Our big adventure across the country begins in less than a month and there’s nothing that makes it more real than cutting off our main source of income. We’ve been down to a single paycheck ever since Becky left her job last year, but our high savings rate means we didn’t really feel the impact (our savings just didn’t grow as fast).
Now that I’ve given notice at my own job, we’ll soon be doing a complete 180° from saving money each month to living entirely off of our savings! It’s scary to think about, but we’re confident in our plan financially, so hopefully it doesn’t keep either of us up at night.
As I haven’t left yet, I will get one final paycheck in 2018 and I recently made a couple of key changes that should make this final paycheck work optimally for us. Without them we would have lent Uncle Sam a decent chunk of money and wasted our usual retirement contributions. Let me explain why:
If I Changed Nothing
By looking at a typical paycheck from last year, I can predict what will happen for my first (and final) paycheck to start 2018:
NOTE: This is a monthly paycheck
- More than $1,000 will be withheld for Federal Taxes (because payroll will assume I’m working the full year)
- ~$1,500 will be placed into my Traditional 401k (based on maxing out the contributions over 12 months)
- ~$237 will be placed into my HSA (based on maxing out the contributions over 12 months)
All 3 of these things will be a big negative to start out the year for one simple reason: We don’t plan to make very much money in 2018.
This final paycheck, a small amount of rental income, and a little bit of blog income combined probably won’t even crack the new standard deduction.
Because our overall income for the year will be low, there’s a very good chance we’ll end up paying $0 in federal taxes! I’ll be happy to fill out that tax form come 2019, but there’s a couple of changes we can make now to make our financials for the year much more efficient.
Adjusting Our W-4 Withholding
The payroll department won’t be aware that I’m not moving on to another job and will withhold taxes assuming my income will last for the full year. I know more than them in this case and have estimated my tax burden to be a solid goose egg for the year. Therefore, there’s no reason to withhold any federal taxes, but I need to inform them ahead of time or some of my money will become locked up for 12+ months!
If the withholding goes through as normal, Uncle Sam will get to watch over my money until I file my 2018 taxes in early 2019 and there’s nothing I can do about it. Of course, I will eventually get it back in the form of a tax refund, but why wait if I can get access to the same amount of money now?
In order to inform my employer to not withhold any federal taxes, I filled out a new W-4 form and put 99 exemptions in Box 5. According to my online tax consultant, “99” is simply an exemption code in payroll software and the IRS couldn’t care less if we owe no taxes at the end of the year. Having said that, do your own research and maybe consult a tax professional before changing your own W-4.
Problem #1 solved and the final paycheck should have $0 in federal taxes withheld (FICA taxes should still be withheld normally).
Now, let’s talk about the retirement accounts.
Changing Retirement Account Contributions
I’m a big advocate of avoiding taxes in the present by contributing as much as possible to tax-deferred accounts such as Traditional 401ks and HSAs. These amounts may end up being taxed when they are withdrawn down the road, but a carefully planned early retirement that utilizes something like a Roth Conversion Ladder can mean avoiding taxes on that money completely.
The main reason this method is so powerful is because you can defer taxes at a high rate now and withdraw them eventually at a lower or even 0% rate some time in the future. The key being deferring taxes “at a high rate now”.
For 2018 and our expected $0 tax bill, we have the exact opposite of a high tax rate right now. In fact, any money we put into a tax-deferred account now could end up hurting us in the long run if we have to pay taxes on it when we eventually withdraw. We would essentially defer paying 0% in taxes for an unknown future tax rate, it just doesn’t make any sense!
On the other hand, this kind of low-income year is the perfect opportunity to utilize a Roth account. By paying the full 0% in taxes up front and moving the money into a Roth account, we will eventually be able to withdraw that money completely tax free along with any gains (which should add up significantly over 30+ years!).
Luckily, my employer also offers a Roth 401k in addition to the regular Traditional option, so I lowered my Traditional 401k contribution to 0% and increased the Roth 401k contribution as high as it would go (90% in my case). I’m normally not a fan of front-loading a 401k, but in this case I think it makes sense because this is the one and only opportunity I expect to have access to a 401k for the year.
NOTE: If your employer doesn’t offer a Roth 401k option, it probably makes sense to still contribute the minimum that maxes out any available employer match. That immediate “gain” on your contribution should outweigh any negative tax implications down the road.
In addition, I lowered my HSA contribution to $0 for the final paycheck. There is possibly an argument to be made for keeping it anyway due to avoiding FICA taxes and any eventual taxes by using it for medical expenses, but either way I’d be losing the most powerful part of the HSA: deferring/avoiding federal taxes now.
My New Final Paycheck
With these three adjustments, my final paycheck should look much different than a typical paycheck from previous years:
- $0 will be withheld for Federal Taxes
- $0 will be contributed to my Traditional 401k and HSA
- The majority of the paycheck will be contributed to my Roth 401k, so take home pay will be almost nothing.
The take home pay being minimal isn’t a problem because we’ve already met our goal cash savings amount to start our trip. If we were still a little short, I could adjust the Roth 401k contribution downward, but it would probably be better to leave it alone and pull the necessary amount out of our brokerage account instead. Given our expected income, any gains would be completely tax free and we still will have maximized our available Roth contributions for the year.
By spending a little time optimizing my final paycheck, we’ll avoid giving the IRS an interest-free loan for the next 12+ months and we’ll use our available tax-advantaged accounts for the year much more efficiently. That’s one more item checked off our to-do list before we hit the road in early February to start our Gap Year!
Is there anything you would have done differently?
Final stretch!! All I’ve to say is have an absolutely fabulous time.
Conversely, is there anything you would have done differently in the preparation?
For anyone planning their own gap year, consider going halfway through the year to avoid what Noah is experiencing. Your salary will hit half and half in each year PLUS you can hit $18k a year in 401k contributions twice, potentially. Noah, I’d consider going some traditional to Roth conversions during your year on the road, at least up to your standard deduction. Happy travels!
Deciding when in the year to leave is tricky, but I think this was optimal for our situation. Particularly because I had a bonus come through at the end of December, but I think the low income works to our advantage, specifically for healthcare.
If we would have left half way through the year, healthcare for the remaining 6 months wouldn’t have been subsidized at all and probably would have cancelled out any tax benefits we would get from additional 401k space. Working until you make $18k post tax in a year could make sense if your company offers a Roth 401k, otherwise deferring taxes with a Traditional 401k in a low income year would actually be counterproductive! More info on the healthcare thing we’re looking at:
https://moneymetagame.com/fi/gap-year-planning-many-mediocre-health-insurance-options/
We do plan to manipulate our income a bit using Trad->Roth conversions to hit the sweet spot 🙂
Loving the support of the Roth right now. I feel like all I hear from the FI forums is “traditional, traditional, traditional,” and I’m like “optimize, optimize, optimize.” If you have an incredibly low effective tax rate, you should take advantage! I’ve contributed to a Roth IRA since I was 17, and I originally started with a Roth 401k when I started working, although this year I finally made enough income to switch to a traditional 401k. I’m still doing a Roth IRA though, because maxing the 401k bumps me back down into a lower tax bracket.