How do I pay zero income taxes?

Paying taxes is not a bad thing

Before I go further, let me share my opinion on taxes. When you talk taxes, it tends to get political. So, I am going to keep this brief and short. First off, the intent of this article is not to advocate not paying taxes. I personally believe paying taxes are an important part of being part of a functioning society. Taxes fund the government to run the country. Now, we are all probably on a spectrum in terms of how much we feel the government should tax us or if we feel the government is utilizing our tax dollars wisely. I don’t blame people for feeling that way. On the other hand, optimizing your taxes to ensure you pay minimal taxes in a legal way is also not a bad thing. So you can treat this article either as a mere intellectual exercise or as something enterprising people can execute on. Whatever your opinion is on taxes, I encourage you to at least be aware of how something like this can be executed.

W2 income is not the way to go tax free

Let’s start with a bit of a sobering truth. If your source of income is W2 income, it does not matter how low it is, you still end up paying taxes. The taxes that you must pay by law in the US, irrespective of your income, are payroll taxes. Everyone must contribute to social security and Medicare. Both are intended to be a form of saving for retirement which you ideally should see paid back to you in some form after the age of 65. This amount is typically 15.3% of which is half is contributed by the employer and the other half by the employee. So, in effect, every W2 employee has to contribute 7.65% of their income (this is not entirely true because the social security portion of payroll taxes cap out at an income of $147,000 for the year 2022 – so the max you will get deducted is 6.2% the social security portion of $147,000 which is $9114. So, for higher income earners, this becomes a smaller percentage of their income). Anyway, the gist is if you earn W2 income, you need to pay social security taxes.

Let’s look at 3 different scenarios by imagining 3 fictitious couples. They are all at slightly different stages of their life and all of them end up paying zero income taxes though the last scenario does involve payroll taxes.  

Scenario 1 (Amy and Victor) – Zero taxes

Our first scenario is around a couple by name Amy and Victor who are now retired, in the year 2022. They are both 50 years of age and have built up a portfolio of $3M in mostly stock and bond assets with a roughly 60/40 Stock/bond asset allocation. Half of this is in taxable brokerage accounts and the other half is in their 401K retirement accounts. That essentially means they don’t get to touch the 401K money until they turn 59.5 without penalty (there is a way to do it at age 55 but we won’t go into that to keep this simple). They are empty nesters and don’t have dependents. Their annual expenses are around $80K. They also have an emergency fund equal to 2 years of expenses in cash. Now, lets examine their tax situation:

• They sell 4% of their $1.5M portfolio of stocks every year approx. generating around $60,000 in income. Because these are assets that were purchased more than 1 year back, these are considered long term capital gains (gains made from the sale of an investment).
• In addition, they also earn around $21,500 in dividends through this $1.5M portfolio. These are considered ordinary income.
• Per the 2022 Long term capital gains tax, a couple filing jointly any long-term capital gains up to $83,350 in annual income is taxed at 0% tax. Their $60,000 in income from the long-term capital gains is therefore taxed at 0% tax rate.
• What about the dividend income of $21,500? These are taxed at ordinary income tax. However, in 2022, tax filers can claim up to $25,900 of standard deduction from their taxes. Standard deduction is the amount up to which people can pay ZERO income taxes. I did not mention which state they live in. They could live in one of the 7 states in the US with no state income taxes or in one of the states which are aligned to the federal standard deduction.
• So, Victor and Amy therefore have created an income stream that attracts zero income taxes.

Scenario 2 (Anish and Akshara) – Zero taxes

Our next fictitious couple are called Anish and Akshara, also in the year 2022. They are 55 years of age and have decided to retire. They are also empty nesters. They have a real estate portfolio of 3 rental properties they have been fully paid off. These were all acquired in the last 10 years. They also have $1M in taxable brokerage accounts and another $1M in 401Ks which they don’t plan to touch until age 59.5. These accounts have a roughly 60/40 Stock/bond asset allocation. Their annual expenses are around $75K. They also have an emergency fund equal to 2 years of expenses in cash. Now, let’s examine their tax situation:

• Their rental properties earn $900 per month (after all expenses are paid) per property generating an annual income of $32,400. Refer my earlier article showing an example on financial independence through rental properties that explains these numbers. However, thanks to the amazing tax deductions (the primary one being depreciation) that can be made for rental properties, they only show an income of $12,000 per year on these 3 rental properties. This is all perfectly legal btw and the US tax code offers this to incentivize real estate investors. This $12,000 is taxed as ordinary income.
• They also earn dividends of $13,000 through their $1M taxable brokerage accounts. This is also taxed as ordinary income taxes.
• They sell 4% of their assets out of their $1M taxable brokerage account portfolio generating $40,000 in income. This is taxed as long-term capital gains.
• Following scenario 1, we already know up to $25,900 of income is tax free thanks to the 2022 standard deduction rate for couples filing jointly. So, the rental property income of $12,000 and dividend income of $13,000 fall within this threshold and they pay zero taxes on these.
• Following scenario 1, we know that up to $83,350 of long-term capital gains are taxed at zero income taxes. So, the $40,000 in long term capital gains is taxed at zero % tax rate.
• So, Anish and Akshara have created an income stream that attracts zero income taxes.

Scenario 3: Sam and Sandra – only payroll taxes

Sam and Sandra are 40 years old and still working and live in Florida. They have 2 kids in elementary school. They both make a combined W2 income of $122,500. They are super savers and have successfully managed to pay off their primary residence and their annual expenses are around $50,000 per year. These expenses include around $5000 per year of child-care expenses. They keep around 6 months of expenses as an emergency fund in cash. They aggressively contribute to their tax advantaged retirement accounts by maximizing them despite their modest income. They maximize their employer 401Ks at $20,500 each. They also contribute to an IRA at $6000 each. Finally, they also maximize their HSA (Health Savings Account) at $7300 for the family. To look at their tax situation, let’s build a table to make it easy. Below are all assuming 2022 Federal tax brackets for married filing jointly:

Note that they still must pay 7.65% of payroll tax amounting to $9,371 per year. But outside of that they pay zero income taxes – in fact they even got a $55 tax refund! They live in Florida, so they don’t pay any state income taxes.

What are some caveats to the above scenarios?

I oversimplified the above scenarios just to help understand a framework on how to think through taxable income and tax deductions and credits. There are a few key considerations from a financial and tax planning perspective:

1. Withdrawing 4% may or may not be appropriate during retirement. I talk about this in the article on ‘How much money do I need to retire?’. But there are scenarios where 4% may be too aggressive or too conservative. This article from Kiplinger’s gives an overview of the challenges. It is beyond the scope of this article to suggest strategies to overcome this but there are ways to mitigate this.
2. Long term tax planning particularly on tax deferred accounts like 401Ks is important – again, it is beyond the scope of this article to talk about different methods like Roth conversions to plan a longer-term strategy for the rest of your life, in order to mitigate taxes. The above simplified scenarios don’t take those into account.
3. Your annual expenses are not very high – Its clear from the above examples that if someone had annual expenses greater than $109K (in 2022 terms to be precise, up to $83,350 + $25,900 = $109,250 can be tax free in the above scenarios), you will end up having to pay taxes. But you obviously need to have a larger portfolio to withdraw that much. And when you do, to be honest, generating capital gains income to support expenses of say around $150K-$200K is not going to attract a lot of taxes. You will still end up paying around 15% taxes at best. If you have annual expenses that requires income well beyond even $200K, then maybe you need to really evaluate whether your expenses are justified.

In general, the examples are over-simplified, and you must always consult with your financial planner before finalizing your plan. The intent was to show that with the right kind of income, you can dramatically reduce your tax burden, if not eliminate it.

Concluding comments

The first 2 scenarios talked about individuals who are 50 or above. But it could be anyone at any age. However, from a practical perspective, not too many people are able to build the size of stock or rental portfolio before that age. However, there is a growing group of people who follow the FIRE (Financial Independence Retire Early) movement who have been successful doing this at earlier ages. So, it can be done.

There are several ways that are way more sophisticated than what I explained above to legally avoid or mitigate taxes. The examples I have provided above are simple ones, but likely more common and what the average Joes like you and I would experience. Ultimately each person’s tax situation is unique and you should consult with your tax planner/financial planner. I merely wanted to provide a framework on how to think about this.

Thank you for reading and I wish you success in your financial wellness journey!

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.