Disclaimer: I am not a certified financial planner or accountant. This article is purely for entertainment purposes. I highly recommend your financial adviser or accountant if this strategy works for your financial situation.
BLUF: By maximizing the 0% capital gains tax for the lower two tax brackets, I’ve found TSP/IRA doesn’t fit my FIRE goals. By utilizing my strategy below, I still won’t pay any taxes on my retirement fund BUT have full access to my entire resources NOW, not at 59.5 years old.
As many in the FIRE (Financially Independent/Retire Early) community, I’ve watched the new Tax Bill progress and change the last couple of weeks and repeatedly ran the numbers on how it would affect me and my family. On top of that, the approaching Blended Retirement System is schedule to start at the begining of next year. Although I am too senior to have a choice in BRS, regardless, I started running the number of numerous different scenarios to see who should and shouldn’t op in for the BRS.
My final conclusion… the TSP and IRA are the WRONG answer for me and most military trying to reach FIRE! With 0% long-term capital gains tax for the lower two tax brackets, changes in the new tax bill, and military member’s artificially low taxable income, there’s a better way protect your retirement investments from taxes/penalties AND have access to your money NOW!
Let first break down each principle that allows the majority in the military to take advantage of this strategy.
0% long-term capital gains tax
The American Taxpayer Relief Act of 2012 permanently set the realized long-term capital gains for taxpayer’s in the bottom two tax brackets at 0%. That means the profit of any stock/bonds/mutual funds that have been held over 1 year is not taxed at all. Basically the same benefits of a ROTH IRA or ROTH TSP but not shackled until you’re 59.5 years old.
This isn’t a strategy to try to time the market. I’m planning to sell my equities and literally by it back in 5 minutes to just restart the clock.
Also, keep in mind that you only pay taxes when the gains are realized, meaning only when it’s actually sold. Even if you had an amazing return one year, you don’t have to realize the gains all in that year. Wait for the opportune time to sell the gains in future years (bad year in the market, deployment year, or if you take advantage of the Career Intermission Program -CIP).
Changes to the tax system
The new tax bracket and standard deductible allows more room to stay within the lower two tax brackets, especially for members just starting their military career. As an individual filer, you can make as much as $50,600 taxable income (upper limit capital gains at 0%: $38,600 + standard deductible: $12,000) and still stay in the bottom two tax brackets. $101,200 if filing jointly (upper limit capital gains at 0%: :$77,200 + standard deductible: $24,000). Remember this is only the lower limit using the standard deductible. You could possibly raise that limit by itemizing.
Lets take this even one step further. Say you’re just making too much money and can’t get it below these thresholds. THIS is when IRAs and TSPs become useful, but not before. As an individual filer, you can now make $74,600 of taxable income ($50,600 + TSP contribution limit for 2018: $18,500: + IRA limit: $5,500) and $130,700 of taxable income ($101,200 + TSP contribution limit for 2018: $18,500 + IRA limit for yourself: $5,500 + IRA limit for spouse: $5,500).
Military pays is artificially low for tax purposes
One of the best financial benefits we get in the military are most of our exemptions and allowances are not taxable income. From our Basic Allowance for Housing (BAH) to our income when deploy to the desert, we enjoy many tax breaks not applicable to the civilian world. Going off our 2017 military pay chart, and E-5 over 10 years makes an annual $38,563 in taxable income. An O-3 with over 6 years is $67,884.
How I use this strategy and why it works
I plan to sell enough long-term equities next year, for gains up to $15,700, to get it taxed at 0% and have it fully accessible.
There are specific aspects about my situation and goals that allow me to maximize this strategy.
- My state of residence doesn’t have income tax, to include capital gains tax. As a benefit of being in the military, we get to maintain our state of residence regardless of where we live. There are currently 9 states that don’t tax long term capital gains.
- New Hampshire
- South Dakota
- I’m married, file joint and for the most part live on a single income.
Married filing joint on a single income allows me plenty of room to take advantage of the 0% capital gains tax without going over into the higher tax bracket.
- My FIRE goal is in line with the tax code.
Tax brackets should keep in pace with inflation but hypothetically running my retirement strategy for 2018 allows me to know how much I need to retire before the financial motivation for earning more income starts to diminish due to increase taxes. Maybe it’s not enough for some but, $95,000 annual income in 2018 purchasing power is more than enough for me and my family to comfortable claim FIRE.
In order to not pay taxes on my retirement investments when I retire, I will limit how much capital gains I claim every year. Although tax brackets and military pay changes every year, my strategy won’t change; claim long-term capital gains up to the 2nd tax bracket limit. This limits my annual gross retirement income to $95,000, but this is more than enough for my family’s expenses. To better visualize my strategy, I show how I would use this strategy if I would retire as a O-5 with 20 years in 2018.
I’ve run my strategy by several people in the military community and here and some common questions I’ve received.
Isn’t the TSP worth contributing to since they match up to 5% under the new Blended Retirement system?
Yes, in the case of those that fall under the new Blended Retirement System, I HIGHLY recommend you contribute to max out the 5% match, but not a penny more.
But the TSP has very low expense ratios?
There are plenty of index mirroring funds with extremely low expense ratios. For example, the Vanguard Total Stock Market Index Fund (VTSAX) has an expense ration of .04%, compared with the average TSP fund expense of .038%.
I need more than $95,000 a year for my family’s living expense.
You would be surprised how far $95,000 a year goes, and how much day to day living expenses shrink once you retire. In my quest to save as much as I can, I realized that I really don’t need much for me and my family to be happy. By no means does this mean we’re planning to just sit around at home, watching TV all day. We plan to travel the world continuously, but with all the travel hacks I know, I estimate we only need ~$50,000 to travel comfortably.
I’m single and make too much for this to apply.
If you’re above the cut line with all the strategies I’ve mentioned above, remember your gains are only taxed when you sell. Wait out on realizing gains until you get that deployment or get married later in life. It might be another reason to take the Air Force’s Career Intermission Program and use the low-income year to realize the gains…
As a final alternative, anything above the 12% tax bracket but below $200,000 Adjusted Gross Income will only be taxed at 15%, which in my personal view is worth the freedom of having access to your money. This is under the assumption you’ve already contributed to the traditional IRA and TSP to lower your limit so you don’t have any tax shelter option left anyway, so mind as well use the strategy every year to pay the minimum amount of taxes possible.
What if they change the tax code again?
Although it is completely possible that the tax laws can change, the possibility of the government going after income that has already been taxed, albeit at 0%, is slim to none. They may change the law to eliminate the 0% capital gains tax, but I’ll cross that bridge when I get there; and at that point, most of my investments should have already been taxed.
What this strategy is not
Just to re-emphasize, this is not a strategy to try to time the market. My plan is to buy and sell my stock within 5 minutes of each other, or in the case for mutual funds, the next day. Which leads me to my second point. The strategy on where you invest for your long-term investment shouldn’t change. This means you should really be investing in low-cost index funds; BUT again, this allows that choice to be yours.
As a final note, this is not a good strategy for people who don’t have the time or desire to regularly keep up with their investments nor is this a good idea for people who would be tempted with large amounts of accessible money. Remember, you should still treat it like your retirement fund, even if you have full access to it.
In conclusion, utilizing the 0% tax on long-term capital gains allows for all the tax benefits of a Roth but without any of the restrictions. If you see any flaws in my strategy or other questions, please don’t hesitate to ask.
Credit to Michael Kitces @ www.kitces.com, his article on utilizing the 0% capital gains tax was extremely informative for me to develop my strategy.