back to free: Give Me Back My Money

To be quite honest with you, I prefer to avoid taxes when legally possible. It also happens that I am interested in financial independence and simple living. If that weren't enough, all these things support each other in the process. So after reading some relevant sections of the tax code I was happy to discover it is possible to live a comfortable life without paying any or much federal income tax.

As it turns out, there's a pretty neat loophole for low income people like myself. I didn't know all of this when I started working, but with The Epiphany all the pieces finally came together. The following is based on 2011 law and is applicable to people who are single and will spend less than $9,350 after working years. If that doesn't apply to you then you'll need to do some more research. Before you go and do something crazy like me, let me say that this is not tax, financial, or legal advice. This is what I learned (which may be incorrect) based on 2011 tax law (which may change). If you do this you will certainly lose all your money, get fined, and end up in jail. This is complicated and very individual!

Step one, is to save as much as possible during working years. Really, you can't get anywhere without saving more than you spend. I now understand I should have maxed out my 401(k) account and after that my traditional IRA with these savings. This is important because earned income that is contributed to a 401(k) or traditional IRA is not taxed on contribution, but on withdrawal. Any extra could have been placed in a taxed account. Alternatively, you could max out the 401(k) account and then fund a Roth IRA and any extra savings could again go in a taxed account.

In either case, you'll need some money you can tap for the five years you need to wait for the process to fully work. That money would either need to be in the taxed account or the Roth IRA. If the money is in the Roth IRA you can only withdraw the amount you contributed, which may not be much since there are annual contribution limits. Contributions to a Roth IRA are not taxed when withdrawn regardless of when they are withdrawn. Contributions that are subsequently withdrawn are not taxed, because you already paid tax on them prior to contribution.

Keep saving until you have 300 to 400 times your planned monthly expenses. Then you will be financially independent if your money is invested and bringing in more money. I say "planned" expenses, because if your expenses during working years are more than they need to be, then you can reduce expenses instead of increasing savings. At this point you should have a large percentage of your money in tax deferred accounts. In your taxed accounts (or Roth IRA contributions if you chose that route) you should have at least five years of living expenses. Otherwise, you could work part-time to cover minimal living expenses, but that would affect how the process would work without being taxed. Now comes the fun part...

Step two, after quitting work you will need to rollover your 401(k)-type account into your traditional IRA. If your 401(k) has good investment options, low fees, and is easy to work with then you might just skip this step since the 401(k) and traditional IRA will be treated (somewhat) similarly after quitting. Not all plan administrators will allow a conversion from a 401(k) to a Roth IRA, so rolling over to a traditional IRA may be easier. The rollover will not be taxed if you don't do anything weird because 401(k)'s and traditional IRAs are both tax deferred retirement vehicles.

Step three, after quitting work, once a new calendar year has begun* you will want to start converting your traditional IRA (possibly 401(k) if you chose that option) into a Roth IRA once per year. You can only do this once per year. The conversions will be taxed as regular income. You can convert up to $9,350 per year if you want to avoid federal income tax. Amounts up to $9,350 will not be taxed at the federal level because of the personal exemption and standard deduction for a single person. Keep converting money from the traditional IRA to the Roth IRA annually until the year you turn age 59.5.

*You may want to wait until a new year so that you don't bump that IRA money into a higher tax bracket when you factor in your previous salary. If you only made a little bit for the year, then you could do the conversion in that same year without much consequence (or just convert less).

Be careful not to convert your traditional IRA money too fast. This is the basis for your income from year six after quitting until you turn 59.5. In the best case scenario you would want your last dollar converted from the traditional IRA to the Roth IRA on the year you turn 59.5, when you can start withdrawing from the Roth IRA penalty free.

During this step, you also start withdrawing your current living expenses from the taxed account (or withdrawing Roth IRA contributions if you went that route).

Step four, in the sixth year after quitting work you can start withdrawing the converted money from the Roth IRA. Only withdraw as much as you need for the year and not more than you converted five years ago. This money will not be taxed on withdrawal, since it was already "taxed" on conversion (actually, it was below the level that would be taxed at the federal level, but it still counts). In this regard a Roth IRA conversion is treated as a Roth IRA contribution (no penalty for withdrawal). The difference is that you need to wait those five years to access the money without penalty. Withdrawal of earnings on contributions are taxed and penalized.

Step five, in the year you turn 59.5, almost all your money should be in the Roth IRA. At that point you can withdraw everything without limit, penalty, or taxes. You probably wouldn't want to withdraw more than 4% of your savings though, in order to preserve capital.

If you have been following along you may have noticed something interesting about the above scenario. Excluding possible state taxes, you wouldn't have needed to pay any tax on the money you earned originally or while it was invested in the traditional IRA. There was:

No tax on your salary that is contributed to tax-deferred retirement accounts (401(k) and traditional IRA).
No tax on the 401(k) rollover to traditional IRA.
No federal tax on the conversion from a traditional IRA to Roth IRA.
No tax on gains or dividends in any retirement accounts.
No tax on withdrawal from Roth IRA.

What I like about this plan:

It is not irrevocable. If your situation changes you can change your plan. Other options such as 72(t) withdrawals seem more complicated and you can't stop them once you start.

If you screw it up, then you pay income tax plus a 10% penalty. If you are below the federally taxable income level, then you just pay the 10% penalty. 10% is still way lower than any other normal tax rate.

You can convert more or less than $9,350 if you want to. You will just need to pay the corresponding income tax at the regular rate on conversion for the amount you withdraw.

What I don't like about this plan:

You have to file extra tax forms each year to help the government keep track of your conversions and withdrawals. They want to make sure you don't take out more than the converted amount.

It's not possible to begin the conversions if you are still working for the same employer. If you were going to quit anyways, you're good.

Here is the plan mapped out: