Tax Efficient Strategies for Early Retirement | Mailbag Episode | 545 | With Rachael Camp
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Hello and welcome to choose a five today in the show. We have a good friend, Rachel camp back for another mailbag episode. And this is a fun one. We talked a lot about strategies for withdrawing money from different accounts. So both taxable brokerage and retirement accounts. Also, some people pitted these against each other, taxable brokerage accounts versus traditional IRAs and 401ks. Is it a death match or is it just, Hey, let's look at the flexibility of having all of these accounts.

We had another question come in. What can a former W-2 employee do to lower taxes in retirement? How to have low enough income for Roth conversions? Is it possible to think about working one more year to pay the penalty to withdraw money early, which is an interesting one? And then finally, more detail on something we talked about previously on a mailbag with the pro rata rule and cleaning up after-tax basis in an IRA for purposes of the backdoor Roth.

I think you're really going to enjoy this episode. And with that, welcome to Choose FI. Rachel, thanks for coming back. This should be a lot of fun. As always, this is our eighth mailbag. And yeah, I always eagerly anticipate. Me too. I'm so excited. We've got some great questions today.

We really do. So the first two that came in are actually, we're going to group them together. And I think this is a topic that actually bedevils people a bit, which is their taxable brokerage accounts. First, notwithstanding, just the terminology, Rachel, is terrible, I think. So we should probably dial in on that, but I'll leave that open-ended and let you kind of jump into that. So I'm going to read Rick's question. Rick.

Rick said, I know for a taxable brokerage, long-term capital gains are taxed at a different, more favorable rate. When I withdraw money from an IRA after 59 and a half years old, are both the contributions and earnings taxed as regular income or are the earnings taxed at the long-term capital gains rate? If so, how do we delineate contributions and earnings taxed

for tax reporting. And Rachel, I guess Rick's really talking here, not just for an IRA, but it would be similar 401k, most any type of retirement fund there. So this represents a really significant question that people have.

even though we try to talk about it as often as we can, it is just straight up confusing. It definitely is. And we cannot touch base on this often enough. So I said we have a couple of questions, but let's start with Rick's because I think this is a perfect jumping off point. Yeah. The fact that we have two different tax treatments here and essentially two different tax brackets, I completely get why this is so confusing. And it's funny because we've actually done a lot of great marketing for the taxable brokerage because now we're getting questions on

Why wouldn't I just exclusively use the taxable brokerage? What's the point of the traditional accounts? So I get that's confusing. It is really simple when we talk about traditional IRAs and traditional 401ks. We are working within the context of just the ordinary income tax bracket.

So the idea here, when we're using traditional IRAs and 401ks, is we're trying to time when we should pay the taxes. So instead of paying tax today, putting money into this account like you would with a brokerage account, a taxable brokerage, those dollars have already been taxed.

You put them in the brokerage account. They're now going to grow. Some of them are even going to continue to be taxed because we've got dividends and potentially interest coming out. And then eventually you take the money out. Whatever the gain is, you're going to pay the capital gains tax there. And he's right to point out that that's a favorable, better tax rate.

Compare that to a traditional 401k or IRA. We're not paying tax on any of the money when it goes in. So everything is pre-tax or it's tax deductible. So we're essentially saying I don't want to pay tax on this money today because I anticipate that in the future when I retire and I take this money out, I will be in a lower tax bracket. So I'm trying to time that and pay it later and

when I can get a lower tax rate on it. So that's the main difference between the two. I want to throw it back to you, Brad. But as far as when money comes out, there's no differentiation between earnings versus basis, unless we have after-tax basis in the IRA, which most people don't. But it's all pre-tax dollars going in there. So when you take it back out, it's very simple. It's taxed at ordinary income tax rates. And it's still beneficial because we are

potentially and hopefully, and for most people, we find ourselves in a much lower tax bracket in retirement. So we're still coming out ahead by using this strategy. Yeah, I love that. And yeah, we cannot dive into this enough. So I'm going to take my summary. And I think

between people hearing both of our summaries, I think they're going to have a handle on this because even just touching on the different phrases sometimes makes it so interesting because this is complex. So let's be clear. You're listening to this. This is not obvious, but once you understand it, it actually is fairly easy, I promise. So first,

The taxable brokerage account is the worst terminology ever. It's basically just your savings. Okay. If you could have those dollars under a mattress, I hope you don't. You could have it in a checking account. I hope you don't. You could have it in high yield savings. You could have it in bonds. You could have it at Vanguard or Fidelity or Schwab in an account where then you can invest in whatever you want. Okay.

Okay. So in most cases for people in our community, that's going to mean most likely low cost index funds or ETFs. Okay. But those accounts are called your taxable brokers, but really just think of it as your savings. Okay. This is not in any type of umbrella of retirement or any other thing. You didn't do anything special. This is just the money that was left over. Okay. Most likely it was sitting in your checking account. You're like, Oh, I'm

I'm saving a lot of money. I need to do something with this money. I don't want it to just sit here. I'm going to go invest in VTI or VTSAX or who knows, some individual stock or something. I'm going to do that at Vanguard or Fidelity or Schwab most likely.

Okay. So terrible terminology, taxable brokerage, but that's what it is. Okay. So that's that now let's like Rachel did. Let's go over to the things that we've heard of, right? Traditional IRAs, traditional 401ks, those you get a tax deduction today for the contributions you put in. Okay. So let's say your gross income is a hundred thousand dollars and you put in $20,000 into your 401k this year. So what actually happens is you're

You magically essentially get $20,000 lopped off of your income. So your income that you goes on your tax return is just the 80,000. So the a hundred thousand minus the 20,000 that you contributed. So only 80,000 shows up on your tax return and then you get the standard deduction and then you get all of whatever else. And then it comes down to your tax liability.

But basically that's what it means to contribute to one of those types of accounts is you get the tax deduction today. Now, Rachel and I deduce this on a prior mailbag, which is basically, this is just a guess. The reason you're putting it in there aside from not being able to touch it in some behavioral things, but realistically the monetary reason you're doing this is you think there's a reasonable likelihood that you're going to be in a lower tax bracket when it comes time to pull that money out or you're

frankly, you might have some advanced strategies like those of us in the FI community know. But either which, you're in a lower tax bracket. Because otherwise, what Rachel and I deduced was if you're in the exact same tax bracket, it actually, it doesn't matter. It's even whether you do Roth or...

or traditional. It's just a bet on your tax bracket in essence of now or later. So that's actually a really interesting wrinkle that most people don't consider, but we did prove that pretty conclusively mathematically. So I believe that based on a lot of these withdrawal strategies that we have, and also not to mention, you're going to be making a whole lot less money if you're at FI, your expenses are under control.

and you have zero income coming in what actually happens when you pull money out and rachel said this so beautifully is when you pull money out of let's say your 401k or ira your traditional accounts every dollar that comes out goes on your tax return as ordinary income as if you earned it from a job it is ordinary income that are subject to the ordinary income tax rates

Now, again, you get the standard deduction. You get whatever other deductions you qualify for, most likely the standard. And then you apply the tax table. So I think for someone who is, let's say, earning a decent bit of money in their normal job, they put it into this pre-tax account. Then later, a couple of decades down the road, it comes time to pull it out. And they've been following the path to FI and they have a mortgage paid off and their life just doesn't cost that much.

let's say they only pull out 40 or 50,000. Rachel, I mean, that goes straight on the tax return, but then you get the standard deduction and it's like, oh, wow, like my effective tax rate on that 40 or 50 that I just pulled out is minuscule. It's a couple percent in most cases. So while every dollar is taxable as ordinary income that you pull out of those accounts, again, with the right strategies, I think there's a way to make it so that that is a really good deal.

in terms of that tax strategy. So Rachel, I will let you get in here, but just last word is then going back to these taxable brokerage. So again, just your savings. Now, the reason why we call them taxable, or at least the reason I call them taxable, Rachel might chime in with a different reason, but it's because along the way, what goes on in here is taxable. So they're not sheltered because

Because again, like in that 401k and IRA, none of the other stuff matters. You can sell it all. And even if you had a massive gain, it doesn't matter. It's not taxable. All that's taxable is when you pull the money out. Okay. So you can do anything within that, which is why we say like, Hey, if something you own spits off a lot of income, like capital gains distribution or dividends, you might want to hold it in one of these tax advantaged accounts because that stuff isn't taxed in the current year.

It's only tax when you pull the money out. And even then it doesn't matter if there were capital gains, none of that stuff matters at all. It's just, Hey, I pulled out a thousand bucks, a thousand bucks goes on my tax return. That's it. So now going back to the taxable brokerage, it's the opposite of that. So you might just reinvest dividends.

That's what I do for all my accounts. I don't give advice here, obviously, but that's what I do for my account. So reinvest dividends, like I get taxed on them. So if I have like a couple hundred thousand dollars sitting in VTI, and even if it just pays a little dividend of one or 2%, something like that, it's still a couple thousand bucks. And while I didn't see that money because it actually just repurchased, I said to reinvest my dividends, that money never actually hit my bank account. I earned that money in this year. And because it's in a taxable brokerage,

that amount comes on my 1099 at the end of the year and it has to go on my tax return. So that's the real critical distinction to remember with taxable. And then just kind of finally is when you do sell those, as Rick said, it's subject to this actually really wonderfully preferential tax rate of, for most people, it's going to be 15% federally. It can be 20, you know, it can be zero, but for most people it's going to be 15. And that's then just on the increase

There's some details, but basically it's the basis is what you bought it for. And then what it's worth now is the fair market value. And when you sell that, you realize that gain. It goes from an unrealized gain to a realized gain. And you just take, hey, what are the proceeds? What did I get minus my basis?

And that's my capital gain. If you've owned that for more than one year, a year and a day or more, it's a long-term capital gain. And that's when you get those preferential rates. So yeah, Rachel, there's a lot of detail. There's a lot to play with also, which is actually makes this a fun strategy to have a little bit here, a little bit there. And, you know, we've talked about that a lot. And I have talked about that with Sean Mullaney and Cody Garrett as well as like, there's a lot of factors with like the ACA subsidies and different things. Like we,

can have some fun in terms of fun. I use that only in our communities as fun, but that we can play around with. Yeah, that was a perfect summary. And the only thing I want to reiterate is that point you made on tax deferred growth. Growth uninterrupted by tax is something we only get in these traditional accounts, retirement accounts, Roth accounts. We don't get that in the taxable brokerage accounts. So while many of us use really tax efficient, low

cost index funds. I certainly do. It still shoots off a little bit of dividends, 1% to 2%, like Brad said. I mean, we're all going through tax time right now. We're pulling our 1099s. We're seeing we've got dividends. Some of us might have interest. We are paying tax on that this year. We don't get 1099s from our IRAs while they grow because...

they get to grow completely tax deferred. So that's one of the main benefits of the traditional accounts versus the taxable brokerage accounts. I think we forget that many of us aren't fully aware that we're paying tax on some of that dividend yield as it's shooting out. But then the other big one is just tax arbitrage, which we've talked about before, which is I want to time when I'm going to pay taxes and 100k income in retirement,

typically almost always has a much lower effective tax rate than earning 100k as an employee. So even if you think to yourself, how am I going to be at a lower tax bracket? I anticipate spending the same amount. Well, you're not saving. We've got taxes we're not paying in retirement. We have a lot of tax efficient strategies we can use in retirement, which we're actually going to get into today. So

It's a really good bet, I think, that we are going to be in a lower tax bracket in retirement. And the traditional account is what allows us to capitalize on that difference in tax rates.

Totally agreed. And to round this out, so we had another question came in from someone who goes by AA40. And Rachel, I think we touched on a bunch of this, but I'm going to read it anyway because I think it adds an extra little wrinkle. I recently found out that capital gains inside a 401k account aren't treated as capital gains, but as ordinary income. And again, my editorial here is that's not...

Not entirely true, right? The ordinary income is the dollars that you pull out. But the beautiful thing is there's no capital gains in a 401k. So that's great. And A40 said, this really threw me off and led me to question the benefits of a traditional 401k. As you know, long-term cap gains in a brokerage account, taxable brokerage can fall into the 0% tax bracket if your taxable income is below the threshold, which

which they said was 89,250 for married filing joint in 2025. Rachel, I'm not a hundred percent sure about that. If I actually thought it was a little higher, but we can hire too. Yeah. I think it was 94 50 for 2024. Correct. So anyway, it's somewhere right around that. I did an episode with Cody Garrett on that, which was absolutely wonderful.

And then they went on to say, well, withdrawals from a 401k, regardless of whether it's growth, capital, whatever it's from, are taxes, ordinary income, not capital gains whatsoever. So aside from Roth conversions, it sounds to me like investing via brokerage accounts is highly underrated.

It gives you way more control, it seems. And as you always say, control what you can control. Shouldn't we be questioning the real value of maxing out 401k and trapping this money until you're 59 and a half and then having capital gains being treated as ordinary income later on? So like I said, Rachel, there's some wrinkles in here. I think neither of us would agree necessarily with the premise of the contention, but I think it's an interesting one nevertheless, because I suspect other people have this thought as well.

And honestly, I kind of laugh because we don't really need to pit these accounts against each other. They're all great and we can use them all for tax diversity, for maximum control and flexibility, which is what we talk about a lot with financial independence and getting to that point is it's not one account is the best and ignore the rest. It's a mixture of these accounts really helps with tax control once you do fully retire. So to their point,

as it being treated different than capital gains, they are, we just hit on this, but everything that comes out is treated as ordinary income, as long as all the monies within the traditional accounts are pre-tax dollars. That doesn't make it worse or better than the taxable brokerage account. It just gives it a different tax treatment and a different strategy that we can use.

which we've hit on, which is tax arbitrage for the traditional accounts. I agree. I do think taxable brokerage accounts are really underrated, especially if we're talking about early retirement. I love it as a bridge account to get you to that age 59 and a half. But a lot of the criticism of the

401k, like it being locked up, it creating huge tax bombs, I think are just completely misguided or misinterpreted because we have so much strategy that we can use once we do fully retire to keep those taxes coming out of the account really low. So I think the mixture of the accounts is important here and gives us most control once we do fully retire. I don't think you need to neglect one account and view that one is better than the others.

Yep. Wholeheartedly agreed. And yeah, we talked about that. I mentioned capital gains tax strategies. I talked about that with Cody Garrett in episode 517. And I think that's

that was a really wonderful episode. And I would highly suggest if you haven't listened to it, to go back and listen. Because yeah, as A40 said, there are significant benefits of taxable brokerage accounts. And also, like Rachel was saying, having this flexibility. I think that to me is what's critical. So because there are so many advanced FI strategies, we want to have access to them all. And that's what's so great. It's like, yeah, you can do

tax gain harvesting. And like they said, well, you know, we, we have to exactly fact check the amount. It was 94,000 plus in 2024.

96. Oh, sorry. I was just going to say, I just pulled it up. 96,700 for 2025 for 0% capital gains bracket. Wow. Wow. Wow. So that is astonishing. Now what that means is yeah, all of those capital gains, like they might not be that preferential 15%, which is still wonderful in and of itself. There was a reasonable likelihood it'll be 0%. And then you can do things like

If your income is low enough, you can do Roth conversions and the Roth conversion ladder, which is another thing we talked about in episode 475 with Sean Mullaney on how to access your retirement accounts before 59 and a half. I think, Rachel, what I didn't realize was we kind of stumbled into, there's this thing going on in the FI community called the middle class trap, which our friends, Scott and Mindy, who are great friends of mine over at BiggerPocketsMoney coined earlier this year and

I have to say, while I absolutely love them, I do not agree with this middle-class trap thing at all because it's literally the polar opposite of what we've been talking about for eight years on Choose a Pie. It's like, no, we have all of these amazing strategies to withdraw our money at essentially 0% tax with the long-term capital gains harvesting and the

the massive standard deduction that we now have. And you could do Roth conversions. You can do all of these other things. And even someone like Brandon, the mad scientist wrote an article, a similar article years ago where he crunched all the numbers and said, not only basically do I not agree with like people who say it's not a good idea to put in 401k, but I would even go to the extent of saying, even if all else failed, just pay the penalty. The worst case scenario is to pay the 10% penalty. And his analysis was it still came out ahead.

So I think what this middle-class trap is saying is like people who basically have all of their money tied up in home equity and retirement accounts and that they're somehow stuck. And I think that's just total nonsense, frankly, because a money in your home equity is not included in your fine number. Let's be clear. Like it's included in your wealth and your net worth, but you would never include that in your fine number. So like that's a distraction and total nonsense. And then you

I mean, realistically also, Rachel, again, I would argue with the entire premise of it. There's nobody who's going to reach five in their forties, which is how Scott and Mindy kind of define this middle-class trap and only have money in a 401k. Like it's not mathematically possible in essence. And Sean Mulaney kind of proved that to me behind the scenes of like, obviously to have a high enough savings rate, you don't have enough retirement vehicles to max out, to wind up with $0 in your taxable record. So again, total nonsense. And I

Like we said, there are a ton of strategies to get money out of your 401ks and IRAs. And even Brandon says, just pay the penalty, worst case scenario. And you still come out ahead. So we're going to have Mindy and hopefully Scott on an episode pretty soon here. We're recording this on March 25th. We're going to chat with them on this Friday on the 28th. So stay tuned for that. I'm not sure which episode will come out first, Rachel. But yeah, long story short,

I think it's a good question, but I think at the end of the day, we want all of this stuff. And frankly, if you have a high enough savings rate, which I think most of us who are going to reach FI in our 30s, 40s, and 50s are going to have that high enough saving, you're going to have all of this money. So you're not going to be stuck with anything. And you're going to have this entire smorgasbord of options of fun things to do. So yeah, I think we all need to take a deep breath and

and just say like, we're really smart as a community. When you have a high savings rate and you have all these different vehicles, you're going to succeed wildly. But to pit one against each other, like Rachel said, it just doesn't make any sense.

Yeah, I completely agree. And I'm excited. We'll get into actually tax strategies for retirement. But just to briefly mention that, I mean, between the standard deduction, the capital gains tax rate of 0% for a married couple, we're talking about $126,700 of tax.

income in a way, and even that's not the right way to really to phrase it, that you can take out. It's actually higher than that because the 0% is just the gains, right? It's not the full amount you're taking out. I see a lot of people get that confused. So we're talking about more than $126,700 of money that can come out at 0% tax rate. So many strategies. 0%.

It's amazing. Yeah. And yeah, like you said, like depending on what the basis is in those taxable accounts, like you could pull out hundreds of thousands in proceeds potentially. So yeah, there's a lot of options here. Nobody's stuck. We can all take a deep breath. It's going to turn out okay. We're all doing great. Yeah, we're all doing amazingly well.

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Okay, let's move on. Jim said, I'm a former W-2 employee, now retired, trying to ensure I maximize my pension and savings for retirement. Other than Roth conversions, what options do I have to minimize current and future taxes?

We have a lot of options. So, I mean, we just talked about the standard deduction, the 0% capital gains tax bracket. Those to me are the heavy headers. And so when I start with tax savings, I always just start there. Let's make sure we're filling up the standard deduction. Let's make sure we're taking advantage of

the 0% capital gains tax bracket. And we have a strategy there called gain harvesting, which I actually think there's an episode you have with Cody that dives into that. That's an underrated one. We hear a lot of people talk about tax loss harvesting, but if you can harvest gains at that 0% tax rate and reset your basis, that can have a huge impact, especially in early retirement. And then the other one is just being really tax efficient with where you place your investments.

So when we have accounts that are shooting off dividends and interest, we want to make sure that we're as efficient as possible there. So I often see people who have, you know, bonds, traditional bonds and taxable accounts. They're shooting off interest that's taxed at the ordinary income tax rate. That's not super tax efficient. You know, we can place investments in different places.

tax vehicles, they give us optimal tax strategy there. So being really careful about where you place your investments is important, but also the vehicle for the investment. So I'm assuming most people listening here are huge fans of low-cost index funds, which are extremely tax efficient. Every once in a while, I'll get some people who are in active

funds, which tend to be really tax inefficient on top of a lot of other problems and create things like short-term capital gains. So being really strategic with the type of investments and where you place those investments gives you more control over the tax impact in retirement. Making sure dividends are qualified is another one there. Just being careful with the high dividend yield, any dividends that are coming off, making sure they're qualified. That's because quite

Qualified dividends are taxed at the preferential capital gains tax rate. Non-qualified dividends are taxed as ordinary income. And then if you're charitably inclined, we've got a lot of opportunities there. I kind of just wanted to rattle these off as a checklist, but-

doing things like contributing to a donor advised fund, if you itemize can be really helpful. If you don't need your full RMD, you can actually send that some of that money to charity and completely avoid the tax there. So different strategies depending on what your goals are. But

I think at a very high level, looking at the standard deduction, making sure we're taking advantage of that every single year, especially in early retirement, looking at the 0% capital gains tax bracket, which we've talked about, and then being really tax efficient with your investments, then you have all the control you need when it comes to taking money out. Yeah, I love that. I will quote Charlie Munger and say, I have nothing further to add. You nailed it.

Yeah, I think just knowing that these strategies exist, I think that's the critical part, right? So for somebody who's not making W-2 anymore, like Jim said, form your W-2, you've got some options. You know, that tax gain harvesting is astonishing. The Roth conversions, like you said, like

Because we have such a significant standard deduction nowadays, like you can convert maybe $20,000 to $30,000, depending on how it all shakes down. Like that's not insignificant. And yeah, obviously you can't know your exact tax situation here on a podcast. But Rachel, there's, yeah, lots of options as you outlined. So, okay, let's move on to Emily's question.

So Emily said, you've mentioned the Roth conversion ladder as the holy grail of tax-free income and therefore growth. I understand how it works, but I'm struggling to understand how someone who has achieved FI would realistically have the zero or near zero income required to make this actually tax-free.

If we assume a fine number of $2 million reached in mid 40s, so with around 20 years of work history in the best case scenario where all of the retirement accounts were maxed out the whole way, presumably at a minimum of half of that $2 million, so about 1 million. I guess they're saying 1 million would be in those retirement accounts and then the remainder would be in regular brokerage accounts or other non-tax advantage accounts. If we assume a 2% yield,

dividends and interest on the lower end of that million. So that million of in the taxable brokerage, she's saying, Rachel, that's still going to end up with $20,000 of income.

which is more than the standard deduction for a single person. Am I missing something here? Or how is a person who has achieved FI realistically supposed to achieve a low enough income to tax advantage of the conversion ladder's theoretical zero tax benefit? So this is a great question. Yeah. And it really builds on what we were just talking about. Perfectly. Yeah, perfectly.

The important distinction here is how that dividend yield is being taxed. Now, I think they mentioned interest as well, but that's one of the reasons we want to be sure we're sheltering that interest in a tax-deferred or tax-free account, preferably tax-deferred. That way you...

You don't have to report that on your tax return and we can shelter that in a different account or we can use a more tax efficient fixed income vehicle like municipal bonds, something government issued that actually gives you a tax break when that interest pays out.

But this is the importance of making sure that you are really tax efficient with your investment. So it's a good point. I think a lot of us in the FI community tend to ignore that there is a dividend yield being spit off of these accounts. And so we do have to include that. But...

Like we've been saying, our hope is that it's qualified dividends and then we're taxed at the preferential capital gains tax rate. So the way we can look at this is people get confused with these two tax brackets. The way that I approach it, the way that taxes approach it, is we first fill up the ordinary income tax bracket first. So let's assume we're retired here. We want to do Roth conversions.

the first thing we can do is say, I want to match up my Roth conversion with the standard deduction. Standard deductions this year in 2025 are super simple. We have nice even numbers. For single person, it's 15,000. For married filing jointly, it's 30,000. So if we're single here, we can kind of start to fill up

our tax brackets starting with $15,000 Roth conversion. We know with the standard deduction, we essentially get that tax-free. And then on top of that, we can start adding the dividends. So we got 20,000 in dividends. Now we're starting to fill up the capital gains tax bracket.

and now we're starting to fill up that 0% within the capital gains tax bracket. So this might be an oversimplified way of looking at it, but if we set things up in a way where our investments are super tax efficient, we're sheltering our interest in retirement accounts, not taxable accounts, then we can actually use this strategy. We can fill up the standard deduction,

with money coming out of the IRA and going into the Roth IRA, that's old taxes, ordinary income. But then everything else we can play within the bounds of the capital gains tax bracket to fill up our income. And that's where we start taking money out of the taxable brokerage account. And you're reporting that gain that's coming out. And we're just making sure we're staying within the 0% capital gains tax bracket. And for this scenario, I think, and what we've talked about, that's really easy to achieve. Like we've mentioned,

We have at least $126,700 of income we can take out at the 0% bracket. It just requires us to be ready to have a taxable brokerage account there to fill it up and then to have tax efficiency so that we're not filling up that ordinary income tax bracket or the standard deduction with things like bond interest when we can use it for Roth conversions.

All right, Rachel. So I got this now and it took me a minute to wrap my mind around. So like Emily saying, yeah, there might be a 2% yield in some way and that's average. And we use that on the first section of the episode of like, Hey, you have VTI and that's in your taxable brokerage. It's still spitting off some money.

Because most likely there's dividends is going to be the biggest portion. There might be some like capital gains distributions, but most of it's going to be dividends. And like you said, if it's qualified, it's going to be at the preferential rate and it'll go against the long-term capital gains, right? Which is what you're saying. And because...

because we've deduced that it's somewhere in the $96,000 range for 2025, the likelihood of you paying anything more than 0% on that is seems very, very slim based on this fact pattern. And then you would have the full amount of the standard deduction to pull money out. So with a Roth conversion, and we didn't really define that here, but essentially what you're doing is you're saying, okay, look, I've got a traditional IRA. So you had a 401k, you,

rolled it into a IRA and then you need to, you're saying basically, Hey, I'm going to convert this to a Roth. And now what happens is you basically say to the government, Hey, please tax me on this amount. So let's say you take $20,000 out. Okay. Please tax me on that. It goes on your tax return as ordinary income, and then you've converted it into a Roth account. But like we're saying, because you get this massive standard deduction, you're

that then gets pulled out from this. So if you're married filing joint, the standard deduction is well in excess of $20,000. So using just my very simple example here, Rachel, you would pay $0. Like I said, you would say, hey, US government, please tax me on this, goes on your tax return, but your tax liability is actually $0. And because

The dividends are also at this preferential rate and you're under that amount. You're paying, unless, you know, we're doing this without tax software in front of us, but we're both fairly confident about this. I actually just pulled it up. Always a little dangerous, but yeah, you're going to pay essentially $0 in tax on this. So Emily's question is a brilliant one, but yeah, I think it's pretty clear that you can do this.

Yeah. So like I mentioned, I actually have tax software in front of me and I plugged this in. So I'm assuming that this is a married filing jointly couple that's retired this year. They need $70,000 in income. And we want to take advantage of Roth conversions if we can. So standard deduction this year for 2025 is $30,000 for a married couple.

So what we can do is start with the Roth conversion. So we're taking $30,000 from the IRA. We are converting it over to the Roth IRA. Of course, we report this on your tax return. But because the standard deduction is $30,000, that takes the taxable amount down to zero. So we essentially got to convert $30,000 over to the Roth side completely tax-free.

but we still need $70,000 in income. So then we can look at taxable brokerage account. And we're assuming, I think we should assume that 50% of whatever we take out is basis. So it's what you put into the account. So we get to take that back out tax-free because you already paid taxes on it. And we're just gonna pay tax on the gain. So if we need 70,000 in income, we can take out 70,000 from the taxable brokerage account. We're going to report $35,000 in gains

And because we're well within the limit of the 0% capital gains tax bracket, none of that is taxed either. In fact, we actually have room up to $96,700 to take more money out at the 0% bracket from that taxable brokerage account. So in this example, we probably should take out more there and really fully utilize that 0% capital gains tax bracket. Make sure we're doing that gain harvesting that you and Cody went over. And we've got...

70,000 in income and a $30,000 Roth conversion. And we paid a whopping $0 on taxes on that. - Yeah, it is amazing.

And yeah, like you said, there's still room for more optimization. That's the wild part. So, right. You have all this money sitting in your taxable brokerage. Like Rachel uses terminology, 70,000 of income. I probably would say 70,000 of proceeds maybe because it's like we all get a little confused in terms of like what's income for a tax return versus what's income. Like I...

Rachel, similar to you, I would think of income as like, oh, this is what I need coming in. But yeah, so as not to confuse, it's like, hey, we're selling $70,000 worth of securities in our taxable brokerage account. That $70,000 is then proceeds. So that money comes into your bank account, but not all of it goes as easily.

long-term capital gains in this case on your tax return. Rachel said, just for our back of the envelope, we'll say 50%. So that's where she came up with the 35,000. But yeah, you could keep doing more to get all the way up to that 96,000 and change for just the gain portion. So your actual proceeds-

we're using that 50 it would be double that right so it'd be like 192 000 total and what you could do then is you could take hey i only need 70 of this this year so i can take the extra 122 000 and then just rebuy my total stock market index fund or s p 500 fund whatever it may be and what you've done then is you've increased the basis right so you've increased it to hey i just bought it for today's amount because

Like we said, there was a capital gain when you sold this and you report that on your tax rent, but you're in that 0%. I don't want to say loophole because that's a terrible terminology, but you're in this incredible strategy, right? And okay, I reported it, but I'm not paying any tax on it. And then I can just buy the securities again and I get it at today's basis, which is incredible.

Rachel, I mean, this is like the greatest thing ever. So I think people should maximize this as much as they possibly can. Completely agree. And it's important to note, we're completely using up all the 0% tax or the $0 tax that we get in the ordinary income tax bracket, right? Because all we get there is the standard deduction. So if we try, if you are thinking, why don't I fill that up with more Roth conversion? Everything that comes out of the IRA is going to be taxed at your ordinary income. So if we take one more dollar out,

now we're in that 10%, that first bracket of the ordinary income tax bracket. What we're doing is we're taking full advantage of the standard deduction, which is what we can use to offset ordinary income. And then we're going over to the capital gains tax bracket and we're saying, now I want to play within the realm of the 0% capital gains tax bracket. So two different things here, but we're taking full

advantage of everything that we can with the ordinary income tax bracket. And then once that's done, we filled up the standard deduction. Now we're hopping over to the capital gains tax bracket and say, how can I take full advantage here and use qualified dividends, capital gains to make sure that I'm harvesting gains or realizing gains at the 0% tax rate. So we're doing everything with the ordinary income tax bracket, and I've got a ton of room in the capital gains tax bracket after that.

Yep. Love it. So you can see why these are so powerful and why we think this money is not, nothing's trapped. There's nothing like we have this entire set of strategies and it's just, it's fun. It really is fun. So, uh, okay. Rachel, I think we've done a pretty good job of explaining that today. We had a question came in from Steven. So I'm going to read the entirety of this and then have you run with it. So Steven said, I had a question that I think about often.

If the stock market returns on average 8% to 10% per year, could someone make the case to allow their 401k to sit one extra year and then pull from it pre-59 and a half without care of the 10% penalty? I'm assuming that means without worrying about the 10% penalty. The thought process in my head is since you gained an extra 10%, or

assuming this year is on average, and Rachel, we know that the world doesn't work that way necessarily, by letting it sit an extra year before taking the money out, i.e. adding one year to working time, and it grows 10%, wouldn't that offset the 10% penalty for life? Feel free to shoot holes in my theory, but it would be great to hear your thoughts. I know it's not as simple as the account continues to grow straight line over the years,

But I'd still be interested in hearing your opinion. So basically trading one year of retirement for, quote, guilt-free early distributions from your 401k. So Rachel, this is a really interesting one. And I know it was interesting enough that you selected it out of a laundry list. So I want to hear you run with us.

Yeah, I mean, there's a few things here. And I want to start with just the penalty itself, because I think it's important to not look at this within the context of if we grow by 10%, we are eliminating a 10% penalty. The penalty is the penalty no matter what happens in the account. And if we can avoid a 10% penalty, then we should.

And so a lot of the strategy that we talk about is making sure we set up our accounts in a way where we don't have to pay unnecessary penalty. That's the importance of a taxable brokerage account when you retire early. And we've spent so much time talking about how much opportunity you have within a taxable brokerage account to take money out at a 0% capital gains tax rate. I'd rather use that strategy than pay penalty when we don't need to.

So I don't really want to look at this within the context of we add 10%, we eliminate the penalty. It's always going to be there no matter what the account does. And if my account grows, I really don't want to pay penalty on it if I don't have to. I'd rather spend that money than pay any type of penalty.

The other flaw in this is just that they assume 10% average return, which we've talked a lot about. We know that's not how the stock market works. And so as soon as we have a down year, then this theory or this strategy wouldn't work. So we can't assume a steady march of 10% every single year. We can't rely on that for a withdrawal rate. We know that. We have sequence of returns risk.

So that's another reason that this is not something I would really recommend. And we just, we aren't hacking the system here by allowing that extra year of compounding and in hopes of offsetting the penalty. But I do think it's important to note that

You talked about this earlier, Brad, but there's the option of paying the 10% penalty if you ever need access to the funds. Sometimes the best solution, if we don't have accounts built up on the taxable brokerage side, and maybe we need one or two years from a traditional account so we can get to the age 59 and a half, sometimes you could pay the 10% penalty and your plan could still be successful. And that's better than...

feeling like you have to return to work. So I do think it's always important because we talk about retirement accounts in the context of it being locked up. And I think that's unfair because it's never really locked up. You just have a penalty if you need to access those funds. And some people might need to access the funds for a year or two in order for their retirement to survive and for them to get to age 59 and a half. And I don't think that's a bad option if it works out and we've stress tested it. But

As far as let's just let the account compound, get that 10%, that's not really going to work. Not a sound strategy that I would employ. Yeah, it's a cute thought, right? But we can never be sure of anything. So you can't, you wouldn't trade a year of your life

for anything. I think ultimately, Stephen, and let's be clear, like I do weird things. I'm sure you do weird things. We all do weird things psychologically to try to make ourselves feel better when it comes to money, when it comes to, hey, am I going to actually be at five? Am I actually going to make no money? Am I going to like, I get it. And that's why we talk about one more year syndrome all the time. Like,

Steven is just adding another wrinkle to one more year of syndrome. Oh, I could work one more year to pay the penalty. And I mean, listen, I get it. I really do. So this is in no way, shape or form or either Rachel or I like talking down to Steven in any way, because we all do wacky things. That's why I say constantly like,

Your money, the actual nuts and bolts of the five journey, like the money is maybe 5% of the journey, five or 10% of the journey. Because once you have it on autopilot, you figured out where everything is needs to go. It's pretty easy. And the rest of it is like basically in your, your brain, it's trying to behaviorally figure out like, okay, how can I make this work?

And listen, at the end of the day, if this makes Steven feel better, then go for it. I'm actually okay with that. But is it a sound strategy, like mathematically? No, of course not, because we can never be sure of anything. And frankly, most of us

are so ultra conservative when it comes to our money and especially all of our five calculations and not including social security at all and taking our expenses and then kind of just magically grossing them up 10, 20, 30% to say, Oh, I think my expenses are actually 40,000, but I'm going to say my fine number is based on 60,000. It's like, it's inexplicable, right? So Rachel, we, we build layer upon layer of conservatism in, and then we still overreact.

fall prey to one more year syndrome. So it's like, yeah. Okay. We all need to take a deep breath and just say, okay, look, we have to look to actual experts. People like Carson at early retirement now, who's written, I think it last counts 61 parts on safe withdrawal rate. And you can say, all right, look, I understand there are very few certainties in life.

But you can also say, all right, look, his math has said something to the effect. The last time I checked a 3.25% withdrawal rate is going to work in just about every scenario. So if you use that, if you were as conservative as Carson would want you to be, you don't then need to build all those extra layers of conservatism. The no social security, the extra expenses, all this other nonsense, right? Like you got to stop the madness at some point.

Like, we have to. And then you have a Frank Vasquez who's incredibly intelligent who would say, hey, maybe the withdrawal rate could be as high as 5% or higher, depending on the whatever portfolio he's put together. And so, like, people of good faith can argue about this. But, like, at the end of the day, you're never going to have certainty. So if you're looking for that, like, is it worth giving up this?

year upon years upon years of your life to like work extra to get that down to, Hey, my withdrawal rate's only 1%. I've done it. But then you gave up your entire forties working an extra five to 10 years. Like, I know I'm kind of rambling here, Rachel, but like, it's so important that like, this is,

psychological and behavioral. And I think we need to understand that. Like, we're never going to come up with the trick that like magically works about this. It's just, what are you comfortable with? And are you okay being a little bit flexible at points, right? Like, Hey, if all goes terribly and you happen to retire,

or reach fi at the worst possible scenario where the market plummets and stays down. Like, are you going to really lemming style ride that into oblivion? Like, I doubt it very much. I suspect you're going to do something to lower your expenses or earn a little bit of money or whatever. Like again, to try to go into something like projection lab, which is a wonderful tool or some other retirement projections and calculators. And like, say I need it to be a hundred percent. Like, I think that's the fool's errand. And I,

I would argue like, let's stop having that being the starting point. Yeah, you couldn't have said it better. I see this constantly. And honestly, it's one of the reasons that even though I'm deep in the FI community and there's some controversial opinions about financial planners, it's why I really believe in the work that we do, because often the work we do is giving a client permission.

yes, you're good to go. Yes, I've stress tested your portfolio. Yes, I've double checked all of your numbers, or you're not good to go. And we need to adjust this or tweak this. Or here's a way to take out money at the 0% tax rate. I see this constantly. And I think the worst thing that can happen is you don't consult somebody on this. If the only thing that's stopping you from retiring is a fear that you haven't run the numbers correctly, or that you're

missing something. We've got a lot of great financial planners now that are flat fee. They can work with on a project basis that you can work with for one year or two years, and they can give you the go ahead and the green lights if that's what you need. But so many people I see are

don't believe they can fully retire on nothing other than just a gut feeling of I don't have enough because the numbers completely contradict their belief that they don't have enough to retire. So I think the worst thing that can happen is to your point, Brad, the one year syndrome, the feeling like, oh, well, because I haven't perfected this strategy, I don't have enough in the brokerage account. I can't do it.

Retirees have so, so many strategies. We've talked about it with taxes, but we also have it with early withdrawals. We've had Rule 72T. We have the Rule of 55. There are so many ways we can work around penalties and early withdrawals and not enough in the brokerage account. So don't let that be the reason that you defer, delay retirement.

Because we have these available to us and we should take advantage of them, especially if it means an extra year of retirement or an extra year before you try some other endeavor. I mean, we should use everything we have available to us. I think we do have to think about it logically. But at a certain point, we have to realize when it's our psychology holding us back and the numbers are all there, it all makes sense. And so sometimes the solution is something different rather than running more numbers. Yeah.

Wholeheartedly agreed. Absolutely. But yeah, great, great question. Nevertheless, and I like, I do love when people come up with novel, novel solutions to things. And like, so this is not to say, like, don't think outside the box. I think that's what we're good at in the fight community is thinking outside the box. And it's not to say that just because someone hasn't uncovered something that there will never be some alternate solution. But, you know, Rachel, obviously a lot of things we are just making up to make ourselves feel better. And I think that's, it's important to be cognizant of that.

All right, Rachel. So to finish off here, we have a really interesting email from Matt. And I'm going to read the intro on this, and then you're going to run through the actual steps. So Matt said, Brad.

I was listening to your latest mailbag episode with Rachel, and I wanted to offer a clarification on what you two were saying about the pro rata rule when looking to convert the after-tax contributions in a traditional IRA into a Roth IRA as part of a backdoor strategy. In the episode, you two made reference to the fact that the conversion would be less attractive to people who have a substantial amount of pre-tax contributions.

whether within a single traditional IRA or across multiple because of the tax implications of the pro rata rule. That is true. And many people, including myself for a long time, chose not to convert to avoid those taxes. However,

there's a loophole, which I guess means there's a loophole within a loophole. If you have access to a 401k that allows inbound transfers of pre-tax funds, you can move everything except the original cost basis of your after-tax contributions to that 401k, leaving you with the funds in the traditional IRA that you can then convert with no tax implications. Granted, not

Not everyone has access to a 401k, let alone a 401k that allows inbound transfers. But if you do, it's a simple strategy to execute. So Matt then came up with a quick write-up of these steps. And Rachel, I know you have dove into this on social media and such. So I'm not sure if it was informed by Matt's email or if you were working on it separately, but this is a wonderful, wonderful email from Matt. So I'll let you pick it up from here.

I love this email. I actually started working on this because I had a client with this situation. And then I saw the question and I got really excited to dive into this because a lot of people don't know about this. But first, I want to start by just saying this might seem tedious, but I actually think this is one of those weird things that are really worth it because I really hate after tax basis in an IRA.

With the after-tax basis, you've got earnings that are growing on it that's all taxed at the ordinary income rate when you could have them in a Roth growing tax-free. A lot of people forget about after-tax basis because they miss it in a tax return, they switch accountants, and so they end up paying double tax when they do eventually pull out money from their IRA. So I always think it's really worth it to clean up after-tax basis within an IRA if we can. So to their point, it's a weird hack. It's

a loophole within a loophole. Everything here is completely legal, but it's a workaround where we can separate those after-tax dollars from the pre-tax dollars. Because to the reader's point or listener's point, if we try to convert that over to the Roth, there's no way to separate it out. We can't just convert the after-tax dollars. The loophole is we can roll over funds into your 401k if you're

401k allows for inbound rollovers, but 401ks only allow for pre-tax dollars to be rolled over into the 401k. So because of that restriction within the 401k, we say, okay, I'll just roll over my pre-tax dollars and you can find your after-tax basis by looking back at tax returns. If you don't know what it is, that's going to be reported on form 8606. So basically you say, all right,

deal, I will roll over my pre-tax dollars into my current 401k. And now what's left within your IRA is all after-tax funds. Because it's all after-tax, we can do it just like a backdoor Roth and convert those funds into the Roth IRA, pay no taxes on it because this is your basis, you've already paid tax. And when tax time rolls around, you've got $0 balance in the IRA. You're

you're avoiding that tax on the conversion, and you've got all your pre-tax money within the 401k. So you've cleaned everything up. And now if you want, you can actually take this a step further and say, wait, I liked my pre-tax dollars within the IRA. I want to roll that back over if you're

401k now allows for it. Now, once the tax year is over, you could hypothetically roll it back into the IRA. That's where you prefer the money to go, but everything's cleaned up and your IRA now only has pre-tax dollars or has a $0 balance. And you can start things like backdoor Roth IRAs. But the gist of this is if you have access to a current 401k with your current employer that allows for inbound rollovers, you can actually get those pre-tax dollars

out of the IRA. You're left with the after-tax dollars converted over to the Roth, and now everything is cleaned up within the IRA. Well, that is mighty interesting. Yeah.

Absolutely interesting. Yeah. And this is something that a lot of people want to do or scared to do. Don't know if they can do it or worried about the intricacies. And this is a really nice, like you said, this is a wonderful email from Matt. So Matt, thank you so much. And Rachel, thank you for making it pretty clear. So yeah, for anybody, obviously, just like always, this is hard to kind of go through on a podcast, but listen to it again and

And just know that this exists. You need to figure out, hey, does my 401k allow for this? That's the first step. But then it does seem fairly straightforward, right? It is. It sounds really overwhelming. It's actually not too bad. There's a great Kitchis article on it, which I'm happy to send over if you want to include that. But it makes it really clear. The other thing is just working with your employer on that inbound 401k rollover. They'll help you through the process. But first, we have to make sure you know what your after-tax basis is. And then after that,

It's not bad. Like I said, I'm helping some clients do it and it's been fairly smooth process. Love it. Rachel, as always, thank you for being here. I really appreciate it. Where should people reach out to you or find you? Yeah. Website, rachelcampwealth.com, which will essentially lead you everywhere, but social media camp wealth on almost every platform. Okay, great. Well, as always, thank you for being here and thanks for listening to choose a value and being part of the community.

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