In the past, we maxed out 40X accounts and then had some money left over to save…before paying our bills [do you like that…”before bills”]. Before we were optimizers we just put that money into savings accounts, then became wiser and used little brokerage accounts.
Then I became even smarter and thought, “let’s pop that money into RothIRA accounts to its tax -free forever, instead of paying yearly interest tax. This absolutely was a good idea to lower the tax burden into the future rather than a brokerage account. Especially since we could use the money before 59 ½ penalty-free.
ZOOM…fast forward (it was fast) now 20 years later, we’re living LifeInFIRE and still optimizing as much of our lives as we can. Listening to a podcast today while at the gym (you know a LOT of early retirees and FI people are fitness-smart, right?), someone left a voicemail saying “I can explain why the traditional is better than the Roth.”
I’ve heard the arguments and read the formula examples from Brandon and Joshua (Bad@$$FIentist, Radical Personal Finance) and thought, “yeah, but not really that different in optimization” in my mind.
WHOA. Today it hit me like a 16% punch in the shoulder. “Hey stupid, you gave the government 16% more that you had to.”
Example of Federal Tax
We did: Paid Federal tax at 25% or 28%, then the money was popped it into RothIRAs. Now tax-free
Should have: Contributed to a Trad IRA deferring tax of 25%/28%, then in FIRE convert those funds while in the 15%/12% tax bracket. Saving 10%-16% on each dollar ($125+ for each $1000) and being in the exact same place (not adjusted for gains). WTF!?
The Retirement and IRA Show podcast calls this the Tax Window. The magical time of low “income” tax, allowing conversion optimization. Others call it the RothIRA conversion ladder. It’s all the same thing…SMART.
Luckily we are able to do Roth IRA conversions each year to optimize (maximize) the 15%/12% income tax bracket and stay in the 0% Long Term Capital Gains bracket. It’s a total money puzzle.
We are happy with our tax optimization strategy, but I only give myself an A- for the overall optimization. Or should I give myself and 84% (100-16% miss)?
The takeaway is: if you’re going to have a low income tax period, you want to max out your low tax brackets—that could be maxing the 0% or 10% even—while still having money to pay for living expenses.
There are age thresholds for planning <59 ½, 62, 65, 67ish, 70, >70 ½, 72. You should know what each of these ages relates to and have a plan for each age and the optimization during the years between the ages.
UPDATE: After writing this post I was having a conversation with the brilliant FItaxGuy Sean Mullaney and he asked one simple question whose answer (luckily) validated our socking away money strategy. Sean asked: “we’re you covered by a workplace retirement plan (401k)?” I said yes, and he basically said, then you were not eligible to use a deductible (traditional) IRA. That left my main options with non-401k money to be brokerage account or roth IRA account. I do not want to bother with the non-deductible backdoor Roth IRA process. So, all is well. I didn’t waste 16% of my money/tax advantages. WHEW.
Note: So much of this financial smarts comes down to being able to save…while living a good, enjoyable life. Thanks Sean. Thank you for making me feel better.
*** Nothing in this article is to be construed as financial advice. I am not a financial planner, nor do I pretend to be. You should always consult your own professional when seeking advice.