grey metal case of hundred dollar bills

How to Legally Pay No Taxes in Retirement

Taxes are a fact of life and reduce the amount of money you think you have saved for retirement.  For example, if you have saved $1,000,000 for retirement in your 401k or IRA but will need to pay 12% in Federal taxes on the money when you take it out, you really only have $880,000.  The picture will get even worse if you owe state taxes in addition to the Federal taxes.  If you can figure out a way to avoid those taxes you would have an extra $120,000, which would be a very nice bit of cash.

I retired three years ago at age 49 and will not need to pay taxes on my retirement savings.  We are a family of three with my wife and young daughter.  Many people ask how we were able to retire early.  One of the ways is by avoiding taxes.  Here is how I do it:

Before I retired, I saved money in three buckets.  One bucket was saving in my 401k since my 20’s and rolling that money over into IRA’s every time I changed jobs.  The second bucket was a ROTH IRA account, which I put any extra money I had to save after maxing out my 401k at work.  The final bucket was taxable assets such as brokerage accounts and real estate.  In my case, it was mostly real estate.

When we decided to retire, I sold all the real estate including our primary residence in California.  I also rolled over the 401k at my last job to an IRA.  This left me with a large amount of money in my IRA, a large amount of money in cash from the sale of the real estate and a small amount of money in my ROTH.

Upon retirement, we moved from California, an expensive state with high income taxes, to Texas a less expensive state with no state income tax.  We do not actually live in Texas but have a motorhome and used it to travel full time around the United States, Mexico and Canada.  However, our legal domicile and only permeant address is in Texas.

When we decided to retire we sold all the real estate so we had enough money in cash to live off until I hit age 59 ½ and could access my retirement accounts penalty-free.  By selling our expensive California house and moving into a cheap motorhome, we keep our expenses low. Even with our full time travel, our expenses are lower than before I retired.

I invest in growth non-dividend stocks like Berkshire Hathaway, I-Bonds and municipal bonds in the taxable account. This gives me exact control of my taxable income.  I only have taxable income if I sell stock or the I-Bonds, not whenever dividends or interest is distributed.  Municipal bonds are tax-free so are not a factor.

Having exact control of our income can have many side benefits as well. For example, should I want to, I can tailor our income to get the maximum ACA health insurance subsidy or I can set it to qualify for child tax credits, homebuyer’s incentives, etc. There is a lot of power in being able to exactly control your income.

All investments that generate taxable interest or dividends go in the retirement accounts either IRA or Roth.  The exception is I-Bonds since they are tax-deferred, only incur taxable income when and in the amounts I choose and cannot be held in a retirement account anyway.  Qualified dividends from stocks can also be tax free if you stay in the 12% tax bracket.  However, you have to be careful how much in qualified dividends you get since the exact dividend amounts are difficult to predict and it can affect how much you can convert from your IRA to Roth tax-free.  I generally keep all dividend stocks in retirement accounts so I do not have to monitor exactly how much dividends my stocks generate each year.

Every year I calculate our Federal tax standard deduction and any non-refundable tax credits we might have such as our child tax credit.  Together my wife and I have about a $25,000 in standard deductions and with a $2,000 child tax credit we can avoid taxes on approximately $40,000 of income.  Every year, I convert about $40,000 from my IRA to my ROTH.  Since the amount I convert is exactly the amount of our standard deduction and non-refundable tax credits, my tax bill is zero.  $40,000 a year over 10 years is $400,000.  The exact amount will vary from year to year depending on current tax law.  Over 15 years (until my daughter becomes an adult) I will be able to convert up to approximately $600,000.  Afterwards, I can still convert up to our personal exemption every year tax-free.

In addition, if you are in the 12% tax bracket, which goes up to approximately $80,000 for a married couple, the long term capital gains tax rate is 0%.  Every year, if I have gains on the stocks in my taxable account, I can sell the stocks and take gains on up to $40,000 on top of the $40,000 IRA to Roth conversion.  I can then buy the stock again with my stepped up basis or I can keep the gains for living expenses.  I can vary the ratio of long-term capital gains to Roth conversions from year to year.  If I have a big gain in stocks in the taxable account, I can reduce the Roth conversion amount and take more capital gains. 

Depending on your number of dependents and other deductions, the amount you can convert tax free will be higher or lower than ours.  Also, note that the amount we convert has nothing to do with our budget or spending since that can come from saved cash or municipal bonds tax-free.  For example, we could spend a million dollars a month if all that income came from municipal bonds and we would still be able to convert the same amount tax-free.

Using these methods, I am able to legally avoid up to $80,000 of otherwise taxable income each year saving me thousands.  By the time I exhaust the money in my taxable accounts after age 60 I expect that the vast majority, if not all, of my big bucket of money in my IRA to have been converted into my ROTH.  I will then withdraw the what is left in my IRA up to our personal exemption each year and make up the rest of our living expenses, if needed, from the ROTH.  If for some reason the money in my taxable accounts runs out before I am 60, I can withdraw money from my ROTH without penalty since my conversions have been sitting in the account for five years and count as withdrawal of principle, not gain.

There will be many advantages of having all of our money in a ROTH account later in life.  First, we will not have to worry about Required Minimum Distributions.  Second, the money we take out of our ROTH will not affect our Social Security payments or Medicare.  Third, the money in the ROTH accounts do not count as assets in college financial aid.  Finally, our daughter will be able to inherit the money we leave behind tax-free.

Our strategy is particular to our situation and us.  Some people do not have young kids, have real estate income, have multi-million dollar IRAs, large pension or some other individual circumstance so this strategy may have limited use.  However giving a little thought to your asset allocation between your taxable accounts, IRA and ROTH might make a difference of hundreds of thousands of dollars to your retirement.

Unlike death, with a little planning, taxes might not be as inevitable as everyone thinks.





3 responses to “How to Legally Pay No Taxes in Retirement”

  1. nhs76 Avatar

    Thanks, a really good article with good suggestions. One additional circumstance that comes into play for many early retirees is ACA Marketplace subsidies for health insurance, if they no longer have access to a workplace or retiree plan. Increasing taxable income via either Roth conversions or capital gains can sharply reduce the advance premium subsidy you get, and that gets reconciled at tax time. In effect, the total marginal tax rate ends up being much greater than 12% at the levels of total income that are described above. Moreover, if Congress allows ACA subsidies to revert to pre-2021 levels in 2023, there will also be a “subsidy cliff” at a very modest income level — for our household of two, it would have been somewhere around $55-60K — and that means you’d have to pay back 100% of the premium subsidies you’ve received that year, a huge liability. But, your overall point about asset types and categories is terrific, and we are following many of these principles.

    1. Hin Avatar

      Great point and thank you for your feedback! I have updated my article to mention ACA subsidies.

  2. […] How to Legally Pay No Taxes in Retirement […]

Translate »