Hey everybody – James at MilitaryMilesAndFinance.com asked me to review his thoughts on whether military members who are aiming for financial independence/early retirement (FIRE) should actually forgo tax-advantaged accounts and focus on investing in taxable accounts. After writing a lengthy response, we decided to turn it into a blog collaboration. Look for some follow-up from him in the future!
Not in the military? This is an interesting concept for civilians to explore too. If you have the possibility to keep your taxable income below certain thresholds, this may apply to you.
Though I don’t agree with part of James’ findings, I want to stress that this isn’t a criticism of James. This is a conversation that we are letting the rest of you witness. I’ll tell him what I think, then maybe he’ll counter some points and hopefully I’ll learn something, and maybe this goes on for a couple more posts. The key is that all of you will get to see our thought process as this happens.
I think this will be a good way to show the process people go through when assessing how to allocate their retirement investments. It’s also a great example of my doctrine vs dogma argument (with “always max out tax-advantaged accounts!” being the common wisdom). It’s good to examine our beliefs!
Make sure you read his post first (that’s the link), because I’m not going to completely recount it here. I’m going to go straight into my response after a very brief summary. In fact – having both posts open in side by side windows might not be the worst idea so you can follow along. You are going to need to read this Michael Kitces post too because it explains the background that makes James’ idea work.
WARNING: There is some seriously brain numbing tax talk here. I had to read James’ post multiple times to fully understand his plan. Partly because it’s just so different and partly because of the tax rules involved. And I had to refer to his post and others (including Michael Kitces’ post that inspired James as well as numerous tax code pages) over and over again to verify things as I was writing this. This is advanced stuff – so advanced that I would say if you read it and don’t understand, this plan is not for you. Not until you can read it and understand fully and have talked to a tax professional. Capiche?
- He will use taxable investment accounts to save for retirement instead of tax-advantaged Thrift Saving Plan (TSP) and Individual Retirement Accounts (IRA)
- He will do this so he has access to his money at any time, instead of after age 59.5 (this is key for those pursuing FIRE)
- In order to make this plan tax-neutral (that is, he won’t spend any more or less on taxes this way vs using tax-advantaged accounts) he will utilize a plan advocated by Michael Kitces, a very popular personal finance blogger with a whole bunch of acronyms behind his name that mean “smart about money”
Let me explain this really quick. Basically, James wants to only pay taxes once (like most of us) on his retirement money. Typically we do that by either paying taxes now and not paying taxes when we pull the money out (Roth accounts) or not paying taxes on it now and paying when we withdraw in retirement (Traditional accounts). You can read up on Traditional and Roth accounts here.
Instead of using those tax-advantaged retirement accounts (Traditional and/or Roth TSP and IRA) James wants to pay taxes on the money now. Then he is going to put the money into taxable investment accounts and withdraw the money very, very carefully only at such times that he is able to do so at a 0% capital gains tax rate. That way, the money goes in taxed, but is coming out tax-free. Basically, he is emulating a Roth account by doing this. It’s a complicated scheme but is feasible, so we’ll discuss how it could work. We’ll also talk about whether or not the average person should do it.
Why do this and not just use Roth accounts? Good question. It’s because James wants access to his money at any time. He doesn’t want to wait until age 59.5. We’ll address that part, too.
James claims that this plan is best for not only him, but “most military trying to reach FIRE.” He says this is because the combination of low capital gains tax rates, changes in the new tax bill, and military member’s artificially low taxable income makes it possible for us to better protect our retirement investments from taxes and penalties while also giving us access to our money now.
It’s possible this is the right plan for James. But in order for me to say this is a good plan for “most” military members, two things have to be true:
- It needs to be applicable to most military members (as in the majority of military members could use the plan)
- It has to be easy enough to accomplish that most military members would be able to carry it out
I don’t think this plan meets those criteria. Let’s explore.
The 0% Long-Term Capital Gains Tax
So…the tax code…it changes. If the past couple of months isn’t proof of that, I don’t know what is. That’s why taking advantage of tax breaks now, instead of hoping to take advantage in the future, makes sense.
Now, I’m not one that thinks the government is always out to get its citizens. I don’t believe the tax code is going to change such that any currently promised benefits (::cough:: Roth tax-free withdrawals ::cough::) are going to be revoked. However, I do believe the government could change the rules for things that aren’t already in play. For instance, capital gains tax rates.
James wrote “The American Taxpayer Relief Act of 2012 permanently set the realized long-term capital gains for taxpayers in the bottom two tax brackets at 0%.” Well, that’s not exactly correct. The American Taxpayer Relief Act of 2012 made the 0% and 15% capital gains rates permanent (as permanent as any law is). The Act didn’t permanently tie the 0% capital gains bracket to the two lowest income tax brackets.
The link between the 0% capital gains tax rate and the bottom two income tax brackets is already gone with the new tax plan (the Tax Cuts and Jobs Act, or TCJA). Under TCJA, the capital gains income thresholds actually line up with what the bottom two brackets would’ve been if no tax reform had occurred. But they don’t align with what the new bracket income thresholds are now. You can’t rely on being in the bottom two tax brackets in order to get 0% capital gains taxes. Instead you have to carefully follow the exact dollar amount. Not an insurmountable challenge by any means, but something to pay attention to.
It’s hard to tell, but the 0% capital gains bracket is actually slightly lower than the top of the 15% income tax bracket. For single filers, the 0% capital gains threshold is $38,600 (instead of $38,700 income tax threshold). For married filing jointly, the 0% capital gains threshold is $77,200 (instead of $77,400 for income tax). The difference between the old brackets and the new brackets is small, and the capital gains thresholds may realign with the income tax brackets in the future. But for now, it’s not exact. Just something to keep an eye on.
Staying Within The 0% Capital Gains Tax Rate
One of the big problems I see is that James’ plan inherently limits the income he can pull from capital gains if he wants to stay at 0% capital gains tax rates. This is because if he earns over the limit for his status (in his case, married filing jointly) he will end up not paying 0% but instead paying 15% capital gains. Keep in mind this is after he has already paid 15% income tax on this money. In order to beat the tax-advantaged accounts, his plan has to stay at a 0% tax rate for withdrawals.
James says the new tax plan allows more room to stay within the lower two tax brackets. I am not here to get into a debate over the merits of the new tax plan. Suffice it to say that many people will see lower taxes for the next few years. Not everybody will, and the tax cuts will phase out. That’s all we need to know for this discussion. Moving on…
James’ plan also assumes that the person executing this plan can manage to stay under the limit for 0% capital gains. For a married couple where only one person works, or for lower ranking single members that might be true. But it doesn’t take much to exceed the limits.
All the Single Ladies (and Gents)
In 2016, 50.0% of Total Force military members were not currently married (that’s precise!). That’s from this demographic report on page 9. So right off the bat, if we are going to assess if this plan works, we need to look at how it affects both married and single members. James used himself to give an example for married members. I’m single, so I’ll look at them.
For a single person, the 0% capital gains tax rate ends at $38,600 of taxable income in 2018. With the standard deduction at $12,000, that means the person can only earn $50,600 including the income from the capital gains harvesting before this plan becomes unfeasible. So virtually all single E-7s and above on the enlisted side, and single O-2s and above on the officer side are already out of the game unless they can find another way to drive down their taxable income. James’ plan talks about not using TSP and IRA, which are the easiest ways to drive down taxable income (if using a Traditional TSP or IRA). He does include a clause in his plan to utilize the TSP or an IRA if your income is too high to take advantage, but then things get even more complicated. The point is to avoid using them, right?
Side note: James, please check your numbers. You wrote “As an individual filer, you can make as much as $57,600 taxable income (upper limit capital gains at 0%: $38,600 + standard deductible: $12,000) and still stay in the bottom two tax brackets.” That’s probably just a typo, but $38,600 + $12,000 is $50,600, not $57,600. I don’t want anybody making investment plan changes based on this. Readers: I’m sure James will update his post so if, by the time you read this, it says $50,600 – all is good.
Okay, so we know a single filer needs to stay below $50,600 in order for this plan to succeed. Let’s use an E-5 at 7 years of service as an example. I’d use the official numbers for pay but they aren’t out yet (::cough:: DFAS ::cough::) so we’ll round it off. An E-5 with 7 years of service in 2018 is making $2925/month in taxable basic pay. That’s $35,100 for the year. That means they still have $15,500 of income to spare because $50,600 – $35,100 = $15,500.
Per James’ plan, this E-7 would “harvest” up to $15,500 in capital gains in order to stay under the 0% capital gains tax threshold. Okay. That makes sense. It’s impossibly to say how much they’d have to sell in order to hit that number – it’s based on the cost basis, and the current state of the market, and when exactly you sell. But it’s doable.
By the way, this plan assumes you don’t make any income from another source. No second job. No home-based business. No rental income. And no interest from savings and taxable dividends from that taxable account you are putting money into. Multiple streams of income can add up quickly! If you do have other taxable income streams, subtract that amount from what you can harvest.
The plan is more feasible if you are married and only have the military income, or if your spouse has a low income. James runs the numbers on this so I won’t go into detail. But basically, this plan relies on keeping income low – generally not something we recommend in the personal finance sphere, although definitely common for a civilian spouse given the difficulty they can have maintaining a career. Constant moves aren’t easy on a career.
Again, looking at the “most military” claim – are most military pursuing FIRE either single O-1s, E-6s or below, or married with a non-working spouse? I don’t know. But anecdotally from spending time in forums where these military FIREes hang out, I’d say no. They tend to either be higher ranking and/or dual income households.
The Difficulty In This Plan
All of the above being true, we now come to what I see as a huge overlooked flaw. This is a tough plan to execute.
If the member has low enough pay to stay within the 0% capital gains range, they still have to figure out exactly which investments have gains, and exactly how much to sell at which time in order to get the right amount of capital gains. That’s tough, y’all. That’s a lot of tracking.
Then they have to arrange it so they rebuy the same investment again immediately. That’s not tough, exactly. But it’s not nothing. And depending on how often your investment trades, you run the risk of selling in the morning at one price and buying back the investment later that day or the next day at a higher price. Yes, the possibility also exists that you could buy it back at a lower price. But you don’t know what will happen.
Why do this? Why track and sell an investment just to buy it back immediately? Well, it changes the cost basis for your investment. Basically you are selling it at a price where you don’t have to pay taxes, then rebuying it at a higher price so that when you sell it again, your gain is smaller so you still don’t have to pay taxes. But it’s a lot of buying and selling and rebuying, not to mention a lot of tracking and income manipulation, to avoid paying taxes.
I Don’t Really Understand Why…
Say this plan works – your income is low enough to harvest capital gains each year at 0%. You’ve carefully tracked your investments and know what you should sell and how much of it.
All you’ve done is achieve exactly what a Roth retirement account would give you, but not in a Roth account.
Now the argument here is that by keeping the money outside of a Roth retirement account, you will have access to your money at any time. You won’t have to wait until age 59.5! Well…
TSP and IRA Access Before Age 59.5
My first thought when I saw this plan is the same as it always is when I see anybody talk about having access to their money now instead of age 59.5. You can definitely access your money without penalty before age 59.5. The tax code is actually quite lenient on this – it’s almost like they want us to retire early! If it weren’t for the fact that there are so many indications that they want Americans to work for 40-50+ years, I’d say it was done on purpose. Here is just a partial list of the ways you can access that money penalty-free before age 59.5:
- Qualified distributions for certain expenses (education and housing being quite common possible reasons)
- The 72T Rule (SEPPs being most important to FIREes)
- Roth IRA Conversion from the TSP (slightly more problematic as a military retiree receiving a pension, but definitely in the realm of doable)
- Roth IRA contribution withdrawals (easiest of the methods)
Not to mention, you still need money after you turn age 59.5. If you can get retirement money at a discounted tax rate without complicated schemes, do it!
There are a lot of relatively easy ways to access retirement account money before age 59.5. Don’t let concern over accessing your accounts be the reason you don’t invest in tax-advantaged accounts. It may be a reason to not focus 100% on them, but it should not be a reason to avoid them. The Age 59.5 Rule needn’t be the motivating factor for coming up with an entirely different retirement investing system.
My biggest concern with this method of investing for retirement is that while it may be the best financial decision *for certain people* based purely on mathematics, there is more to personal finance than mathematics. You have to take other things into account. For instance:
- The person’s willingness to closely track their investments and tax situation;
- Plus their ability to understand and implement this plan;
- Plus the likelihood they will keep their hands off their money if it’s not “locked” away in a retirement account (psychology!)
It’s entirely possible that James will benefit from this plan. That’s not really my concern. My concern is the “most military,” or really anybody looking at this plan who isn’t James. In order to execute it, you have to put in work. You have to have a really good understanding of tax law. You have to have faith that the tax law won’t change in a way that makes your plan unexecutable.
And you have to have the mental fortitude to not touch your retirement money. I left this one to last because I wanted to talk mostly about how the plan works technically, but this is important. It’s true that there are many ways to pull money out of retirement accounts penalty free. But having that money in a retirement account is psychologically beneficial to some people. It keeps them from saying “screw it” and pulling that money out to buy a boat. I don’t think James would do that – the fact that he is willing to go to this level of effort for his retirement money shows he is pretty smart with money. But I know people who would do this. We all do. There wouldn’t be a retirement crisis in America if everybody was great with retirement investments, would there?
The fact that most people don’t know they can pull their money out of retirement accounts is actually a good thing. Taxable accounts don’t have the same mental barrier. For that reason, as well as the other concerns I listed above, I don’t think this is the best plan for “most” military and other lower income individuals. It’s not a bad plan mathematically, per se. But I think it’s too complicated for most of us. Frankly, as a lazy investor – this sounds like a headache to me.
Note: James does address these issues at the end of his post, but I don’t think they can be overstated. This plan is workable, but not easy, not for the faint of heart, and not for anybody that can’t leave the money alone.
My Recommendation (for James or anybody)
If you are willing to track your investments closely and try this out, why not do both? As I mentioned, you are going to need money after age 59.5 too. Why not put some money into tax-advantaged accounts for then, and some money into taxable accounts for the early stages of FIRE? You’ll still be able to execute the 0% capital gains technique, while hedging your bets against tax changes and planning for later in life.
Plus, if you put that money into a Traditional TSP or IRA account, you’d continue to lower your taxable income, allowing for even more capital gains harvesting while working. And you’d also have the opportunity to do a Roth IRA conversion on that money if you want.
A typical military retiree aiming for FIRE is going to retire between ages 38-45. Sure, some retire later. But let’s assume that most people wanting FIRE aren’t going to stay in 35+ years. In that case, the taxable account only needs to last you 21 years or less – most likely less. The likely longer timeframe – from 59.5 to death – can be supported by tax-advantaged accounts without complicated schemes. Plus contributions to a Roth IRA can easily support either period.
So my recommendation would still be to focus on tax-advantaged accounts, but put any extra money into taxable accounts and consider doing some capital gains harvesting. That will ensure you are set for a traditional (59.5 or later) retirement, plus give you lots of options for FIRE.
James: you’re up!