My tax strategy used to be pretty simple, hope for the biggest refund possible! It felt like Christmas in April when I plugged in the numbers and saw…… woohoo refund!
Then I read the article, “Never Pay Taxes Again”, on gocurrycraker.com and it completely flipped my strategy upside down.
They stated that they “had taxable income of about $100,000/year and paid close to $0 in income taxes….legally.”
Wait, I want to pay $0 in taxes! Sign me up.
Because, here’s my thesis. It’s complicated, but hang with me. Not paying taxes is better than paying taxes.
They went on to describe three ways that anyone can use to pay $0 in taxes. Here they are:
Method 1
Earn less than $25,900 a year.
Using the 2022 tax rules, a married couple can earn up to $25,900 a year without paying taxes. This is because the government allows a standard deduction of $25,900. Further, if you earn more than $25,900, you may be able to deductions such as capital losses, HSA and 401k contributions in order to get your earnings back under $25,900 and not pay taxes.
This is the most straightforward method, but unless you’re super frugal, it’s not easy to live on less than $25,900. Let’s look at some other methods.
Method 2
Earn $25,900 and supplement with up to $83,350 in qualified income
Once earned income exceeds $25,900 (including deductions), taxes must be paid. Unless….that income comes from qualified income sources, such as qualified dividends or long-term capital gains. In 2022, a married couple filling jointly is permitted $25,900 a year in earned income AND $83,350 in investment income.
That’s $109,250.00 each year TAX-FREE
Let’s take a look at an example of how this may play out in real life:
- A married couple lives in the US and earns a combined $33,200 from their W2 jobs.
- They max out their HSA contributions ($7,300 in 2022) which knocks their taxable income down to $25,900.
- Then, the standard deduction ($25,900 in 2022) further reduces their taxable income to $0.
- They decide to supplement their earned income with other income sources such as rental income and qualified dividends.
- Remember, that the tax rate on qualified income sources is 0% when taxable income is below $83,350. Therefore, I can collect qualified income of up to $83,350 and pay $0 in tax. Voilà $109,250 tax-free.
Here is an output from the tax calculator at gocurrycraker.com showing the same thing. I highly recommend this calculator, unless you just love doing the math yourself.
Method 3
Live overseas and earn up to $249,900 tax free.
Say what? How much?
That’s right, thanks to a beautiful little thing called the Foreign Income Tax Exclusion (FEIE), a US Citizen can exempt up to $112,000 per person ($224,000 for a married couple) in income from US Taxation. Add in the standard deduction, that we’ve already covered, and you’re up to $249,900 tax-free.
A couple of things to know about the FEIE.
- The FEIE only exempts earned or self-employment income. Income from investments, rental properties, IRA withdrawals, Social Security, pensions, etc… are all subject to taxation.
- The FEIE exempts income sourced from the United States and deposited into US bank accounts, as long as the Citizen / resident alien is outside US borders
- The FEIE is super cool, but there are lots of details you need to be aware of to take full advantage. Check out this article for a full breakdown.
The possibility of earning $249,900 tax-free is awesome, but most people aren’t in that situation. Let’s look at an example that’s a little more realistic.
- A married couple lives overseas and earns a combined $67,300 from their W2 jobs. All $67,300 is claimed under the FEIE.
- They also max out their contribution to their HSA ($7,300 in 2022).
- They can also supplement their income with up to $75,810 of qualified income (ex. sell stock and realize long-term gains, collect qualified dividends, income from rental properties, etc) and it’s all tax free. That’s $143,110 TAX-FREE!
If you’re scratching your head on the math, I don’t blame you. The way the IRS calculates total tax using FEIE is funky. You calculate it in three steps:
- Step 1 – Calculate the total tax as if you weren’t using FEIE. Here, the total tax on $34,100 of earned income (you still get the HSA and standard deductions with or without FEIE) is $3,681 and the tax on the $75,810 in qualified income is $3,984. Thus without the FEIE, they would pay $7,665 in taxes.
- Step 2 – Then they calculate the total tax on just the portion that is claimed under FEIE. In this example, we claimed all $67,300 as exempt under FEIE. The tax on $67,300 is $7,665
- Step 3 – Finally, we subtract the amount calculated in step 2 from the amount calculated in step 3. Here, the result is $0.
If you’re like me, your head is spinning a little bit, but hang on because we haven’t even got to the coolest part.
ROTH IRA CONVERSIONS!!!!
“Ugh, you’re a nerd.”
“That’s right, I blog about taxes. That’s pretty nerdy. But I can’t help it, I think it’s awesome. Also, you’re reading it so what does that say about you?”
“Are you talking to yourself?”
“Uhh…let’s move on.”
Roth IRA conversions are in my opinion the number one tax hack there is.
If you’ve never heard of a Roth IRA conversion, it simply means that you can convert your 401ks and Traditional IRAs to a Roth IRA. The money that came into your 401ks and Traditional IRAs was pre-tax and once it’s converted to a Roth IRA, it can be withdrawn tax free! However, any dollars converted to a Roth are considered ordinary income, and you must pay tax on them.
Now, here’s the hack, you can offset this with the $25,900 standard deduction! So, you can convert $25,900, to your Roth, each year completely tax free! $25,900 that came in tax free, grows tax free and will be withdrawn someday, tax free. Wow.
Again, let’s use the examples from above to see how a Roth Conversion would affect our couple living overseas.
- Our married couple lives overseas and earns a combined $67,300 from their W2 jobs. They also All $67,300 is claimed under the FEIE. They also max out their contribution to their HSA ($7,300 in 2022).
- On top of that, they convert $30,000 from their 401ks to their Roth IRA.
- In the previous example, they were able to supplement their income with up to $75,810 of qualified income. However, the Roth Conversion changes things a bit and they’re only about to supplement with $21,810 tax-free. Still, that’s $119,110 TAX-FREE!
Here’s how the math works this time. Again, three steps:
- Step 1 – Find what taxes would be without the FEIE. The couple’s total income is $119,100. That is $67,300 in W2 + $30,000 Roth Conversion + $21,810 in capital gains). Ordinary income is only $97,300 ($21,810 is capital gains). First we find taxes on ordinary income. $97,300 – $7300 (HSA deduction) – $25,900 (standard deduction) = $64,100. The tax on $64,100 comes to $7,281. Next, we find the taxes on the $21,810 in capital gains. Here the tax is $384. So, total taxes without the FEIE come to $7,665.
- Step 2 – Find what taxes are on the portion we plan to exempt using FEIE. Recall that FEIE only exempts EARNED income. Capital gains or Roth conversion are not considered earned income (even though Roth conversions are considered ordinary income). Thus, we can only shelter the $67,300 our couple W2’d . The Tax on foreign earned income of $67,300 is $7,665.
- Step 3 – Subtract the amount of tax on the portion covered from FEIE with the amount figured as if we are not using FEIE. $7,665 – $7,665 = $0.
- Step 4 (BONUS) – For people that are really, really into this, there’s another cool hack that allows you to make an even larger Roth Conversion. For tax credits to have an effect, you actually need to have a positive tax bill (aka you have to owe something). So, using the example above, if this couple has kids and wants to take advantage of the Child Tax Credit (let’s say it’s ~$2000 per child and they have two kids) they would need to have a $4,000.00 tax bill…not $0. So they increase your Roth Conversion amount until the tax owed is $4000, then the CTC knocks it back down to $0. BTW, the Roth Conversion winds up being $44,815.
The Ultimate Tax Hack
If you want to run through a few more examples to make sure you got it, this article from hackyourwealth.com. does a great job of breaking down several scenarios that include FEIE+Roth Conversion+Cap Gains+Deductions.
Ok, are you all with me?
Good. At this point one more big question remains. Why would I do a Roth Conversion instead of harvesting capital gains? In method 4 (the one with a Roth conversion) our couple was only able to enjoy $119,110 tax-free. However, in method 3, (using just FEIE+ cap gains harvesting and no Roth Conversion) they wound up with $143,110 tax-free. So, how is that better?
The answer is……more math! Yay math!
I know, just hang in there. We’re so close.
It’s better because, when you harvest capital gains, you no longer have to pay taxes on the amount you just harvested, which is great. However, future growth is not protected. On the other hand, when you do a Roth Conversion, all future growth is protected. So even though we only converted $30,000 to our Roth, the future value of the Roth conversion is much greater.
One more time, let’s refer to our example. In method 4, our couple paid $0 in taxes to convert $30,000 to their Roth IRA. Now, let’s say they let it grow in their Roth IRA account for 15 years and earn an average 7% annual return (conservative IMO). That $30,000 turns into $82,770.95 that they won’t pay taxes on when they withdraw it!
Compare that to the $75,810 in capital gains harvesting. Sure, they paid $0 to harvest that $75,810, but if they reinvest that they’ll need to pay taxes on any future gains.
This is why it’s my goal to limit my capital gains as much as possible and I maximize my tax-free Roth Conversions every year. If you’re an expat, an early retiree (or just a regular retiree), with lower income levels, you definitely need to be doing Roth Conversions.
So, what’s your ultimate tax hack? Nerd to nerd, I’d love to know.
