Cliff’s Notes: Never Pay Taxes

In my experience a great blog post is much more than an idea.

It is more like a seed pod that is dropped into fertile soil. It germinates and sprouts and expands in all directions in the readers mind, transforming him much as a piece of ground is enriched by the presence of a growing tree.

There are so many good blog posts, but not so many great ones.

In the field of personal-finance I would say that have read only three great ones so far.

The first of course was Mr. Money Mustaches powerful post on the Shockingly Simple Math Of Early Retirement.

I’ve written about this ad nauseum  because the post was so transformative in my own life. How powerful that simple chart.

The second was the Mad Fientist’s excellent post on The Triple Value Of Money. This was fundamental because it quantified the oft underestimated power of saving and investing money as opposed to spending it now..

Which brings me to today’s post.

Today’s post was written by Jeremy and Winnie of Go Curry Cracker.

From what I can gather, this is a couple very much after my own heart.

First of all, they’re self-proclaimed foodies. And they choose to waste their money where I choose to waste mine. And you know what? They’re already traveling the world at a young age, fully retired, following their bliss. So scoreboard. It is possible.

Secondly, they love travel ,and are currently slow voyaging through developing countries as a form of geographic arbitrage. This is an obvious area of overlap for the value obsessed travel hacking aspect of my blog.

And finally, they are an international marriage who make good use of their complementary skills. Jeremy is an excellent writer, and Winnie shoots incredible photographs of their travels. I see obvious parallels to the wonderful international marriage that I fell into. Synergy.

But enough blabbering, onto the post…

This is a post about the tax advantages of being an early retiree.

Please read this before continuing… Never Pay Taxes Again

Behold the sweet symphony of Go Curry Cracker

Welcome back. Pretty great,huh?

I see this article as a symphony in five movements so let’s break it down.

Movement 1: Why You Should Care About Taxes.

If using after-tax money to buy things is like using a deflated currency, (a premise well proven in the triple value post) then using tax-free money is like using inflated dollars. Think of it like earning money in a first world country and then buying an item in a Third World country. Same item lower price.

There is then some foreshadowing of the subsequent four movements…

Movement 2: Choose Leisure Over Work.

Because the early retiree chooses not to have any earned income, he is able to take advantage of a predictable quirk in the tax code.

There is an important distinction between earned income (the way you probably make money now, by means of a paycheck,), and investment income (long-term capital gains, and dividend income.)

This distinction is hugely advantageous to hedge fund billionaires(duh,) trust fund babies (duh,) evil right wing petrochemical trust fund fascists (duh,)  and early retirees (who knew?)

Who let in the riff raff?

You see, investment income is not taxed at all until you get to the 15% tax bracket for taxable income. ($70,700 in 2012, or $73,800 in 2014.)

This means in that 2014 you can have up to $94,100  of retirement income, ($20,300 in earned income + $73,800 him investment income) tax-free.

Movement 3: Live Well For Less.

Once you earn more than a certain threshold, your money starts being taxed. The threshold is determined by the standard deductions which anyone can claim. In 2012, at the time the article was written, the threshold was $19,500. Now in 2014 the threshold is $20,300 for a married couple.

This threshold is sort of a nonissue, at face falue, for an early retired couple as they presumably have no earned income. (But keep reading.)

Movement 4: Leverage Roth Ira Conversions.

The Roth IRA conversion involves converting a (Traditional) IRA into an (After tax) Roth IRA.

You can withdraw money from a Roth IRA any time five years after the conversion tax free.

This is very useful to an early retiree.

Importantly, the amount that you convert is counted as ordinary income.

So as an early retiree, if you have no earned income, you can currently convert up to $20,300 from an IRA to a Roth IRA per year tax free.

I actually see this as an extension of the sweet music played during Movement 2.

By choosing leisure, and having a nice long retirement, You open up a huge loophole that allows you to turn your traditional IRA account into the ultimate savings vehicle. Pretax money is put in and it grows tax-free.  It is converted into a Roth IRA (tax-free) where it then grows some more. It is eventually pulled out (tax-free.)  Taxes are completely avoided at every step  in the chain.(Cha-ching).

Importantly this also allows you to access your 401(k)/IRA money five years after initiating early retirement.

Movement 5. Harvest Capital Gains And Capital Losses.

The mechanics of harvesting capital gains and capital losses are well explained here, and here.

In many ways this is the ultimate heads I win, tails you lose scenario.

For tax loss harvesting, if your taxable stocks go down, you sell them. You can then use the amount lost to counteract future capital gains or ordinary income, thereby avoiding taxes.

For tax gain harvesting, If your taxable stocks go up, you can sell them and buy them again so that their current value is reset at their higher current level (their so called “basis” is changed.) This allows you to take bigger capital losses in the future when the stock’s value goes down.

This selling at an increased value would ordinarily be taxed as a capital gain, but won’t in this instance unless the amount gained (in addition to other investment income) exceeds The $94,100/year threshold mentioned above.

To my way of thinking this is an extension of Movement 3: Live Well On Less. By being disciplined in your spending you open up a huge reservoir of value to make your non-tax sheltered investing very tax efficient.

Movement 6: Grand Finale.

There is then an lively discussion on the ethics of taxation.

It’s an interesting take, but you already know my take on this.

When voting we should vote for the fairest system possible. (This post actually illustrates nicely the intrinsic unfairness of our current tax system. And I’m all for it changing for the fairer.)

But when doing your own finances we should act as rational economic actors and take advantage of every loophole there is. Otherwise we’re leaving money (and by extension freedom) on the table.  And let’s face it, we’re smarter than that.