When it comes to financial independence and retiring early (FIRE) taxes can make or break a financial plan. Early retirees, defined as people retiring in their 20s, 30s, 40s and 50s, are in a unique scenario requiring specialized tax planning to optimally navigate tax code designed for people roughly twice their age.
Retiring well before traditional retirement age poses unique challenges and lucrative opportunities when it comes to social security eligibility, early, penalty-free access to retirement accounts and legitimate ways to never pay taxes again. In this guide we’ll explore each of these topics and provide concrete, actionable takeaways to approach, achieve and embrace early retirement in the most tax-efficient way possible.
A few points on methodology before we get started:
- All numbers and concepts are reflective of tax rates and laws at the time of writing. As legislation changes, concepts and principles will be updated but math may reflect prior tax year values.
- In scenarios where we consider self-employment income, we do not factor in the employer/business-side of the Social Security and Medicare taxes. These are taxes the business pays per se, not the individual
- Due to the many combinations of state taxes, city taxes and the complexities representing scenarios for readers in every locale, all calculations will assume domicile in one of the 7 income-tax-free states: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming
The most important concepts for the early retiree, or really anyone focusing on taxes, are the progressive nature of taxes, the last-dollar principle, the taxation of different income sources and Social Security credits. This will set the foundation for our later topics.
Progressive Nature of Taxes
The US tax code is progressive. When income increases the following events happen:
- Income is subject to higher tax rates
- Deduction, credit and shelter eligibility begin to phase out or is eliminated
- Earned Income credit is eliminated
- Savers credit is decreased then eliminated
- ACA subsidies are decreased then eliminated
- Ability to contribute to IRA and 401k simultaneously is decreased then eliminated
- Ability contribute to a Roth IRA is decreased then eliminated
- Additional taxes are phased in
- 0.9% Medicare tax on earned income
- 3.8% Medicare surtax / Net Investment Income Tax (NIIT) on capital gains
This is in contrast to a flat tax where all income is taxed equally or a regressive tax where greater amounts of income are taxed at decreasing rates.
- Greater income can mean greater tax liability
Suppose a single person working for megacorp made $60,000 in 2023. After standard deduction, that number drops to $46,150. This puts them in the 22% tax bracket.
How much does this person owe in federal income taxes?
Hint: being in the 22% tax bracket does NOT mean the entire $46,150 is taxed at 22%.
Using the 2023 tax brackets for ordinary income, let’s calculate the federal income tax liability:
- The first $11,000 is taxed at 10%
- Then, the amount over $11,000 but less than $44,725 (i.e. $33,725) is taxed at 12%
- Finally, the amount over $44,725 ($1,425) is taxed at 22%.
- 10% bracket: 11,000 * 10% = $1,100.00
- 12% bracket: 44,725 – 11,000 = 33,725 -> 33,725 * 12% = $4,047.00
- 22% bracket: 46,150 – 44,725 = 1,425 -> 1,425 * 22% = $313.50
- Total = 1,100.00 + 4,047.00 + 313.50 = $5,460.50
Even though this person falls into the 22% tax bracket, “only” 3.0% (1,425 / 46,150) of their $46,150 of taxable income is actually subject to the 22% tax rate. The rest of the income is subject to lower tax rates.
Wait a minute! This person earned $60,000 yet they’re only being taxed on $46,150. This is due to the standard deduction. The first $13,850 of earned income is taxed at 0%.
The last dollar earned, the 46,150th dollar (or 60,000th dollar depending on how we want to look at it), is taxed at 22%. Meanwhile, the first and middle dollars are taxed at varying lower rates.
If earned income is less than or equal to the standard deduction, taxable income is $0 and no federal income taxes would be owed (social security and medicare, or the self-employment tax for those that are self employed, would still apply).
As we work our way through this guide we’ll explore tools and strategies that exploit the fact that the first and last dollar earned are taxed differently. This will allow an early retiree to potentially lower or eliminate income taxes.
- Be mindful how the last dollar is taxed as it’s often different than how the first or middle dollars are taxed
- The standard deduction serves as a 0% tax bracket
The are two income tax brackets: one for ordinary income and one for long-term capital gains.
Did you see that? There’s a 0% tax bracket for long-term capital gains, too. More on how we can use this to our advantage later.
What kind of income is considered ordinary vs long-term capital gains?
- Earned working for an employer (W2)
- Wages, Tips, etc.
- Supplemental Income (i.e. bonuses)
- Through running a business or freelance work (1099)
- The interest earned in a checking or savings account
- Proceeds from holding bonds
- Capital gains from assets held less than 1 year (short-term capital gains)
- Nonqualified dividends
- IRA Distributions
W2 and 1099 income is also subject to employee payroll taxes:
- Social Security @ 6.2%
- Income above $160,200 is NOT subject to Social Security taxes
- Medicare @ 1.45%
- Income above $200,000 is subject to an additional 0.9% Medicare tax
Long-Term Capital Gains
- Capital gains from assets held 1 year or longer (long-term capital gains)
- Qualified dividends
- Gains above $200,000 are subject to an additional 3.8% net investment income tax (NIIT)
- Social Security and Medicare taxes are not assessed on investment and interest income
- Long-term capital gains:
- are gains on assets held 1 year or longer
- are taxed at lower rates than ordinary income
- have a 0% tax bracket
- Short-term capital gains are:
- are gains on assets held less than a year
- are taxed as ordinary income
- have a 0% tax bracket (the standard deduction)
Social Security Credits
Social Security to an early retiree is a distant uncertainty. Whether it will be exactly as it is today, modified or completely dismantled is anyone’s guess. Thus, the approach is to fiscally plan for no benefit to be received while going through the motions to secure whatever benefit might be available.
To be eligible for Social Security we of course have to pay into the system. In particular:
- Earned money has to be subject to Social Security taxes. Money earned abroad and certain types of government and educational institution compensation is not subject to SS tax and is therefore not counted as paying in.
- One has to earn $1,640 or more for 40 three-month quarters (lower amounts are needed for prior years due to inflation adjustments). These quarters don’t have to be consecutive, but an equivalent of 10 years of contributions need to be made before reaching SS eligibility age.
For the early retiree in their 20s or 30s, there’s a possibility they may not have paid in for 40 quarters. It would be advantageous to earn and report some wage (W2) or self-employment (1099) income later in life to lock in 40 quarters of contributions to ensure coverage.
- To be eligible for Social Security one has to have at least $1,640 of income subject to social security tax for 40 quarters
- To review contributions to date, quarters earned and overall SS eligibility, visit https://www.ssa.gov/mysocialsecurity.
Early, penalty-free access to retirement accounts
In the following sections we’ll review different ways an early retiree can access pre-tax money penalty-free before age 59.5.
No, we’re not talking about the arbitrary, strings-attached loopholes that only allow money to be spent on specific things or in specific scenarios like a new home purchase or healthcare costs.
We’re talking about early and penalty-free access to do whatever we want with the money. These are the Rule of 55, Roth IRA Conversions and 72(t) SEPP.
Just in case you were wondering, here’s the list of all the strings-attached loopholes currently available for early, penalty-free access. It wouldn’t be a bad idea to keep these on file just in case. Some of these are better than others:
- Qualified higher-education expenses
- Qualified first-time home purchase up to $10,000 in a lifetime
- Health insurance premiums if collecting state unemployment
- Medical expenses above 7.5% of AGI
- Become disabled
- Die (the beneficiary won’t pay the penalty)
Rule of 55
This first mechanic is age dependent and applies only to people between 54 and 58. It should be considered before the other approaches as it’s the most flexible of the three (aside from the rigid age requirement of course). Feel free to skip to the next section for the non-age-dependent options.
The IRS has a rule called “Rule of 55.” This rule states if we leave our employer in the calendar year in which we turn 55 or older we can access “qualified retirement plans” such as 401k, 403a and 403b (see the IRS website for a complete list of applicable plans) without incurring the 10% early-withdrawal penalty. The reason for leaving the employer can be anything – resignation, layoff, termination with cause – anything.
For example: if you’re 54 in March, leave your employer in June then turn 55 in November, you’re eligible to avoid the 10% penalty.
One key point: only the funds in the 401k account associated with the employer we left are eligible for the penalty waiver. Other 401k accounts from previous employers are not eligible. To work around this, consolidate all 401k accounts with the current employer before leaving the employer.
To take full advantage of this rule ask the plan sponsor if they permit reverse rollovers. That is, rolling IRA funds into a 401k. According to the Plan Sponsor Council of America, 69% of employers allow reverse rollovers. Why would we want to roll IRA dollars into a 401k? If we have $100,000 in an IRA and roll it into the 401k, that $100,000 is now eligible for penalty-free early access.
Working for yourself? Open a solo 401k at your favorite brokerage; all the above concepts apply. A solo 401k is for anyone that’s self employed and has no full-time employees other than the business owner, and if applicable, their spouse. Disregarded entities such as single-member LLCs can take advantage of this, too.
Company-Sponsored Plan Not Offered
Suppose we’re not self employed and our employer doesn’t offer a company-sponsored retirement plan. Start a side hustle then open a solo 401k.
This doesn’t have to be anything fancy, just something to check the box. Cut someone’s lawn and make $20, roll available accounts into a solo 401k, then quit the lawn care business.
Be sure to report these earnings as business income come tax time and don’t write them off with home-office deductions or what not. The point is to formally generate [nominal] self-employed income / profit.
- 401k funds can be accessed penalty free by leaving an employer the year in which we turn 55, 56, 57 or 58
- 401k accounts can be sponsored by an employer as well as a sole proprietors and disregarded entities such as LLCs
- IRA dollars can be accessed penalty free by rolling them into the 401k prior to leaving the employer
Roth IRA Conversions
We know that contributing to a 401k or IRA during our working years can turbocharge our savings and accelerate the journey to early financial independence. The challenge with contributing to these vehicles is of course accessing the funds before age 59.5 (or age 55 as we saw above).
Before we dig in it’s helpful to understand how Roth IRAs work:
- Contributions can be withdrawn at any time tax and penalty free. Suppose we contributed $5,000 to a Roth IRA two years ago. We can safely withdraw $5,000 today tax and penalty free, no strings attached.
- Growth (dividends, interest and capital gains) in Roth IRAs can NOT be withdrawn before age 59.5 without incurring taxes and penalties. That $5,000 we contributed 2 years ago? It grew to $6,000. The $5,000 can be withdrawn but the $1,000 of growth can’t be transferred out until age 59.5 unless we want to pay taxes and penalties on the $1,000.
As it turns out, there’s actually a third mechanic of Roth IRAs: conversions. We can convert some or all of our traditional IRA dollars into Roth IRA dollars whenever and as often as we like. Converted funds can be withdrawn tax and penalty free after 5 years.
Suppose in 2023 we convert $20,000 from a traditional IRA to a Roth IRA. In 2028 we can withdraw $20,000 from the Roth IRA tax and penalty free, no strings attached. Any growth on that $20,000 can’t be withdrawn before age 59.5, however, without the usual taxes and penalties.
How much should we convert each year? Convert no less than your standard deduction minus any ordinary income. For example, if an early retiree single filer earns $1,000 in interest and $1,000 in short-term capital gains from selling options for a total of $2,000 in ordinary income, convert no less than $11,850 (2023 single filer standard deduction of $13,850 minus $2,000 in ordinary income).
Should we do this even if we don’t need the funds? Yes! It’s tax-free money. The funds don’t need to be spent, simply converted (read: transferred) into a Roth account.
As we learned earlier, the last dollar is taxed differently than the first dollar. In our original example of earning $46,150 after deductions, suppose the worker was contributing a few thousand dollars to a 401k over the years. In doing so they avoided paying 22% tax on those dollars – the last dollars they earned which were subject to the 22% tax bracket. When they convert the money from a traditional IRA to Roth IRA in early retirement these dollars are the first dollars earned and are taxed at 0% courtesy of the standard deduction.
There is no limit to how much we can convert each year. Keep in mind converted amounts above the standard deduction “breakeven” will be taxed as ordinary income and subject to the ordinary income tax brackets.
Suppose we want to perform a Roth IRA conversion. Here’s how we’d go about executing the concept:
- Contribute to pre-tax accounts like a 401k and IRA during working years
- Retire early
- Roll any/all pre-tax retirement accounts into a traditional IRA. There are no taxes or penalties associated with this step and brokerages should not charge any fees.
- Determine how much should be converted.
- This is usually best performed in December as we’ll have a better picture of ordinary income earned for the year.
- By populating the FIRE Tax Optimizer tool with this year’s income we’ll be able to easily identify the minimum size of our Roth IRA conversion space.
- Convert funds from the traditional IRA to the Roth IRA by logging into the brokerage and transferring shares (or selling shares and transferring the settled cash depending on brokerage capabilities)
- While no early withdrawal penalty will be incurred, standard federal income taxes will be assessed on the amount converted. Remember, these funds were deducted from our income during our working years and we didn’t pay taxes on them. Now that we’re “withdrawing” the funds they will show up on our income statement and are taxed as ordinary income. Amounts in the “negative income” space will be tax free.
- At tax time next year (and every subsequent year a Roth IRA conversion is made), fill out Form 8606. This lets the IRS know we made a Roth IRA conversion and the funds are excluded from the 10% penalty.
- Wait 5 years for the converted funds to ferment
- Withdraw the converted funds tax and penalty free (or simply leave them in the Roth IRA for continued tax free growth; the money can be withdrawn whenever we like)
- Repeat every year when possible, creating a “ladder” of converted dollars.
- Roth IRA contributions can be withdrawn at any time tax and penalty free
- Growth withdrawn before age 59.5 is subject to tax and penalties
- Conversions can be withdrawn after 5 years tax and penalty free
- For every year earned income is less than the standard deduction, a conversion should be made in an amount no less than the standard deduction minus any earned income
- There is no limit to how much can be converted from traditional IRA to Roth IRA; amounts over the standard deduction “breakeven” will be taxed as ordinary income
What if we want immediate penalty-free access to funds in our traditional IRA? This is where the 72(t) SEPP (substantially equal periodic payments) rule comes into play. This rule is the least flexible of the three penalty-free withdrawal options – once it’s established it must be maintained for a minimum of 5 years or until age 59.5, whichever is later. Failure to maintain withdrawals, or an error executing throughout the years, will trigger penalties retroactively for ALL years since the 72(t) was initiated PLUS back interest on the retroactive penalties.
Rule 72(t) turns a retirement account into an immediate annuity, a fancy way of saying “being able to withdraw a defined amount of money each year.” There are three methods in which we can implement rule 72(t):
- Minimum Distribution Method – the amount withdrawn each year is variable
- Amortization Method – the amount withdrawn each year is identical
- Annuity Method – the amount withdrawn each year is identical
These implementation methods require a bit of math and pulling many pieces of information under a single roof. To help us run the numbers we’re going to use a 72(t) calculator. We’ll need to determine the account balance, “reasonable” interest rate, life expectancy table, and calculation method in order to understand how much we can withdraw each year.
First, we need to determine how much of our traditional IRA we want subject to the 72(t) distribution. Why is this important? Once we start taking SEPP distributions, any contributions and non-72(t)-related withdrawals in the account will break the rules and invoke retroactive penalties and interest.
Organic growth and dividends that occur are okay. Similarly, we’re free to buy/sell within the account. However, new funds cannot be added and any withdrawals have to be part of the SEPP distribution. If we ever want or need to contribute to an IRA in the future, we’ll need to contribute to a different account.
If we want to allocate only part of our IRA to 72(t), roll that portion into a separate IRA and setup 72(t) on the newly created account; 72(t) is account specific. In other words, we can setup 72(t) on one account while doing roth conversions on a different account.
“Reasonable” Interest Rate
Next, we need to determine the interest rate. According to the IRS (see: page 7):
The interest rate that may be used to apply the fixed amortization method of the fixed annuitization method is any interest rate that is not more than the greater of (i) 5% or (ii) 120% of the federal mid-term rate (determined in accordance with section 1274(d) for either of the two months immediately preceding the month in which the distribution begins).
This effectively sets a floor for the minimum rate that can be used. When 120% of the mid-term rate is below 5%, we can use 5%. When 120% of the mid-term rate is above 5%, 120% of the mid-term rate can be used.
The IRS has a page that lists the applicable mid-term rates. Click the link associated with one or two months prior to the month in which the 72(t) is setup, scroll to page 2, and note the interest rate.
If we were to setup 72(t) on Mar 17, 2022, we would review the Feb 2022 and Jan 2022 (either of the two months immediately proceeding the month in which distribution begins) interest rates.
In this example I am using the “Annual” column since we will be making single, annual, distributions from the account. If we elect to do monthly distributions, use the value in the “Monthly” column.
Since both of these are below the 5% floor, we’ll go with the 5% interest rate.
Life Expectancy Table
There are three different life expectancy tables available for use in calculating 72(t) distributions: Uniform Lifetime, Single Life Expectancy and Joint Life Expectancy. There are actuarial differences between them but the main takeaway is that single life expectancy offers the greatest distribution amount.
Finally, we need to select the calculation method. My recommendation is to stick with the annuity or amortization methods as the annual payment amount is fixed. Why is it advantageous to have a fixed amount? We don’t have to calculate unique distribution numbers each year. This allows us to setup automatic annual withdrawals at our brokerage to ensure we don’t make an error and subject ourselves to penalties.
Suppose we have $300,000 in IRA funds and we want to setup 72(t) withdrawals on $200,000 starting Mar 17 2022.
- Roll $200,000 into a separate IRA account
- Identify the annual withdrawal amount on $200,000 by populating the online calculator
- Account Balance: $200,000
- Reasonable Interest Rate: 5.00%
- Your Age: <your age goes here>
- Beneficiary Age: 0
- Life Expectancy Table: single life expectancy
- Review the results and identify the SEPP Payment for the method selected – $11,205 in this example (age 40 was used in this example; be sure to use your real age).
- Configure the brokerage account to auto transfer $11,205 annually starting Mar 17, 2022. Be sure there is ample settled cash in the account before the transfer date. If capital is invested we’ll need to sell shares a few days prior to the auto-withdrawal date to ensure cash is available for the transfer.
- Fill out this form, print to PDF and keep it with your finance files. It documents the SEPP configuration used such as start date, calculation method and interest rate should you ever be audited.
- At tax time next year (and every subsequent year a SEPP withdrawal is made), fill out Form 5329. This lets the IRS know we made a SEPP distribution and the funds are excluded from the 10% penalty.
- 72(t) allows immediate penalty-free withdrawals from IRA accounts
- Once 72(t) is established it must run for a minimum of 5 years or until reaching age 59.5, whichever is later
- Annuity and amortization methods offer fixed annual distributions over the life of the 72(t) whereas the minimum distribution method requires a unique amount to be calculated each year
- 72(t) distributions are account-specific; they can be setup on one or more IRA accounts while leaving others unaffected.
- To decrease the amount withdrawn via 72(t) decrease the value of the underlying account prior to starting the process
- Contributions and non-72(t)-related withdrawals in accounts with an active 72(t) plan will void the process and invoke retroactive penalties and interest
Never Pay Taxes Again
When we transition to early retirement our source of income is no longer wages (W2) or self-employment (1099). As we learned earlier, this means we no longer pay Social Security and Medicare taxes. Meanwhile, most portfolios have assets invested in the stock market which causes the asset’s value ebb and flow. We can harvest capital gains and losses associated with these movements on a yearly basis and turn them into tax benefits. Also, as we mentioned earlier there are 0% federal tax brackets! Let’s if there’s a way we can mix and match these concepts so we can never pay taxes again.
Social Security Optimization
By becoming an early retiree and discontinuing W2 and 1099 income we immediately stop paying Social Security and Medicare taxes. Pretty straight forward.
The question that comes to mind is: won’t we get less from SS if our lifetime contributions are less due to shifting our income sources? If we’re assuming that 20-30 years from now the program will remain exactly as it is today, yes. But we won’t be missing out on much. Let me explain why.
Social Security monthly benefits are calculated in a three-tiered manor. In the first tier we earn $.90 for every dollar of eligible contributions. Not too shabby. However, after we cross through the relatively low ceiling of the first tier and enter the second tier we earn $.32 for every additional dollar – nearly a 66% haircut. What about the third tier? 15 cents on the dollar.
Consider someone earning $27,000/year starting in 2008 and receiving $1,000 bumps every year for a total of 11 years. Their 11 years of lifetime contributions fully fills the first tier, as we can see when we plug this into our FIRE Social Security calculator.
Any additional earnings experience significantly diminished returns. Delaying early retirement for the purposes increasing SS benefits is not an optimal move.
- By embracing early retirement we can lower our lifetime contributions to SS and Medicare while getting the most bang for our buck
Tax Gain Harvesting (TGH)
Tax gain harvesting is all about selling investments that have appreciated in value, tax free. Recall that Roth IRA conversions work to fill “negative” income caused by low-to-no ordinary income and the standard deduction. Tax gain harvesting works to fill the 0% space of the long-term capital gains tax bracket.
It’s important to note this concept only applies to assets in taxable accounts such as an individual brokerage account. Assets in 401k, traditional IRA and Roth IRA accounts receive the benefit of tax-free growth and therefore never experience capital gains taxes.
As a reminder, long-term capital gains are gains on assets held for 1 year or longer. This concept does not apply to short-term capital gains. That is, assets held for less than a year.
Let’s refresh ourselves with the long-term capital gains tax brackets.
Unlike other forms of income, we only owe capital gains taxes when the gain is realized.
What does it mean to realize a gain? Suppose we purchase 100 shares of stock that’s trading for $50 – a $5,000 investment. A year from now the stock is now worth $60 and we have a gain of $1,000 (100 * $60 – $5,000 initial investment).
However, this gain is “on paper;” we can’t spend it. To get our hands on, or realize, the $1,000 we would have to sell the 100 shares.
When we sell the shares our account now has $6,000 from the proceeds of the sale: $5,000 from the initial investment, called basis, and $1,000 of capital gains. The year in which the gain is realized is the year in which we’ll be assessed taxes.
It’s important to understand the difference between proceeds, basis and gain.
- Proceeds is the total amount received after selling stock
- Basis is the initial investment used to purchase stock
- Gain is the difference between proceeds and basis
Let’s continue the example used in the Roth IRA conversion section.
A single filer earned $2,000 in ordinary income in early retirement, experienced a “negative” income due to the standard deduction, then used a Roth IRA conversion to generate $11,850 of ordinary income to “break even” at $0, all tax free.
Over the course of a year that person also received $8,000 in qualified dividends. According to the long-term capital gain tax brackets this leaves $36,625 available ($44,625 – $8,000) to realize long-term capital gains at a 0% rate.
This person bought 400 shares of stock 10 years ago for $50. That stock is now trading at $200 and the investment is worth a total of $80,000 (400 shares * $200 per share). They have a basis of $20,000 (400 * $50 initial share price) and a gain of $60,000 ($80,000 proceeds – $20,000 basis).
To realize $36,625 in gains we would need to sell 61% ($36,625 target / $60,000 gain) of our shares – 244 (round down to the nearest whole share).
We login to our brokerage, sell 244 shares, then immediately buy them back (or spend the money). We just realized $36,600 (244 shares * $200 current price – 244 shares * $50 initial price) completely tax free!
This person had an income of $58,450 completely tax free!
If the scenario was a married couple, the numbers can double to $116,900!
- There is no benefit in performing tax gain harvesting in accounts that provide tax-free growth
- Tax gain harvesting only applies to assets held 1 year or longer
- Taxes are owed on capital gains in the year in which they’re realized
- Gain is the difference between an investment’s proceeds and basis
- Individuals and married couples can earn over $58,000 and $116,000 per year, respectively, completely tax free
Tax Loss Harvesting (TLH)
With all this talk about gains it would be unrealistic to ignore the fact that losses occur. The idea behind harvesting capital losses in early retirement is to lower ordinary income so we can increase the size of the tax-free Roth IRA conversion.
Losses are calculated the same way as gains: subtract the basis from the proceeds. The only difference of course is the number will be negative in value.
Similar to tax gain harvesting, tax loss harvesting only applies to assets in taxable accounts such as an individual brokerage account. Assets in 401k, traditional IRA and Roth IRA accounts receive the benefit of tax-free growth and therefore are not eligible to reap the benefits of harvesting losses.
Tax loss harvesting has some unique attributes:
- Capital losses are applied to capital gains first, then ordinary income. Hence, harvesting losses should not be performed in the same tax year as harvesting gains.
- Even though long-term capital gains and qualified dividends are taxed at the same rate, receiving qualified dividends does not impact our ability to apply capital losses to ordinary income.
- Capital losses can be harvested on assets held for any duration
- After selling a stock for a loss we must not purchase that stock in the next 30 days. Failing to wait 30 days before repurchasing generates a wash sale event and the loss is disallowed
- A maximum of $3,000 in capital losses can be applied to ordinary income in any single year
- Unused capital losses can be carried forward indefinitely to subsequent tax years and must first be applied to offset any/all of that year’s gains, then up to $3,000 of ordinary income
A single filer earned $2,000 in interest income in early retirement and received $8,000 in qualified dividends.
This person bought 400 shares of stock 6 months ago for $50. That stock is now trading at $25 and the investment is worth a total of $10,000 (400 shares * $25 per share). They have a basis of $20,000 (400 shares * $50 initial share price) and a loss of $10,000 ($10,000 proceeds – $20,000 basis).
To realize the $10,000 loss, we need to sell all 400 shares.
We login to our brokerage, sell 400 shares, done. As long as we don’t buy the same stock over the next 30 days, the $10,000 loss can be used at tax time to offset ordinary income.
Since the loss was realized this year and we experienced no capital gains, we’ll be able to deduct $3,000 from our ordinary income and increase our Roth IRA conversion by the same amount. In fact, we’ll be able to do this for the next 2 years. 3 years from now we’ll be able to offset the final $1,000.
- There is no benefit in performing tax loss harvesting in accounts that provide tax-free growth
- Tax loss harvesting in early retirement is used to raise the ceiling for tax-free Roth IRA conversions
- Capital losses are used to offset capital gains first, then ordinary income
- Tax loss harvesting should not be performed in the same year as tax gain harvesting
- To be able to apply the capital loss at tax time we must avoid generating a wash sale event
- Receiving qualified dividends does not impact our ability to apply capital losses to ordinary income
In this context we will be using margin loans as a form of tax arbitrage.
Suppose we need or want one-time access to taxable funds in excess of what the 0% tax bracket affords. We have two choices:
- pay taxes on the amount in excess of the 0% tax bracket
- pay interest on a margin loan for the amount in excess of the 0% tax bracket
Instead of selling positions and paying 15%, 20% or more in taxes on realized gains over the 0% bracket we instead sell fewer positions over time and borrow the rest on margin.
We avoid the higher tax brackets, pay a nominal amount of margin interest then pay off the margin loan in the following year(s) when tax scenarios are more favorable.
This approach has three other potential benefits beyond paying less or no tax:
- capital remains exposed to the market allowing for growth and dividends
- margin interest may be tax deductible allowing for greater Roth IRA conversion space
- Modified adjusted gross income (MAGI) for the year will be lower, increasing ACA subsidies or securing other MAGI-dependent government benefits
To demonstrate the concept we will exaggerate the scenario by declaring that all proceeds from sales are gains (as opposed to a mix of basis and gains). The effectiveness of this concept diminishes as the ratio of gains to basis decreases.
We will use 5.33% as the margin interest rate, a rate which is publicly available on amounts from $1 to $1,000,000 at Interactive Brokers at the time of writing.
A single filer in 2023 intends to sell $100,000 of positions.
Option 1: sell $100,000 worth of positions and realize the taxes in a single year.
Login to the brokerage account, sell enough positions to equal $100,000, done.
In this scenario we realize a little over $8,300 in taxes and our MAGI increases by the full amount of the gains realized.
Option 2: sell some of the positions in year 1 to stay in the 0% bracket and borrow the rest on margin. Then, sell additional positions in year 2 and 3 to pay off the margin loan.
Login to the brokerage account, withdrawal $100,000, sell enough positions to equal $34,000, done.
- In year 1 withdraw $100,000 on Jan 1 and sell $34,000 of positions for a total margin loan of $66,000
- In year 2 login and sell another $34,000 on Jan 1, reducing the margin loan to $32,000
- In year 3 login once more and sell $32,000 on Jan 1, paying off the margin loan
Each year our MAGI increases by the full amount of gains realized: $34,000, $34,000 and $32,000, respectively.
By using margin to avoid long-term capital gains taxes we lower the cost of accessing capital by 37% ( ( $5,223 in margin interest / $8,306 in capital gains taxes ) -1 ). This also has the added benefit of keeping MAGI lower ($100,000 vs $34,000) which could be used to optimize ACA subsidies or secure other MAGI-dependent government benefits.
When generating a margin, loan do not borrow more than 20% of the total account value. This is to help ensure a margin call is avoided should markets experience a downturn, such as in 2008, when some investment accounts lost half their value or more.
In this example we had a max loan value of $66,000. This means the account value should be no less than $330,000 ($66,000 / .2) at the time the margin loan is generated. Larger loans are possible but increase the risk of a margin call during market downturns.
- Using margin loans is a form of tax arbitrage, paying margin interest instead of taxes at a more favorable rate (~5.33% margin interest vs 15-20% taxes)
- By using margin, capital remains invested allowing for potential growth and dividends
- Margin interest may be tax deductible, increasing Roth IRA conversion space
- Borrowing on margin does not increase MAGI, allowing MAGI-dependent benefits such as ACA subsidies to remain non-impacted
- Do not borrow more than 20% of the account value when generating a margin loan
A lot of topics were covered in this guide. I hope you found the material useful, relevant, and actionable. As tax brackets and laws change, this post and the tools will be kept up to date. Be sure to check back for updates!
If you would like to have your specific scenario reviewed, schedule a consultation and get direct answers to your questions.
The two tools used to calculate and demonstrate the ideas and concepts in this post are the FIRE Tax Optimizer and FIRE Social Security Calculator.
FIRE Tax Optimizer
The FIRE Tax Optimizer is useful for estimating and optimizing current-year (payable in April next year) taxes and provides comprehensive details on sources of tax liability.
Types of Income Supported
- Wages, Salary, Tips
- Net Rental Income
- Self-Employment Net Income
- Self Employment S-Corp Distribution
- Taxable Interest
- Qualified Dividend
- Unqualified Dividend
- IRA Distribution
- Short Term Capital Gain and Loss
- Long Term Capital Gain and Loss
Adjustments to Income Supported
- Payroll HSA Contribution
- Non-Payroll HSA Contribution
- IRA Contribution
- 401k Contribution
- Employer Healthcare
- Educator Expense
- Student Loan Interest
- Self-Employment Tax
Tax Calculations Supported
- Medicare Tax
- Additional Medicare Tax
- Net Investment Income (NII) Tax
- Social Security Tax on Earned Income
- Self Employment Tax
- Ordinary Income Tax
- Long Term Capital Gain Tax
- Total Tax
- Marginal Tax Rate
- Effective Tax Rate
The 2023 FIRE Tax Optimizer (for filing in April 2024) is part of the 2023 FIRE Tax Tools Bundle that sells for 9.99 USD.
The 2022 FIRE Tax Optimizer (for filing in April 2023) is part of the 2022 FIRE Tax Tools Bundle that sells for 9.99 USD.
FIRE Social Security Calculator
The FIRE Social Security Calculator is useful for forecasting the monthly social security benefit and understanding how benefits are impacted by early or delayed retirement, changes in earned-income assumptions, and how past earnings are indexed for cost of living adjustments (COLAs).
The 2023 FIRE Social Security Calculator is part of the 2023 FIRE Tax Tools bundle that sells for 9.99 USD.
The 2022 FIRE Social Security Calculator is part of the 2022 FIRE Tax Tools bundle that sells for 9.99 USD.