How to mint money using tax arbitrage

***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:

$1*(1+(6%-2%))^30=$3.24

REAL (inflation adjusted) Value of $1 in 30 years WITH fees:

$1*(1+(6%-2%-1%))^30=$2.43

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.

 

Big takeaway:

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.

 

Disclaimer:
This site is for entertainment purposes only, as disclosed here: https://frugalprofessor.com/disclaimers/