I do not follow the news media. But some of that still makes it to my world once in a while. Rich people being “greedy” and paying less in taxes is sometimes reported in them. I am sure you have heard that before. I am not rich (yet) but I do not really fault them for paying less on taxes if that is what they are doing legally. In fact, you should do the same too if you can unless you run a charity for the taxmen (and women).
I read somewhere that the job of the government is to try to get as much in taxes from you as possible and your job is to pay as little as possible. That is why you should take advantage of every tax breaks, deductions or strategies that will work for you. I have not seen or heard of anyone who is interested in paying more during tax time. So instead of blaming rich people for paying less tax, you should learn their strategy and use it in your favor.
Just so we are on the same page, I am not suggesting you cheat in any way, I would strongly condemn such behavior. But there are many legal ways to pay less in taxes, which you can take advantage of.
Ok, now that is out of the way, I want to discuss the simple ways which will help you pay less tax.
So how do you pay less tax?
There are many tax strategies. But I am not going to talk about all of them. I believe in simplicity and I will talk about the simplest ways. The simple way is you should put your saving in following tax-deferred accounts.
What is 401k?
You are probably familiar with 401k. Many employers offer a 401k plan. Some of them may even match the contribution or part of the contributions you put on it. It is a tax-deferred saving for your retirement. Money goes in tax-free and grows tax-free, but you have to pay taxes when you take out after the age of 59 and 1/2.
If you are like me who wants to retire in your 30s or 40s, 59.5 seems too far in the future. But there are ways to take this out tax-free and at an earlier age which I will talk about in a little bit.
You can put up to $18,500 in your 401k in 2018 per individual. Remember, you have to do it through your employer and the money is deducted from your paycheck. There are other ways for self-employed and small business owners but that is not the scope of this post.
What about IRA?
IRA works similar to 401k except that your employer does not get involved like 401k. Money goes in tax-free and grows tax-free but you have to pay taxes when you take out. You can set up yourself and is not much difficult than opening a taxable investment account. I recommend using Vanguard but there are many other providers.
The maximum annual limit for IRA is $5,500 per individual and $6,500 if you are over the age of 50.
Is HSA the same?
Yes and no. HSA is a health saving account, unlike 401k and IRA which are retirement saving accounts. But it works similarly in a way that you do not need to pay income taxes on the amount you contribute to HSA. Money goes in tax-free, grows tax-free and comes out tax-free. On top of that, you do not have to wait until you reach age 59.5. That is even better than 401k and IRA because it comes out tax-free and there is no wait time.
The only caveat is that you can only use it to pay for your medical expenses, which includes health insurance premiums, vision, and dental expenses. This is not really a bad deal since medical expense is one of the factors that most retirees fear about. But you have to pay 10% penalty plus income taxes if you withdraw for any other reason.
But that is not a bad price to pay for a healthy life. If you did not need to use HSA for your medical expenses, it is probably because you did not incur a lot of medical bills. Which does not sound bad at all. In addition, there are still ways to avoid taxes on the withdrawal which I will discuss below.
The contribution limit for 2018 is $3,450 for individual and $6,900 for the family.
Some employer health insurance plans may contribute to HSA. If your employer does that, then it counts towards your limit. For example, on my health insurance plan, my employer puts $1,000 total for me and my wife in our HSA, so we can only contribute $5,900 in addition.
So what does that add up to?
- 401k – $18,500 + employer contribution
- IRA – $5,500
- HSA – $3,450
- Total: $27,450 + employee contribution
This is the amount you do not have to pay taxes on. That amounts to $ 4117 in federal tax savings if you are on 15% tax. Similarly, you might be saving on your state taxes depending upon the state you file your taxes in.
If you are married, multiply that by 2. It saves me more than $10,000 for my household just on income taxes. That is a lot of immediate tax savings but it does not end there. The money in your tax saving accounts grows tax-free as well. So I am saving future taxes as well.
What about withdrawal?
How do all these work for an early retiree?
How you can avoid paying taxes as an early retiree?
Since you are a retiree, I am assuming you will not have an earned income after your early retirement. Earned income is the income you get from your active work, a.k.a. paycheck.
Now is the time to do your Roth Conversion. Since you have no earned income, your only income is the amount you take out from traditional IRA to put in Roth IRA. You pay income taxes on this amount and leave it in Roth account for 5 years.
How much income tax you pay depends on the amount you withdraw. You have to pay taxes at ordinary income rates. For example, if you were married filing jointly in 2018 and had no earned income, you could do Roth conversion on $24,000 tax-free with the standard deduction. Compare that to the rate you would be paying taxes on it during your working years.
After 5 years, it is your money to spend. Remember, you need to keep it in Roth account for 5 years before you can withdraw penalty-free. For reference, $24,000 will be $35,263 in 5 years at 8% annual growth, enough for the Millionaire Immigrant family for a year.
Did I make it more complicated?
No matter how you try to simplify, taxes may still seem complicated. This is why you should seek professional advice. A missed step could cost you heavily in penalties and fees.
Disclaimer: I am not a tax expert and I do not claim to be so. Always take tax advice from a CPA or qualified tax advisors.
How do I personally plan to use this strategy?
I and Mrs. Millionaire Immigrant both max out our IRA, 401k, and HSA accounts which will result in $54,900 in savings. We invest 401k and HSA through our employer retirement plans and IRA through Vanguard. We invest in low-cost index funds or similar investments (my company retirement plan does not provide index funds as options).
Any additional savings goes to our taxable accounts, also through Vanguard. This is the money we plan to live on during our first five years of retirement before we can dip into Roth converted money.
Bonus: Roth IRA
You can also contribute to Roth IRA in addition. I did not discuss this earlier, but you can start contributing to Roth IRA anytime. However, there is an income limit and you may not be eligible if you have a high income.
There is also a limit on how much you can contribute each year. This amount is $5,500 per individual in 2018. Although this is after-tax money (not a tax saving), any growth on it will also be tax-exempt in the future. Which means you do not need to pay capital gain tax, which you might have to pay otherwise. But you still have to wait for 5 years to take it out penalty free.
Contributing to the Roth account (except for Roth conversion) may not be of advantage for everyone. This is why I did not talk about it earlier. If you do not have to pay capital gain taxes anyway, which you may not if your income is less than $38,600 (x2 if married filing jointly). This is the income of the year you cash out your gains most likely after retirement.
Are there any Risks?
There are always risks associated with anything you do in life. The market may go down. The 8% rule is a long-term average, not a guaranteed return every year. Similarly, tax laws may change and tax rates and brackets may change. They may even stop you from allowing strategies like Roth conversion.
So you will have to be prepared for any such risks.
The best way to tackle risks is by being informed. The more you know what you are doing, the less risky it is. So get educated and get advice from professionals.
I do not want to worry about the US economy turning to Venezuela or the Aliens attacking the earth and wiping out the whole world. There is no way in my life I can prepare for such low probability events.
For more probable events such as market crash for an extended period, like in the early 2000s, 2008 or even 1970s or 1930s, you can always prepare for it to a certain extent. Hint: do not panic, it will most likely come back up.
What if it is worse than the worst in the history, which is beyond that you are prepared for. If you need to be back in the workforce for a couple of years, until it calms down, so be it. I can live with that risk for a low probability event like that.
Good luck on your pursuit to early retirement! Hope to see you on the other side some day. What do you think of my tax savings plan?