
Do you feel burned out at work? Do you want to take a sabbatical and travel?
Recently I’ve been thinking about how one can take some extended time off while simultaneously using that time to do some very efficient tax planning.
Are you curious how you can do the same?
Today I’m going to show you a step-by-step method that simultaneously allows you to:
- Take a year off with your spouse – travel, recharge, learn a new skill, learn a language, or transition careers
- If you two have any 401ks or IRAs, convert some of that money tax-free into a Roth IRA
- Get a nice tax-free step-up in your stock basis for regular investments you own
- Pay zero income taxes on 6 figures of income
All totally legally, too. I’ll link you directly to the IRS rules and an online TurboTax tool where you can verify it all.
It’s gonna be a long one, but I promise it’ll be worth it.
First, a caveat…
This won’t work in all cases — it’s best suited for people who have already been in the workforce for at least a few years
To capture all the benefits I just mentioned, you’ll need:
- A sizeable amount of money already invested in regular taxable investment accounts and / or 401ks and IRAs
- Sizeable capital gains already accrued in your regular investment accounts (not required for 401ks and IRAs, since they are tax-deferred – more on this later)
- A source of spending money – you’ll either need a passive income source, the ability to earn some pocket money while traveling (e.g., freelancing, writing, teaching English), or enough financial cushion to cover your spending for the year – I recommend 6 months of cushion for living expenses, and you can get a lot farther with that in low-cost countries (e.g., in Asia, Latin America)
These criteria mean this strategy probably won’t work well if, say, you just graduated from school or you don’t have much investment savings.
It works best for married couples who have worked and saved and invested for at least a few years, and who now want to take a break or pivot their careers or even just consider retiring early.
It also works for single individuals, but the amounts for everything will be half the married couple amounts.
Finally, this method works best if you have modest spending levels. If you’re a high-roller with a life of 5-star luxury, then all the more power to you, but today’s strategy probably won’t help you much toward further luxury.
At a high level, the strategy involves:
- Keeping your income below taxable levels, then paying zero taxes on it
- Keeping your investment income in the 15% tax bracket, then paying zero taxes on it (yes, you read that right)
- Taking advantage of Roth IRA conversions and paying zero taxes on it
- Stepping up your tax basis in investments in your regular investment account, then (you guessed it) paying zero taxes on it
Let’s see how the details work!
After I explain the steps, we’ll walk through detailed examples to see how it might be put into practice.
STEP 1: KEEP YOUR U.S. INCOME UNDER $27,700
The IRS generally taxes all worldwide income of U.S. citizens. That means all your wage income, self-employment income, rental property income, ordinary dividends and interest (among many other types) are taxable.
So, the reason why a modest spend level is important (and traveling in low-cost countries helps this) is because, unless you have a LOT of savings, a high spend level means you’ll need a high income level to sustain it.
The higher your income, the greater the risk you’ll have to pay taxes.
Under current tax rules, a married couple can earn up to $27,700 in ordinary income and pay zero taxes (2023 numbers, adjusted annually for inflation). That is because the IRS allows that much for the married filing joint standard deduction.
You can juice your tax-free income further by applying additional adjustments like the $22,500 contribution limit (2023 numbers) for tax-deferred 401k contributions (per spouse). If you are doing a solo 401k, you can deduct even more, but the exact amount will be case specific.
Assuming you just do the $22,500 per spouse, that raises your tax-free income to $72,700. How cool is that?
There are other adjustments/deductions you can pile on to further increase your tax-free income, such as self-employed health insurance payments, health savings account contributions, and student loan interest deductions.
But for simplicity we won’t consider those here.
All these various “allowances” are usually increased by Congress or by a set inflation schedule every 1-2 years.
Bottom line: If you keep your US income below $27,700, your tax liability is guaranteed to be zero under the IRS tax tables, because your taxable income (after the standard deduction) will be zero. And you can enjoy even more tax-free income if you do things like 401k contributions.
STEP 2: IF YOU ARE LIGHT ON ORDINARY INCOME, DO A ROTH CONVERSION. LIKE, NOW.

If you have one or more IRA and 401k accounts, then you probably know you aren’t allowed to withdraw from them at all until you’re 59.5 years old; otherwise you get slapped with an extra 10% tax penalty.
Once you turn 73, things get flipped around and you are forced to start taking mandatory distributions from those accounts.
On top of that, whenever you withdraw money from these accounts, it gets taxed at ordinary income rates — using the plain old tax tables.
That’s because you got a nice tax deduction at the time you contributed to these accounts. The money was able to grow tax-deferred. So later, when you start to withdraw that money after 59.5, Uncle Sam comes knocking on your door again to collect a long-deferred tax bill — on the entire amount.
The only upside is you have some control over timing those withdrawals — at least between the ages of 59.5 and 73.
After that, you’re required to take mandatory distributions, so you lose some of the timing control over your tax liabilities.
But you can avoid this by doing Roth Conversions. This is where you take IRA or 401k money, which was tax deductible at the time of contribution, and you move it into a Roth IRA in a way that avoids tax.
How do you avoid tax?
Normally, when you move money from a tax-deferred account like an IRA or 401k into a Roth, you must pay taxes on the converted amount in order to pay no taxes on it in the future, which is the key feature of a Roth IRA. That’s because you took a tax deduction when you made the initial IRA or 401k contribution.
If you’ve decided now that you’d really rather have that money put into a Roth IRA instead, the converted amount is considered ordinary income subject to taxes.
However…if your ordinary income already falls short of the $27,700 MFJ standard deduction (half for single filers), then you can use the shortfall to do a tax-free Roth Conversion.
The converted amount is still considered ordinary income, but it gets wiped out by the standard deduction, up to $27,700.
Since on the backend Roth IRA withdrawals are tax-free, this means:
- Your original IRA or 401k contributions avoided tax on the way in
- You avoided tax again converting that money into a Roth
- That money will get withdrawn, yet again, tax-free on the way out
Dollar for dollar, this allows money to pass cleanly through all the way to retirement having never been taxed!
Even more awesome: Roth IRAs are not subject to Required Minimum Distributions like IRAs and 401ks are.
Holy moly.
This makes the Roth IRA one of the most valuable investment vehicles in existence. And it makes this conversion hack a particularly sweet deal.
It means that if you have a decent chunk of change locked up in IRAs and 401ks, you can easily capture the full tax-free value of your $27,700 “free pass” during your year off.
You end up with a fully optimized Roth Conversion.
Bottom line: If you have tax-deferred funds in an IRA or 401k and your ordinary income is low enough that you haven’t used up your standard deduction, consider doing a Roth Conversion to take advantage of the “shortfall.” All money converted in this way goes straight toward your retirement and will never be taxed!
STEP 3: GET A TAX-FREE STEP-UP IN YOUR STOCK BASIS
OK, on top of the Roth Conversion, there’s more tax-free goodness with our investment income.
As long as you remain at or below the 15% marginal tax bracket, you can zero out your tax liability on qualified dividends and long-term capital gains.
This is where the criteria I mentioned at the beginning of this post comes into play.
To implement this strategy, you will need a sizeable amount of qualified dividends and / or capital gains accrued in your regular investment account that you can take advantage of by the time you file your taxes.
This capital gain must be in your regular taxable investment account, not your IRA or 401k.
Your IRA and 401k are used for Roth Conversions because the stocks in them have no tax basis. Everything gets taxed at ordinary rates at withdrawal.
However, for your regular investment account holdings, you can get a nice tax-free step-up in basis if your taxable income is $89,250 or less MFJ, half for single filers.
Normally, once your income exceeds $27,700, you start paying taxes. UNLESS…it consists of qualified dividends or long-term capital gains. In that case, you will pay zero tax on that income as long as taxable income is $89,250 or less MFJ.
So what you’ll do in this case is harvest some long-term capital gains. Specifically, you’ll sell some stock that has increased in value and then immediately buy the stock back.
Normally, when you sell stock that has increased in value, you will owe taxes on the gains. For stocks held longer than 1 year, you will owe taxes on long-term capital gains.
However, if your taxable income is $80,800 or less, your long-term capital gains are taxed at 0%.
By harvesting capital gains (up to $80,800 taxable income), you’ve stepped up your basis tax-free.
This now also increases the chance that you’ll have capital losses you can claim in the future to offset gains or even ordinary income. More about that in our example below.
Here’s a chart to show you how this works:
Capital gains tax ratesFiling status | 0% if taxable income less than or equal to... | 15% if taxable income between... | 20% if taxable income greater than... |
---|---|---|---|
Single Filers | $44,625 | $44,626 – $492,300 | $492,300 |
Married Joint + Surviving Spouses | $89,250 | $89,251 – $553,850 | $553,850 |
Married Filing Separately | $44,625 | $44,626 – $276,900 | $276,900 |
Head of Household | $59,750 | $59,751 – $523,050 | $523,050 |
As you can see, for a married couple filing jointly, you could harvest up to $89,250 in qualified dividends and long-term capital gains tax-free!
Does it get any better than this?
So, you can earn $27,700 (minimum) tax-free by using deductions to wipe it out. Your taxable income will then be zero.
Then you can sell some stock to lock in $89,250 of long-term capital gain, and then immediately buy the stock back to get a tax-free step-up in basis.
This technique will help you build long-term wealth because those gains become tax-free forever.
So at a minimum, you can earn $27.7k + $89.25k = $116.95k and pay zero taxes!
In the example below, I’ll show you how this amount can be even higher and STILL result in zero taxes.
If you’re interested in the policy underpinnings of this, the 0% long-term capital gains rate was birthed by the Jobs Growth and Tax Relief Reconciliation Act of 2003, also known as the Bush tax cuts, which was scheduled to expire at the end of 2010, but was extended two more years under the “fiscal cliff” legislation (Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010), and then ultimately made permanent as a part of the Taxpayer Relief Act of 2012. The Tax Cuts & Jobs Act in 2017 modified the capital gains tax rates by linking them to specific taxable dollar amounts.
Couple things to note.
One, remember that investments must be held for at least 1 year to receive favorable long-term capital gains tax treatment. Stocks held for less than 1 year get short-term capital gains treatment, which is taxed at ordinary income rates. Qualified dividends must comply with IRS rules to receive the same favorable long-term capital gains tax treatment.
Two, while there are special rules for “wash sales” that you have to pay attention to when you sell an investment at a loss (you are restricted on what you can buy immediately after selling a losing stock position), wash sale rules do not apply when you sell stock for a gain. So you can immediately buy the same stock again after selling it to lock in your basis, pay your taxes (at 0%), and then get a nice tax-free step-up in basis!
Bottom line: If your taxable income from all sources is $89,250 or less, you get a 0% tax rate on qualified dividends and long-term capital gains…up to $89,250.
How much should I convert to a Roth vs. stepping up my stock basis?
If you have “space” to do both, how much should you allocate to Roth Conversion vs. harvesting gains?
The Roth by far has the best tax profile, so you should always optimize for that first before using any remaining allowance to step up your stock basis.
Money converted into a Roth is tax-free for life. The gains can increase to infinity and none of it can be taxed.
However, a step-up in stock basis is limited. If the stock increases again in the future, as it likely will, that future gain will be taxed.
Let’s walk through an example
Let’s see how we can score some massive tax-free income by combining the different rules together, shall we?
Let’s say my wife and I decide to take a year off and travel the world starting January 1. We spend the entire year abroad, except the last 2 weeks of December, when we return home to celebrate Christmas with family.
That means we remain abroad for more than 330 days of the year (more later about why that is significant).
We start our travels in Australia, which happens to have a nice tax treaty with the U.S.
We stay in Australia for 3 months, traveling most days, but doing some online freelancing work in various locations when we have downtime. Our freelancing gigs during these 3 months generate $65,450 — nice!
Along the way, we also decide to do a 401k-to-Roth Conversion in the amount of $20,000.
We also have stock investments and, toward the end of the year on December 30 we harvest capital gains and recognize $89,250 long-term capital gains.
So, how do we figure our tax liability in this case?
First let’s look at our earned income.
Our tax treaty with Australia says that income received in a self-employment capacity (Independent Personal Services) is only taxable in Australia if we stay there more than 183 days in the year OR we have a fixed base regularly available to us for the purpose of performing our job activities.
In this case, neither is true. We leave the country after 90 days, and we do our online freelancing work wherever we happen to be in our travels.
So Australia taxes this income $0.
Then we shift our analysis to the U.S.
Our gross income is $65,450 of wage income + $20,000 from the Roth Conversion. Total: $85,450. Remember, the Roth Conversion is taxed at ordinary rates because it was tax-deferred initially.
Now, to determine our taxable income, we first make our adjusted gross income adjustments.
Since my wife and I both have solo 401ks, we max those out and take our adjustment of $22,500 each, total $45,000. That leaves $40,450.
We then make another adjustment of $5,000 for our combined high-deductible health insurance plan premiums for the year. That leaves $35,450.
We then make an adjustment of $7,750 for money we put into our family HSA (Health Savings Account), which we use for routine medical expenses before our high-deductible health coverage kicks in. That leaves $27,700, which is our adjusted gross income.
We then apply the standard deduction to wipe it out.
That leaves taxable income of…zero.
Now we look at the $89,250 long-term capital gains harvest.
The entire gain is taxed at 0% because it is $89,250 or less taxable income.
So we earned $65,450 wages, $20k Roth Conversion, and $89,250 capital gains harvest — and we paid exactly zero taxes.
Total income: $174,700. Taxes: $0.
DON’T FORGET THE “FOREIGN EARNED INCOME EXCLUSION”
Even if you don’t have retirement money to convert to Roth or capital gains to harvest, you can still get a big tax break on wage income.
The key is to spend your year off traveling abroad.
With a year to explore, you can check off a lot of stuff on your bucket list!
The reason why being abroad is key is because if you stay abroad for at least 330 days (does not have to be consecutive) over a 12-month period, you can claim the Foreign Earned Income Exclusion.
The Foreign Earned Income Exclusion is a WONDERFUL thing. It lets you completely exclude from U.S. taxes up to $240,000 of foreign earnings MFJ, half for single filers (2023, adjusted annually for inflation).
I said, you can completely exclude from taxes $240,000.
Does it get any better?
Only “earned income” abroad qualifies for this. What is “earned income” for these purposes?
It is:
- Salaries and wages
- Commissions
- Bonuses
- Professional fees
- Tips
It is not:
- Dividends
- Interest
- Capital Gains
- Gambling winnings
- Alimony
- Social security benefits
- Pensions
- Annuities
So, if you earn some cash freelancing or teaching English while traveling abroad, how can you be sure that the income qualifies as “foreign earnings”?
Because the IRS tells us:
The source of your earned income is the place where you perform the services for which you received the income. Foreign earned income is income you receive for performing personal services in a foreign country. Where or how you are paid has no effect on the source of the income. For example, income you receive for work done in France is income from a foreign source even if the income is paid directly to your bank account in the United States and your employer is located in New York City.
One caveat: Remember that just because you are off the hook for U.S. taxes on your first $240,000 of income doesn’t mean you are off the hook for foreign taxes in the country you’re in. You might owe taxes to local government authorities.
However, also keep in mind that, even if you pay local taxes to a foreign government, you will get relief from Uncle Sam in the form of a Foreign Tax Credit IF you also end up owing U.S. taxes.
So, you will never have to pay taxes twice, because you’ll always get credit that exactly offsets whatever taxes you paid to a foreign government.
So, where the sweet spot comes in is: Many countries have tax treaties with the U.S. that exempt U.S. citizens from foreign taxes in certain situations.
Depending on how you earned your foreign income and what country you were in when you earned that money, it’s possible to be exempt from foreign taxes (under existing tax treaty) AND also exempt from U.S. taxes (under the Foreign Earned Income Exclusion).
Is this much happiness allowed?
Bottom line: The Foreign Earned Income Exclusion lets you earn up to $240,000 of foreign earnings MFJ, half for single filers.
Foreign Earned Income Exclusion & capital gains
Keep in mind that the Foreign Earned Income Exclusion only applies to EARNED income, not long-term capital gains. Capital gains are NOT considered earned income.
Which means, even if your earned income falls short of the FEIE cap, you could still owe taxes on your capital gains.
Let’s walk through two examples to illustrate the Foreign Earned Income Exclusion
Our first example just considers earned income, nothing else.
Similar to the last example, let’s say my wife and I decide to take a year off and travel the world starting January 1. We spend the entire year abroad, except the last 2 weeks of December, when we return home to celebrate Christmas with family.
So we remain abroad for more than 330 days of the year. Like before, we start our travels in Australia, which has a nice tax treaty with the U.S.
We stay in Australia for 180 days, traveling most of the time, but freelancing in various locations along the way. We then spend a few months traveling the great outdoors in Canada, and also freelance in various locations along the way. We then travel our last couple months in Asia before returning home.
During our Australia and Canada travels, our freelance work brings in a whopping $380,000 — who wouldn’t freelance for that kind of dough, eh? In Asia, we don’t freelance; we just travel.
Because we satisfy the tax exemptions for freelance work provided by Australia’s and Canada’s tax treaties with the U.S., we’ll owe no taxes to those foreign governments on any of our freelance income. Nice!
Now we shift to the U.S. tax system. What do we owe here?
We know we get $240,000 excluded for a married couple filing jointly. The way tax liability is computed under FEIE is based on something called the stacking rule: “whatever total taxes you would have paid WITHOUT the Foreign Earned Income Exclusion” MINUS “whatever taxes you would have paid ON the earned income excluded by the Foreign Earned Income Exclusion.”
In other words:
- Step 1. Calculate the tax on taxable income WITHOUT taking FEIE into account.
- Step 2. Calculate the tax you WOULD have owed on your foreign earned income BUT FOR the exclusion. Important: do not make any adjustments or deductions to your foreign earned income; you must treat GROSS foreign earned income as if it’s TAXABLE income.
- Step 3. Calculate the difference between the two amounts. That is your tax liability.
So with this in mind, what taxes would we owe WITHOUT taking the Foreign Earned Income Exclusion into account?
Similar to our previous example, we need to determine our taxable income first, so we first make our adjusted gross income adjustments.
As before, since my wife and I both have solo 401ks, we max those out and take our adjustment of $22,500 each, total $45,000. That leaves $335,000.
We then make another adjustment of $5,000 for our combined high-deductible health insurance plan premiums for the year. That leaves $330,000.
We then make an adjustment of $7,750 for money we put into our family HSA. That leaves $322,250, which is our adjusted gross income.
We then apply the standard deduction to wipe out $27,700 of income.
That leaves taxable income of $294,550.
When we look at the tax tables, we find that for $294,550 of taxable income, the MFJ tax liability is $57,492.
But this is all BEFORE the Foreign Earned Income Exclusion.
What taxes would we owe only ON the part excluded by FEIE?
FEIE lets us shelter $240,000 as a married couple filing jointly.
Since we don’t make any adjustments or deductions for this part of the analysis and simply treat foreign earned income as taxable income, our tax liability on $240,000 is simply $44,400 under the tax tables.
So to compute our final taxes owed to the IRS, we just take the first number ($57,492) and subtract the second number ($44,400). That leaves a final tax liability of $13,092, which is what we ultimately pay to the IRS.
While we didn’t completely zero out our taxes, FEIE saved us $44,400. Pretty sweet!
Of course, had our foreign income been $240,000 or less, we would have owed $0 in taxes.
One strategy that becomes apparent is that, if you are abroad for multiple years, and your income stream is “lumpy,” you might be able to influence the timing of your income to stay under the FEIE limit each year.
Our second example considers both earned income AND a Roth Conversion and capital gains.
Same as before: we travel to Australia first for 180 days, freelancing along the way; then Canada for a few months, freelancing along the way; finally a couple months in Asia before returning home.
But this time, during our Australia and Canada travels, our freelance work only brings in a total of $170,000.
While in Australia, we do $20k Roth conversions. We also harvest $89,250 capital gains.
So total income is $279,250, but earned income is only $170k (ordinary income is $190k) and $89,250 is capital gains.
What are our taxes?
We still satisfy Australia’s and Canada’s tax treaty exemptions for freelance work, so we owe no taxes to those governments. Win.
Now we shift to the U.S. — what do we owe here?
We know we get $240,000 from the Foreign Earned Income Exclusion for married filing joint. We use the stacking rule: “whatever total taxes you would have paid WITHOUT the Foreign Earned Income Exclusion” MINUS “whatever taxes you would have paid ON the earned income excluded by the Foreign Earned Income Exclusion.”
What taxes do we owe WITHOUT the Foreign Earned Income Exclusion?
As before, we determine taxable income by making AGI adjustments first.
However, unlike before, let’s pretend in this example that we don’t contribute anything to 401ks.
We only make a small adjustment of $5,000 for health insurance premiums. That leaves $185,000.
We then make an adjustment of $7,750 for our family HSA. That leaves $177,250, which is AGI.
We then apply the standard deduction of $27,700.
That leaves taxable income of $149,550.
The tax liability for $149,550 of ordinary taxable income is $23,516.
Then we evaluate our $89,250 long-term capital gains. With taxable income of $149,550, we don’t get 0% capital gains tax treatment.
Our capital gains tax rate will be 15%. So on $89,250 of capital gains, we’ll owe $13,387.50 in capital gains taxes.
That means our all-up tax liability is $23,516 + $13,387.50 = $36,903.50.
But remember, this is BEFORE FEIE, which lets us shelter up to $240,000.
We have $279,250 income but only $170k is EARNED income, so that’s the only part that can be excluded by FEIE. The $89,250 harvested capital gains is not earned income and therefore cannot be excluded. Neither can the $20k Roth conversion (even though that is considered ordinary income).
With FEIE, our tax liability excluded on $170,000 is $28,015.
Now we compute our final taxes owed by taking the first number ($36,903.50) and subtract the second number ($28,015). That leaves a final tax liability of $8,888.50, which is what we ultimately pay to the IRS:
So FEIE shielded earned income but not capital gains or Roth conversion. Even though we didn’t use the entire FEIE allowance (only used $170k worth), we still owe some taxes.
Bottom line: FEIE is useful for reducing taxes on earned income, but not capital gains or Roth conversions.
Whew! This was a big post. Hopefully you learned some cool strategies and tactics for planning your taxes efficiently to take a year off and travel, AND pay $0 taxes!
If you’re curious about seeing what your taxes might be for different scenarios, TurboTax has a nifty tool called TaxCaster that you can use to estimate your tax liability. You can see how each incremental dollar of income changes your taxes. Cool.
What are your favorite tax tips and strategies? Leave a comment below.
Be sure to check out my podcast update to this post on Roth laddering and the standard deduction!
Andrew,
Great article just what I needed to read. I “feel” like I have about 85% of your sharing but that 15% is really important for me to grasp and am hoping you can fill in the gaps.
1) we work overseas at an international school in Singapore. We use the FEIE, Foreign Tax Credits, Housing Allowance, as well as various credits (Child Tax Credits, Child Dependent Care Credit).
2) Utilizing the above we wipe out nearly all of our earned Income; however, we still have about $40,000 of AGI (outside the FEIE). We manage to wipe this $40,000 with our standard deduction and various credits.
3) My Question: (sorry it took a while to get here): Can Harvest gains in our brokerage account to the tune of roughly $70,000? The stacking rule would put the AGI of $40,000 back in the mix, but could we take an additional 70,000, remaining in the 0% tax bracket for LTCG? OR are all the exclusions added back resulting in us being well past the 0% bracket.
I “feel” like I’m close to understanding this. I would so appreciate clarification on this.
Warm Singapore Regards,
Jeff
I was googling this very question, and came upon your post. Let’s say i have $2 million in a 401k. If I take off work for a year, and have no earned income, and during that year roll the entire 2 million into a roth, would i have zero tax on that rollover? Seems like a big loophole.
Hi Andrew! And thank you so much for such a detailed explanation of what could be possible. Here is my specific situation. We have moved to Colombia. We left the USA in Feb. 2021 and returned for 32 days before going back to Colombia for the rest of the year. We will have spent 299 days overseas in the 2021calendar year. We have gotten our residency cards here since we plan to live here for many years. I have a couple questions. Will we be able to claim a partial FEIE for 2021? We are self employed, MFJ with gross income of approximately $100,000 with Schd. C losses of approx. $55,000 leaving an AGI of $45,000. We want to rollover as much as possible from our IRA to our Roth IRA without triggering additional taxes to pay. I have downloaded your spreadsheet (btw, awesome and Thank You!) but I am not sure I still understand my specific situation and how much we can rollover this year. Any additional insight you can give would be very much appreciated.
Hi Andrew, I just came across your site yesterday, I am so happy I did and I wish I did much earlier. As I plan to retire by Dec 31, 2022, I have been doing a lot of preparation/planning for the past year. Your articles are really great, practical, clear, concise, and very relevant to everything I have been researching.
Regarding your point about “So at a minimum, you can earn $25.1k + $80,800 = $105.9k and pay zero taxes!”, if I just sell stock from my taxable account with total long-term capital gain of $105.9k do I still pay $0 taxes? I am not sure if I can also offset the long-term capital gains with the $25.1k standard deduction. I hope this makes sense.
Thank you,
Billy
Thanks for your nice comment!
The first tranche of your capital gain is taxed at 0%, so you don’t need standard deduction for that anyway. Standard deduction is only useful in this regard against ordinary income.
Bill,
Assuming you had no income you could take your standard deduction + the Long term capital gains rate 0% for a total of $105,100. Keep in mind depending on your state, you may have some state tax to pay.
Fellow attorney here. 🙂 I googled this specific question and found your site – thanks for the great article! I have three questions. First, when considering whether a “tax-free” rollover to a Roth IRA (during a low income year) is a good idea, how important is it to consider the total amount of money in the traditional account from which you’re rolling over, as compared to the amount in the Roth? So if you have 100k in a traditional 401k and 12k in a Roth IRA, would the tax savings from the rollover exceed the amount of compounded returns you would have made leaving the money in the higher-amount 401k? Second, near the end of Step 3, you say “We then make another adjustment of $5,000 for our combined high-deductible health insurance plan premiums for the year.” Why did you get deduct that premium when you are also taking the standard deduction at the end? And third, do you have a post on backdoor Roth IRAs? I’m trying to figure out how to contribute post-tax monies into a Roth and whether there are limits. Thanks!
Hey Kate.
1. It depends largely on the tax rate that you’re taxed at in each scenario: rolling over now vs. keeping it in the 401k. You only know one of them so you have to make an educated guess about the other one.
2. Because this example assumes you are self-employed (freelancing gigs) – you can deduct if you are self-employed or if you itemize.
3. I don’t think I have a post specific to backdoor Roths, but I might have something on the podcast (I forget at the moment). But TLDR = yes there are limits, it’s the same limits that apply to an after-tax IRA $6,000 if you’re under 50 for 2021.
Hi Andrew,
Really great article and creative approach!
Do you think it’s possible to do add a mega back door Roth with this strategy? The idea being to put taxable account money into a after-tax solo 401k and distribute to a Roth. There would be less tax advantage than the other strategies but a nice enhancement if the funds are available.
Not sure of this is possible though.
Nic
Hey Nic, yes you can always add the mega back door Roth strategy on top. But keep in mind that, since it’s after-tax dollars that are contributed to the mega back door Roth, you need earned income to accomplish that – and the more earned income you have, the higher your tax bracket will be. You don’t want your earned income to be too high, otherwise you start negating some of the tax benefits described here.
Hi Andrew, I love your blog. I’m currently in a position where I’m not planning to work for several years and am hoping to take advantage of the backdoor conversion strategy for my retirement savings. One thing I came across in my research was a discussion of the IRA Aggregation rule. Bear with me as I’m not very tax savvy, but my understanding after a quick read was that you might have to pay taxes on the conversion in proportion to all of your IRA assets (e.g. if you convert $20k and have a balance of $200k in a traditional, you’d only be able to convert 10% of it tax free). Is this interpretation completely wrong? I may be mixing concepts here. As I won’t be working for several years, I have no active income and my passive income from rental properties is offset by the cost of those properties.
Thank you very much for your insight!
Hi Stephanie, it sounds like you may referring to what’s called the “pro rata” rule for Roth conversions.
What the “pro rata” rule says is this: “anything you convert from an IRA to Roth will be taxed pro rata in proportion to the % of PRE-tax dollars you have across all your IRAs combined vs. the % of POST-tax dollars you have across all your IRAs combined.”
That’s a mouthful, so example:
– you have 3 different IRA accounts with $6k pre-tax combined, and $4k post-tax combined
– Now you want to convert $1k to Roth
– Once upon a time, you could cherry pick from just the post-tax dollars so that you could potentially pay no taxes (assuming those post-tax dollars had not grown)
– Now, however, the pro-rata rule requires you to pay taxes on $600 of that conversion, and you get $400 tax-free — this is in proportion to the %-ages across your combined IRAs
What’s the solution to this?
The best was is to roll your pre-tax dollars into a 401k, say, the one for the job you’re about to leave…before you leave.
401ks, even though they are pre-tax, do not factor into the pro rata rule at all, so the strategy is to move those pre-tax dollars into a 401k first, isolating the remaining IRA dollars to be completely post-tax dollars. Then do the Roth conversion. The pro rata rule still applies, but since there are no pre-tax dollars left in the account anymore….
What kind of sabbatical are you taking for several years? Sounds like a dream. 🙂
Andrew, reading your response to Stephanie, I have a follow up question to the proposed solution for the pro-rata rule. You stated that one can roll their pre-tax dollars into a 401k, then do the Roth conversion. If I’m tracking what you’re saying, you would then be doing the Roth conversion on the dollars in the 401k account, correct? If so, are you converting them to a Roth 401k account or a Roth IRA? Also, do all 401k plans permit a Roth conversion?
Roth 401k. But you can roll it back into a Roth IRA right after that (if you wanted). Not all 401ks have a Roth option, but many do. It depends on what was set up by your employer.
For those willing to take more than a year off, I see this as a viable strategy. You need to basically ensure that you are unemployed the full calendar year, from January to December. For most people, if you want to plan a career break for about a year or less, it may not be possible to have the flexibility to dictate exactly when your career break would begin and end.
Hey Harry, just curious why you feel it might not be possible to control the dates of taking a year off to ensure being unemployed during the full calendar year? An employee presumably can decide when to stop working, e.g., 12/31 and can at least decide when to start looking for a new gig (e.g., 1/1 of the year after), even if they cannot control the exact start date an employer wants them to report to work by after being extended a new job offer. To be sure, sometimes year-end bonuses get paid out the following year, which can disrupt timing, but these things can be negotiable. There is also some flexibility to shield income that gets paid in the new year by simply putting it in a pre-tax 401k, HSA, or other tax-deferred/tax-free vehicles.
Hi Andrew! This article is great! I recently moved abroad and will definitely be reviewing it again when it comes tax time for 2018. All the other tools on your site will also come in very handy. One thing though, I think I may have discovered a mistake. Who knows, with tax law, it may be more of a different interpretation. Anyway, I wanted to run it by you and see what you thought.
Your article states:
We know we get $202,600 from the Foreign Earned Income Exclusion for married filing jointly. We use the stacking rule to calculate: “whatever total taxes you would have paid WITHOUT the Foreign Earned Income Exclusion” MINUS “whatever taxes you would have paid ON the earned income excluded by the Foreign Earned Income Exclusion.”
You’ve used quotes here, but I wasn’t able to tell exactly what it is you are quoting. So I did a little digging, and found what I believe is the IRC sections that address this specifically. 26 U.S Code Section 911(f)(1)(A). Here’s the text if you want to read it yourself, https://www.law.cornell.edu/uscode/text/26/911
My understanding of this code is that the stacking rule only applies to your “taxable income” after all itemized deductions take place. In other words, when calculating the amount of tax to exclude, you assume the $202,600 is fully taxable and not like the AGI which is then reduced by deductions and exemptions (exemptions in 2017, no more exemptions beginning in 2018).
For example, married filing jointly using your first example, the couple earned $250,000. Assuming no FEIE, they had $43,000 in adjustments and a resulting AGI of $207,000 less $20,700 in deductions and exemptions for a resulting taxable income of $186,300 with a resultant tax bill of $39,150. Your example then calculates tax owed on the excluded $203,000 as if it were total income: $203,000 less $43,000 in adjustments for 401k, Insurance premiums, and HSA = $160,000 AGI less $20,700 standard deduction and exemptions for a taxable income of $139,300. The tax bill on $139,300 was $26,268. So then the difference would be $12,882 that would be paid to the IRS.
I believe that the income that is to be exempted is supposed to be considered “taxable income” and doesn’t need to be reduced by adjustments and deductions prior to calculating the exludable tax amount. A taxable income of $202,600 would have a tax bill of $43,612.50 for 2017. So under your example, I calculate that they would have $0 tax liability and would have “wasted” $16,300 of tax free income space ($202,600 – $186,300). They could have then done a $16,300 Roth IRA conversion to take full advantage of this tax minimization strategy. In other words, the $186,300 of taxable income is where the income excluded using the FEIE should be taken from.
Just curious what your thoughts are here? Thanks!
Kevin, the quotes in that particular example were used to make the sentence simply easier to read – they weren’t quoting a source.
The stacking rule uses a gross earned income number, e.g., $202,600. BUT to calculate your ACTUAL tax liability (and therefore your actual FEIE), you have factor in your adjustments and deductions. That’s bc everyone’s situation is different: some people earning $202,600 gross earned income have different tax liability than others earning the exact same amount of gross earned income. One’s exact tax liability, and therefore exact FEIE, is individual-specific even though it may be based on the same gross earned income amount of $202,600.
That is why I said: tax liability is computed as: “whatever total taxes you would have paid WITHOUT the Foreign Earned Income Exclusion” MINUS “whatever taxes you would have paid ON the earned income excluded by the Foreign Earned Income Exclusion.” It’s what YOU would have paid, and that depends on YOUR actual adjustments and deductions, which is why you have to factor them in.
So again, the stacking rule uses a gross earned income number, but to compute your actual tax liability you must calculate your adjustments/deductions.
You cannot fill any “wasted” FEIE by doing a Roth conversion bc that is not “earned income.” FEIE only applies to earned income.
Yes, a Roth conversion isn’t earned income, but my understanding is that I’m not excluding it with the FEIE, but instead offsetting it with the standard deduction and personal exemptions. According to IRC Section 911(f)(1)(A), the stacking rule applies to TAXABLE income and not the AGI. Say someone makes $50,000/year AGI. They are able to exclude all $50,000 using the FEIE, and have a resultant AGI of $0. For 2017, you have a married filing jointly standard deduction of $12,700 and personal exemptions of $8,100 which results in a -$20,800 taxable income. This means you could have earned $20,800 from some other source of income, such as rental income, capital gains, or a Roth IRA conversion, and still ended up with a $0 taxable income. But if you did a $30,000 Roth conversion, then $9,200 would have been taxable ($30k less $20,000 in deductions and exemptions). But you’d have to pay tax as if it were the taxable income from $50,001 to $59,200 using IRS’s tax tables. The Foreign Earned Income Tax Worksheet for Line 44 of the 1040 calculates the difference in tax owed between [Line 43 (taxable income) on the 1040 + FEIE income (again using the tax tables)] and [FEIE income (using tax tables)]. No where can I find where it does two full AGI tax calcs and then takes the difference.
I didn’t say the stacking rule applies to AGI. Let me try this another way. FEIE thresholds refer to gross earned income earned abroad. But when it comes to computing your ACTUAL tax liability, that’s when you use the stacking rule.
Yes, the stacking rule uses taxable income in its formula. Taxable income = gross income less adjustments less deductions. Hence my previous comment which said: “to calculate your ACTUAL tax liability…you have factor in your adjustments and deductions.”
That’s also why the article says: tax liability is computed as: “whatever total taxes you would have paid WITHOUT the Foreign Earned Income Exclusion” MINUS “whatever taxes you would have paid ON the earned income excluded by the Foreign Earned Income Exclusion.”
The “whatever total taxes you would have paid” part = your tax liability. Nowhere in the article or my comment does it say tax liability is calculated on AGI; tax liability is, by definition, calculated from taxable income.
I think what may be tripping you up re: the Roth conversion is, you’re attempting to do it in 2 sequential steps: first use FEIE to achieve $0 tax liability, THEN use Roth conversions to fill up to the standard deduction / personal exemptions limit. In other words, drain it down to $0 and then fill it back up again.
But that’s not how the IRS will let you do it. The IRS makes you add up everything at the same time AS IF there was no FEIE. And THEN subtract the FEIE portion. That’s what you were referring to re: Line 44 calculating the difference in tax owed on Line 43 taxable income + FEIE income vs. tax owed on FEIE income only.
You don’t get to use FEIE to drain down to $0 first. You calculate tax liability (including Roth conversions) “standing on top” of FEI, and then once you know that tax liability number, you then “slice off” the tax liability owed on FEI to determine your actual taxes owed.
I agree with what you say 100% less a few things based on semantics. Where I’m getting hung up is on how you calculate “tax owed on FEIE income only”.
Your example says “On just $202,600 of income, by applying the exact same adjustments and deductions, our tax liability is $26,268:” You’ve taken the $202,600 allowable FEIE as if it were an gross income, then adjusted it to get a lower AGI, and then taken deductions from it to come up with a lower TAXABLE income. Which you then calculate a tax liability on: $26,268.
I’m saying you are supposed to consider the entire FEIE portion ($202,600) as TAXABLE income which would have a tax liability of $43,612.50. This appears to be what is happening when you use the Foreign Earned Income Tax Worksheet for Line 44 of the 1040. Am I reading the form wrong?
Well shoot. You’re correct. FEIE is computed with no further adjustments or deductions taken into account, as if the FEIE number = taxable income. Thanks for catching that! I’ll update the post.
Awesome! To good to be true is finally, well….true!!!
Great Blog. Are you planning to update the spreadsheet (verify zero tax calculation) with the new Trump’s tax rates for year 2018?
Yes, eventually. Will wait for the tax legislation to be officially signed into law (any day now), and then will go back and update a lot of these spreadsheets (which will take some time though)!
Hello Andrew. Any chance for an updated XLS with Trump Tax incorporated? Thanks in advance.
Hi Tang, yes it’s on my to do list for later!
Great Post. I learned lot of new things which I can implement it. Thank you for making my life better. I plan to take a year off.
Sweet! So glad you found this insightful. 🙂
This is fantastic! I haven’t seen such a detailed and comprehensive life plan laid out so well before. Great content!
Thanks Steve!
It’s a pleasure to find someone who can identify the issues so clearly
I have a question regarding the Stacking Rule, Foreign Earned Income Exclusion, Foreign Housing Exclusion, and long-term capital gains.
We work overseas and are able to exempt ALL of our income using the Foreign Earned Income Exclusion. Our effective AGI is $0.00. My question is, can we go into our brokerage account and harvest gains, up to $109,000, and pay no taxes on this as we would be in the 0% long-term capital gains bracket? Or, for tax purposes does the FEIE and Foreign Housing Exclusion get added back in (stacked) on top of the LTCG to determine our taxable income?
Example: We earn $108,700 and wipe this out with our FEIE. We then take $109,000 from our brokerage account and step this up.
If the stacking rule applies would it be
$109,000 + $108,700 = $217,700 resulting in all of the $109,000 LTCG being taxed at 15%?
If so, how would all of the credits and standard deduction work (standard deduction, child tax credits, child dependent car credits, foreign tax credits, etc.)? Would these credits and deductions be able to be used to reduce income thereby allowing us to effectively eliminate the LTCG? For example 15% of $109,000 = $16,350 dollars in taxes; however, would we not have access to the Standard Deduction and the rest of the credits to effectively wipe these taxes out?
Follow-up questions:
1) Are all exclusions added back into income to determine taxes? For example, the Foreign Housing Exclusion, FEIE?
2) What about a situation where we sell our primary home in the U.S. (assuming we are now living full time and this is our primary residence), and have a gain of $500,000. We know this is a housing exclusion, but what if we also harvested $50,000 from our brokerage account in the same year. Does all of this get stacked back on top of our income for determining taxes, or is the housing gain excluded? If so, why is this excluded but not (if this is the case) the FEIE?
I so appreciate your willingness (fingers crossed) in answering this question