The US Tax System is FANTASTIC for Early Retirement

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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.

Stackable Programs

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 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.

Canada USA
TFSARoth 401(k)
Traditional Deductible IRA
Traditional Non-Deductible IRA
Roth 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 lessa full deduction up to the amount of your contribution limit.
more than $61,000 but less than $71,000a partial deduction.
$71,000 or moreno deduction.
married filing jointly or qualifying widow(er)$98,000 or lessa full deduction up to the amount of your contribution limit.
more than $98,000 but less than $118,000a partial deduction.
$118,000 or moreno deduction.
married filing separatelyless than $10,000a partial deduction.
$10,000 or moreno 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)< $184,000up to the limit
>= $184,000 but < $194,000a reduced amount
>= $194,000zero
married filing separately and you lived with your spouse at any time during the year< $10,000a reduced amount
>= $10,000zero
single, head of household, or married filing separately and you did not live with your spouse at any time during the year< $117,000up to the limit
>= $117,000 but < $132,000a reduced amount
>= $132,000zero

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 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.

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15 thoughts on “The US Tax System is FANTASTIC for Early Retirement”

  1. Very good post Wanderer. You are right we have it somewhat better than you folks up north but only if you put in the effort to understand the system. One important point you left out is that it is possible for a couple earning $90K in dividends and capital gains here and still pay $0 in taxes! That’s why dividend investing is more popular in US than elsewhere I have seen. While there are disadvantages and potential risks (major one being, will Obamacare survive after the election?), overall the US tax system favors passive income and capital returns upto a fairly good limit.

    1. Impressive! In Ontario, a couple can pay $900 on $90K of dividends and capital gains. Not quite tax-free, of course, but I doubt many people would complain about an effective tax rate of 1%.

      (Assumptions: the couple is resident in Ontario, and 2015 tax rates are used. They earned $50K in dividends, all of which are treated as “eligible” dividends for tax purposes, and $40K in capital gains. The income is split 50/50 between them – which generally can’t be done through any elections, so they’d both need to have identical portfolios).

      I just re-ran the numbers out of curiosity for BC and the couple would owe zero tax. Same for Quebec.

    2. Great points, though I’m only seeing $75k in tax-free dividends and capital gains (ie the top of the 15% tax bracket for a married couple), not $90k. That’s pretty sweet, and another example of the system taking care of you if you know the right secret handshake…

  2. I’m writing from the Netherlands and unfortunately such schemes do not exist here. In addition they assume that you have 4% taxable return on your net capital, no matter what the actual return is. In cases when people keep their savings in low yielding assets (not hard to find such nowadays) this can be quite a rip off. Anyway, it’s a great post for the US and Canadian readers. These are great schemes and if you use them wisely, it could really speed up the way to your early retirement.

      1. As far as I know if you live over 180 days a year in the country, your global savings (besides of some exceptions like immovable property) are all taxed here, no matter where your account is. How the tax authority will catch you that’s another question, but when it comes to tax, I’d rather optimize than avoid. There are some good things though, like mortgage interest is tax deductible.

  3. In the US there is a “catch-up” contribution for 401(k) accounts so my husband (62 and not an early retiree) can contribute an extra $6,000. Also, his employer used a formula and adds $14,000 to his contribution so that is +$38,000 per year into the 401(k).

    Then he can put $6,500 ($5,500 +$1,000) catch-up into an IRA and I can put in $5,500 (I am only 48).

    Love your site. Thanks!

    1. Yeah, I saw that, but it seems like a consolation prize compared to the contribution room lost, especially when you take into account how much it could have grown over that time period.

      Also, what formula gives you an extra $14k in 401k contributions?!? That is crazy high!

  4. I can’t take advantage of most of these because we make just over the limit, we don’t even get the child credit! Question: What do you think of annuities? Would love to see a post on that. Love your blog!

    1. Not a big fan of annuities. They’re expensive, they’re opaque, and you can’t get out of them easily. You can implement something similar with a balanced portfolio without having to pay the high fees.

  5. I think a big thing in the US is that to retire early you have to contribute to taxable account- registered accounts have rigid withdrawal rules that don’t let you take money out until you hit 65 or something. At least that was the case when I read a book about that.

    Here in Canada RRSP and TFSA are both flexible and can be taken out anytime- a boon for an early retiree. Plus once your income comes from TFSA and dividends – you essentially get free health care automatically without any complex machinations. And you can get max child subsidy – recently increased. And free tuition in Ontario- recently implemented.

  6. Hi wanderer, I read a lot of FI blogs but I haven’t seen anyone really talk about inheritance. I am in the somewhat rare position of having a large amount of funds in a taxable account. After my mother passed away I sold her house and ended up with nearly $400K which I put in FSTVX, Fidelity’s total market fund. I ended up with a large Capital loss to report as well. I’m an employed (~70K/yr USD) 33yo with a 401k and Roth IRA. Due to having a wife and child, my 401k contributions (~6k/yr), the capital loss, and part of my income being from a rent stipend which goes directly to my landlord (aka tax free income for me basically) I didn’t have to pay taxes last year. My question is, should I be moving money from the taxable account to max my Roth IRA every year? Is it better to max out my 401k even though if I just take the income and put it in my Roth IRA I don’t believe I’ll be paying taxes on it? I’ve got this capital loss to use up. In this situation it’s kind of difficult for me to figure out the best strategy. I plan to retire at the 1 million mark, hopefully before age 40.

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