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 $24,800
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 $24,800 in ordinary income and pay zero taxes (2020 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 $19,500 contribution limit (2020 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 $19,500 per spouse, that raises your tax-free income to $63,800. 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 $24,800, 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 70.5, 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 70.5.
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 $24,800 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 $24,800.
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.
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 $24,800 “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 $80,000 or less MFJ, half for single filers.
Normally, once your income exceeds $24,800, 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 $80,000 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 $80k or less, your long-term capital gains are taxed at 0%.
By harvesting capital gains (up to $80k 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 rates
|Filing status||0% if taxable income less than or equal to...||15% if taxable income between...||20% if taxable income greater than...|
|Married Joint + Surviving Spouses||$80,000||$80,001-496,600||$496,600|
|Married Filing Separately||$40,000||$40,001-248,300||$248,300|
|Head of Household||$53,600||$53,601-469,050||$469,050|
|Taxable Trusts & Estates||$2,650||$2,651-13,150||$13,150|
As you can see, for a married couple filing jointly, you could harvest up to $80k in qualified dividends and long-term capital gains tax-free!
Does it get any better than this?
So, you can earn $24,800 (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 $80k 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 $24.4k + $80k = $104.4k 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 $80k or less, you get a 0% tax rate on qualified dividends and long-term capital gains…up to $80k.
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 $55,900 — 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 $80k 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 $55,900 of wage income + $20,000 from the Roth Conversion. Total: $75,900. 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 $19,500 each, total $39,000. That leaves $36,900.
We then make another adjustment of $5,000 for our combined high-deductible health insurance plan premiums for the year. That leaves $31,900.
We then make an adjustment of $7,100 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 $24,800, 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 $80k long-term capital gains harvest.
The entire gain is taxed at 0% because it is $80k or less taxable income.
So we earned $55,900 wages, $20k Roth Conversion, and $80k capital gains harvest — and we paid exactly zero taxes.
Total income: $155,900. 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 $215,200 of foreign earnings MFJ, half for single filers (2020, adjusted annually for inflation).
I said, you can completely exclude from taxes $215,200.
Does it get any better?
Only “earned income” abroad qualifies for this. What is “earned income” for these purposes?
- Salaries and wages
- Professional fees
It is not:
- Capital Gains
- Gambling winnings
- Social security benefits
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 $215,200 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 $215,200 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 $300,000 — 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 $215,200 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 $19,500 each, total $39,000. That leaves $261,000.
We then make another adjustment of $5,000 for our combined high-deductible health insurance plan premiums for the year. That leaves $256,000.
We then make an adjustment of $7,100 for money we put into our family HSA. That leaves $248,900, which is our adjusted gross income.
We then apply the standard deduction to wipe out $24,800 of income.
That leaves taxable income of $224,100.
When we look at the tax tables, we find that for $224,100 of taxable income, the tax liability is $41,943.
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 $215,200 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 $215,200 is simply $39,807 under the tax tables.
So to compute our final taxes owed to the IRS, we just take the first number ($41,943) and subtract the second number ($39,807). That leaves a final tax liability of $2,136, which is what we ultimately pay to the IRS.
While we didn’t completely zero out our taxes, FEIE saved us $39,807. Pretty sweet!
Of course, had our foreign income been $215,200 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 $150,000.
While in Australia, we do $20k Roth conversions. We also harvest $80k capital gains.
So total income is $250k, but earned income is only $150k (ordinary income is $170k) and $80k 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 $215,200 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 $165,000.
We then make an adjustment of $7,100 for our family HSA. That leaves $157,900, which is AGI.
We then apply the standard deduction of $24,800.
That leaves taxable income of $133,100.
The tax liability for $133,100 of ordinary taxable income is $20,862.
Then we evaluate our $80k long-term capital gains. With taxable income of $133,100, we don’t get 0% capital gains tax treatment.
Our capital gains tax rate will be 15%. So on $80k of capital gains, we’ll owe $12k in capital gains taxes.
That means our all-up tax liability is $20,862 + $12,000 = $32,862.
But remember, this is BEFORE FEIE, which lets us shelter up to $215,200.
We have $250k income but only $150k is EARNED income, so that’s the only part that can be excluded by FEIE. The $80k 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 $150,000 is $24,580.
Now we compute our final taxes owed by taking the first number ($32,862) and subtract the second number ($24,580). That leaves a final tax liability of $8,282, 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 $150k 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!