciates to $300k in 20 years, when you sell, that $200k gain is tax free. Given time, value, and money, it is not impossible for someone to make 500k or millions in gain on investments over time. 15% or more capital gain tax on gain is significant.
But how can I purchase significant equity if the annual limit for Roth IRA is $5,500? Well, hold on to your hats, here comes… (drum rolls)… the MEGA backdoor Roth IRA!
This is another way to get post-tax money to your Roth IRA. Here’s how:
- Contribute to post-tax 401k
- Convert the post-tax 401k money to Roth IRA
IRS allows you to contribute up to $55,000 annually (current limit) to 401k.
- $18,500 is pre-tax
- Company match counts in pre-tax
- The rest is post-tax
Let’s say your workplace matches $6,500, this leaves $30,000 that you can contribute post-tax ($55,000 – $18,500 – $6,500).
As soon as the money is available in your 401k, call your investment broker to transfer the post-tax contribution in your 401k to your Roth IRA.
If you do this right away, there should be minimal appreciation on your post-tax money. Even if there is, you will just pay small tax on the gain alone (not the principal, which you already paid tax on).
Thus, you can contribute significant amount of money each year to your Roth IRA account and can make sizable equity investment.
These $30k yearly investment over 12 years (with 8% interest) will compound to $615k. After age 59 1/2, you withdraw all tax free!
But since this is a blog about early retirement, what if I need the money before 59 1/2? First, you can withdraw the contribution amount (i.e. principal) tax free (since you’ve already paid tax on it). The catch is, that contribution needs to be in the account for 5 tax years before you can withdraw the amount tax and penalty free. For example, if you convert $30,000 in 2018, you can withdraw that $30,000 after 2023 with no penalty (otherwise, it’s 10% penalty).
For early retiree in the example above, you can withdraw the $360,000 contribution before age 59 1/2, if you plan it around this 5-year rule. As for the earnings, leave it growing in the tax-sheltered account for longer term to fund your life in your 60’s (should be a good cushion, given time, value, and money).
Roth IRA Conversion Ladder
Ok, so I can withdraw some money from my Roth IRA without any penalty and tax. What about my money in 401k? How should I withdraw it if I retire early? Let’s say you quit your job at age 45 and convert your 401k into Traditional IRA. Do I have to wait for 15 years in order to tap into my “traditional” money without paying the 10% penalty? Do I pay the one time tax of converting Traditional IRA to Roth IRA? Of course not! Introducing, the Roth IRA Conversion Ladder.
You can withdraw any amount of money that you convert from Traditional IRA to Roth IRA tax and penalty free. There are two rules:
- You have to wait 5 tax years after a conversion in order to withdraw it tax free
- You have to pay ordinary income tax at the time of conversion
The premise of FIRE life is, you plan to be in a much lower tax bracket so you can optimize, or rather, minimize the tax consequences for rule #2 above.
The strategy is to not touch your Traditional IRA for the first 5 years of your early retirement life. You will have to live from your after-tax money or withdraw the principal from your Roth IRA above. Then after 5 years, you can start converting your Traditional IRA to Roth IRA every year, and limit the conversion amount so you can stay within a reasonable tax bracket. For example, if the realized tax for married couple making up to $50k / year is 11 %, you’ll pay $5,500 that year to convert $50k to Roth IRA, assuming no other income (and you can withdraw tax/penalty free 5 year after that). If you have 2 children, you can claim $4,000 (for the year 2018) for each child tax credit, bringing your tax bill down to $1,500. Then, you can claim other qualified tax deduction to bring it lower.
For example, if you convert $50k to Roth IRA on year 2020 (and pay effective tax that year on conversion minus tax credit/deduction), you can withdraw that $50k on year 2025, tax and penalty free.
Root of Good has a detailed article on how to do Roth IRA Conversion Ladder.
Cash (for the opportunists)
“Buy low, sell high. Don’t lose money”
This is always the mantra of investment. Don’t you wish that you have spare sizable cash when the stock market dropped in February and you can scoop up some funds on the drop? How about that time when real estate crashed and you wish you could’ve bought a property in a desirable location? Those who hold cash when opportunity presents itself tend to win.
But this part is a bit of the gamble since you don’t know what the future looks like. And you would rather your cash invested in an equity that performs much better than just a money market. I did ride some of the wave when real estate was on the rising. But I was also on the recipient end when the market dropped and forced to hold a non-performing rental property for over 10 years until the price rose enough to make it justified to sell.
Our take here is, you want to have some form of equity or line of credit that’s liquid enough so you can sell / borrow (at low interest rate) when a great opportunity comes knocking at your door. For example, I use the Vanguard Total Market Index fund (VBTLX) to hold some money that’s relatively less volatile and provide better yield (2.5% – 3%) comparing to a money market (e.g. Capital One at 1.2%). I also opened a HELOC (Home Equity Line of Credit) with low interest rate that we can temporarily use for a down payment of a good real estate deal (only if the rent covers both the PITI of the rental + monthly HELOC payment used to make the deal happen).
Obviously, there’s always a risk associated with investment. It is all about tradeoff, risk vs. reward. You should always buffer yourself to ride a downturn for an extended period of time. But the one thing I learn about the market/real estate, it will always bounce back. As long as you don’t sell on the low, you can ride it out.
College Fund (ESA, 529)
This topic is subjective to each family’s situation and need. While it is an emotional investment to provide for your children’s future education, the truth is, there’s no guarantee that your kids will want to go to college in the future. Or if 4-yr university education is still applicable a decade from now. Maybe by that time, everything is self-learnable from the internet. Best case, your kid gets a full scholarship and you end up not using all of these monies for college-related expenses. Then you end up withdrawing that fund at 10% penalty (+ income tax) for non-qualified expense.
However, if you still have extra funds to invest at this point and you feel that this is the right call for your family, there are 2 investment vehicles to fund your children’s education in the future that is tax efficient (similar to HSA, but the money is used for educational-related expenses).
- ESA (Educational Saving Plan)
- There is an income limit in order for you to qualify (at the time of this writing, the limit is $110,000 or $220,000 if filing joint return)
- $2,000 limit for annual contribution
- The beneficiary must be below age of 30
- There’s no income limit to contribute
- The annual contribution is capped at $14,000 (gift tax consequences otherwise)
- No age limit on beneficiary
The money coming in is post-tax. It grows tax free. Contribution is tax and penalty free as long as it’s use for qualified, education-related expenses. You want to open it under your name and name your children as the beneficiary. Open separate account for each child. Beware that this might affect your children’s eligibility to receive a financial aid since the money invested in college saving counts towards Expected Family Contribution (EFC). We find it kind of ironic that the parents who prepare for their children’s education can get “penalized” (get less money from a grant, for example).
alohaJim and mrsRandom opted not to utilize this route due to some inflexibility described above. Instead, we plan to utilize our Roth IRA to fund our children’s future education (if it’s still applicable in 18 years or so). But as a small token of good faith, we did contribute a small seed money to a Vanguard 529 account with our son as the beneficiary. Worst case, mommy or daddy can take a college class for fun during our early retirement.
What’s your tax-saving strategy will look like?
In conclusion, these strategy will work best for those who are still in wealth accumulation phase and don’t decide to retire tomorrow. But if your are close to FI, you want to make sure that you have enough post-tax, non-retirement equities that you can utilize before tapping into your retirement accounts.
Everyone’s situation is different. I urge you to crunch some numbers, use our calculator page to help your decision. But if you want to hit FIRE soon, you’d want to save at least 50% of your take home income. Live waaay below your today’s income. Delay gratification. Have a plan. Be flexible.
And even if you don’t plan to retire early, I’m sure you will be in a much better state in your golden years comparing to the old saying of save 10-15% of your take home pay and everything is going to be alright. Is it?