If you’re on a path to retire early, it makes sense to acquaint yourself with some wondrous tax savings.
When you’re approaching retirement, these savings deliver motivation to stay the course (there’s a pot of gold at the rainbow’s end). When you’re already retired, these savings point to lucrative tax strategies (there’s a pot of gold sitting on the doorstep).
Because this post provides an introduction only, I don’t explain every tax break in exhaustive detail. But if it’s details you seek, each savings tip links to authoritative sources.
This post also shares my household’s tax planning. Early retirement has figured into our taxes since 2013, which is the first full year we were both retired (I left the workforce in 2008; Mrs. Moose did so in 2012). So far, our tax breaks have produced real world savings of over $85,000—with even more savings due to follow in future years (yet more rainbows and pots of gold).
Will these tax breaks work for you? Consider the enticing opportunities:
1. Your Federal Rate Drops to 10 or 15 Percent
When you stop working full-time, your taxable income plummets. Whereas your federal rate once might have topped out at 25 percent or more, it now peaks at only 10 or 15 percent.
Many early retirees enjoy investment returns or pursue part-time jobs. But even when these produce six figure incomes, it’s still remarkably easy to reach the nirvana of a 10 or 15 percent tax bracket.
Federal tax brackets aren’t based on “gross income,” they’re based on “taxable income,” a figure which is obtained only after backing out:
(1) adjustments to gross income (Form 1040, lines 23-36);
(2) standard or itemized deductions (line 40); and
(3) exemptions for the taxpayer, the taxpayer’s spouse, and any dependents (lines 6 and 42).
Let’s calculate the taxable income for John and Jane Dough, a married couple who retired early. In 2016, they earned $25,000 from part-time work and $75,000 in capital gains from selling stocks. This generated gross income of $100,000—more than enough to stay comfortable. Now, let’s also say they paid $6,550 to their Health Savings Accounts, itemized $20,000 in deductions, and received $8,000 in exemptions for their two person household. These back outs yield a taxable income of $65,350.
So here’s the key tax break: despite the Doughs’ six-figure gross income, their adjustments, deductions, and exemptions have dropped them into the 15 percent bracket for joint filers. Here’s a chart that reports the lower brackets for all filing statuses:
|2016 Federal Tax Brackets: 10% and 15% Rates|
|Filing||10% rate applies to||15% rate applies to|
|Status||taxable income of:||taxable income of:|
|Individual||$0 to $9,275||$9,276 to $37,650|
|Married Filing Jointly||$0 to $18,550||$18,551 to $75,300|
|Married Filing Separately||$0 to $9,275||$9,276 to $37,650|
|Head of Household||$0 to $13,250||$13,251 to $50,400|
The Mooses’ Record. So far, we’ve been able to cap our taxable income each year, paying 15 percent in 2013, 10 percent in 2014 through 2016, and 10 percent in 2017. Had we both lingered in the workplace, our bracket would have been at least 25 percent for each year.
2. Your Capital Gains Aren’t Taxed
If your taxable income stays within the 10 or 15 percent tax brackets, you pay no taxes on capital gains. For an introduction to capital gains, which are reported on line 13 of Form 1040, click here. For more details, see IRS Publication 550.
If you’re curious about how this tax break applies to John and Jane Dough, I’ve run the numbers. The good news: thanks to their 15 percent bracket, the amount owed on their taxable income of $65,350 is ZERO (to see a mock-up of their capital gains worksheet, click here). The bad news: their Adjusted Gross Income (AGI) of $93,450 ($100,000 minus $6,550 in HSAs) is high enough to trigger the Alternative Minimum Tax (AMT). This imposes taxes of about $3,000. Had the Doughs sold less stock and thereby stayed below the AMT threshold for joint filers—$83,800 AGI in 2016—they would have avoided federal taxes completely. Was the Doughs’ tax plan half-baked? 🙂
The Mooses’ Record. We still hold capital loss carryovers from the Great Recession, so we’ve been tapping those to offset earnings and capital gains. Once we’ve exhausted our carryovers, we’ll switch to using our 10-15 percent bracket to avoid capital gains taxes. Unlike the Doughs, we’ll hopefully remember to keep our AGI below the AMT threshold.
3. Your Qualified Dividends Aren’t Taxed
If your taxable income stays within the 10 or 15 percent brackets, you pay no taxes on qualified dividends. For an introduction to these type of dividends, which are reported on line 9b of Form 1040, click here. For more details, see IRS Publication 550.
The Mooses’ Record. During 2013-2016 we’ve stayed within the 10-15 percent brackets and saved $1,851 in taxes on qualified dividends:
|Tax Year||Tax Rate||Qualified Divs||Fed Savings||State Savings||Total Savings|
4. You Can Collect an Obamacare Premium Tax Credit
Despite the results of the recent presidential election, it seems likely that Obamacare will remain in place for the 2017 tax year. After that, who knows?
For 2017, if your Modified Adjusted Gross Income (MAGI)* stays below 400 percent of your household’s applicable poverty level, you can receive a Premium Tax Credit (PTC) for any policies purchased at an approved health insurance exchange. For details about the PTC, which is reported on Forms 8962 and 1040, line 69, see IRS Publication 974.
PTC eligibility is complicated, so use a reliable calculator. For a PTC calculator that covers the 2015 tax year, click here. For a 2016 PTC calculator, click here. For a 2017 PTC calculator, click here.
The Mooses’ Record. The PTC was first offered in 2014 and has benefited us each year since then. We’ve received PTCs of $6,468 for 2014, $6,844 for 2015, and $8,328 for 2016. We project a PTC of $10,041 for 2017—for a four-year total of $31,681.
5. You Can Convert Funds in Traditional IRAs to Roth IRAs
Subject to various rules, the IRS permits taxpayers to transfer money from Traditional IRAs into Roth IRAs. This process is known as a “Roth Conversion.” For details, see IRS Publication 590-A.
Why might an early retiree perform a Roth Conversion? The decision depends on several factors:
A. Taxes. You pay federal income taxes upfront on any amounts converted to a Roth IRA, but you don’t pay taxes on the Roth’s future gains if you meet certain requirements when the funds are withdrawn, i.e., the converted money has stayed in the Roth account for at least five years and you’re at least 59½ years old (or disabled or dead). If you’re an early retiree in your forties in the 10 or 15 percent tax bracket, you might conclude that your tax rate will be higher in your sixties or seventies. After all, current rates are historically low and $19 trillion in federal debt is building political pressure to increase tax revenues.
B. Time. The benefits of compounded interest pay off the longer the transferred money stays in your Roth account. If you’ve retired in your forties, and you’re predicting it will be twenty years or more before you tap into Roth funds, time works very much in your favor.
C. The Lack of Minimum Required Distributions (MRDs). Traditional IRAs require account holders to make mandatory distributions each year beginning at age 70½. These MRDs can push taxpayers into higher brackets. In contrast, Roth IRAs require no MRDs during the life of the original owner. If you believe your future taxes will increase due to mandatory MRDs, the time might be ripe for Roth conversions.
D. Tax Code Revisions. Future lawmakers are free to change the current rules that govern Traditional and Roth IRAs. As a hedge against changes that harm your interests, you might want to consider reallocating retirement assets to effect an more even split between your Traditional and Roth accounts. Roth conversions can help you perform this reallocation.
The Mooses’ Record. While we were employed, we maximized our contributions to retirement accounts. Some years we qualified for Roth IRAs and other years we didn’t because our combined incomes were too high. When we both retired, we began converting some of our holdings in Traditional IRAs over to Roth IRAs. I believe this strategy produces future benefits that outweigh the smallish taxes we’ve paid upfront. The chart below reports our conversions and the taxes we’ve paid (for 2016 I’m projecting zero taxable income). Note: during tax years 2014-2016, we’ve intentionally limited our Roth conversions in order to qualify for the Obamacare PTC (see Section 4 above).
|Tax Year||Tax Rate||Roth Conversion||Fed Taxes||State Taxes||Total Taxes|
6. You Can Contribute to Health Savings Accounts
As an early retiree, you receive bad tax news and good tax news. The bad news is that without a source of earned income, you can no longer fund retirement vehicles such as 401ks, SEPs, and IRAs (although you can fund such accounts through part-time jobs). The good news, however, is that you don’t need a job in order to fund your Health Savings Accounts (HSAs).
HSAs represent a terrific tax break because they offer three different levels of tax savings: (1) deposits are deductible; (2) earnings grow tax-free; and (3) withdrawals aren’t taxed if they’re used to pay qualified medical expenses. For details, see IRS Publication 969.
The Mooses’ Record. Despite our early retirement, we’ve continued to max our HSA contributions (including $1,000 per year in catch-up contributions after I turned 55). The chart below shows our tax savings through the end of 2017. We’ll receive more savings as our HSA investments grow tax-free.
|Tax Year||HSA Funded||Tax Rate||Fed Savings||State Savings||Total Savings|
7. You Can Deduct Medical and Dental Expenses
If you’re under age 65, you can only deduct those medical expenses that exceed 10 percent of your Adjusted Gross Income (AGI). Once you turn 65, however, the threshold for deductibility drops to 7.5 percent of AGI. And if your filing status is married filing jointly, the 7.5 percent threshold applies even if only one spouse has reached age 65. See IRS Publication No. 554 at Chapter 4. Note: starting with tax year 2017, the 7.5 percent threshold expires and taxpayers of all ages will be subject to a threshold of 10 percent.
Most full-time employees earn too much to deduct medical expenses. But once you retire, this deduction becomes more relevant. The most common strategy is to lump your family’s discretionary medical expenses into a single calendar year so that you exceed the 10 percent AGI threshold. For details about which expenses are deductible, see IRS Publication 502.
The Mooses’ Record. We delayed some discretionary health spending until after we retired. We didn’t tap HSA accounts for this spending (had we done so, we couldn’t have claimed the deduction). Nor did we seek to deduct our health insurance premiums (premiums subject to a PTC aren’t deductible). This chart reports our savings:
|Tax Year||Tax Rate||Expenses over 10% AGI||Fed Savings||State Savings||Total Savings|
8. You Can Deduct Sales Taxes
Upon retiring, you pay lower state and local income taxes. This cuts into your deductions if you itemize (see 2016 Form 1040, Schedule A, line 5). But there’s good news: you can make up for this loss by electing to deduct sales taxes in lieu of income taxes.
The IRS provides two methods for claiming a sales tax deduction. If you’ve saved your receipts throughout the year, you can add up whatever sales taxes you paid and deduct that amount. Alternatively, you can use the IRS’s Sales Tax Deduction Calculator to figure your deduction.
The Mooses’ Record. The approach we pick each year depends upon which deduction offers the most benefit. In 2013, sales taxes provided a tax reduction of $147 ($112 federal and $35 state). For tax year 2014, state income taxes provided the greater benefit, resulting in a tax reduction of $294 ($201 federal and $93 state). For tax year 2015, we deducted sales taxes, resulting in a tax reduction of $97 ($66 federal and $35 state). For tax year 2016, we deducted sales taxes again, saving $159 ($109 federal and $50 state).
9. You Can Move to a State with Lower Taxes
Without a full-time job to tie you down, you have more choices about where to live. If you’re inclined to move, assess which states offer the cheapest living costs, including those that charge the lowest taxes on income, property, sales transactions, and estates.
The Mooses’ Record. Post-retirement, we’ve remained in Colorado, which ranks as eleventh in the nation for early retirees (see The Best States for an Early Retirement).
10. You Can Sell Your Home Tax-Free
Without a job tying you down, you’re free to relocate to a new neighborhood. If you sell and have lived in your house for two of the last five years, you avoid taxes on any profits—up to $500,000 for married couples and up to $250,000 for singles. For details, see IRS Publication 523.
The Mooses’ Record. We sold our home in 2015 and saved $36,553 in taxes. To see what I’ve written before about our big move, including the tax savings, click here.
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As always, consult your tax advisor to find out which early retiree strategies work best for you. The tax code is a vast labyrinth of breathtaking complexity. Hopefully, the above list eases your journey, but hiring an experienced guide will make things much easier.
Finally, if you know about any tax breaks that I’ve neglected to include in this list, please comment below.
*For most taxpayers, there’s no difference between MAGI and Adjusted Gross Income, because most households don’t experience any of the three narrow circumstances that trigger MAGI calculations: non-taxable social security benefits (see Form 1040, lines 20(a)-20(b)), tax-exempt interest (see Form 1040, line 8b), and excluded foreign earned income and housing expenses for those who live abroad (see Form 2555, lines 45 and 50).
Photo of early retiree plunging headlong into his taxes by www.efile.com.