By Dr. Jim Dahle, WCI Founder
Early retirement provides some amazing opportunities tax-wise. It's entirely possible to pay no taxes at all during early retirement. However, that isn't usually the goal. Still, most early retirees are paying less in taxes (at least as a percentage) than at any other point since they started earning and, in many cases, less than they will be paying in later retirement after Social Security and Required Minimum Distributions (RMDs) kick in for them.
In today's post, we'll go over a few examples of early retirees that illustrate important principles of taxation during this time period.
You Only Pay LTCG Taxes on the Gains
The Johnsons made big money for a decade (about $1 million a year) and paid correspondingly high tax rates. About 1/3 of their income was going to payroll, federal income, and state income taxes. They were sick of it. So, they saved up a whole bunch of their income, invested it wisely, and retired at 50. They have some tax-deferred and tax-free accounts, but like most early retirees, they have a substantial taxable account too. That is what they are planning to live off of during their early retirement years.
Their total nest egg is about $4 million, and they've decided they can safely spend about $150,000 a year. Their taxable account is about $1.5 million. A significant chunk of that money just went into the account in the last few years, and so the gains are minimal on those tax lots. Naturally, they've chosen to sell the lots with the highest basis first. The taxable account kicked off $30,000 in qualified dividends. They sold $120,000 worth of high-basis shares they had owned for at least a year—only about $15,000 of that $120,000 consisted of gains. This amount could be even less if they've been carrying forward capital losses from tax-loss harvesting. They also earned a little interest on the cash in their savings account, about $5,000. The total of their taxable income was:
- $5,000 in ordinary interest
- $15,000 in long-term capital gains
- $30,000 in qualified dividends
- Total: $50,000
What is their tax bill? The standard deduction is $29,200 [2024]. Their taxable income is only $20,800. The ordinary interest would be taxed at $0 because it is more than covered by the standard deduction. The rest of their income is in the 0% qualified dividends and 0% LTCGs brackets. So, they pay nothing in tax. Nothing in federal income tax. Nothing in payroll taxes. While state-dependent, they quite possibly also pay nothing in state income taxes (they actually would owe about $1,000 in state tax if they lived in Utah).
The Johnsons have gone from paying over $300,000 a year in taxes to paying $0 a year in taxes. Pretty sweet, right? Actually, most people would argue that this setup isn't very wise for them and that they'd be better off selling lower-basis shares, doing Roth conversions, or even tax-gain harvesting to at least maximize the benefit of that 0% bracket and maybe even the 10% and 12% brackets.
More information here:
Life in the 0% Long-Term Capital Gains Bracket
How to Use Tax Diversification to Reduce Taxes Now AND in Retirement
IRMAA and PPACA Subsidies
There are two other factors that come into play that aren't usually considered when you think about taxes. The first is called IRMAA, the Income Related Monthly Adjustment Amount for Medicare. Basically, if you have more taxable income in retirement, Medicare costs you more than it otherwise would. Here are the IRMAA brackets:
These numbers are Modified Adjusted Gross Incomes (MAGI) (not a taxable income), but still, the Johnsons are way below where they would have to start paying IRMAA. This wouldn't apply anyway, since they're 50, not 65, and don't qualify for Medicare yet.
The second factor, which is relevant to the Johnsons' situation, is the Patient Protection and Affordable Care Act (PPACA) subsidies. Buying health insurance off the PPACA exchanges is usually a good move for early retirees. While health insurance isn't cheap for people in their 50s, the subsidies for someone with income so low that they don't even pay any taxes are substantial. For the Johnsons with a $50,000 MAGI, their health insurance subsidy will be $1,147 per month or $13,764 per year. That may or may not cover the entire premium, but it's basically the equivalent of almost $14,000 a year in tax-free income and nothing to sniff at.
Even with a MAGI of $150,000, they'd still be getting a subsidy of $257 per month. The subsidies are normally paid to those with income ranging from 100% of the Federal Poverty Level (138% in states that have expanded Medicaid) to 400% of the Federal Poverty Level (FPL). FPL is determined by geographic area and family size. For a family of two in most states, it is $19,750 for 2024. So, 400% of FPL is $79,000. However, through 2025, that 400% income cap doesn't even apply, thanks to the American Rescue Plan and Inflation Reduction Act. Here's a good resource and a calculator if you'd like to learn more about PPACA subsidies.
More information here:
Healthcare in Retirement Could Cost You $500,000; Here’s How to Plan for It
What If You Have No Taxable Account?
The Gonzalez family in Texas is actually wealthier than the Johnsons. I guess we shouldn't be surprised since they didn't retire until age 55. They have $6 million. However, they've taken advantage of access to a wide variety of retirement accounts throughout their careers and even done a few Roth conversions. Their $6 million is $4.5 million in tax-deferred accounts ($2 million in IRAs, $2.5 million in 401(k)s, and $1.5 million in Roth IRAs, of which $400,000 is contributions). They're planning to spend $200,000 this year and are trying to decide how they should take it.
They know that the Age 59 1/2 rule only applies to traditional IRAs and Roth IRA earnings. They figure it will be easy to avoid that 10% penalty. They'll just take tax-deferred money from the 401(k)s where the penalty doesn't apply and use contributions/conversions to the Roth IRAs. Looking at the brackets, they see this:
They figure that paying taxes at 12% is a good deal but that 22% isn't such a good deal. That allows them to take $94,300 + the standard deduction of $29,200 for a total of $123,500 out of their 401(k)s. They'll take the other $76,500 out of their Roth IRAs. Their total tax bill is $10,852. It's not $0, but it's dramatically less than they were paying before retirement and only about 5% of what they can spend.
What About Kids?
While many people don't retire until their kids are gone or even out of college, what if that's not the case? There are “kiddie benefits” in the tax code that most high-income professionals are normally phased out of and can't get. That might not be the case for an early retiree. What if the Gonzalez family still had a 16-year-old at home in 2024? That's a $2,000 child tax credit. Now, their tax bill is only $8,852.
That child has an older sibling in college. They easily qualify for the American Opportunity Tax Credit (AOTC), available up to a MAGI of $180,000 for a married couple. Since they paid $15,000 in tuition, they qualify for the entire $2,500 AOTC, reducing their tax bill to $6,352.
Maximizing the Situation
Careful planning in these early retirement years can go a long way. You can have plenty of spending money without much of a tax bill, but you can also work the system to lower future tax bills using “tricks” that cause you to pay a little more in taxes now but reduce future tax bills for you or your heirs. These include tax-gain harvesting and Roth conversions. Let's go back to the Johnsons who have decided they want to do as big of a Roth conversion as they can while not paying taxes at more than 12%. How much of their tax-deferred accounts can they convert this year?
Their taxable income was only $20,800. But most of that was qualified dividends/LTCGs, and those stack on top of any Roth conversion, which is taxed as ordinary income. Still, they don't want to be bumped into the next QD/LTCG bracket (15%). That bracket starts at a taxable income of $94,050. That is just slightly lower than the top of their 12% tax bracket ($94,300). At any rate, the difference between $94,050 and $20,800 is $73,250 and that is the amount on which they're going to do a Roth conversion. That will cost them $8,326 in additional tax. That's still a pretty good bargain, although it would reduce any PPACA subsidy.
What if instead they decided to tax-gain harvest? The equivalent would simply be to sell low-basis shares rather than the high-basis shares they were planning on selling. Since the top of the 0% LTCG bracket is $94,050 and they've only got $5,000 in interest and $30,000 in qualified dividends, they could realize gains of as much as $94,050 + $29,200 – $5,000 – $30,000 = $29,850 before having to pay any tax. By carefully choosing tax lots to sell, they can probably get pretty close to that for their $115,000 in spendable income and still pay nothing in tax (other than a reduced PPACA subsidy if applicable). If they were willing to pay 15% in tax (and I'm not saying they should), they could sell any shares they wanted and tax-gain harvest most of the others as the 15% LTCG bracket extends to $583,750. However, the PPACA/NIIT taxes (3.8%) would kick in at $250,000 of taxable income.
More information here:
Why So Many Non-Qualified Dividends? Let’s Look Through My Tax Info to Figure It Out
Principles to Remember
What good is a WCI post without a list? Here's what to think about when considering taxes in early retirement.
- Taxes can be very low in retirement, especially early retirement before Social Security, pensions, and RMDs. You can just enjoy the low taxes, or you can take advantage of the opportunity of being in those low brackets to do Roth conversions and possibly even tax-gain harvest.
- Due to healthcare costs, there is more to the calculations than just taxes. Consider the impact on PPACA premiums and, later, IRMAA surcharges.
- The 10% penalty applies to IRAs before age 59 1/2, but so long as you've separated from the employer, 401(k)s and 403(b)s are free game starting at 55. There is no 10% penalty when it comes to 457(b)s. This is a good reason for retirees to wait to roll money out of a 401(k) until they are 59 1/2. However, there are lots of exceptions to the 10% penalty, including health insurance premiums, educational costs, and early retirement via SEPP withdrawals.
- While you generally want to sell/spend high-base shares first, there are times when it can make sense to sell lower-base shares or even tax-gain harvest to take advantage of the 0% (or possibly even the 15%) LTCG bracket.
- Qualified dividends and long-term capital gains stack on top.
- Roth IRA contributions can come out penalty-free at any time. Conversions (i.e., Backdoor Roth IRA contributions) require a five-year waiting period from the time of the conversion before the principal comes out penalty-free.
- Tax diversification is very useful. You can carefully blend tax-deferred withdrawals with tax-free withdrawals to maintain your desired tax rate.
- You generally want to spend taxable money before tax-protected money in retirement.
- Even those seeking an early retirement should still max out retirement accounts rather than investing preferentially in a taxable account.
- Retiring early may bring you tax deductions—especially child-related tax deductions—that doctors never qualified for during their working years, due to their high income.
- No payroll taxes are due in retirement because they are only collected on earned income.
- It is entirely possible to spend six figures each year without paying any income tax at all, and you don't have to buy any “special” insurance products to do that.
What is the take-home message for you? Do these analyses make you more or less likely to consider an early retirement? How likely is it that the tax code will remain largely intact by the time you are ready?
Nice post. I enjoyed learning more about reducing taxes in early retirement. The examples were helpful. Thanks!
Glad you enjoyed it.
Hi Jim, love your stuff!
However, either I’m about to learn something incredible for my situation, or you need a bit of clarification on the Gonzalez example.
401(k) money can only be withdrawn at 55 without the 10% penalty if a) you terminate service from the employer providing that 401(k) in or after the year you turn 55 AND b) if that employer’s plan has this option in place (not all do). Right?
even better actually. If your plan allows the rule of 55 (and most do), you can avoid the penalty when you are 54 because it is the year in which you turn 55. So if you turn 55 in October or November or December this year but took a distribution in January of this year, you’re fine
Does anyone know off-hand if the new Ascensus i401k allows it?
Most do so I would expect so.
In my example, the Gonzalezes had separated. Your statement is correct though.
Awesome article! Thank you for publishing this. I have read many of your other articles talking about taxes in early retirement but I found this one, with the drawdown strategies, especially helpful and informative. I had actually been spinning in circles in my head about some of this recently (though I am still quite a bit away from needing any of the info). This was really great helping me plan and understand my future.
I really want to thank you especially because your website has really helped alleviate my burnout. I even truly enjoy my job now and I honestly credit that to the information you’ve provided through this site and your books. Hope to meet you at the conference this year and fangirl a bit!
Our pleasure. I truly believe that financially secure doctors are better doctors.
Great post! I early retired a few years ago and have applied a lot of these lessons. Never really thought about just how low taxes can be at this stage in my life.
Two additional points to consider. At under 250% of the federal poverty limit, they have “cost sharing reductions” in which they juice up the benefits of Silver plans to be higher than “normal” Silver plans. At under 200% of FPL, those benefits will make the Silver plans have nearly the same level of benefits as Platinum plans, which typically means significantly lower deductibles and out-of-pocket limits relative to regular Silver plans. The $50K AGI you provided for the Johnsons could potentially be in the range of these CSR’s, depending on where they live and also whether they have any dependents since the FPL levels are impacted by these factors.
Also, for ACA subsidies, I think the best way to look at those is basically as an additional tax on AGI since higher AGI’s usually translate to lower subsidies. The marginal “tax” rate (ie caused by the reduction of subsidies at higher AGI’s) can be substantial due to how the subsidies are calculated – approaching 20% of AGI. My experience is that this tends to rule out significant Roth conversions, at least until once reaches Medicare age when the ACA subsidies are no longer an issue. Here’s an article that does a good job of explaining this: https://seattlecyclone.com/aca-premium-tax-credits-2021-edition/
Good tip.
WCI,
All good points. I especially like #8:
“You generally want to spend taxable money before tax-protected money in retirement”
People often forget the money wasn’t tax-free that went into the taxable account and its tax inefficiency costs you every day you keep it and it often keeps you from spending money that was tax-free and put in the 401k or TIRA to get that account down to a reasonable size by the time you reach SS & RMDs.
As always, a wonderful article: you don’t find something similar anywhere. ACA is the big obstacle if you retire before 65, especially when the 400 % over FPL was in place.
Yes, important to know if it applies to you or not.
Thanks for this fantastic post. We’re almost identical to the Johnson’s but 7 years older and have a bit more saved. We recently did all the things you mentioned and it’s fairly amazing to be able to do all this.
i retired at 55. i am living off my taxable brokerage for now. i did get to avail of a little of 0% ltcgs for about 20k but that was my first year and i didn’t know where the deductions stacked. so far have done about 700K in roth conversions since no W2 in 3 yrs. no more losses to harvest in taxable and no window for 0% ltcgs since i am doing conversions up to 24% this year. roth assets are 1.5 times now of tax deferred. paying taxes out of taxable. for every 100K in liquidation from my taxable, i assume paying around 10K in taxes since i can mix and match low basis and high basis investments for the liquidation but generally i liquidate the worse performing investments first and leave the better ones to grow further. this allows the taxable to continue to grow in spite of getting pulled from. started at 3% draw rate, still more than what we used to live on. i don’t count taxes paid for conversions as part of my draw. with draw adjustments, current draw in 4th yr of retirement is 4.4% of original retirement liquid assets but now only 2.7% of assets at onset of 4th yr. i will go to 4.5% draw rate in a year or so with current assets with guyton klinger and i would be able to replace my highest ever salary inflation adjusted. just worried about getting used to lifestyle creep.
Lifestyle creep doesn’t happen to people who worry about it. They usually have the opposite problem.
regarding the johnsons, 1M annual salary for the past decade with ONLY 4M in liquid assets. i doubt how realistic 150K annual spending limit will be. to earn that much for at least the past 10 yrs and only have that much( even if they are only 50) implies they are spending much more than 150K per year and a decline in lifestyle is hard to stomach.
this has no bearing on the soundness of tax gain harvesting vs doing conversions for their situation. just the expected spending might be unrealistic.
You’re seriously picking apart the financial habits of a hypothetical family I made up to demonstrate a point about taxation? Merciless.
didn’t realize they were made up
It must have been very convincing! It did make me chuckle a little though. I mean, your assessment is probably right, I just didn’t think all that through necessarily before coming up with the example.
i’ve seen a real life examples of a couple in a financial planning video, recently retired, that have a 1.8 million dollar home(with 400K mortgage left), a boat, 4.5M liquid assets plus a 78K annual pension who think they will live on 141K per year for their annual spending. that level of expected spending is certainly at odds with a high dual income family with an expensive home and a boat. in their case they certainly could spend more without issues especially with the pension but it is just amazing they think that is all they are going to spend. while they can live on it that would probably a big drop in their lifestyle.
that video was actually about planning for their tax efficiency in retirement
I don’t know how else to get people’s actual expenses other than ask them what they are. Obviously those expenses have to include taxes, and advisory fees and everything else. But I don’t think it’s totally bizarre that a couple can have a fancy house and a boat and still only spend $141K a year. Replacing that boat might be a problem but boat maintenance is usually less than $10K a year. And property taxes, even on a very expensive house, don’t have to be that high. Ours is a four figure amount. When you have no payments and you’re only feeding two people, $12K a month goes a long way. We spend quite a bit more than that right now even with no payments, but we also travel extensively, spend extravagantly, and have four kids between 9 and 20.
At any rate, if they’ve got $4.5M and only need $63K from it, I don’t see why you’re so worried about them. I mean, they could take $180K from the portfolio, add it to the $78K pension, and spend $258K. That probably covers just about all of our current spending as long as we’re not buying a new car or boat that year. And that’s with 6 people, one of which thinks an entire family size bag of orange chicken is an after-school snack.
growing kids and the food budget…
that couple is in great shape. that is a great pension. . it is their estimate that seemed unrealistic to me especially since they still have a 400K mortgage leftover, still premedicare age and still with 16K in car loans and travel estimate of 10k annually. living in an expensive house isn’t just reflected in the mortgage payment. it’s everything else associated with living in a nicer neighborhood, nicer cars, social functions more befitting the neighborhood(my sister attends fancy hospital fundraisers a couple of times a year).. as you said they could spend more than 250K without issues. a lot of people may overestimate how much they can reduce their spending in retirement and not prepare enough. this couple is more than prepared but likely still overestimates their reduction in expenses and that is why i thought your example was a real life couple as well.