Tax optimization in drawdown phase
This post is part of the Financial Freedom Guide series
The following strategies work once you have achieved Financial Freedom, are in the drawdown phase, or when your income is simply lower for a while:
Tax arbitrage through Roth conversions
If you followed my advice during the accumulation phase, it is likely you built up some pre-tax balances in your Traditional IRA and/or other US retirement accounts. This was a great move because doing so saved you federal and state income taxes in the years you contributed. Now it's time to lock in those savings and bring your overall tax rate on this income down to as little as 0%!
Along with lower income levels come lower marginal tax rates. Better yet, if you move your tax residency to a no income tax state - or abroad, as other countries are unlikely to recognize US Roth conversions as taxable income - your total marginal tax rate will drop even lower. There's a reason why so many retirees move to no-income tax Florida!
In the "ideal" case, you do a small Roth conversion every year up to the amount of your standard deduction ($25,100 for married couples in 2021). The Standard Deduction is effectively a 0% tax bracket. This means you paid zero tax on your money when you earned it (and contributed it to your Traditional IRA/ retirement account), and now permanently 0% now that it has been converted to Roth. You can do this every year, called “Roth laddering”, and slowly chip away at your Traditional balances until they are 100% in Roth. The next two tax brackets (currently 10% and 12%) may also make sense for those whose Traditional balances are high enough that they grow faster than you can convert them using the standard deduction.
What's even better is that those Roth conversion amounts (but not earnings on them) can be withdrawn tax and penalty-free after 5 years (to be more precise: once 5 tax years have elapsed, including the year of conversion). This means you can freely spend a solid amount of your retirement savings long before age 59 1/2! - Of course you may be even better off if you leave your money in your Roth account and continue to benefit from tax-free earnings (and potentially inherit your Roth balances to your kids tax-free), while drawing on your taxable regular brokerage account first.
Pay 0% tax on your "taxable" investment earnings
Yes, I'm not kidding - married US taxpayers can earn as much as $106,150 in qualified investment income in 2021 and pay 0% tax! Here is how it works:
The IRS taxes long-term capital gains (e.g., on stocks held >1 year) and "qualified" dividends (paid by US and certain other corporations whose shares you hold 60+ days for common stock and 90+ days for preferred stock around the ex-dividend date) at favorable rates. Namely, if you are in the bottom two tax brackets (i.e., the 10% and 12% brackets in 2021), your capital gains tax rate drops from 15%+ down to 0%!
As a married couple filing jointly in 2021, you can earn up to $81,050 in taxable income and still fall into the 12% ordinary income/ 0% capital gains tax bracket. Add this to the $25,100 standard deduction "0% tax bracket" and you can earn up to $106,150 in taxable income without any federal tax due on your investment earnings. Combine this with tax residency in a no income tax state (or not US state at all) and you can easily bring your taxes on investment earnings down to ZERO.
So this is nice, right? You've achieved Financial Freedom and get to enjoy your investment earnings without any tax due. In fact, if your income is below the upper limit of the 12% tax bracket ($106,150 for married couples filing jointly in 2021), you may want to consider doing the opposite of tax loss-harvesting:
Tax gain-harvesting
Tax gain-harvesting means deliberately realizing capital gains to max out the 12% ordinary income/ 0% capital gains tax bracket. This works for those in the accumulation phase with low enough incomes as well. You simply sell and immediately re-buy the same security in order to realize capital gains. No need to worry about wash sales. As long as your other taxable income plus your capital gains do not exceed the 12% ordinary income tax bracket, your capital gains tax on the sale is ZERO. Critically, this "steps up your basis". And that basis is the purchase price against which future capital gains (or losses) are calculated. In other words, you will have locked in tax-free income for good. Loving this yet?
Pick the best tax jurisdictions abroad
Countries (and/or their subdivisions) decide whether to tax your different types of income and/or property based on one of four global tax systems: No tax, territorial, residence, or citizenship-based. Let’s focus on income taxes for a minute:
No income tax jurisdictions don’t have an income tax, simple. Just check if they have wealth, property, sales, or other taxes and/or restrictions (like unattractive living conditions, immigration obstacles, or sky high living expenses) that may offset the allure. Examples for countries without income tax include Monaco, the United Arab Emirates (including Abu Dhabi and Dubai), and many Caribbean nations - yes, tax havens!
Territorial income tax jurisdictions tax income sourced from within them but not from other countries. Most jurisdictions spare only non-residents for income sourced from outside the jurisdiction. Territorial tax jurisdictions, however, also do so for residents. This is attractive if you live there but source your income from another country that has low to no taxes on the income you are earning. For example, if in retirement, you earn all your income through your stocks in the US but live in a territorial income tax jurisdiction, you pay no income tax to the place you live in and pay low to no tax to the US (remember the 0% US dividend and capital gains tax example we reviewed above?). Territorial tax jurisdictions include Costa Rica, Panama, Malaysia, Singapore, Taiwan (if your income doesn’t exceed certain limits), and many others. There are also some attractive countries that normally use residence-based taxation but offer “non-habitual residence schemes” that tax new residents only on locally derived income for a certain period of time (i.e., the same way as a territorial tax jurisdiction would). Examples include Portugal (10 years) and New Zealand (4 years).
Residence-based income tax jurisdictions tax residents on their worldwide income. There are a multitude of different residence rules, ranging from 183 days per year physical presence rules to treating anyone as resident who so much as had Harry Potter’s room under a staircase at their disposal in which they could have stayed (but not necessarily did). Often multiple of these rules apply and if these jurisdictions charge high tax rates (like many countries in Europe), you may want to be very careful not to accidentally trigger their residency rules.
Citizenship-based income tax jurisdictions tax citizens on their worldwide income - regardless of where their citizens live or earn their income. The United States is the only major country on the planet to fully implement citizenship-based taxation (in addition to residential and territorial taxation on non-citizens).
So if you are (a) not a US citizen, and (b) don’t feel your taxes are commensurate with what you get for them, vote with your feet and simply move to where you feel treated better.
If you are a US citizen, however, there are a few tricks up your sleeve:
All the tax strategies detailed in the sections above make the US - for now - a veritable tax haven
If you live in a high tax jurisdiction, use the foreign tax credit (FTC)
If you live in a low tax jurisdiction, use the foreign earned income exclusion (FEIE)
BONUS
The foreign earned income exclusion is particularly attractive if you live in a no or territorial income tax jurisdiction and have US-source earned income. You could, for example, run your online business through a US-based sole proprietorship or corporate pass-through entity (e.g., an LLC or S-corp). Your residence jurisdiction wouldn’t tax this income, as either it doesn’t have an income tax at all or because the income isn’t sourced locally. The US also wouldn’t tax this income as long as it doesn’t exceed the FEIE cap of $108,700 per person in 2021. This means up to $217,400(!) for a married couple if both earn the maximum amount or more. Tada! You can earn six-figure non-investment income and pay 0% US income tax! Are you getting ready to pack your bags yet? :)
Further reading:
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