Author Topic: Early Withdrawal / Tax Strategies while Self Employed in FIRE  (Read 3258 times)

MooseOutFront

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This post relates to the topic of tax optimization in early retirement.  A great primer on how to pay no tax on your 401k ever is found here:
http://www.financialsamurai.com/how-to-pay-little-to-no-taxes-for-the-rest-of-your-life/
and here:
http://www.madfientist.com/traditional-ira-vs-roth-ira/

Basically, a married couple with 2 kids filing jointly in 2014 can do the following tax free:
Convert 401k/IRA to Roth IRA up to the total of your exemptions and deductions. For us it is $28,200 ($3,950*4 exemptions+standard deduction of $12,400).  Then you can take capital gains and qualified dividends from this number up to the top of the 15% federal tax bracket, $73,800 married filing jointly, for a total of tax free LTCG and Dividends of $45,600 all at $0.00 federal tax.

Sounds great you say, but the problem, sir, is that I plan to work part time in early retirement or I'll have income producing properties filling up that initial tax free space of $28,200.  This resigns me to having to pay 15% marginal rate on all my 401k/Traditional IRA to Roth IRA conversions.  Not a crazy high rate, but it sure would be nice to be able to find a way to convert it at 0.00%.

Enter the Solo 401k.
http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans

This can be used so long as the business has no full-time employees other than owner and spouse.  The annual limit is $17,500 for employee plus you can give yourself an employer match up to 25% of the income you take from your business.  I'm still a little fuzzy on the specifics, but the IRS website specifically states that the self employed person can contribute up to 100% of compensation to the solo 401k and that there's a max of $52k for 2014.

So, new scenario:
Wife and I each do contract work after "retiring."  (This is our actual plan) Each proceed to make $20k in taxable income.  Between $17,500 limit each and employer match we are able to contribute the entire $40k to two Solo 401ks.  This makes our taxable income $0 (other than self employment FICA taxes), and we then proceed with the plan from the beginning of this post to convert $28,200 to Roths tax free and take capital gains and dividends of up to $45,600 tax free to either live on or reset basis on.  After 5 years we can start to live on the amount converted to Roths tax free.  In the meantime we spend either current Roth contributions, cash savings, dividends, or capital gains.

This isn't fully fleshed out, and I would love smarter tax people to shoot holes here, but I wanted to get my thoughts down.  I've always liked the articles about Roth conversion ladders and living on tax free capital gains, but the fact that we don't plan to have $0 income in retirement always made those exercises seem academic in nature to me.  Never really considered socking away the semi-retirement income in 401ks in its entirety.


« Last Edit: June 18, 2014, 03:08:04 PM by MooseOutFront »

johnhenry

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Re: Early Withdrawal / Tax Strategies while Self Employed in FIRE
« Reply #1 on: June 18, 2014, 03:26:30 PM »
You are wise to consider the Traditional -> Roth IRA conversions in years when your income is low/nil.  As you point out, the standard deductions, exemptions will shield a healthy amount.

Any IRA or 401(k), including Solo 401(k) must be funded with earned income.  So you can use your part-time, earned income to max out a Solo 401(k), but if all of your income is from rental, you would not be able to fund a tax-deferred account to lower your taxable income.

johnhenry

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Re: Early Withdrawal / Tax Strategies while Self Employed in FIRE
« Reply #2 on: June 18, 2014, 03:50:24 PM »
Quote
we then proceed with the plan from the beginning of this post to convert $28,200 to Roths tax free and take capital gains and dividends of up to $45,600 tax free to either live on or reset basis on

I think I missed this when I read it the first time.  In this scenario:

 20,000 - your part time wages/salary
 20,000 - spouse part time wages/salary
======
 40,000 - total earned income
-40,000 - contributions to Solo 401(k)
======
           0
+28,200 - income resulting from IRA -> Roth IRA conversion (I'm not sure if this is earned income or if it matters, but it is income)
+45,600 - LTCG from sale of holdings in taxable accounts
======
 73,800

 I don't have my tax forms in front of me.... but I think.... that you'd be able to do $28,200 in conversions to Roth OR realize $45,600 in LTCG, but not both in the same year.  I think you'd still be in the 15% bracket, which would keep you from paying tax on the capital gains.  But I think you'd wind up paying some on the Roth Conversion amount.  I could be wrong about that....

 Don't forget to plan for health insurance accordingly if you plan to have a year where income is very low.  I think it's possible to get yourself in a situation where you make too little to qualify for a subsidized ACA plan, and instead qualify for medicaid, which is means-tested.

MooseOutFront

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Re: Early Withdrawal / Tax Strategies while Self Employed in FIRE
« Reply #3 on: June 23, 2014, 09:41:26 AM »
Any IRA or 401(k), including Solo 401(k) must be funded with earned income.  So you can use your part-time, earned income to max out a Solo 401(k), but if all of your income is from rental, you would not be able to fund a tax-deferred account to lower your taxable income.
Ah.  That's most unfortunate that you get screwed on rental income in the tax code in so many ways.  I know there are advantages to rental income in the tax code also, but somebody seems to have gone out of their way to make sure it's not too sweet a deal.

Regarding using the rollover to full up your exemptions + deductions and then still having to the top of the 15% tax bracket to fill with capital gains at 0% tax, I believe that's how it works.  Or at least the examples I've read had it that way.  Admittedly I've not done this in practice or filled out a dummy return doing it yet.

bacchi

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Re: Early Withdrawal / Tax Strategies while Self Employed in FIRE
« Reply #4 on: June 23, 2014, 10:25:00 AM »
Enter the Solo 401k.
http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans

This can be used so long as the business has no full-time employees other than owner and spouse.  The annual limit is $17,500 for employee plus you can give yourself an employer match up to 25% of the income you take from your business.  I'm still a little fuzzy on the specifics, but the IRS website specifically states that the self employed person can contribute up to 100% of compensation to the solo 401k and that there's a max of $52k for 2014.

It's 100% after the self-employment tax. See the next section on the IRS page.

nawhite

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Re: Early Withdrawal / Tax Strategies while Self Employed in FIRE
« Reply #5 on: June 23, 2014, 04:47:37 PM »
I've found that health insurance subsidies put a damper on the 0% effective tax rate. Basically when your income is so low you are looking at a 0% tax rate, your health care subsidy will be significant. For my situation every additional dollar of rollover I did resulted in $0.13 of less health care subsidy i.e. a 13% tax on the rollover funds.

Just another wrinkle for your plans.

MooseOutFront

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Re: Early Withdrawal / Tax Strategies while Self Employed in FIRE
« Reply #6 on: June 23, 2014, 08:44:42 PM »
I've found that health insurance subsidies put a damper on the 0% effective tax rate. Basically when your income is so low you are looking at a 0% tax rate, your health care subsidy will be significant. For my situation every additional dollar of rollover I did resulted in $0.13 of less health care subsidy i.e. a 13% tax on the rollover funds.

Just another wrinkle for your plans.
Yes that is a huge consideration.  For whatever reason I feel like this will evolve some over the next 5 years.  Where I currently live I need to make sure to have enough taxable income to qualify for the subsidy, but I admittedly haven't dug into the finer points yet.