How Are Investments Taxed – USA

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.

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A few weeks ago, we did an example of how our portfolio is taxed after retirement, and showed that by constructing a portfolio using low-cost index ETFs and holding those assets in the right retirement accounts, it’s possible to harvest about $70,000 in dividend income to pay for my living expenses while paying no federal tax, and only $300 in provincial taxes (which were mandatory health insurance premiums).

So while that’s all fine and great for Canadians, how does this work out for American early retirees?

Well, let’s find out!

Roth IRA Conversion Ladder

The first thing we have to consider when doing our US taxes as a FIRE person has nothing to do with the portfolio at all. It’s about a tax strategy that early retirees have used to great success in retirement, and it’s the 5-year Roth IRA conversion ladder.

One of the annoying things about the US retirement system is that if penalizes you for accessing your own money if you withdraw it before the age of 59 ½. I mean, I get that they want to discourage people from blowing their retirement savings on a new boat, but if you’ve successfully hit Financial Independence way earlier than 59 ½, why should you be penalized for it?

Fortunately, the FIRE community has come up with a clever way around this, and it’s called the 5-year Roth IRA conversion ladder.

I wrote about this strategy here, but to briefly recap, this strategy involves converting over a portion of your Traditional IRA/401(k) into your Roth IRA once you start retirement. The conversion is added to your income as ordinary income, but once you retire and have no other earned income, you can use your standard deduction against this conversion to basically do it at a 0% tax rate.

Each conversion becomes available to withdraw from your Roth after 5 years, so it’s important to start this process as soon as you retire, and to do it every year, because there’s a delay in the money becoming available to withdraw into your checking account.

So for the American early retiree, the standard deduction should be used for a Roth conversion. For this tax year, the standard deduction for a married couple filing jointly is $29,200, and if done correctly, should look like this.

Portfolio Income

Next let’s deal with the income coming from the portfolio itself.

Let’s say that an American early retiree is using the USA workshop portfolio, which basically looks like this:

So we have 3 sources of income: Bonds pay interest which are taxed as ordinary income at the highest marginal rate. Domestic equities pay qualified dividends, which are essentially tax-free for most early retirees (more on this in a bit), and international equities which pay a combination of qualified dividends and foreign dividends.

Let’s take our portfolio as an example. It’s currently worth about $2.4M CAD, or $1.7M USD. If this portfolio was invested as an American would, what would our dividend income look like?

Ok so now that we know what we’re working with, how does this portfolio’s income look like to the IRS?

First of all, the bonds should (ideally) be completely contained within the 401(k). How large your balance is depends on how much you’ve contributed into your 401(k) over the years, but for a portfolio of the size we’re talking about, we would need a 401(k) size of about $680,000. For a married couple in which both spouses are working and maxing out their 401(k) each year, I think this is a plausible goal since our RRSPs are at around that level, and American 401(k)’s have a higher annual contribution limit than Canadian RRSP’s.

So, if the bond portion of our portfolio can be completely contained within the 401(k), then the interest income from those is essentially tax-free. Of course, withdrawing that cash from our 401(k) would potentially cause it to be taxed, but since we’re doing those withdrawals as part of our Roth Conversion ladder under our standard deduction, those withdrawals are tax-free too!

Qualified Dividends

Now let’s talk about qualified dividends.

Qualified dividends are dividends that are paid by U.S. corporations, and they’re taxed at the much lower long-term capital gains tax rate. When you get your tax forms, look at 1099-DIV. Box 1a shows how much dividends you received for the year, and box 1b shows how much of that is a qualified dividend.

Qualified dividends are your friend, because these are taxed using the Qualified Dividend Income (QDI) and Long-Term Capital Gains (LTGC) tax brackets, which are shown below.

This means married couple can earn up to $94,050 in qualified dividends for 2024 tax-free! There are certain holding requirements for a dividend to be qualified, specifically you must have held it for more than 60 days during the 121-day period that starts 60 days prior to the ex-dividend date. This means that if you just put money into your portfolio or did a rebalance, some of those dividends may not be qualified (yet), but for more FIRE enthusiasts that don’t frequently trade, this is not going to a major issue.

VTI, which is the Vanguard Total Market Index, paid $6,630 in qualified dividends, so for our retiree that doesn’t earn any other income, this income is tax-free since it fits inside our 0% QDI/LTCG tax bracket.

For our international stock market index, VEU, the dividends you get are a blend of qualified and ordinary dividends. The fund company provides a table where you can look up how much of your dividends are qualified, and for VEU, that number is 65%.

For that reason, it’s a good idea to keep international stock ETFs inside your Roth IRA, if you have room, so that those dividends can be realized tax-free.

Using our own situation as an example, our combined TFSA room (which is the Canadian equivalent of the Roth and has similar annual contribution limits) would allow us to shelter about $370k of our international equity in our tax-free accounts. That leaves about $140k that’s still left in our taxable account, and this will produce dividends, 65% of which will be qualified and tax-free, and 35% which will be taxed as ordinary dividends. Now, our income looks like this.

So unfortunately, we can’t get to completely $0 in taxes, but the only portion of our income that’s actually taxed is the Ordinary Dividends from VEU, which in this example, is $1470, which is taxed at the lowest federal bracket of 10%, resulting in a $147 tax bill. It’s not $0, but it’s pretty damned close.

Capital Gains Harvesting

You might notice that there’s plenty of room left over in our 0% QDI/LTGC bracket, which an early retiree should ideally use up, and here’s where the US taxation system has an advantage over the Canadian one. In Canada, if we want to realize capital gains for free, we have to use our personal exemption for it, so we have to decide whether we want to use it for capital gains or withdrawing money from our RRSP.

In the US, you don’t have to choose, you can do both! This is because IRA withdrawals are being done with the standard deduction, while capital gains have their own special 0% tax bracket that’s separate. So in this case, you would want to calculate how much 0% LTGC room you have left, and realize that amount by selling and then re-buying the same ETF in your taxable account.

Note that as the name implies, this 0% tax bracket only applies for long-term capital gains, meaning you have to be selling ETF units that you’ve owned for more than a year. If it’s owned for less than that, it gets taxed as ordinary income.

This makes it really important that you select the right shares to sell. For example, if you bought 100 shares of VTI 2 years ago, and then you bought 100 shares this year, you have to make sure you’re selling the 100 shares that were held for longer to take advantage of long term capital gains tax rates. Your brokerage company should keep track of all this for you and give you a chance to specify exactly which shares to sell when you input your sell order.

As you can see, you can harvest quite a bit of capital gains each year for free, and if you proactively do this over time, you should be able to get away with never paying capital gains taxes ever. Now you know what it’s like to be one of those fat cats that everyone hates. Welcome to the dark side, young padawan. Mwahahahaha!

State Taxes

Note that I’ve only talked about federal taxes here, because unlike in Canada where every province has fairly similar tax rules, in the US, states taxes can vary wildly. For example, California treats qualified dividends and long term capital gains the same as ordinary income, so you get hosed no matter what kind of income you make. On the other hand, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming don’t have any state income taxes at all (though they do charge sales tax and property taxes).

This is why in the US, where you retire is a surprisingly important decision, since it can have a big impact on your post-retirement tax situation. Many early retirees make their money in a high-tax state like California and New York, since that’s where the high-paying jobs are, and end up relocating to one of these states with no income taxes once they leave their job so they get the best of both worlds. I guess that explains why there are so many retirees in Florida…

Conclusion

By structuring your portfolio such that the right assets are sitting in the right accounts, understanding how qualified dividends and capital gains are taxed, and relocating to a low or no-tax state, you can realize the dream of zero (or close to zero) taxes in retirement, America-style!

Have any of you early retired? If so, how have you structured your investments, and what do your taxes look like? Let’s hear it in the comments below!

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