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Do you dream of achieving an early retirement? I’m increasingly finding that it isn’t always about leaving the workforce entirely. It’s often more about gaining time and autonomy in your life. It’s about redefining what truly meaningful work means and reaching a point where work becomes optional.

There are both practical and psychological implications associated with pursuing and attaining early retirement. However, since it is also tax season, I thought this would be a good opportunity to examine how financial success in early retirement can be closely linked to your tax decisions.

Proactive tax planning is crucial for everyone, but it can make a particularly significant difference during the early stages of retirement. In this piece, we’ll explore why that’s the case and touch on a few ideas:

• What constitutes an “early” retirement?
• What tax planning opportunities are available?
• What tax planning challenges should you be aware of?

What is Early Retirement?

The average retirement age in the U.S. is approximately 62. However, this figure can vary based on several factors, including gender, education level, and health status. There can also be notable differences in retirement age across states. For instance, the average retirement age in some states is closer to 65.

The average retirement age has been steadily rising over the past few decades. This trend is likely attributed to several factors, including increased life expectancies, escalating healthcare costs, and modifications in Social Security eligibility.

It’s important to remember that the average retirement age is just a general statistic. The best age to retire will depend on your individual circumstances, including your financial situation, health, and personal goals. Some people want, or need, to work until they drop. Others strive with a maniacal focus on early retirement, most notably those embracing the FIRE approach.

No matter how you define “early” for yourself, the challenge lies in generating and maintaining sustainable retirement income. Holding life expectancy constant, the earlier you retire, the more strain you place on these income sources. But what does all of this have to do with taxes?

When you work, you typically pay higher taxes. There are strategies you can use to manage these taxes, but ultimately, you will encounter limitations based on your earned income, such as salary or business income. Another challenge is payroll taxes, which are the portion of your income allocated to funding Medicare and Social Security.

It’s not that limitations on tax planning don’t exist during retirement; rather, you will likely have more control over how you generate taxable income in the first place. This creates various opportunities, which we’ll explore next.

Tax Planning Opportunities

Access Your Retirement Accounts Without Penalty

In the U.S. retirement savings landscape, 401(k) plans are among the most common types of accounts utilized by workers in the private sector. However, other similar accounts are also available, such as IRAs, 403(b) plans (for non-profit organizations), and 457(b) plans (for government employees). If you are self-employed, SEP IRAs or Solo 401(k) plans may be available options.

In the traditional (non-Roth) version of all these accounts, contributions are made on a pre-tax basis. Therefore, what they share in common is that when you begin to spend from these accounts in retirement, you’ll encounter income taxes and potential penalties if you’re not careful.

The standard age for penalty-free withdrawals is 59 ½. If you take a distribution before this age, you may incur a 10 percent penalty. However, if you manage to achieve early retirement at a younger age, several exemptions to this penalty could apply. Here are some of the most common opportunities I observe in practice for retirees.

• Rule of 55 (for 401(k)s):
  • If you leave your job (voluntarily or involuntarily) in or after the year you turn 55, you can take penalty-free distributions from that specific employer’s 401(k) plan.  
  • Put another way, this rule applies only to the 401(k) plan from the employer you left. It doesn’t apply to previous employers’ 401(k)s or IRAs.  
• Substantially Equal Periodic Payments (SEPP) or 72(t) Distributions:
  • You can take penalty-free distributions before age 59 1/2 if you set up what’s called a series of substantially equal periodic payments.
  • This approach can be powerful, but it’s somewhat complex and requires good organization and record-keeping to ensure compliance with IRS rules.
• Disability:
  • If you unfortunately become permanently disabled, you can take penalty-free distributions, regardless of your age.  
• Qualified Domestic Relations Order (QDRO):
  • Distributions made under a QDRO, which is a court order related to a divorce, are generally penalty-free.  
• Certain Medical Expenses:
  • Distributions used to cover certain unreimbursed medical expenses that exceed 7.5% of your adjusted gross income may be free from penalties.

So, assuming you can avoid the penalties, the next level of tax planning involves taking the correct amount of distributions to place you in the desired tax bracket or, at the very least, steer clear of unexpected tax surprises.

Build Your Roth-style Accounts When Possible

What’s notable about a Roth conversion is that it may be the single most important tax-planning tool in your toolkit. However, they are also widely covered in financial publications, including our own blog.

I’ll emphasize one key point for early retirees: Given the right circumstances, the initial years of early retirement can be the most opportune time for making Roth conversions. This means you are deliberately accelerating taxable income now to benefit from tax-free treatment in the future.

The rationale is that the years of early retirement may subject you to your lowest tax rates. For example, regarding your federal income taxes, this could encompass the 10, 12, or 22 percent tax brackets. This is a bit of an oversimplification because your actual taxes are also affected by factors related to Social Security, Medicare, or RMDs (all discussed later).

A significant caveat: If you plan to make substantial Roth conversions in early retirement, it assumes you won’t need those same converted dollars for your living expenses. In other words, you must sustain your lifestyle with other resources, such as cash reserves, investments in taxable brokerage accounts, or even strategic borrowing.

Additional benefits of building your Roth-style accounts include:

• Better tax diversification of your accounts, allowing you greater flexibility to adapt to future tax code changes.
• Asset location, which enables you to strategically place different types of investments in your Roth versus non-Roth accounts to more efficiently capture tax-free growth.

Where You Can Get Flexibility and Favorable Tax Treatment

Moving on from retirement accounts, you may have built a significant portion of your retirement wealth in taxable brokerage accounts. There are a few reasons why these types of accounts can be so beneficial for early retirees:

• Flexibility and Accessibility
  • Unlike qualified retirement accounts (401(k)s, IRAs), there are no age restrictions on withdrawals. You can access your funds at any time without penalties.  
  • If you can’t arrange an exemption to the penalty (as described earlier), the flexibility of having taxable accounts can be crucial.
• More Favorable Tax Rates (Possibly)
  • Long-term capital gains (profits from assets held for more than a year) are taxed at favorable rates, often lower than ordinary income tax rates. This can significantly reduce your tax burden when selling investments to fund your lifestyle.
  • For those of you in lower overall tax brackets, there may be opportunities to take capital gains and pay no federal tax at all. Others may face tax rates in the 15 to 20 percent range (for example), which still might be more advantageous than your ordinary income tax rates.
  • Certain types of dividends are also eligible for potentially lower capital gains tax rates, while interest is always taxed at your ordinary tax rate.
• Tax Loss Harvesting:
  • You can strategically sell investments that have lost value to offset capital gains, reducing your overall tax liability. I describe the nuances in more detail in our earlier post: Should You Tax Loss Harvest in Down Markets?

This isn’t universal, but taxable brokerage accounts often make sense to “tap first” in early retirement. There are other strategies, such as pro-rata, where you take what you need proportionately from all available accounts. Effective tax planning involves determining the optimal priorities and combinations tailored to your specific needs.

Relocation Can Impact Your Taxes

Have you thought about relocating to a new state for your retirement? It’s a big decision! Several factors can impact your overall cost of living in the new state, including housing and healthcare. However, let’s explore some key areas that directly influence the taxes you will pay.

• State Income Tax:
  • Determine State Income Tax Rates: States vary significantly in their income tax rates. Some states, such as my current state, Texas, do not have an income tax, while others have high rates. California currently holds the distinction of having the highest marginal income tax rate of 13.3 percent.
  • Consider the Taxation of Your Retirement Income: Most states exempt Social Security income; however, a handful of others tax a portion of it. Most states, among those that have an income tax, will tax distributions from retirement accounts; however, some exemptions may apply.
  • Residency Rules: Establish clear residency in your new state to avoid being taxed by your former state of residence. Each state has its own residency rules.
• Property and Sales Taxes:
  • Research Property Tax Rates: Property taxes can vary widely between states and even within different counties or cities within a state.
  • Consider Homestead Exemptions: Some states offer homestead exemptions for seniors, which can reduce property tax liability. The typical age at which this option is available is 65, but this varies by state and locality.
  • Compare Sales Tax Rates: Sales tax rates also vary significantly between states. You could factor in the impact of this on your everyday spending.
• Tax Implications of Investments:
  • State Tax on Dividends and Interest: Some states tax dividends and interest income, while others do not.
  • Consider State Tax on Capital Gains: Some states tax capital gains, while others do not.
• Healthcare Costs and Taxes:
  • State-Specific Healthcare Costs: Healthcare costs can vary between states.
  • Tax Implications of Healthcare: Some states offer tax deductions or credits for healthcare expenses.

Bonus Tips on College Planning

If you are supporting children in college during your early retirement, you might qualify for one of two main tax credits: the American Opportunity Tax Credit (AOTC – up to $2,500 per eligible student) or the Lifetime Learning Credit (LLC – up to $2,000 per tax return). For 2025, both require a Modified Adjusted Gross Income of less than $90,000 (Single) or $180,000 (Married Filing Jointly).

Next, here’s a sort of indirect tax and college planning tip. You may want to review how the taxable income you report can affect the financial aid you receive. I provide an in-depth example in our earlier piece, How to Play the College Financial Aid Game.

Based on current rules, the income reported on your tax return is typically the primary factor determining the amount of need-based financial aid you can expect to receive. It’s essential to carefully analyze the numbers to decide if intentionally lowering your income is beneficial for saving on college costs. At our firm, we utilize a tool called College Aid Pro™, which significantly assists with this type of evaluation.

Tax Planning Challenges

One of the reasons tax planning challenges exist is the complex nature of our tax code. It’s not just about looking at a tax table and finding what bracket you fall into. The actions you take or don’t take have other ramifications. Let’s examine a few examples.

Social Security

Social Security income can play a key role in your retirement planning. For most, the earliest age at which benefits can be claimed is 62, and the latest is 70. Determining the optimal claiming age is a crucial decision and one that we covered in an earlier article.

One reason you might delay claiming your Social Security is that it is usually taxable, which could impact some of your other tax planning strategies in early retirement.

The amount of Social Security benefits that may be subject to federal income tax depends on what’s called your provisional income. It is calculated by taking your Adjusted Gross Income (AGI) and adding any tax-exempt interest, as well as 50 percent of your Social Security benefits.

Depending on where this provisional income falls, up to 85% of your benefits may be taxable. This may not seem significant at first glance. However, consider one of our retired clients who lives a modest lifestyle and receives Social Security. We assist them in avoiding federal taxes (for now) by managing their taxable income. We aim to keep their income below the threshold where they would otherwise experience a jump in their federal tax rate from 0% to 18.5%.

The challenge is that you can’t solely depend on standard tax tables to resolve this. In practice, we utilize advanced tax planning software and run iterations until we achieve the desired result. It’s not the most glamorous work, but it can be effective.

Two Stages of Health Insurance

Stage 1 – Before Medicare

If you’re retired, but under the age of 65 and don’t have access to a retiree health insurance plan from your previous employer, there’s a good chance you’ll get your health insurance through the marketplace or exchange.

This type of insurance, introduced with the Affordable Care Act, may help cover the gap between the start of your early retirement and the onset of Medicare.

The primary concept relevant here is the Premium Tax Credit (PTC). For individuals and families who maintain their household income (MAGI) below specific thresholds, the PTC ensures that their insurance premiums do not exceed 8.5% of their MAGI.

Put another way, the higher your income, the higher your effective insurance premiums are. It’s like a portion of your health insurance premiums is a tax. Then, it’s up to you to decide whether it’s worth trying to minimize this tax.

It may take some creativity to plan well around this. Strategies like the Roth conversion mentioned earlier can increase your income and may inadvertently lead to higher health insurance premiums. In more extreme cases, you may consider strategic borrowing options, such as a Home Equity Line of Credit (HELOC), a Securities-Based Line of Credit (SBLOC), or a Reverse Mortgage Line of Credit (RMLOC). While any of these options involve some risk, the money you borrow doesn’t typically increase your taxable income.

Stage 2 – Medicare

For most of you, when you reach age 65, you transition into Medicare. The income considerations are not as severe as those covered by the Affordable Care Act plans, but they can be important to know if your income falls in the higher ranges in retirement.

Medicare has an “income-related monthly adjustment amount”, also known as IRMAA. These are added to your Part B and Part B premiums.

The main way to stay on top of the IRMAA is to project and monitor your income for the next two years. Why two years? It’s because the Social Security Administration uses your MAGI from two years ago to determine your current IRMAA. For example, 2025 premiums are based on your 2023 MAGI.

If you’re not already on Medicare, remember this starts to become a consideration the year you turn age 63.

Don’t Forget About Required Minimum Distributions (RMDs)

I thought it would be appropriate to conclude with this challenge. Recent tax law changes have delayed the age at which RMDs must begin. It used to be 70 ½; now, it’s between ages 73 and 75, depending on your year of birth. Why mention this in the context of taxes for early retirees?

The actions you take, or don’t take, during early retirement can significantly impact your future RMDs and your overall lifetime tax burden.

Setting aside the nuances of inherited IRAs, RMDs only apply to accounts on which you haven’t paid taxes, such as traditional (or pre-tax) IRAs and 401(k) plans.

The extent to which you avoid distributing from such accounts merely defers an inevitable tax bill. This tax bill will eventually be paid either by you or by those who inherit your retirement accounts.

A balancing act is involved in proactive tax planning. Strategies, such as the Roth conversions mentioned earlier, can help mitigate the impact of RMDs.

For those who are charitably inclined, it’s worth exploring Qualified Charitable Distributions (QCDs). The way they work today is, if you’re over age 70 ½, QCDs can be used to satisfy required minimum distributions (RMDs) while reducing taxable income.

Concluding Thoughts

Whether you read or skimmed through this piece, I hope you can appreciate that proactive tax planning can play an important role in your early retirement plans.

Our tax code is incredibly complex and seems to grow more complicated each year. As we have a new administration this year, we’ll see what changes are made that impact any or all of the items we covered.

As broad as this piece is, it doesn’t cover everything. For example, how do the concepts we just discussed integrate with other sources of income, such as part-time wages, pensions, permanent life insurance, and rental income? Also, are there opportunities for tax credits in retirement that you didn’t have while working? There are numerous combinations that can unfold.

Even if you are interested in learning about this topic yourself, there are many nuances and intertwining factors that can make it essential, if not outright necessary, to seek professional advice throughout the process. There is great value in working with a qualified financial advisor who can help navigate the intriguing overlap between tax and retirement planning.

If you have comments or questions on this piece, please drop me a line at: [email protected]

References

1. https://krishnawealth.com/cultivate-your-optionality/
2. https://krishnawealth.com/is-now-the-time-to-do-a-roth-ira-conversion/
3. https://krishnawealth.com/should-you-tax-loss-harvest-in-down-markets/
4. https://taxfoundation.org/data/all/state/state-income-tax-rates/#:~:text=Some%20states%20tie%20their%20standard,or%20offer%20none%20at%20all.
5. https://krishnawealth.com/how-to-play-the-college-financial-aid-game/
6. https://krishnawealth.com/the-top-four-questions-im-asked-about-social-security/
7. https://www.healthcare.gov/
8. https://krishnawealth.com/the-value-of-having-debt-capacity/

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