How to Retire Tax Free: Life after Financial Independence
As you noticed in my last post, 6 Investing strategies to accelerate Financial Independence, most of my funds are in tax advantaged accounts: 401k, IRA and HSA. And some are in taxable accounts at Vanguard.
Let’s say I was able to save enough money to support my family for the rest of the life at age 50. How am I going to access these tax advantaged accounts without paying too much tax or penalty when they have age restrictions?
Let’s say I decided to retire at 65 instead. Still, taking money out of any of these accounts will incur taxes. Then the retirement funds will dry out a lot faster. How am I going to optimize taxes as much as possible and also at the same time safely and legally?
In this post, we are going to talk about the tax free retirement strategy once you accumulated enough money to support the rest of your life. This post has important information to completely understand my investment strategy from the last post. If you wanna know how much money is enough to support the rest of your life, see my next post, How to calculate your FIRE number: You might have enough money to retire already.
0. Understand income tax brackets
Traditional 401k, Traditional IRA and possibly HSA (if withdrawal from HSA happens for non-qualified medical expenses) are subject to income tax at the time of the withdrawal. Here are the federal income tax brackets for 2020. We will not talk about state income tax in this post.
1. Withdrawing Traditional 401k and Traditional IRA
If you own Traditional 401k or Traditional IRA, any money you withdraw from these accounts are considered income and will be subject to your income tax at the time of withdrawal.
Assuming you are not working, your income is currently $0. And if you withdraw $50000 from your Traditional 401k or Traditional IRA, then your income for that year becomes $50000. However, based on the 2020 tax laws, you do not have to pay income tax for your income up to $12400 for singles and $24800 for married joint filers. This is called Standard Deduction. So if you withdraw $24800 as married joint filers from your Traditional 401k or Traditional IRA, then you will not pay any tax.
However, the money you withdraw is still subject to the penalty if you are under 59.5. To avoid this penalty, you should use a strategy called Roth Conversion Ladder. Basically any money that you converted from Traditional 401k or Traditional IRA to Roth IRA can be taken out without penalty, 5 years after the conversion.
However, the money that you converted is also subject to income tax just like the direct withdrawal from Traditional 401k or Traditional IRA. So, you should convert only up to the Standard Deduction amount when you do not have any other income to make sure you do not pay any income tax. The same 5 year rule of Roth Conversion Ladder applies to Backdoor and Mega Backdoor Roth IRA conversions.
Based on this information, people over 59.5 can withdraw money from their Traditional 401k or Traditional IRA up to Standard Deduction with no tax. And people under 59.5 can start converting their Traditional 401k or Traditional IRA to Roth IRA up to Standard Deduction with no tax or penalty every year after they stop working. And they can use the converted money 5 years after the conversion.
That means people who retired before 59.5 need to utilize another income source to support their first 5 years of early retirement unless they were able to do Backdoor or Mega Backdoor Roth IRA conversions during their working years so enough funds have been already converted to Roth IRA more than 5 years before the retirement.
Do you realize how powerful this is? Withdrawing funds from Traditional 401k or Traditional IRA without paying tax means you did not ever pay tax for that money because you also contributed pre-tax money!
The only thing you have to be careful with this strategy is that there is Required Minimum Distribution (RMD) for Traditional 401k and Traditional IRA. That means you have to start taking money out from these accounts starting at 72 and eventually emptying out within a certain period.
If you have a lot of funds left in these accounts, RMD will force you to pay taxes as the required amount becomes more than Standard Deduction. It is recommended in that case to convert most of the funds from Traditional 401k or Traditional IRA to Roth IRA before 72.
2. Withdrawing Roth IRA
Now you understand that you can withdraw $24800 per year from your Traditional 401k or Traditional IRA without paying any tax or penalty, but certainly $24800 is not enough for a lot of people to enjoy their retirement. Another source of income you can utilize is Roth IRA.
Roth IRA is the most flexible tax advantaged account. If you are over 59.5, you can withdraw whatever amount of money without paying tax and the money you withdraw does not count as income and it does not affect your income tax bracket. So you do not have to worry about withdrawing up to Standard Deduction amount.
If you are under 59.5, you can withdraw the following without paying any tax or penalty:
- The contribution amount
- The funds that you converted from Traditional 401k or Traditional IRA at least 5 years ago
- The funds that you put in using Backdoor or Mega Backdoor Roth IRA conversions at least 5 years ago. (If you are not familiar with Backdoor or Mega Backdoor Roth IRA conversions, read my previous post, 6 Investing strategies to accelerate Financial Independence)
If you make sure you withdraw from these funds only, then the money you withdraw does not count as income. Another good thing about Roth IRA is that it does not have RMD. You can enjoy tax free growth and tax free withdrawal until your death.
3. Withdrawing HSA
Withdrawing HSA with qualified medical expenses are tax free and penalty free for any age. However, if you are withdrawing without qualified medical expenses, then the money that you withdraw will be subject to income tax. In addition, if you are younger than 65, you will have to pay penalty.
It is recommended you collect all the receipts of the qualified medical expenses and withdraw money without paying tax or penalty. You can use that money you withdraw for any purposes at that point. If you do not have qualified medical expenses, then you can withdraw up to Standard Deduction from Traditional 401k, Traditional IRA and HSA combined after 65 without paying tax or penalty assuming you are not making any other income.
4. Withdrawing Taxable Accounts
Withdrawing taxable accounts by selling stocks or taking out dividends from your brokerage accounts at Vanguard for example is subject to capital gains tax but it is not subject to income tax.
What a lot of people do not know is that long term capital gains tax is 0% if your income is less than $78750 excluding Standard Deduction. Long term capital gains mean that you held the stocks/index funds more than a year before selling. So if you are withdrawing less than $78750 of dividends or capital gains from your taxable accounts where your stocks were held for more than a year, you will pay no tax.
That means you can still withdraw your Traditional 401k and Traditional IRA up to Standard Deduction (combined amount $24800) and then withdraw the dividends or capital gains of $78750 from your taxable accounts and then withdraw more from Roth IRA or HSA, and you still pay no tax! I imagine that $103550+ per year is more than enough for most retirees.
5. Tax-gain harvesting
Tax-gain harvesting is where you can offset your capital gains by selling and re-buying the stocks you own in your taxable accounts when your capital gains tax rate is 0%.
Using the above strategy, let’s say you withdraw $24800 from Traditional 401k and Traditional IRA combined and then $50000 more from taxable accounts every year to fund your retirement. Then you realize that you can still withdraw $28750 more from your taxable accounts without paying tax.
In that case you can sell your stocks with capital gains of $28750 that you held for more than a year and then buy the exact same stocks or any similar stocks right away. This practice increases the cost basis of your stocks, meaning that when you eventually sell these stocks again, capital gains (selling price — purchase price) have become much smaller so you will pay less capital gains tax.
You can imagine a scenario where you bought VTSAX 10 years ago and now it appreciated a lot and you have $30000 of capital gains. Assuming you stopped working and your income tax bracket is currently 0%, you sell it and buy it right away for the same price. And then after 1 year, when you are trying to actually sell and use, you only have $2000 of capital gains. You just saved capital gains tax on $28000!
Now you know where to put your money and how to access those money when you stop working. It is time to talk about how much money is enough to fund your retirement. See my next post, How to calculate your FIRE number: You might have enough money to retire already.
This is the third post of the “Financial Independence, How To” series. The rest of the series is here:
