***I spent 2-3 days in 2018 writing down everything I know about the U.S. tax code with the hopes of turning it into a book someday. It’s not exactly a page turner, but it may very well make you hundreds of thousands of dollars richer over your lifetime through the minimization of your lifetime tax burden. You can read the extremely rough draft here (link).***
As I have mentioned before, this blog post was the single most influential personal finance post I’ve read in my life: http://www.gocurrycracker.com/the-go-curry-cracker-2013-taxes/. In it, Jeremy from GCC reveals his formula for minting money.
How to mint your own money through tax arbitrage
Take $1 of income that I make today. I have one of two options: shove it in 401a/401k/403b/457 pre-tax, or alternatively shove it in a taxable brokerage account after tax.
My effective marginal tax rate is 45% today. Let’s assume:
- A 5% investment return
- 30 year investing horizon
- 2% dividend yield
- 15% tax on dividends
Let’s first consider the case of the $1 going to the taxable brokerage account:
Because it’s coming to me after tax, my $1 of income immediately turns to $0.55 after applying my marginal rate of 45%. Further, because I’m invested in a taxable account, every time I receive a dividend from the stock I’ll be forced to pay a 15% tax. This will produce a drag on my returns equal to 2%*15%=0.3% every single year, which is unfortunate but unavoidable. So the value of this investment in 30 years is $1*(1-45%)*(1+(5%-0.3%))^30=$2.18. If we assume we’re in a reasonable tax bracket in retirement, this will be taxed at a 0% LTCG bracket and truly equal $2.18 in 30 years.
Let’s now consider the case of the $1 going to the tax-deferred (401a/401k/403b/457) account:
There are no immediate taxes to be paid on the $1 of income. Further, since the investment is sheltered, there is no drag on the portfolio of 0.3% as above created by taxation of dividends. Here’s what the $1 looks like in 30 years: $1*(1+5%)^30=$4.32.
But we all know that this money hasn’t been taxed yet, so the natural question is what rate will it be taxed in retirement?
The brilliance of the GoCurryCracker approach is that, in retirement and unlike your working years, you can pay $0 of taxes in retirement. Here’s how we’d do so with the above scenario.
Step 1: Roll over the $4.32 from a 401a/401k/403b/457 to a Traditional IRA.
Step 2: Convert the $4.32 from your Traditional IRA to a Roth IRA.
Step 3: Here’s the key ingredient. You can convert up to your standard deduction + 2*personal exemptions if married filing jointly (i.e. 12.7k+2*4.05k=20.8k in today’s tax code) for 0% in taxes. If you cared to convert more, then this would be taxed at the 10% rate, then 15%, and so on. At a 0% conversion tax, the $4.32 remains valued at $4.32.
Step 4: Wait 5 years after Roth conversion to access the principal (what you’ve converted).
Step 5: Repeat Steps 1-4 year after year to produce what’s known as the “Roth Conversion Ladder” for hundreds of thousands of dollars of tax-free earnings.
Step 6: Supplement the above Roth conversions with tax-free earnings on LTCG and dividends from taxable accounts during retirement, for close to $100k/year in income tax free per year.
Doing the above arbitrage, the value of your money is 98% (=4.32/2.18 – 1) larger in retirement because you optimized. If you understand the above, you know have the power to mint money. It’s not an accident that I shove every penny that I can into tax advantaged accounts. It’s because the math says to do so.
Also note that 401a/401k/403b/457 accounts are known as “tax deferred” accounts because taxes are to be paid upon withdrawing the money. Well, if you implement the above strategy as outlined, they really become “tax free” accounts.
Public Service Announcement
I’ve harped on this elsewhere in the blog, but a friendly reminder that investment fees really matter. Really. An example:
- Investment return 6%
- Inflation 2%
- Investment fees 1%
- Investment horizon 30 years
REAL (inflation adjusted) Value of $1 in 30 years WITHOUT fees:
REAL (inflation adjusted) Value of $1 in 30 years WITH fees:
By avoiding the 1% fee, your real purchasing power in 30 years increases by 34% (=3.24/2.43 – 1). This benefit would increase as the fees increase, of course. The great paradox of investing is that you will outperform 99% of investment professionals by buying an index fund or two (with expense ratios of 0.04% or so) and keeping your tax burden low by buying and holding and occasionally tax loss harvesting.
If you do the following simple steps, you will be hundreds of thousands of dollars richer in retirement:
- max out tax advantaged accounts every year (401a/401k/403b/457, HSA/FSA, IRA, 529?)
- invest in low cost index funds
- strategically minimize your tax burden in taxable brokerage accounts
As I’ve said before on this blog, I feel like I’ve uncovered a great mystery that can make anyone who listens hundreds of thousands of dollars richer in retirement through following a couple simple bullet points above. I cannot meet a single individual without feeling inclined to teach them the above. But I inevitably come across as the crazy guy who arrogantly thinks he holds the keys to the universe; particularly when nobody seems to care about retirement. But by the time most people wake up and realize they need to act, it’s several decades too late because that’s how compound interest works. Further, tax arbitrage can only be accomplished up to the annual contribution limits (18k for 401k, 5.5k for IRA, etc). Once Dec 31 rolls past, the opportunity is lost forever (with the exception of IRAs which can be contributed to until tax day (~April 15) of the following year). One of my great financial mistakes is not realizing this sooner and failing to max out 401ks in my early 20s.
This site is for entertainment purposes only, as disclosed here: https://frugalprofessor.com/disclaimers/
10 thoughts on “How to mint money using tax arbitrage”
Thanks for helping to make this easy to understand. When should you start the Roth conversion ladder? After reading some of GGC’s stuff (which is awesome!), I think it’s once you’re basically in a 0% effective tax bracket. Is that right? For instance, would you start the conversion ladder in a 45% bracket? I think the answer is no, but just double checking.
0% Roth conversion begins the first calendar year after early retirement (or I suppose during a period of unemployment if this happened to you). There is the 5 year period during which you can’t touch it, after which the principal, not the interest accrued during the 5 years, is able to be withdrawn.
Thanks for posting all this – just getting into your blog and doing my best to understand. When you write “You can convert up to your standard deduction + 2*personal exemptions if married filing jointly (i.e. 12.7k+2*4.05k=20.8k in today’s tax code) for 0% in taxes” — that is assuming no income otherwise, right? That is, there’s not some special tax exemption for Trad-> Roth conversions — it’s just that we are all allowed (if MFJ) to make standard deduction+2*exemptions before paying any taxes. (And so if I have, say, $50k of earned income and $20k from a Roth conversion, then I’d pay taxes as if I had a gross income of $70k.) Right?
Your understanding is correct. Roth conversion is taxed like other ordinary income.
Unfortunately, the article is a bit stale because it doesn’t account for the massive Jan 1, 2018 tax law changes. To understand the implications of the tax law change, read the draft “book” I put together last year: https://www.dropbox.com/s/lv96xgpfp95d3tk/20180531%20-%20Incomplete%20Rough%20Draft.pdf?dl=1
After the tax law change, personal exemptions are dead…now replaced by a much larger standard deduction (12k single, 24k married). The PDF highlights other major differences (the $10K SALT deduction limit being the other major one that comes to mind).
This is very interesting, but what about income received during retirement? Say, social security payments? Is Roth conversion still tax free for the first 24K?
Roth Conversions would be taxed on top of Social Security. In the simplest example in which social security income is zero, the Roth conversion would be the only source of income and $24k/year could be taxed for free.
If you want to learn a lot about the tax code, check out this “book” I’ve put together: https://www.dropbox.com/s/lv96xgpfp95d3tk/20180531%20-%20Incomplete%20Rough%20Draft.pdf?dl=1
Thanks for your quick reply. Am I understanding correctly, once social security income is taken into account, the tax rate on even the first $24K Roth conversion may well be 15% or higher? What you described in the article (tax free $24K) only applies to early retirement, before one receives social security income?
I have read your book. The relevant section “A Note about Future Tax Rates” seems not to have taken into account the social security income. If it is taken into account, the advantage of Traditional over Roth may be reversed? I am not disputing what you said, but I just wanted to understand it better, because your article raised many intriguing possibilities. Thanks again for sharing.
I’m not an expert by any stretch on social security taxation, but these links seem relevant:
Depending on total household income, then 50% or 85% of social security benefits are taxed. Therefore, Roth conversions would augment your taxable income in addition to the (50% or 85%) * your social security benefits.
That said, this is what I learned from 5 minutes with google so please take it with a grain of salt.
Can we play Devil’s advocate for a Roth IRA over a trad IRA?
The main argument for trad IRA seems to be: more control. YOU choose exactly how much “taxable” you receive each year, obviously, in periods of lower income.
COUNTERPOINT: To access money immediately — trad IRAs are more rigid. You either have to take a 10% penalty, or do a roth IRA conversion ladder (where you have to wait 5 years and pay “work tax” rates anyway).
With a ROTH, you can pull up principal at any time, and I think even INTEREST EARNINGS up to 10,000 for a first-time home purchase.
Thusly, a ROTH offers more short-term flexibility (<5 years).
It looks like many posts were made concerning early retirement, but I'd argue a 5 year wait period is MEDIUM TERM, not a short-term horizon, say you need capital for a business opportunity or property investment, etc.
Good points. I echo some of your points on page 30 of this pdf in the section called “Non-Tax Reasons Why Roth IRAs are Pretty Cool”: https://www.dropbox.com/s/lv96xgpfp95d3tk/20180531%20-%20Incomplete%20Rough%20Draft.pdf?dl=1
I actually withdrew $100k from our roths at the age of 35 to buy our first time home as well as support our family of 7 without income for 6 months finishing the phd before my current job started.
For most people trying to save up for retirement, I would assume that they will have a chunk of money in a taxable brokerage account. I consider myself to be one of those people. I’ve got over $200k in taxable right now, so that has me less concerned about the 5-year roth conversion ladder trad 401k liquidity issue you mention. Further, I would assume that many people saving for retirement will have a mix of roth AND trad accounts. For those with roth accounts, they can withdraw the principal as you note. If I add roth orincipal + taxable brokerage, I’m close to $400k, so that helps me sleep better at night knowing that I won’t have to incur 10% penalties + taxes to generate liquidity from a trad 401k.
In addition to the PDF, you may also enjoy this post: https://frugalprofessor.com/trad-vs-roth-marginal-vs-marginal-vs-marginal-vs-average-wisdom-from-mdm/
Thanks for the great comments! I’m basically in complete agreement with you.