Choosing the Perfect Early Retirement “Income”

Let’s imagine you find yourself in the fortunate position of no longer having to work for money (a.k.a. financial independence).  If you managed to achieve FI early enough in life, you might have walked away from work well before supplemental income such as social security or a pension kicks in.

Depending on how you choose to spend your time, it’s possible you will bring in little to no regular income during this early retirement phase of life, but that doesn’t mean it’s optimal to report little to no income to the IRS!

If you followed the standard advice of maxing out retirement accounts and/or invested money in a regular brokerage account, there are numerous levers available to precisely control the “income” you report each year.  This taxable income doesn’t necessarily have to match the amount of money you plan to spend each year because of how the different investment buckets are treated by the tax code.

Let’s look at some of the different considerations for efficiently accessing the money needed to fund your lifestyle while minimizing taxes at the same time.

Even if you aren’t financially independent or early retired, but decide to take a mini-retirement or a Gap Year while earning little to no money, choosing an ideal income applies to you as well!

The 3 Primary Investment Buckets

1. Tax Deferred or Pre-Tax Buckets

Examples:

  • Traditional IRA
  • Traditional 401k

Important Details:

  • All money in these accounts are treated the same whether they are contributions, gains, or otherwise
  • Can not be accessed directly without penalties until age 59½
  • Can be converted to the Roth bucket and accessed penalty free after 5 years
  • Conversion to Roth is taxed as regular income

2. Post-Tax or Roth Buckets

Examples:

  • Roth IRA
  • Roth 401k

Important Details:

  • The money in these accounts are split into two different parts: Contributions and Gains
  • Direct contributions from the past can be taken out at any time, this is not considered income and is completely tax free
  • Indirect contributions (such as Traditional to Roth conversions) can be taken out after 5 years, this is also completely tax free
  • Gains can not be accessed penalty free until age 59½

3. Regular Investments

Examples:

  • Brokerage Account
  • Anywhere you own stocks, mutual funds, or index funds outside of retirement accounts

Important Details:

  • The money in these accounts are split into two different parts: Cost Basis and Gains
  • All of the money can be accessed penalty free at any time
  • Most withdraws from the account will consist of both Cost Basis and Gains
    • The Cost Basis is not considered income and is completely tax free
    • The Gains are taxable and the tax rate will depend on how long the investment was held
      • Investments held for greater than 1 year are taxed more favorably as Long Term Capital Gains
      • Investments held less than 1 year are taxed as regular income in the form of Short Term Capital Gains
    • It is possible for the Gains to be negative and offset other positive gains or regular income

Note: I decided to leave the HSA out of this discussion because it has it’s own unique set of rules and considerations.  I recommend the Mad Fientist’s post on the subject if you want all of the details on the “Ultimate Retirement Account”.

Maximizing Tax Free Income

Now that we’ve covered the basics on the different buckets, let’s take a look at how much “income” we can report to the IRS without paying a cent in taxes.  I’ll be looking at the 2018 tax code which underwent several changes compared to 2017.

First, the Standard Deduction:

Table courtesy of Forbes.com

The standard deduction is the amount of regular income you can earn without paying any taxes.  If you are trying to maximize tax free income, it makes sense to report at least this much income.

Next, 0% Long Term Capital Gains:

Table courtesy of fool.com

After filling up the standard deduction with regular income, you can add additional income in the form of long term capital gains up to the amounts in the first row of the table above without paying any taxes.

Finally, Tax Credits:

The most common tax credit is the child tax credit which is worth up to $2,000 per qualifying child in 2018, but there are several other kinds of tax credits you may be eligible for as well.

For each tax credit, you can increase the amount of income reported up to an amount that will be taxed equal to the total of the tax credits.

For example, a married couple with 2 children can report $103,866 in income without paying any taxes!

  • $24,000 in regular income (standard deduction)
  • $53,200 in Long Term Capital gains (0% LTCG bracket)
  • An extra $26,666 in LTCG ($26,666 x 15% LTCG bracket = $4,000 child tax credit)

Max Reported Tax Free Income:

Note: While this information applies at the federal tax level, you should also take into consideration how your state may tax the same amount of income.  If you’re retired and not tied down to any particular state, it may even make sense to take advantage of some geographic arbitrage by moving to a state with better tax treatment!

Minimizing Health Care Costs

Now that we’ve explored the maximum amount of income we can report without paying any taxes, let’s take a look at one reason we might want to scale that number back: Health Care Subsidies.  As health care subsidies are currently based on income and determined through IRS tax forms, it makes sense to treat the cost of healthcare much like a tax.

Note: if you get your health insurance from anywhere other than an ACA exchange, most of this won’t apply to you.

The important numbers to keep in mind to qualify for health care subsidies are 100% and 400% of the Federal Poverty Level (FPL).  Anything below 100% and you are ineligible for subsidies because you are expected to use Medicaid instead.  Anything above 400% and you are no longer eligible for any subsidy.  Keep in mind that going from 399% to 401% of the FPL can result in a huge difference in the cost of your health insurance plan, so it’s very important to keep these cutoffs in mind when planning out your income for the year.

Another level to keep in mind is 138% of the FPL for states that have expanded Medicaid because that becomes the new lower bound to qualify for subsidies.

Federal Poverty Level ACA Cutoffs for 2018:

Choosing the Perfect Income

We’ve looked at how much income you can earn without paying any taxes and also touched on why staying below certain poverty level cutoffs may make sense to minimize health care costs.  So where is the happy medium?

Here’s the steps we went through to determine our own “perfect income” for the coming year:

  1. Estimate how much we need for expenses during the year
  2. Choose how we will get health insurance
  3. Pick an income that minimizes both taxes and health care costs
  4. Determine if we can cover our expenses without exceeding the desired reported income
  5. Adjust income up/down as necessary to meet our needs

Logistics of Meeting that Perfect Income

Once you determine what income you want to have for the year, it’s time to put a plan in place to actually get that income.  If you have a decent amount of money in each of the 3 investment buckets mentioned above, then this process becomes fairly simple.

First determine if there is any income you can’t avoid.

If you have any money stored/invested outside of tax-advantaged retirement accounts, it’s possible that money will generate income that must be reported.  This can come in the form of interest, dividends, capital gains, or even rental income if you own a property with positive cash flow.

In addition to the forms of passive income above, you may also have earned income for the year from traditional employment, side businesses, and/or and self-employment activities that must be taken into account first.

All of this income adds up to form your baseline for the year that can then be adjusted up or down to match your desired income.  Don’t forget to separate qualified dividends and long term capital gains from other forms of income when determining your tax burden.

If your baseline income above is too low:

  • Convert money from Traditional retirement accounts to Roth accounts to increase regular income
  • Withdraw money from your brokerage account to create capital gains income
  • Harvest capital gains from your brokerage account to increase LTCG income

If your baseline income above is too high:

  • If you have any earned income, contribute that to a Traditional retirement account to reduce regular income
  • Harvest capital losses from your brokerage account (if you have any) to reduce income

Don’t Forget to Cover your Expenses!

Aside from reaching the perfect reported income to minimize taxes and health care costs, it’s important to make sure you are able to cover your expenses for the year at the same time.  Having the perfect income on paper doesn’t mean much if you don’t have the cash to cover your needs!

The nice thing about having a variety of investment buckets to access is that it may be possible to access cash without having to worry about it impacting your reported income.

Expenses can be covered with a combination of available cash, the baseline income you calculated above, money withdrawn from a brokerage account (cost basis and gains), and previous Roth account contributions or conversions (don’t forget about the 5-year wait on the conversions).

The amount taken from each of these sources will depend on how much money you need and how each of them impacts (or doesn’t impact) your reported income for the year.

Looking Beyond the Current Year

Now that I’ve laid out the steps and considerations for funding a lifestyle of little to no work while minimizing taxes and health care costs for a single year, it’s time to look at staying efficient for years to come.

With a sizable amount of money in each of the 3 investment buckets discussed above, it’s possible to achieve just about any desired amount of spending while still keeping the optimal reported income for a specific year.  Unfortunately, this may not hold true over many years in a row as you begin withdrawing and shifting that money around.

For example, if the primary source of funding your expenses is withdrawing old Roth contributions, that will only work so long as you still have Roth contributions to withdraw!

Ideally, you will probably want to at least have a rough outline of each year’s withdrawal plan between now and age 60 or so when all of the investment buckets become much easier to access without penalty.  This will help insure you aren’t digging yourself a hole in the early years that you end up having to dig yourself out of later with early withdrawal penalties and higher taxes.

Depending on how many years you need to fund and which buckets your investments currently sit in, it may be necessary (or optimal) to increase your reported income in the present across lower tax brackets in order to avoid that money being forced into the higher tax brackets later in life via Required Minimum Distributions.

Hopefully this information gave you an idea of how to plan out a year (or more) of living off investments while avoiding any unnecessary taxes or health insurance costs.  Everyone has their own unique situation which will require adjustments to the general outline above, but the core principles should apply fairly universally.


7 thoughts on “Choosing the Perfect Early Retirement “Income”

  1. I am 62 and now retired. During my career it was always advised to max out that 401K with tax deferred $’s. This was the dumb advice I got. Back then, I had kids and lots of deductions and paying the taxes on those funds would have been easy and I had lots of deductions. Now it is the wife and I and now we have to pay taxes on the money we withdraw. Back in those days there was no Roth.

    We are fortunate though to have pensions, plenty of 401K (now in an annuity that pays 4% plus market). I also started SS due to a shorter, per genetics, life span.

    Tax deferred anything when working with lots of deductions is a major problem. The other major problem we should lobby our government about is having to take 401K money at 70-1/2. That hurts our kids and puts a burden on the SS in the future.

    1. Whether or not to do pre-tax depends on a lot of factors, but usually makes sense for anyone retiring early. Retiring closer to traditional age with additional planned income sources such as SS and pensions would probably skew more towards brokerage/Roth unless you were in a high tax bracket.

      As for the RMD’s at 70½, I’m not sure I follow on how it hurts kids and/or SS. I believe the idea is to get that money out of pre-tax buckets and taxed at some point. The promise of IRA’s/401k’s was to defer taxes until later in life, not indefinitely, but I’d be happy to hear you expand your thoughts.

  2. Wow, great post! I think it’s important to mention that none of these methods will work to reduce your self employed tax burden. An extreme example: Someone making $1,000 in SE income will pay more tax than a W2 worker who earned $20k if MFJ.

    We’re quiting our jobs and traveling full time beginning in August and January will begin our first year with no jobs for us. So I’ll be converting some IRA funds to Roth funds to fill up the $24k deduction.

    1. Thanks Ken, that’s a good reminder about SE income. It is possible to offset it with tax credits, but the standard deduction won’t help as you mentioned.

      Congrats on being so close to pulling the trigger and traveling full time!

    1. Agreed, we aren’t opposed to taxes in general given what they provide for us and others, but there’s no reason to pay more than we have to. Even without the federal income taxes I focused on above, there’s no getting around sales tax, property taxes, and many other kinds of tax!

      Thanks for chiming in Angela 🙂

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