If you are as naïve as I was when I first started investing 15 years ago, you probably assume you will be paying the tax man until the day you die. The only thing certain in life is “Death and Taxes” right? Wrong! At least, when it comes to income taxes.
The single greatest secret I share on the Secret Life of FI is probably this: middle income American families can (and should) live tax free off their retirement investments.
Sure it’s going to take some discipline: setting a modest budget before and after retirement, a non 401k/IRA brokerage account, and even potentially some paper work shuffling (converting IRA to Roth yearly in retirement). If you plan ahead though, you can potentially withdraw tax free in retirement.
Below, I’ll share the how and why and answer some of the most common questions you may have.
Can I really pay 0% income taxes?
The answer is yes! On top of Roth IRA distributions always being tax free, your can take distributions from your taxable brokerage at 0% tax annual withdrawals below the limits of $41,675 (single) and $83,350K (married filing jointly). That’s right, tax free. See tax tables here for 2022.
The greatest irony of the US tax code is it punishes employment. Simply put, if you work you pay A LOT of taxes; if you don’t work (and you have reasonable living expenses), you can stop paying income taxes because you have no income.
Too bad 90%+ Americans pay their bills with earned income for 40 or more years and have no idea their annual living expenses can be covered tax free if they plan, invest, and retire early.
Consider this: the average US household’s annual expenses in 2022 were $70K. That already high figure is still below the $83,350 tax free threshold for capital gains.
Unless you are interested in Fat FIRE, live in San Francisco, or are sacrificing now for a more extravagant retirement, your retirement expenses are unlikely to exceed the 0% capital gains tax rate in most years. Plan ahead to convert your IRAs/401Ks to Roth and invest anything additional in a taxable brokerage account in your working years, and you can live income tax free in retirement.
Where can you withdraw the money from tax free?
If you are over 59 1/2:
- brokerage account
- Roth IRAs (basis and earning)
- IRAs (up to the $25,900 standard deduction + credit/deductions on your taxes) can be withdrawn tax free.
If you are under 59 1/2:
- brokerage account
- Roth IRAs basis (if its at least 5 years old)
- SEPP IRA accounts (Substantially Equal Periodic Payments, tax free under $25,900 standard deduction) – similar tax consideration to the IRA, but available before 59 1/2
Its best to build a sizable taxable brokerage account before you retire if you can, so that you have more flexible liquid cash available. I recommend at least 5 years of estimated living expenses in your brokerage.
Over those 5 years, you can convert $25,900 (married filed jointly standard deduction all Americans enjoy) of your IRA/401Ks to Roths, which you can access in 5 years. Because you are spreading out the conversion from IRA to Roth at equal or below the standard tax deduction of $25,900, you will pay no tax on it, and be able to withdraw it tax free in 5 years.
A further note: after you are 59 1/2, if you are still living off brokerage, you don’t have to stop these IRA to Roth conversions. As long as you keep your retirement expenses low, you can continue to convert IRAs to Roths one year at a time, below the $25,900 limit, and continue to convert your retirement funds that would otherwise be taxable (IRAs) to non-taxable (Roths).
As you can see, if you have no debts and therefore reasonable living expenses, whether you are younger or older than 59 1/2, you have tax free options to access your hard earned retirement. Check out the The MadFientist guide for a thorough breakdown of how to access your retirement funds early here.
Won’t I get a 10% penalty if I withdraw before 59 1/2?
Only if you are sucker! And you’re no sucker. After all, you are reading through the Secret Life of FI (and other resources I recommend) because you want to retire early and choose how to spend or donate money on your terms.
The 10% only applies to early distributions from tax advantaged accounts (IRAs/401Ks). As we saw above, you can set up a SEPP program, or convert to Roth IRAs that you can access in 5 years to avoid the 10% penalty.
What if I withdraw over $25,900 on IRAs? Will I owe tax then?
The answer is simple for IRAs.
- On Roth IRA, no. All tax free. That is why I recommend to convert every year to create a tax free income stream.
- On Traditional IRAs or SEPP IRAs, yes. Withdrawals (or conversions to Roth) over standard deduction ($25,900) is the same as normal taxable earned income, just like when you worked full time. Its doesnt matter if you are younger or older than 59 1/2.
What if I withdraw over $83,350 on brokerage? Will I get taxed?
On brokerage, the answer is . . . it depends on how much your withdrawal is taxable “gain.” If you withdraw $150K on your brokerage account, for example, and that money had say $100K of “gain” in value over your initial purchases basis, you will owe tax on the “gain” of $100K.
You’ll pay 15% (far lower than the normal earned income tax rate) on all of the “gain” made on your withdrawal that exceeds the $83,500 in a taxable brokerage account – so $83,350 is tax free but $16,650 remaining is taxed at 15%. See if you can use Tax Loss Harvesting to reduce or avoid the additional taxes.
Conclusion
As you can see, the U.S. tax code advantages those with taxable brokerage accounts and retirement investments. A tax free retirement life is achievable if you don’t live a lavish lifestyle, and you wisely invested money in both before and after tax accounts in your working life.
Some paper work shuffling and a little math might be necessary depending on the age you retire and how much brokerage you have saved up. However, it does not have to be as complicated as many tax and financial professionals proclaim. You can access your hard earned cash in retirement tax free or very low tax.
Note. If you are getting near your FI number and early retirement, and you believe your annual expenses could push beyond the 0% capital gains tax bracket, I encourage you to visit the Secret Life of FI’s Tax Loss Harvesting Secrets to learn more about ways to reduce your taxes in retirement (or if part of your wealth building includes a taxable brokerage account).