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Hey you know what I’ve always wanted to do? Pay more taxes to the government.
Over the course of the last few weeks since this silly little blog went viral, we’ve done our fair share of reader case studies figuring out how quickly our intrepid Revolutionaries can kiss the 9-5 goodbye forever. A few have been featured publicly on this site, and far more behind the scenes in our inboxes. FIRECracker gets off on spreadsheets. Don’t judge.
And after the first five, or ten, or twenty, you start to notice a few patterns. The first being that people are in far better shape than they thought. Even without six-figure salaries, with a few tweaks we can often bring their retirement plan down from “never” to “totally doable.” And second, people generally don’t understand how important taxes are. For higher earners especially, just the act of walking into a bank and filling out a bunch of forms shaved up to 5 years off their retirement!
So let’s dig into this.
First of all, taxes are an important part of keeping a country running. They pay for roads and schools, and I’m sure there’s enough government oversight that would prevent a totally irresponsible waste of taxpayer money like, say, the CIA running an illegal brothel in New York and slipping random people LSD just to “see what would happen.”
But wouldn’t it be great if there was a government program that directly benefitted YOU? That padded YOUR bank account with taxpayer money to help you retire in your 30’s? Well good news, because that totally exists!
In Canada, we have two main government programs to help people retire: the Registered Retirement Savings Plan (or RRSP) and the Tax-Free Savings Account (TFSA). Americans, I’m not ignoring you, but as the Canadian system is significantly simpler it’ll be easier to explain ours, and then go over how the American system is different rather than the other way around.
Here’s how RRSPs work. You contribute into them, either directly from your paycheque or by walking into a bank and transferring a lump-sum amount. That amount gets deducted from your taxable income, so when you do your taxes at the end of the year, the government sends you a nice taxpayer-footed refund check. That taxpayer was you, but still. Free money! Investment earnings made inside the RRSP are tax-free, but when it comes time to withdraw money from the account, you have to add that money onto your income and pay tax on it then.
The TFSA operates slightly differently. You put after-tax money into it, and all future investment earnings are tax-free. And because you’ve already paid taxes on the money you put in, you can withdraw at any time with no penalty.
Putting it Together
So how do the RRSP and TFSA fit into an early retirement plan? How much should you contribute to either? The answer is simple: the maximum.
The RRSP contribution limit is 18% of your previous year’s income, and the TFSA limit is $5500 per year. When you put your money into an RRSP, that money is still yours, but you get an additional refund check from the government which you can then forcibly shove into your TFSA.
And on top of that, many employers have an RRSP matching program of some sort (both mine and FIRECracker had one). These work by matching a certain percentage of your contribution (say, 50% in my case) up to a certain limit. So you get even more extra money out of that.
Basically, opening up an RRSP, a TFSA, signing up for your employer’s RRSP matching program and contributing the maximum to both accounts is the easiest way to shave years off your early retirement. And if you’re late to the party, you contribution rooms from previous years for both accounts carry forward indefinitely, so if you open up your account now you can still use up all that unused room starting today.
But wait! While the TFSA withdrawals are tax-free, what about that pesky part about the money in the RRSP needing to be taxed when you withdraw? Don’t I have to take that into account?
Nope. You can get it out tax-free!
Once you’ve left your job, your earned income essentially goes down to zero (unless that book you’ve been working on all of a sudden gets picked up by Hollywood). That leaves a nice little personal exemption credit of about $11k (or $22k for a couple) that you an use to melt down your RRSP, $22k at a time while paying no tax. And if you structure your investment portfolio like I told you to, the only taxes you’ll be on the hook for will be in the form of dividend income, which are essentially untaxed if you make less than $50k each.
USA! USA! USA!
And now let’s turn our attention over to our Americans readers. Hey y’all!
The same basic principles apply to you, but for whatever reason your government turned your retirement account names into an unreadable alphabet soup.
Our RRSP is your 401(k), 403(b), 457(b), or TSP. 401(k)’s are for private corporations, 403(b)’s are for non-profits, 457(b)’s are for state government employees, and the TSP is for federal government employees, plus members of the armed forces. For the most part, these plans function the same so I’m just going to refer to them all as 401(k)’s going forward.
401(k)’s, like RRSPs, allow you to contribute directly from your paycheque and lower your taxable income. This will result in either less taxes being taken out of each paycheque or a fat juicy refund come tax time. 401(k)’s are also commonly used as part of an employer’s matching program, so make sure you sign up for the sweet sweet free money!
The two major differences with an RRSP vs a 401(k) is that a 401(k)’s contribution limit is set at a flat $18,000 (in 2015) rather than a percentage of your income (unless your employer imposes a specific restriction on this). The second is that unlike RRSPs, your contribution rooms do NOT carry forward. If the year rolls over and you don’t use it, POOF, it’s gone. So if you haven’t been taking advantage of your company’s 401(k) plan this entire time, you need to get on this TODAY. You can’t figure it out later because by then your contribution room would have been wasted.
Now on to your version of a TFSA. Yours is called an Individual Retirement Account, or IRA (hey, at least this one has the word Retirement in it). And it comes in two flavours: Traditional IRA and Roth IRA. Unlike us Canuckistans, you Americans have the freedom to choose how your IRA operates: a pre-tax contribution system like your 401(k) or a post-tax contribution system like our TFSAs. I gotta admit, you Americans sure do love your freedom.
Whichever you choose, you can put a maximum $5500 in each year. And again, these contribution rooms do NOT carry forward, so don’t wait to set one up or you lose that room forever.
So which to choose? Generally, if you’re trying to retire early, the Traditional IRA that allows you to contribute pre-tax dollars. Why? Because if you use the Roth IRA you have to pay taxes NOW, while the Traditional IRA allows you to defer it, and by using some IRA-jujitsu that we’ll talk about in a minute, we can sneak that money back out of the IRA once you’re retired essentially tax-free.
Note that there are tons of stars-and-asterisks here. Unwilling to let something simple remain simple, the IRS has imposed all sorts of rules on who’s eligible for a Traditional IRA, especially if they also have a 401(k) at work. If you make too much, you may not be allowed to open a Traditional IRA and therefore be forced to use a Roth IRA. And if you make a RIDICULOUS amount of money, you may not even be allowed to use a Roth IRA either! However, in banking terms this is commonly referred to as a “champagne problem.”
Putting it Together
So how do these accounts fit into our early retiree financial plan? Same as before. Open them suckers up and shovel as much money as you can into them. Each dollar you manage to contribute is less tax you have to pay, and therefore less time until you can retire.
Hoo boy. Here’s where things get funky, so strap yourself in.
Unlike us up here in the frigid North, your retirement accounts have a nasty surprise in them: If you withdraw anything before you hit the strangely precise age of 59.5, you get hit with a nasty 10% penalty.
As an intrepid reader just pointed out, the 457(b) is special in that it does NOT have this 10% penalty, so if you work for a non-profit DEFINITELY make sure you’re enrolled in that sucker!
So are we toast? Is all hope lost? Of course not!
There is a LEGAL way to meltdown all your money and get it out tax-free. However, it does require jumping through some more hoops.
First of all, when you finally retire and say goodbye to your hateful job once and for all, roll your 401(k) into a Traditional IRA. This can be done tax-free.
Now the IRA-jujitsu part. The IRS allows you to convert a portion of your Traditional IRA into a Roth IRA every year. However, when you do this, it becomes reported as taxable income. However, remember that in retirement, your earned income will drop to 0, so you can sneak out an amount equal to your standard and personal deductions tax-free. For a married couple with no kids, this is about $20k. If you have kids, it goes up even more. So you can safely convert that amount every year into your Roth IRA tax-free by getting it out under the cover of these deductions.
Once it’s in the Roth IRA, the IRS allows you to withdraw it tax-free, but you have to wait 5 years starting the year the conversion occurred. So what you need to do is do this conversion every year, making sure you keep your amounts low enough to get them out tax free. Then in 5 years, you’ll be able to start withdrawing that first conversion that was done 5 years ago, again, tax-free.
This is called a 5-year Roth IRA Conversion Ladder, and an extremely detailed and excellent article was written by my good buddy and fellow FI-er Justin from RootOfGood.com. See that for more details.
Aaand We’re Done
Phew. So there we have it. Retire early and get Uncle Sam to help pay for it (or whatever the Canadian equivalent is. Auntie…Beaver?)
All information in this article is based on my understanding of the tax laws at the time of me writing it. Rules may change over time, and there are a lot of stars-and-asterisks that may apply to your special situation that I’m not aware of, so before you actually implement anything, please consult a tax professional, ESPECIALLY if there’s a lot of money involved.
And special thanks to Justin from RootOfGood.com for taking the time to sit down and explain all this craziness to me. I’ve never met a guy so good at (LEGALLY) hacking his tax bill, and here’s how we managed to get the tax bill on his family’s $150k salary down to $150. I shit you not, he is THAT good.
Update: Based on reader feedback, we’ve fixed the e-mail subscription so you can now subscribe to “only your comments”. No more cluttered inboxes! YAY!