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A few posts ago we talked about how the Government, specifically tax shelters such as RRSPs or 401(k)’s, can be used to legally pay less taxes and help you retire faster. And because this blog (according to Google Analytics) has a surprisingly international audience, we did our analysis for both the Canadian and the USA tax programs. And in doing so, we realized something:
The US Tax System is FANTASTIC for Early Retirees!
I know, I know. Nobody has ever looked at the US Tax System, thrown up their hands and yelled “WOOHOO!” in the history of ever, but when you actually break it down and figure out how to navigate it, you discover a few things that make retiring early in the US of A MUCH easier than in the Frigid North. It’s not all blue skies and sunshine though, but first, let’s start with what the Yanks have going for you.
First the Good News…
Higher Deduction Limits
Let’s do a quick recap: in Canuckistan, we have essentially two types of retirement accounts: the RRSP and the TFSA. The RRSP allows us to contribute pre-tax money, reducing our taxable income and therefore our overall tax bill. That money grows tax-free, and if we withdraw from our RRSP slowly enough in retirement, we can get it out tax-free. For our TFSA, we contribute after-tax money, let the money grow tax-free and we can withdraw it whenever we want. Go read the original tax breakdown article for details.
Generally, you’re going to want to max out both these programs if you want to retire early. Any tax paid while you work is less money that can be saved towards your Financial Independence. Tax = bad.
So how much can we contribute? Well, our RRSP contribution limits are calculated as 18% of our previous year’s income. So if you made $50k last year, you can contribute $9k this year. As for our TFSA, it’s $5500 per year flat.
Now let’s compare that to the USA equivalents. The RRSP equivalent is the American 401(k), 403(b), 457, and TSP, depending on what type of company you work for. Generally, ALL of these accounts have a deduction limit of $18,000 as of 2016 regardless of income. This is huge. In order for Canadians to have that kind of contribution room, we have to earn $100k, but in the States, everyone gets that massive contribution room right off the bat!
Add to that the Roth/Traditional IRA contribution rooms of $5500, and it’s possible to shelter $23,500 from taxes per person, per year. So a married couple would be able to shelter $47,000 each and every year even without earning $100k each (and get it all out tax-free using a Roth IRA Conversion Ladder). I think this is actually a big part of the reason why there are so many more American Early Retirees than Canadian.
This surprised even me, but it’s possible for people to qualify for multiple retirement accounts at the same time. This typically happens for employees of Universities or certain types of government contractors, but if your organization is both a non-profit AND paid by the government, it’s possible to qualify for both a 403(b) and a 457 plan! And mind-bogglingly, the contribution rooms don’t overlap, they actually stack up, meaning you’d be able to sock away $36,000 each and every year! That is absolutely insane, nothing in Canada comes close to being able to shelter than much income. Our RRSP’s max out at around $24k (and that’s only if you make $133k a year).
Unsurprisingly, this is often not advertised (or very unenthusiastically advertised) by these companies’ HR departments, so if you think you may qualify, hound your HR people until you get a clear answer. The benefits are too big to miss out on.
What About Health Insurance?
And then the big question that people keep asking us: what about health insurance? If I quit my job, I lose my health benefits right?
It turns our the Affordable Care Act (or Obamacare, as the COOL kids call it) is very friendly to the Early Retiree. Besides defining standards for health insurance plans, banning coverage denial due to pre-existing conditions, and creating centralized health care exchanges to make comparing plans easier, Obamacare includes federal subsidies (namely the Premium Tax Credit, or PTC, and the Cost Sharing Reduction Subsidy, or CSR) to help pay for your health care plan. These subsidies are income tested, not means tested. See where I’m going with this?
Once your quit your 9-to-5, your earned income drops to essentially 0. This means you qualify for all these federal subsidies. This means for a household of 2, you could earn up to $16k (the Federal Poverty Level) and you’d basically get free health care.
I’m oversimplifying a bit, of course, as some of the math is dependent on what state you live in, whether your governor has blocked the Medicaid expansion, etc. But here’s an article from our good friend Jeremy from GoCurryCracker.com detailing how he optimized his income to get free health care in early retirement.
So there you have it. Even Obama wants you to become Financially Independent 🙂
Now the Bad News…
Now, with all that good stuff out of the way, the US tax system is not all peachy-keen compared to the Canadian one. It does have some big disadvantages unfortunately, and they are…
It’s Confusing As All Hell
Here’s a list of all the retirement accounts available for both countries.
|Traditional Deductible IRA|
|Traditional Non-Deductible IRA|
Yeesh. I’ve only covered a handful of these that are the most useful to most readers, but there are a bunch more out there than I haven’t scratched the surface of (those are mostly for self-employed or small business owners). While the US system is clearly more favourable to people trying to become Financially Independent, it’s also way more confusing.
And it’s not just the number of accounts, it’s all the stars-and-asterisks that the IRS imposes on each account. Take the Traditional IRA, for instance, if you also qualify for a 401(k)/403(b)/457/TSP via your employer, here are the rules for how much you can deduct from your IRA:
|If Your Filing Status Is…||And Your Modified AGI Is…||Then You Can Take…|
|single or head of household||$61,000 or less||a full deduction up to the amount of your contribution limit.|
|more than $61,000 but less than $71,000||a partial deduction.|
|$71,000 or more||no deduction.|
|married filing jointly or qualifying widow(er)||$98,000 or less||a full deduction up to the amount of your contribution limit.|
|more than $98,000 but less than $118,000||a partial deduction.|
|$118,000 or more||no deduction.|
|married filing separately||less than $10,000||a partial deduction.|
|$10,000 or more||no deduction.|
Source: 2016 IRA Contribution Limits
And here are the rules for a Roth IRA:
|If your filing status is…||And your modified AGI is…||Then you can contribute…|
|married filing jointly or qualifying widow(er)||< $184,000||up to the limit|
|>= $184,000 but < $194,000||a reduced amount|
|married filing separately and you lived with your spouse at any time during the year||< $10,000||a reduced amount|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $117,000||up to the limit|
|>= $117,000 but < $132,000||a reduced amount|
Soruce: Roth IRA Contribution Limits for 2016
And let’s not forget the age limits of 59 1/2 for getting money back out of your IRAs. While it’s still possible to do this by creating a Roth IRA Conversion Ladder, that’s a lot of hoops you need to jump through.
It’s Unforgiving As All Hell
A few months ago, I was chatting with Justin from RootOfGood.com during his visit to Toronto, and I was asking about why he chose to go the Roth IRA Conversion Ladder route rather than using Rule 72(t) to access his IRA’s by taking Substantially Equal Periodic Payments (or SEPP, as the uncool kids call it). Basically, that rule allows you to calculate a set amount you can withdraw each year without that 10% early withdrawal penalty. On the surface, I thought SEPP had all the advantages of the Roth IRA Conversion Ladder with that pesky 5-year waiting period. His response was that if you make even one mistake in the next 50 years, like take a little too much of forget to take it when you’re supposed to, you get slammed with a 10% penalty on every single withdrawal dating back to the start of time. OUCH.
And that right there is the biggest downside of the US Tax System. There are all these cool levers and tricks you can pull, but if you make one mistake you get screwed big time.
Every day we get emails from Canadian readers who say “Crap, I had no idea that’s how TFSA’s work. What do I do?” And our reply to them is “Relax, just open one now.” This is because in Canuckistan, RRSP and TFSA contributions carry forward if you don’t use them. So if you forgot for the last 5 years to open one, you haven’t lost anything.
Not so with the US system. All that juicy $23,500 you could have sheltered from tax each year? If you didn’t use it because you didn’t understand how it worked, tough shit, it’s gone.
So What’s an Early Retiree To do?
The US tax system is hands-down fantastic for people saving for Financial Independence, but this dichotomy is fascinating. From a completely neutral outside observer’s point of view, it seems the system is meant to separate people into two groups: the Insiders and the Outsiders. The Insiders are the people “in the know,” the ones who understand the system and how to exploit it to their benefit because they either had the foresight to sit down and learned everything themselves or they had someone around them who could teach it to them. These are the people who can use the system to really super-charge their wealth, sometimes to a ridiculous level like how Justin manages to pay only $150 in taxes while making a $150k income.
The Outsiders, meanwhile, get silently shafted. They didn’t know how any of this shit works, nobody taught it to them, so they never bothered with it. And if they suddenly find out 15 years too late that all these loopholes exist, well then too fucking bad. You didn’t get on the train 15 years ago, and now you are way too behind to ever catch up.
A cynical person would see this as yet another part of a system designed by the rich to keep poor people down. After all, rich people have tax lawyers and financial advisors to explain all this stuff to them, while the poor are left to their own devices to flounder. I (again, as completely neutral outside observer’s) think it’s a way for politicians to claim they’re helping middle class families (“Look at all the tax breaks I’ve given them!”) while making sure it doesn’t cost the government too much money by making it so confusing that not everyone participates. I’d be interested to hear your thoughts (especially our American readers) down below in the comments.
But regardless, everyone reading who wants to become Financially Independent and retire before they’re too old and rickety to do anything fun has to learn how to use their tax code, Canadian or US, to help them retire. ESPECIALLY if you’re American, you have way more tools to help you than you think.