How to reduce taxes to ease early retirement
Reducing taxes for early retirement
It takes a lot of money to retire. It takes even more money to retire early (because, as it turns out, it has to last longer). And if you want to retire early without a restrictive frugal lifestyle (aka #fatFIRE)? Well… it takes millions.
As you can see below, even with a relatively aggressive 4% withdrawal rate, it would take over $2m of invested capital to replicate a $100k/year salary. Want $200k a year? That’s a lot closer to $5m.
Although this is pretty intimidating, with some conscious effort you can significantly reduce your effective income tax rate in retirement, reducing the amount you need to save by 10-20%.
Best ways to reduce effective tax rate for early retirement and FIRE
So. We have established that you need a lot of money to fatFIRE. How can we make that number a little bit smaller? By being smart about taxes, of course. Here are some of the best ways to get your tax rate down.
Live someplace without state or local income tax
This one is pretty obvious, but it’s important. Some states have income taxes approaching 10%, which increases the amount you need to save for retirement by an equal amount. The only way around it? Live someplace without a state income tax! Here are the states without income tax for easy reference:
Luckily for me, I am originally from Washington so it wouldn’t be a hardship for me to return home. For others this may present a bit of an issue, as the rest of the states on the list are decidedly RED. The point is, if you can stomach the politics - or move to Washington - you can significantly reduce your effective tax rate.
Can’t move? Don’t worry, there are lots of other ways to lower your taxes for retirement.
Take advantage of tax free securities
Having a low tax rate is great. Having NO tax is amazing! Luckily, the US government does treat some investments preferentially when it comes to taxes, specifically municipal bonds.
Municipal bonds are bonds that are issued by state and local governments to fund their capital improvements or operations. For instance, a city might need a water treatment plan and issue a bond to finance it’s construction. It pays interest just like any other bond, but that interest is tax free.
Because munis (as they are referred to), have lower tax rates they often trade at a lower yield than other bonds, but I still think they are more attractive overall. Why? Because even if you make the same as you would buying a treasury or corporate bond, the taxes you pay on those investments have the effect of raising your taxable income which could also raise your effective tax rate. The point is, even if returns end up being the same with a tax free muni vs a taxable corporate, you still want the muni because your total income will be lower.
Increase your post-tax retirement money
Hopefully, you have been taking advantage of the post-tax investment accounts that are available to you including Roth IRA’s and 401k’s. Even with a higher tax rate now than I expect to have in retirement, I would much rather pay my taxes now so that my effective tax rate when I retire is as low as humanly possible. This is the same logic I am applying to the municipal bonds above: all things being equal, I would rather make a choice that lowers my overall taxable income in retirement so any income I HAVE to take is taxed at a lower effective rate.
But, not everyone can contribute to post tax accounts.
Use a backdoor conversion to increase your post tax money if you cannot contribute
At a certain point (around $140k for individuals) the government stops letting you contribute to post tax accounts. It’s a bummer for those who are trying to FIRE with high incomes.
Luckily, there is a way to get at least some money into a post-tax account. It’s called a backdoor IRA contribution, and it’s pretty simple. You open a normal IRA, contribute as normal, then convert it to a Roth IRA. You need to pay income taxes on the original contribution, as well as any gains since the regular IRA was opened. But other than that, you have an easy method to convert pre-tax contributions to post tax. Here’s a post from Nerd Wallet with more details.
Invest in real estate
Real estate is by far the most tax advantaged investment vehicle in the US. It’s actually incredible how many tax advantages real estate gives you as an investor.
First of all, mortgage interest (up to a certain amount) is tax deductible. That means that you can buy a house or condo, rent it out, and then you can deduct what is probably the largest single expense on your income statement. For this reason alone, I believe that everyone should own at least one property with a mortgage, but it gets even better from there.
You can also deduct depreciation on real estate rentals. To oversimplify, this means that you can deduct the cost of the capital improvements in the property (the physical building, not the land) over time. A standard depreciation schedule is 27.5 years, and each year an equal amount of the total depreciation value is deducted. For instance, a $600k house with $100k land value and $50k in remodel costs has a total depreciable value of $550k ($600-$100+$50). Divide $550k by 27.5 and you get $20k in depreciation every year.
Pretty nice, huh? Well it gets even better. Lets say after a while of renting out your property (it cannot be your primary home), you want to buy a new one. Well, the 1031 exchange lets you sell your old one and buy a new one without paying capital gains on any appreciation in your initial property. This gives you a lot of flexibility with real estate investment that you don’t have with taxable investment accounts. You can’t sell 10 shares of Tesla and buy an equivalent amount in Apple without paying capital gains first. With a 1031 exchange you can continue this “rollover” process indefinitely, although keep in mind that you may be subject to something called depreciation recapture, so it’s not all roses.
I write a lot more about real estate taxes in the post here, if you want to take a look.
What does it all add up to?
With all of the tricks above, you should be able to ensure that a large chunk of your income in retirement is low or no tax. Furthermore, you should be able to lower your effective tax rate on the income that you do have, so that you pay as little as possible in total income taxes. But… what does that mean?
If you add up all the potential benefits from above, it can be quite substantial. Let’s assume the following:
Current income: $200k
Location: San Francisco, CA
Effective tax rate: 34%
Take home pay: $131k
Now, my assumption is that you would need $5m to replicate this income at a 4% withdrawal rate. But, with a lower effective tax rate it could be much easier to reach the $131k in take home pay.
New location: Seattle, Washington (no state income tax)
Portfolio: 30% real estate, 50% stock market, 10% corp bonds, 10% municipal bonds)
Income from muni bond portfolio:
$5m*10%=$500k at 2.1% = $10.5k tax free
Income from stock market VTSAX:
$5m*50%=$2.5m at 1.9% yield = $47,500 at 15% qualified div. rate
Income from corp bond portfolio:
$5m*10%=$500k at 3.7% = $18,500 at income tax rate
Income from real estate portfolio:
$5m*30%=$1,500,000 investment at 6% cap rate yields $90,000 per year
Depreciation of $36k per year (assuming $1m capital value) = $54k in taxable income
Here’s what all of that adds up to:
Total income: $166,500
Total taxable income: $72,500
Total Income taxes: $15,000
Total qualified dividend taxes: $7,125
Total taxes: $22,125
Total take home: $144,375
Now, I know what you’re thinking. $144k isn’t that much more than $131k. But it is! That is pure income. None of the principal for any of the investments was touched to generate that income. What’s more, I didn’t even add the benefit of having some of that money in a Roth account (which it would probably be).
$144k in income comes out to a 2.88% yield on the $5m invested. That means that if you want to draw down your assets in your 401k, you could take home way more.
Conclusion: If you are smart, you can get way more from your money
If you use the advantages available to you, it isn’t hard to make a smart portfolio that is incredibly tax advantaged. Even though I completely eliminated any drawdown in principal in the scenario above, and I ignored the benefit of post-tax retirement accounts, I would have been able to shave off around $500k in savings needed to retire (or about 10%), just by being smart with taxes (I could generate $131k in income with only $4.5m at 2.88% yield).
No matter how you look at it, it pays to be smart about your taxes in retirement.