March 2024 – Tax Planning for Early Retirement

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OVERVIEW

Embarking on an early retirement journey is a significant life decision that requires thorough financial planning, including considerations for taxes. Effective tax planning can help optimize your financial resources during retirement and ensure comfortable and sustainable financial outcome.

 

FACTS & CONSIDERATIONS

Most qualified retirement accounts have early withdrawal penalties. This means that a taxpayer could set up all their retirement accounts correctly, but the decision to retire early will cause them to pay fines and penalties regardless.

– How can taxpayers set up their retirement portfolio to safeguard themselves against early retirement penalties?

– Ensure there are enough liquid assets in their non-qualified brokerage accounts to last until at least age 59 1/2, if not later. Early retirees can then draw from these liquid assets penalty-free until they reach retirement age, in which case they can then begin withdrawing from their qualified retirement accounts penalty-free.

– Portfolios should be set up with enough liquid assets in them to last the taxpayer until they reach retirement age.

– Portfolio assets should be allocated in such a way that drawing on them will not impede the portfolio’s long-term goals.

– What to do if early withdrawals from retirement accounts are unavoidable:

– Implement a Series of Substantially Equal Periodic Payments (SoSEPP) from the first year of distribution until appropriate retirement age. This sets up a continuous withdrawal plan on your retirement account, and you may only institute this with one retirement account. While the withdrawals themselves will be taxable in the years they are taken, there will be no early withdrawal penalty. To Note: this method is restrictive and easily violated – we recommend that you work carefully with your financial advisor on the plan for this and follow the plan carefully to avoid incurring penalties for early retirement withdrawal.

– Implement The Rule of 55 related to employer-sponsored retirement plans. This rule allows that if a taxpayer turns 55 and loses or leaves their job in the same year, the taxpayer can take penalty-free distributions on their 401(k). Their withdrawals will be taxable, but there is no early withdrawal penalty. To Note: for certain public safety employees, this rule reduces the eligible age from 55 to 50.

– Take Roth Contribution Distributions. If early retirees need to, they can withdraw from their Roth accounts to the extent that they have contributed to them. If the withdrawals do not touch the earnings in the account, the withdrawals will be penalty-free. To Note: there is a five-year hold on the amounts in Roth IRAs that came in via conversion. Please take extra care that if you retire early and withdraw from your Roth account, you are specifically withdrawing amounts you have contributed and not converted. If you are withdrawing amounts that have been converted, please be sure the amounts were converted into the account five years prior to your withdrawal.

 

NEXT STEPS

Early retirement comes with unique financial considerations, and tax planning is a crucial aspect of securing a comfortable and sustainable financial outcome. While this guide provides general strategies, it’s important to tailor your approach to your specific financial situation. Please feel free to reach out to us with your specific questions and we will be happy to assist you as you work with your financial advisor to establish the plan that works best for you.