Marginal tax rates under the ACA

In a recent thread on the MMM forums, there was a discussion about how the phase-out of ACA premium subsidies can act as a second parallel tax system to the standard federal income tax. I had always been aware of this in theory, but had previously dismissed it as a pretty minor factor for planning because the percentage of your MAGI you’ll pay for insurance after subsidies is fixed at a relatively low rate (ranging from roughly 2% of MAGI at the low end of the income scale to a bit less than 10% at the upper end of the subsidy-eligible range).

What I failed to consider was that as your income increases and the percentage of income you owe for the reference insurance plan also increases, this new percentage is applied to your entire income, not just the marginal income. This causes the marginal rate of subsidy phase-out to be greater than the percentage of MAGI now owed. In fact in many cases the marginal rate is in excess of 15%!

See the graph below for how this works.

Those big vertical lines represent cliffs at 133% of the poverty level (where there’s a sharp jump from 2.08% of MAGI to 3.11% of MAGI) and at 400% of the poverty level (where premium subsidies go away completely). Between the cliffs there’s a pretty big range where the marginal rate is right around 15%. Above 300% of the poverty level the applicable percentage of income is fixed at 9.86%, so that’s also the marginal rate that applies in this range.

How does this look when added on to the standard federal income tax brackets in early retirement?

Example 1: Single person

Let’s start with a pretty simple example, of a single person using the Roth conversion ladder to access their IRA funds during early retirement. All of their income is generated using this method. They claim the standard deduction and aren’t eligible for any tax credits besides the ACA premium assistance.

The blue line in this graph is exactly the same as in the first graph, representing the marginal rate for phase-out of the ACA premium tax credit for a single-person household.

The red line is federal income tax: 0% below the standard deduction, then a 10% bracket, 12% bracket, and 22% bracket. The yellow line is the sum of the two. To the right of the subsidy cliff the blue line goes to zero, so the red and yellow lines are identical at that point.

What we can see from this graph is that the total marginal rate for this individual is in excess of 20% for the entire ACA phase-out range, and in excess of 25% for a large chunk of it.

How about a single person drawing down their taxable investment account, getting all their income from dividends and long-term capital gains?

In this case the red and blue lines are hardly visible at all. During the ACA phase-out range the tax rate for long-term gains is 0%, so the yellow line overlaps the blue line. After that there’s no more ACA subsidy to phase out so the yellow line overlaps the red line.

I think this graph helps rebut the somewhat common question about whether Roth contributions make sense when taxable investments have a 0% income tax rate at lower income levels. If it’s tax-free either way, why tie the money up in a Roth IRA, right?

Well, if you’re planning to take ACA subsidies, it’s not tax-free either way. You’ll be paying for those “tax-free” capital gains in the form of lower ACA tax credits, while withdrawals of your Roth principal don’t count toward your MAGI and therefore don’t affect your ACA tax credit in the slightest.

The graph of capital gains income above is basically the same for other family sizes: only ACA phaseouts count toward the marginal rate in the phase-out range, then there’s a period of truly zero tax after the ACA cliff, then the 15% capital gains rate starts to apply later. The income levels stretch out based on family size, but the general form of the graph stays the same.

Example 2: Family of four

Now we’ll look at a family of four: a married couple with two kids under the age of 17. All of their income comes from Roth conversions. They claim the standard deduction, child tax credit, ACA premium tax credit, and nothing else.

This family has a pretty big range (up to nearly $61,000 in gross income) where the child tax credit erases their federal income tax liability, so only the ACA phase-out contributes to their total marginal rate. After that it looks pretty similar to the single-person example, with total rates around 30% up to 300% of the poverty level, then dropping down to 22% until the subsidy cliff.

What happens as the kids grow up? Once they hit age 17 they’re no longer eligible for the $2,000 child tax credit, but as long as they remain dependents of their parents there’s a $500 “credit for other dependents.” If both kids fall into this situation, it looks something like this:

This is starting to look a lot more like the graph for a single person. Not quite all of the ACA subsidy phase-out range has total marginal rates in the 20-30% range, but it’s pretty close.

Fast forward a few years, the kids finish school, earn their own money, and stop being tax dependents. What happens then? The parents will still paying taxes as a married couple, and will now using the two-person household poverty level for their ACA subsidies.

This graph has an x-axis at the same scale as the previous graphs for a four-person family. Notice that the ACA phase-out range has moved over to the left and compressed into a smaller range. This couple will need to sharply reduce their income if they want to keep paying the same amount for health insurance as before their children moved on, and maybe to keep getting any ACA subsidies at all. This is happening at the same time as they’re getting older and facing higher premium costs if they were to lose their subsidies.

Conclusions

I know that this sequence of graphs has caused me to reconsider my family’s long-term tax strategy. I had previously thought it best to focus on spending down taxable investments early on in FIRE, then focus more on Roth conversions later on.

Now that I see how the child tax credit gives us a pretty big amount of space where Roth conversions are taxed the same as capital gains, but only until the kids turn 17, perhaps accelerating some of those Roth conversions would make sense in order to build up some more basis in those accounts and allow us to more easily reduce our income when we have no more dependents to declare.

I’m also starting to think the standard advice in the FIRE community to prioritize pre-tax retirement accounts over Roth while in the accumulation phase may be misguided. The assumption is that someone who spends a fraction of their income while working will be very likely to retire into a lower tax rate. As we can see in these graphs that isn’t such a sure thing when you also consider the ACA subsidy phaseout as part of your marginal tax rate in retirement.

Someone earning enough to hit the 35% bracket during their career would still be seeing a pretty definite win by deferring a bunch of taxable income until retirement. For people even in the 24% bracket while working, we can see plenty of relatively low retirement incomes where you’ll be paying more than that.

Of course if you would rather buy insurance from a private carrier instead of relying on Medicaid you’ll need to come up with some level of income that counts toward MAGI in retirement. But maybe the best thing for most folks with relatively normal salaries to do is to save just enough pre-tax to hit the very low end of the ACA subsidy range each year in retirement and go with Roth for the rest.

What do you think? I’d love to hash this out more in the comments.

My illustrious acting career

One of the great things about being FIREd is having the ability to take time to try new things. Last week I had the opportunity to try my hand at being a background actor (aka “extra”) on a new TV show.

Going into it, I had no idea what to expect. I found out about the opportunity from a friend of mine who saw the casting call posted to Craigslist. Neither of us had any previous experience with this sort of thing. We both responded saying we were interested and available. She was called in to film on one day for a scene in a bar, and I was called in to film on three days: one day filming in a gymnasium scene and two days filming outdoors in a park.

The first day was pretty disorganized. They called a bunch of us in bright and early, got us set up with our costumes for the scene, and then we sat outside for about eight hours before we actually had to do anything. There was an assistant director who was our point of contact, and he kept telling us we would be needed in an hour or so. They must have had a bunch of things run behind schedule, as they didn’t end up needing us until the very end of the day.

When we were called in it was a pretty surreal experience. I had never been on a professional set like that before. There were lots of people involved, each with their own jobs. They would all do their thing to get set up for the next shot, perform the scene, reset everything back to the beginning for the next take, and repeat from there. I was pretty impressed by how well everyone seemed to work together.

The second day I went in was a bit more involved. At the beginning they had us consult with a wardrobe professional, handing out the costumes we were supposed to wear and having us try them on. They also had us spend a few minutes with hair and makeup artists to get us looking our best for the camera.

Once all that was done we headed to the set location in the middle of a public park. We were on camera much more that day. Not nearly so much sitting around waiting to be called in like the first day.

The filming was a bit challenging for everyone because the park we were in was underneath a flight path into the airport, so there was airplane noise interrupting things every couple of minutes. We got into a nice rhythm of setting things up during the airplane noise so that we were ready to go right away when it was over.

Another challenge was related to sunlight. It was cloudy when we started out shooting the scene, but later in the day the sun came out. This difference in light levels isn’t great for the continuity of the scene. Makes perfect sense when you think about it, but it’s something that I hadn’t considered before as just a viewer of TV shows. The crew brought out this big 20′ square shading device and set it up over our heads to make some shade and get the light levels down to about what they were when it was cloudy. Once again, I was impressed with how much everyone in the crew performed their different roles to keep things moving along.

That day was pretty tiring. We were there for about 12 hours, right until sundown. Then we had to show up again before sunrise the next day for the final day of filming. That morning they only needed us for a few shots, and we were done with our scene by lunchtime.

All in all, this was a very positive experience for me. Besides the opportunity to see how a TV show is made behind the scenes, I also met a bunch of interesting people. Most of my fellow extras were not new at it, and had even retained talent agents to try and find them as many roles as possible.

I don’t think there’s enough film work available in the Seattle area for anyone to make much of a real career out of acting here; it’s more something that people interested in it can do from time to time for a bit of extra cash if they have flexible jobs. I met a woman trained as a chef who works in sales, has been on a couple of reality shows, and aspires to have her own cooking show someday. I met a man who did web development for a few years before leaving that to become a juggler and pub trivia quizmaster, and who had made two appearances on game shows. There was a real estate agent who was also making his first appearance as an extra, and plenty of others each with their own story.

We all came together for three days working at minimum wage to fill out the background of a few scenes on a TV show. I think we did pretty well at it! It was fun to try once, and I can’t completely rule out doing it again in the future, but I’m also not going to scour the web for the next available opportunity. It started to feel a bit too much like work by the end, especially that last day with the pre-dawn start time.

2020 Seattle-area ACA plans: an early look

Next year will be our family’s first experience buying health insurance on the individual market through our state’s ACA exchange. In 2019 there are four companies offering insurance in King County (home to Seattle, many of its suburbs, and nearly a third of Washington’s population): Ambetter, Kaiser Permanente, Molina, and Premera. Premera offers EPO plans, while the other three insurers are HMOs.

That’s this year. What about next year?

While the insurers aren’t actively selling their plans yet, they have all submitted proposals to the state insurance commissioner for the plans they would like to offer and rates they would like to charge. The commissioner has to review and approve these rates before the plans go on sale during open enrollment later this year.

I spent a little time looking through these proposals to see what’s in store for next year. All four of the companies currently offering individual insurance in King County plan to continue doing so next year. We’ll also see the addition of two more companies to the local exchange: BridgeSpan and LifeWise.

Keep reading for a company-by-company summary of the proposals for next year.

Continue reading 2020 Seattle-area ACA plans: an early look

The negative-tax small business

As someone who recently joined the ranks of the FIREd, I have plenty of options for how to spend my time. It’s pretty nice! While I’m confident that our savings should be enough to see us through the rest of our lives, I fully expect to come across some opportunities to do interesting things and also earn some money on the side.

My first thought when considering the impact a small side gig might have on our finances is that the self-employment taxes will be huge, and that the amount left over might not be worth the effort. As I found out, this is not necessarily the case for a FIREd family.

Example 1: Roth conversion ladder

Consider a retired couple with two kids living at home, spending $50,000 per year. They have essentially all of their savings in retirement accounts, and use the Roth conversion ladder to access this wealth prior to age 59½.

Their federal income tax situation, in a nutshell, looks like this:*

  • Adjusted Gross Income: $50,000 from Roth conversions
  • Standard deduction: $24,000
  • Taxable income: $26,000
  • Tax before credits: $2,742
  • Child tax credit: $2,742
  • Total tax (before ACA credits): $0

No income tax for this family. Not bad! This family buys their health insurance through their state’s ACA exchange. With an AGI of $50,000, the second-cheapest silver plan will have annual premiums of $3,225. They pay for these premiums out of their $50,000 budget.

Now consider what might happen if one of the adults in this family starts a small part-time business, bringing in a pretty modest $15,000 per year. They use this money to help pay their living expenses, reducing their need for Roth conversions by an equal amount. This business would expose the family to self-employment tax of 15.3% on the business income, but it also opens up a few interesting tax breaks for self-employed folks.

First, self-employed people can deduct the cost of their health insurance premiums. This deduction is calculated prior to AGI, similar to the treatment that people who get health insurance through their employer get to claim.

Self-employed people also get to deduct half the cost of their self-employment tax from their AGI, similar to how employees have their employer pay half their FICA taxes and this half never enters into their own personal income tax calculations.

The tax cuts that went into effect in 2018 introduced a new deduction for business owners: the 20% qualified business income deduction. This applies to business income that is not otherwise deducted from income, so the deductible half of self-employment tax and the health insurance deduction don’t count toward the income that is used for this deduction.

Finally, the fact that this family now has some work-related income makes them potentially eligible for refundable child tax credits and the earned income credit.

Let’s see how their taxes shape up now!

  • Roth conversion income: $35,000
  • Business income from Schedule C: $15,000
  • Gross income: $50,000
  • Deduction for half of self-employment tax: $1,060
  • Deduction for health insurance premiums: $2,679
  • Adjusted gross income: $46,261
  • Qualified business income deduction: $2,252
  • Standard deduction: $24,000
  • Taxable income: $20,009
  • Tax before credits: $2,022
  • Child tax credit: $2,022
  • Regular income tax: $0
  • Self-employment taxes: $2,120
  • Additional child tax credit: $1,716
  • Earned income credit: $1,099
  • Total tax (before ACA credits): $-695

That’s right, negative $695 of tax! Far from being an expensive proposition tax-wise, this self-employment activity unlocked tax credits that more than paid for the self-employment tax. The pre-AGI deductions from self-employment also increase their ACA premium tax credit by $546. That’s a total benefit of $1,241, even before taking into account the effect that this extra $15,000 of work income will have on their eventual social security benefits.

Example 2: Spending down a taxable account

The previous example looked at a family who was going with the Roth conversion ladder for 100% of their spending. Now let’s look at a family in a situation more similar to my own, starting out in FIRE with a taxable brokerage account that they want to spend down before moving on to tax sheltered funds.

Same family size and $50,000 spending as before. This time they take the full $50,000 from a taxable account: $10,000 of dividends and $40,000 from selling shares with an average basis of half the current market value, leading to $20,000 of long-term capital gains income.

They also do $20,000 of Roth conversions to prepare for future years when they’ll be relying on seasoned Roth basis for their Roth conversion pipeline.

Tax situation before starting a small business:

  • Roth conversion income: $20,000
  • Qualified dividend income: $10,000
  • Long-term capital gains: $20,000
  • Adjusted Gross Income: $50,000
  • Standard deduction: $24,000
  • Taxable income: $26,000
  • Tax before credits: $0
  • Child tax credit: $0
  • Total tax (before ACA credits): $0

Similar to the family living off Roth conversions above, the family in this example has no federal tax liability before starting their small business. Let’s see what happens afterwards with $15,000 of self-employment income.

As they’re still trying to spend down their taxable account, they keep withdrawing from their taxable savings as before, and save their full self-employment earnings in Roth retirement accounts. They reduce their Roth conversions by $15k to keep their taxable income pretty steady.

New tax situation:

  • Roth conversion income: $5,000
  • Business income from Schedule C: $15,000
  • Qualified dividend income: $10,000
  • Long-term capital gains: $20,000
  • Gross income: $50,000
  • Deduction for half of self-employment tax: $1,060
  • Deduction for health insurance premiums: $2,679
  • Adjusted gross income: $46,261
  • Qualified business income deduction: $2,252
  • Standard deduction: $24,000
  • Taxable income: $20,009
  • Tax before credits: $0
  • Child tax credit: $0
  • Regular income tax: $0
  • Self-employment taxes: $2,120
  • Additional child tax credit: $1,716
  • Earned income credit: $0
  • Total tax (before ACA credits): $404

In this scenario the family is ineligible for the earned income credit due to their taxable investment income. Anyone with more than $3,500 of such income is ineligible for the earned income credit. The additional child tax credit and the additional ACA credits still combine to more than annihilate the self-employment taxes.

This is a result I didn’t really expect when looking into the impact a side business would have on an early retiree’s taxes. I thought that surely the taxes would go up. In many cases, especially where kids aren’t involved, that probably would happen. But when you bring kids into the mix, tax credits meant to help low-income working families can help you too!

* All calculations in this post use tax formulas from 2018. Amounts in 2019 will differ slightly due to annual inflation adjustments in the tax code.

FIRE: Two weeks in

Greetings, dear readers!

It has been a while! After opening this blog with a couple of posts four years ago, life got in the way and I never had the necessary combination of time, motivation, and ideas to write something new here…until now.

I FIREd two weeks ago and thought I’d dust off this blog to record some of my thoughts and experiences during this pretty big life transition. Will I make a long-term habit of posting here? Probably not! I’ve started personal blogs a few times before and have never made it to a dozen posts before fizzling out. That said, maybe now that I’ve let go of the day job and embarked on this new adventure I’ll come up with a nice variety of thoughts that I feel like sharing with the world.

I thought I’d start with some examples of how I’ve spent my time now that I’m out of the workforce.

My first day of FIRE was pretty mundane. I went to the dentist. My corporate dental plan goes away at the end of the month, so that was an opportune time to go in and get my mouth all poked and prodded and tidied up. On my way home from the dentist I stopped at a thrift store to pick up some clothes my son needed. Again, pretty mundane stuff, but it felt great to have the time to do both of those things without any rush imposed on me by an external work schedule.

One morning my wife and I did a scavenger hunt in our old neighborhood, full of cryptic clues leading us all over the place on foot. The neighborhood community center organizes the event every year as a fundraiser but we never actually found time to try it until now. We really enjoyed it!

On a Tuesday we went to a hike out in the mountains. It was a trail that tends to be packed with people on the weekends. We didn’t exactly have it to ourselves on a Tuesday, but it was rather uncrowded nonetheless. How nice to have the freedom to take a day and do that when the crowds aren’t there!

Last weekend I spent an afternoon helping some friends do some electrical wiring as part of a larger remodeling project they’re doing. This is something I have a bit of experience with from previous DIY projects. Lending a hand felt nice.

That weekend we also went to a beach park we had never visited before, just a short drive from our house. They were having a sand castle contest that day, which was fun to see.

One thing I’m really looking forward to during my retirement is having time to pick up new skills. The first one of these: home canning. This has been something I’ve wanted to learn for years, but never quite got around to it. When our CSA has given us too many cucumbers I’ve made refrigerator pickles, and when our apple tree at our old house produced a bunch of fruit we’ve filled our freezer with applesauce. The art of home canning always seemed like just a little bit too steep of a learning curve when we were also in the midst of all this produce to process.

Now we have an apricot tree. It’s much more prolific this year than the previous two years we’ve owned it. In fact it’s so prolific that a couple of branches broke under the weight of all the fruit! Rather than compost all those unripe apricots, we found a nice recipe for how to make jam out of them. It’s pretty delicious! We had enough fruit to make gallons of jam, too much to keep in our refrigerator. The time was right to finally get canning!

I read some online tutorials, bought a couple dozen Mason jars from Goodwill, got some new lids for them, and went to work. The result: 10 pints of delicious jam ready for the pantry, plus quite a bit that went straight to the fridge. As the rest of the apricots ripen, there will more where that came from! The cost is quite attractive too. With a free source of fruit, I can fill and seal a jar of jam for less than a dollar. The savings are sure to add up, especially given the number of apricots I see ripening outside and the number of peanut butter and jelly sandwiches we eat in our house.

That’s all for now. So long, and thanks for reading!

Optimizing the Affordable Care Act

As I write this, we are almost halfway through the second year of health insurance being available to everyone on state exchanges regulated by the Affordable Care Act (also known as Obamacare). This law has not been without controversy or legal challenges. Regardless of your opinion on whether the ACA was a good idea, it is here and is likely to stick around for some time.

People planning to retire early in the US will likely find themselves buying health insurance from their state exchange until they become old enough to qualify for Medicare. These insurance policies can be subsidized for people with lower incomes. For early retirees who have some flexibility in how much taxable income they have in a given year, understanding how these subsidies work can become especially important.

There are two main types of subsidies available: premium discounts and cost-sharing subsidies.

Premium discount subsidies

Insurance plans on exchanges are grouped into the following “metal” levels:

  • Bronze plans will pay for 60% of the average customer’s medical bills.
  • Silver plans will pay for 70% of the average customer’s medical bills.
  • Gold plans will pay for 80% of the average customer’s medical bills.
  • Platinum plans will pay for 90% of the average customer’s medical bills.

In general, the higher metal levels will have higher monthly premium costs. The lower metal levels will have lower monthly premiums, but the deductibles and out-of-pocket expense caps will be higher because the plan is not required to cover as much of the cost.

People whose modified adjusted gross income (MAGI) is between 100% and 400% of the Federal Poverty Level who don’t qualify for Medicare or Medicaid are potentially eligible for premium subsidies. For reference, the 2014 FPL (used for computing premium subsidies in 2015) is $15,730 for a two-person household. This means that a two-person household with MAGI between $15,730 and $62,920 could qualify for a subsidy. Households outside this range will pay full price for all plans offered through the exchange.

Every state (and even different areas within the same state) will have different plans available at different costs. Because costs and options can vary from place to place, Congress decided to use the second-cheapest silver plan in your area as a baseline for subsidies you might receive.

The subsidy is designed to make this baseline plan cost a certain percentage of your MAGI after applying the subsidy. The percentage is a sliding scale ranging from 2% of MAGI for people between 100%-133% of the FPL all the way up to 9.5% of MAGI for people with MAGI between 300%-400% of the FPL. The subsidy amount is calculated by subtracting the applicable percentage of your MAGI from the full cost of the baseline plan. This subsidy amount can then be applied to any plan available on the exchange.

As an example, suppose Alice and Bob live in Seattle, are both 40 years old, and have a MAGI of $40,000. This amount is 254% of the Federal Poverty Level. Based on the sliding scale (source: Table 2 of the IRS Form 8962 instructions), a household with that income will be eligible for subsidies if the second-cheapest silver plan costs more than 8.17% of their MAGI, or $272.33 per month.

The Washington Health Plan Finder site lists 67 total plans available for them, of which 24 are silver plans. The second-cheapest of these silver plans has a premium of $507.12 per month. Therefore Alice and Bob would be eligible for a subsidy of ($507.12 – $272.33) = $234.79 per month. Whichever plan they pick, they can apply this $234.79 subsidy. If they choose the cheapest bronze plan (costing $387.68), the net cost after premium subsidy would be ($387.68 – $234.79) = $152.89 per month.

The chart below shows the relationship between MAGI and the net cost of the benchmark silver plan.

Cost sharing subsidies

In addition to the premium discount subsidies, there are also “cost sharing subsidies” available to households with MAGI under 250% of the FPL. These subsidies make silver plans (and only silver plans!) cover a higher percentage of your medical bills. The changes are as follows:

  • Over 250% of the FPL, silver plans will pay for 70% of the average customer’s medical bills (normal amount).
  • Between 200% and 250% of the FPL, silver plans will pay for 73% of the average customer’s medical bills.
  • Between 150% and 200% of the FPL, silver plans will pay for 87% of the average customer’s medical bills.
  • Between 100% and 150% of the FPL, silver plans will pay for 94% of the average customer’s medical bills.

As you can see, households that have MAGI under 200% of the FPL can get a plan that is basically as good as (or better than) a platinum plan, for the price of a silver plan.

Let’s look at what happens to the second-cheapest silver plan for Alice and Bob (40-year-old couple in Seattle) as their income changes.

Income range Annual deductible Coinsurance percentage Out-of-pocket maximum
Over 250% of FPL $4,000 20% $10,000
200%-250% of FPL $3,000 20% $8,000
150%-200% of FPL $1,000 10% $2,600
100%-150% of FPL $400 10% $1,000

Each income bracket down, the plan starts paying sooner and the annual “worst case” medical bills get lower.

Here’s that same chart from above, but updated to include these out-of-pocket maximum values. Note that these values are just an example. Different plans achieve the required cost sharing percentages in different ways.

See the big jumps there? While the premium subsidy tapers off gradually as your income rises, that’s not the whole story. The premium is the minimum you’ll pay for your health care during the year if you don’t have any need to get help from a doctor at all. If you end up needing significant medical attention, even a short hospital stay can easily push a family’s annual cost up to the plan’s out-of-pocket maximum. As you can see from the chart above, this total cost function is not a smooth curve at all; there can be some very significant costs to moving from one cost sharing subsidy income bracket to the next.

Modified Adjusted Gross Income, defined

What is MAGI, anyway? It’s your Adjusted Gross Income (the number at the bottom of the first page of your Form 1040), modified as follows:

  • Tax-exempt interest (from Form 1040, line 8b) is added.
  • Certain untaxed foreign income is added.
  • Any untaxed social security benefits are added.

Of particular interest to early retirees:

  • Any wage or side business income increases your MAGI.
  • Any interest, dividends, and capital gains in taxable accounts increase your MAGI.
  • Any taxable Roth conversions increase your MAGI.
  • Any taxable traditional IRA or 401(k) withdrawals increase your MAGI.
  • Any tax-free Roth withdrawals do not change your MAGI.
  • Any tax-free HSA withdrawals do not change your MAGI.
  • Any tax-deductible HSA or IRA contributions decrease your MAGI.
  • Itemized deductions (state tax, mortgage interest, charitable contributions, etc.) or your standard deduction do not change your MAGI.

Optimizing your income

This has been a lot of background information on the ACA so far. What do we do with all this information? How do you withdraw from your various retirement accounts to get the best deal on health care, while still having enough cash available to live a good life in retirement and also keeping your taxes low?

This is a hard problem with a lot of moving parts. The answer depends on your individual circumstances. The major things to consider are:

  • How much do you plan to spend per year after you retire? What multiple of the FPL is this amount?
  • When you retire, what types of accounts will hold your money, and in what ratios?

Depending on what types of accounts you will have, your MAGI may be the same as your spending. It could also be higher or lower. You may even have the ability to pick a target MAGI in advance and make it happen for a given spending level by moving money from different places.

Withdrawals from taxable accounts can affect your MAGI in various ways depending on which shares you sell. If you sell highly appreciated shares (say, shares that have quadrupled in price since you bought them), each dollar you take out of the account might add 75¢ to your MAGI. If you sell shares that have only gone up by 5% since you bought them, you might only add 5¢ to your MAGI for every dollar you withdraw. This quality can give you some tremendous flexibility in your retirement.

If you’re planning on doing the Roth conversion pipeline strategy, be aware that Roth conversions after retirement will generally increase your MAGI dollar for dollar. Five or more years down the line when you withdraw the money, these withdrawals will not add to your MAGI at all.

HSA withdrawals (when used to pay qualifying medical expenses) also do not add to your MAGI at all.

Given all of this, pick a target retirement MAGI for yourself that can meet your desired spending targets and is achievable with the funding sources you have. You may start retirement by selling less-appreciated shares from your taxable account to pay your expenses, while having most of your MAGI come from Roth conversions building up your pipeline for later. Then once your taxable account only has more highly-appreciated shares, you may decrease your Roth conversions as your capital gain income increases.

Let’s go back to Alice and Bob. They are a 40-year-old couple that just retired this year. They have $250,000 in a taxable brokerage account, $50,000 in an HSA, and $500,000 in a traditional IRA, for a total stash of $800,000. They plan to withdraw $30,000 each year, a little bit less than a 4% withdrawal rate. This withdrawal amount happens to be just under 200% of the FPL. They plan for $30,000 to be their MAGI target as well so they can qualify for the second-highest cost sharing subsidy.

For the first few years, Alice and Bob will withdraw $2,500 of qualified medical expenses from their HSA, and the remaining $27,500 from their taxable account. They will start selling least-appreciated shares to minimize capital gains. Each year they will convert ($30,000 – capital gains) from their traditional IRA to Roth IRA to start their Roth pipeline. Assuming historically typical investment growth, their taxable account should last at least ten years, with 12-15 being more likely. By the end of this time they should have enough seasoned Roth principal to start withdrawing $27,500 from that account tax-free each year and converting a full $30,000 from traditional. They will continue with this until they turn 65 and are eligible for Medicare.

What if Alice and Bob want to spend $35,000 per year? They might not be able to sustain that rate of spending while keeping their MAGI under $30,000. In that case they can do extra Roth conversions and harvest some extra capital gains for the first couple of years of their retirement, paying a little bit of extra tax and sacrificing ACA subsidies during years when they’re still relatively young. By realizing extra income in the beginning, they raise the cost basis on their remaining taxable shares and build up some extra Roth principal. This will allow Alice and Bob to sustain a situation of (MAGI < spending) for the future years when they are older and would benefit more from higher health insurance subsidies.

A note on Health Savings Accounts

HSAs are a great account for early retirees. This has been covered elsewhere. Some of the great, unique features include the ability to withdraw the money tax-free as long as you haven’t yet withdrawn more than your total medical expenses since you opened the account, as well as the ability to keep contributing to the account after you retire and no longer have any earned income. These properties can make the HSA a great backup source of retirement income in years where you need a little bit of extra cash but have almost gone to your maximum target MAGI for the year.

Despite this, you should not plan to contribute to an HSA in a year where you also qualify for cost-sharing subsidies under the HSA. To meet the required coverage percentages for these subsidies, insurance companies often have no choice but to lower plan deductibles past the point where the plan would qualify as an HDHP that allows you to make HSA contributions.

However if you find yourself in the situation of purposely having a high MAGI for the first few years of retirement to enable lower-MAGI years later, don’t forget about the possibility of making HSA contributions. These contributions can help you in the current year by reducing your regular income (from Roth conversions, etc.) dollar for dollar while helping you in the future by allowing you to shelter some of your taxable money in the HSA where it will never count against your MAGI again.

A note on mortgages

Much ink has been spilled about the relative benefits of paying off your mortgage early versus investing that money in the market to get a higher expected return. While you’re still in the accumulation phase, the math generally favors making only the required payments on the loan and no more. Be aware that if you continue having a mortgage during the first part of your retirement, you will likely need to withdraw more from your various accounts to make the mortgage payments than if you had paid off the loan before retiring. This will likely cause you to have a higher MAGI than if you had no mortgage, which could in turn cause you to have higher health care expenses. Remember to consider this when deciding whether to carry a mortgage during retirement.

A note on Medicaid

I haven’t mentioned Medicaid much here. Medicaid is administered on a per-state basis with financial assistance from the federal government. As part of the ACA, states may choose to expand Medicaid to households with MAGI up to 138% of the FPL, in exchange for additional federal funding. The subsidies discussed above are only available to people whose income is too high to qualify for Medicaid in their state. Thus the subsidies for households between 100% and 138% of the FPL are only available to people who live in states that chose not to expand Medicaid.

The quality of coverage and selection of doctors available under Medicaid varies from state to state. While the program is intended to provide complete health care to lower-income individuals and families, many people report that the overall quality of care is not as good as what is available under privately-purchased health plans. Consider this when planning your retirement income, to ensure that your MAGI never drops below the Medicaid cutoff if you do not believe Medicaid provides good enough care in your state.

Final thoughts

While the ACA adds plenty of complexity to early retirement planning, it also removes a large source of uncertainty from the expense side of the equation. No longer do people need to remain working a job for the sole purpose of ensuring continued access to health care in the case of pre-existing conditions. Love it or hate it, the ACA is here and you should plan for how it will fit into your individual situation.

If you have any other thoughts about how to use the ACA in retirement planning, please comment below! Comments about the politics behind the law are off topic and will be removed.

Accessing your retirement accounts early: yes you can!

I have been posting on the Mr. Money Mustache forums for some time. Every week, new people come into the community, excited about the possibility of retiring early and trying to plan how to get there. This is great! One question that comes up extremely often, almost daily, is some variation of the following:

I want to retire early, but I am worried I have saved too much in my retirement accounts (IRA, 401(k), etc.). I can’t touch any of this money before age 59½. Should I quit contributing to my 401(k) and start saving more in a taxable account instead so that I have enough money to make it to 59½?

No! Keep saving in your tax-sheltered accounts! The idea that you can’t withdraw from your retirement accounts early is an extremely common misconception, but a misconception nonetheless.

Far from being an untouchable pot of money for an early retiree, retirement accounts are a great tool to help you save money on taxes while you’re working, while offering several options for withdrawing that money at whatever age you decide to leave the workforce.

In this post I will explain three main ways to access these funds before the “traditional” retirement age.

Option 1: Roth Conversion Pipeline

How it Works:

Roth IRAs are pretty straightforward for “normal” retirees: pay tax on your income in the year you earn it, save some of it in your Roth account, let it grow for a few decades, then withdraw it completely tax-free during your retirement after age 59½.

What happens if you want your money before age 59½? Many so-called experts would say “you can’t do it! You’ll pay huge penalties! There be dragons here!” The problem with the expert wisdom is that it’s just not true! Some lesser-known provisions related to Roth IRAs make them really great tools for early retirees.

If you withdraw from a Roth IRA prior to age 59½, the taxation and penalties depend on exactly which dollars you took out. There is a set of ordering rules that determines this. In a nutshell,

  1. Direct contributions come out first,
  2. Amounts converted from pre-tax retirement accounts come out next (older conversions before newer conversions), and
  3. Earnings come out last.

The direct contributions can always be withdrawn tax-free and penalty-free. Amounts converted from pre-tax retirement accounts can always be withdrawn tax-free (since you paid tax when you converted it), but there will typically be a 10% early withdrawal penalty if you take out money that you converted less than five years ago. If you dip into the earnings before age 59½, you will pay your regular income tax rate plus a 10% early withdrawal penalty on this money.

The Roth conversion pipeline is a strategy where you use these rules to your advantage, allowing you to get money out of your pre-tax retirement accounts early without paying any early withdrawal penalty.

The key thing here is the five-year rule for withdrawing conversions penalty-free. If you converted $10k in 2010, you can withdraw that $10k in 2015 completely free of tax or penalties! If you converted $11k in 2011, you can withdraw $11k in 2016 for free as well!

The idea of the “pipeline” is that if you convert some money every year, after five years you will be able to withdraw some money every year as well, completely tax-free. That’s all there is to it! You can gradually draw down your pre-tax retirement account balance during early retirement by converting one year’s worth of expenses into a Roth IRA, letting it sit five years, and then taking it out. Any growth on this money should remain in your Roth IRA, where it can continue compounding tax-free and can be withdrawn freely after age 59½.

Pros:

  • This method is flexible. You are free to convert a different amount every year to account for any lifestyle changes that you may anticipate five years in the future.
  • This method is easy to understand.

Cons:

  • This method may result in high taxes during the last few years of work, when starting the conversion pipeline and earning money from a job at the same time. To avoid this, consider having some money in taxable accounts and/or direct Roth contributions to pay for part or all of the first five years of early retirement.
  • The tax-free withdrawal amount is based on nominal dollars. If a period of high inflation begins during your early retirement, you may find the amount you converted five years ago to be insufficient to pay your living expenses in current dollars. When making a Roth conversion, use a reasonable estimate for inflation to reduce this risk. For example, if you convert 30% more than your current living expenses each year, you will be prepared for five years of 5% inflation.

Option 2: Substantially Equal Periodic Payments

How it Works:

Any early withdrawals made from retirement accounts under a series of “substantially equal periodic payments” (SEPP) are not subject to an early withdrawal penalty.

These payments can be calculated in one of three ways as defined by the IRS. The easiest method is the same as for calculating required minimum distributions: take your year-end account balance, divide it by your life expectancy (from a table), and withdraw exactly that much from the account. Do this every year to calculate your payments for the next year.

The other two methods take current interest rates into account in addition to your current age. They are a bit more complicated, but may result in a larger payment.

Pros:

  • You can make withdrawals directly from a traditional IRA with this method. You do not need to transfer money between accounts periodically, wait five years, or make estimates for financial needs years in advance.
  • These withdrawals are consistent. You will withdraw a certain percentage of your account balance each year, and this withdrawal will be a slightly larger percentage of your account each year as you age.

Cons:

  • This method is very inflexible. If you choose to take withdrawals using the SEPP provisions, you must keep taking them for five years or until you turn 59½ (whichever is later). If you fail to withdraw the correct amount even one year, you will owe 10% early withdrawal penalties (with interest) on all previous SEPP withdrawals.
  • An early retiree will likely find that SEPP payments for a younger person are a low percentage of their account. Someone in their 30s will withdraw 1.9%-2.7% of their account if they use the required minimum distribution method. Therefore someone depending on a 4% withdrawal rate will need to get some money from other sources (taxable accounts, rental real estate, etc.) to bridge the gap.
  • SEPP withdrawals from a Roth IRA are possible, but this money will be taxed as income.

Option 3: Pay the *%&@ Penalty

If you take money out of a traditional or Roth IRA before age 59½, and no other exceptions apply, you will pay your regular income tax rate on this money plus a 10% early withdrawal penalty. This doesn’t mean you “can’t” do this, just that there’s a cost to doing it.

Given the alternatives above, paying the penalty shouldn’t generally be your first choice. However you should be aware that it is an option, and you should not be afraid to use it if it’s the best option available to you at the time.

For example, suppose that you’re relying on the Roth conversion pipeline for the bulk of your early retirement expenses. You planned ahead for some inflation, but the actual inflation rate turned out to be higher than you expected. If this happens, you can simply withdraw some extra money from your traditional IRA and pay an early withdrawal penalty. The world will not end if you need to do this sometimes.

Remember, if your tax rate is at least 25% while you’re working and 15% or below when you’re retired, paying tax and an early withdrawal penalty during retirement will be no worse than if you paid your regular tax rate on that money while working and saved it in a taxable account! Again, the strategies above can help you do even better for the majority of your spending, but a little bit of early withdrawal penalty here and there is okay.

Final Thoughts

I hope this post helps debunk the myth that you can’t touch your retirement accounts until you turn 59½. You don’t need to quit saving in your tax-deferred accounts if you want to retire early. You may find some extra flexibility during early retirement from having some of your money in a taxable account. A diversity of possible income sources can help you optimize your life from year to year, taking advantage of things like ACA health insurance subsidies and other programs. However, contributing the bulk of your savings to tax-deferred retirement accounts will generally help you pay less tax and retire sooner. The strategies above can help you tap into that money before 59½.

Have questions? Ask them below!