After I graduated from college, I explored several subjects for different careers, searching for which path to take. This is kind of hilarious, because usually you go to college with a plan in the first place, but I guess when your degree doesn’t necessarily lead you in any one direction, there comes a time where you’re just glad to have finished, and now you get to worry about next steps.
One subject that I explored was Finance. My interest in money had developed long before, but I had never really sat down to learn about monetary systems, banks, and bond formulas. I bought an old edition of a finance textbook online, and went to work. It was boring as hell.
Of course, many subjects never matter until you really have a vested interest in knowing about them. This can be true of just about anything. Unfortunately, this often means that really useful things are avoided if they aren’t directly on the radar.
In this post I’m going to describe how to pay $0 (or a minimum) amount in taxes to withdraw 401k money. How many people is this relevant to? I have no idea. But it can be done, and certain people should seriously consider it. Not all of my information is rock solid, so do your own research, but the concepts I hope will prove enlightening.
The Strategy
This strategy is really only useful if you plan to take a gap year, an unpaid sabbatical, if you plan to be a missionary overseas, or if you just want to travel for a few years. The principal assumption is that you will be living predominantly off of savings for a time and your taxable income will be low or non-existent. I’ll explain why.
When you go to withdraw money from a 401k, there are some strict rules that must be followed, predominantly this one: you must be at least 59.5 years old or you pay a 10% penalty on the amount you withdraw. Ouch! It’s not the worst thing in the world if you really need the money, but it’s also only part of the equation. The money you withdraw is also considered taxable income, since the way it got into your 401k was after FICA taxes but before federal and state taxes. So if you reside in Colorado, for example, you get to pay an additional 4.63% tax for state taxes, and you will also pay federal taxes as determined by your tax bracket. Let’s just assume you’ve worked the whole year and you are in the 22% bracket. Congratulations, you now get to pay 10% + 4.63% + 22% = 36.63% of your withdrawal in taxes! That’s over 1/3 to Uncle Sam! Suckage.
There’s not much you can do about reaching 59.5 years of age to avoid that 10% penalty except hang on for the ride and hope you don’t croak before then. As for the federal and state taxes, well, maybe you become a Florida resident and avoid the 4.63% Colorado tax, but you’re still going to have to pay federal taxes at some point.
Enter: Roth Conversions!
See, the traditional 401k and traditional IRA are all built on the simple principal of not paying federal and state taxes before being contributed but paying these taxes when withdrawn. The Roth 401k and Roth IRA are built on the opposite: paying federal and state taxes before being contributed but not paying these taxes when withdrawn. This may not be around forever (though it probably will be), but there is a way to convert Traditional money to Roth money by initiating a conversion. What happens is, you go to the institution that your 401k is through, and you designate a certain amount of, say, your 401k to be converted to your Roth IRA. What happens is that when you convert it, the amount of the conversion becomes taxable income for that year. Uncle Sam wants his cut, so if you are converting from an account that didn’t pay federal and state taxes to an account that did, Uncle Sam is going to make sure he gets his cut in the process.
BUT! Uncle Sam only gets to take a cut as per your tax bracket, for federal taxes.
So…let’s say that you’re living overseas off of savings. You have earned $0 of taxable income. And let’s say you think, “Gee, let’s take $12,000 of 401k money and convert it to money in my Roth IRA account!” (I believe this requires you to convert to a traditional IRA first, but let’s ignore this for the sake of illustration, the end result should be the same)
Well, congratulations! You now have to declare $12,000 as taxable income for the year! (I think this would go in box 4a on your 1040, but don’t quote me on that). Bummer. You still get to pay 4.63% for Colorado tax and 22% for federal, right? Right?
Enter: the standard deduction! If you are single or married and filing separately, you get to claim a $12,000 standard deduction! It’s so convenient you were converting exactly that much 😉 . So now, after subtracting that standard deduction from your Adjusted Gross Income, and all other things being equal, your taxable income is $0. Take that, Uncle Sam! You pay $0 in federal taxes on that conversion.
But wait! What about state taxes? Well, I revisited my own Colorado tax filing for 2018 and saw that in box 1, the instructions explicitly state: “Enter Federal Taxable Income from your federal income tax form: 1040 line 10”. What is line 10 on the 1040? Your taxable income, which was after the standard deduction. In other words, $0.
The only other caveat that I can think of is that you MUST keep that money in your Roth IRA for 5 years to avoid the 10% early withdrawal penalty.
(I am also not particularly sure whether the conversion converts as pure contribution or as some pro rata contribution/earning ratio. Since contributions to a Roth IRA can be withdrawn penalty free but earnings cannot, this matters, but I’m a lazy blogger. I’m also seeing some interesting strategies involving how much you can normally contribute to a Roth, but those look sketchy because I’m pretty sure you still have to pay tax on all conversion amounts. But I’m not a CPA.)
Do this year after year, and you can easily convert large sums of 401k money tax-free. But there are a lot of caveats here, you have to know your tax situation. For most people this will be fairly simple, but it can get complex pretty quickly.
By living off of savings and therefore minimizing your AGI, you are basically using the standard deduction as a hack to reduce the taxes you pay when converting 401k money to Roth IRA money. Sometimes to $0.
I also want to note line 10 on the 2018 1040: It states, “Taxable income. Subtract lines 8 and 9 from line 7. If zero or less, enter -0-“. Line 7 is your AGI, line 8 is your standard deduction, and line 9 is qualified business income deduction (we’re kind of ignoring that). So if your AGI is 0, the standard deduction DOES NOT HELP YOU. You cannot enter a negative number in box 10. Your standard deduction is WASTED if you have no AGI. So having 401k money to operate on is important.
Anyway, I think this strategy is especially suited for long-term volunteers and missionaries. That’s a lot to take in if you’re not familiar with taxes, but if you have any intentions of becoming a missionary or volunteering overseas, you should absolutely take advantage of any 401k contributions and employer matches available to you. Someday I may research the caveats for a 403b and 457, but the 401k is the only one currently relevant to me, so go figure. Only specific circumstances make this ideal, but if those apply to you, you should milk them for all they’re worth.
If you find yourself converting $60,000 of 401k money over 5 years and you are able to execute this strategy, it could basically save you about $21,978, which is not chump change. Even if you claim additional but small amounts of money on additional earnings, being in a lower tax bracket can easily save you thousands and thousands of dollars when doing this.
(again, always do your own research before acting on what you see online)