Early Retirement Tax Planning 101

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Complaining about taxes is our national pastime. Many people think others aren’t paying their fair share. At the same time, we’re all certain we’re paying too much.

Cut taxes with simple tax planning to retire sooner

Nearly everyone complains about taxes. Few people take the time to actually understand the tax code and learn the easy, legal and low risk ways they can reduce their tax burden by tax planning. For the first decade of my career, I was guilty of this.

I spent a lot of time over the past five years learning the ins and outs of the tax code while planning my early retirement and writing about it. Thinking about the tax consequences of my financial decisions has become second nature. This makes me an outlier.

I recently reviewed the blog posts I wrote last year and began laying out my editorial calendar for 2019. Most of the topics I write about have a tax planning component.

So before going further into topics that involve advanced tax planning, it makes sense to take a step back to reinforce a few foundational concepts that form the basis for all tax planning decisions.

*Throughout this post, I use 2019 tax rates, assume tax rates won’t change and ignore inflation to demonstrate basic principles without adding unnecessary complexity or speculation.

Marginal vs. Effective Tax Rates

Not all earnings are taxed at the same rate. For example, in 2019, a married couple, without children, filing their taxes jointly, pay no federal income tax on their first $24,400 using the standard deduction.

They can earn another $19,400 and pay only 10% income tax on that amount. The next $59,550 is taxed at 12%. As you earn more, rates of taxation increase incrementally to 22%, 24%, 32%, 35%, and finally 37% for the highest earners.

These percentages are known as marginal tax rates. Your last dollars earned will be taxed at their marginal rate.

The average rate of taxation is your effective tax rate. The effective rate is calculated by dividing total tax paid by your total earned income.

Let’s demonstrate with a hypothetical scenario. A couple earning $200,000 and not utilizing tax advantaged investment accounts or itemizing deductions would pay $30,493 in federal income tax. A visual is helpful to see how we get that number.

Earned IncomeIncome Tax RateIncome Tax Owed 
$24,4000% (Standard Deduction)$0
$200,000 (Total Income)Effective Rate = 15.2%$30,493 (Total tax due)

Tax Deferred Investing

The second thing to understand is having a high savings rate gives flexibility for tax planning. This allows you to defer taxes on a percentage of your income, enabling substantial tax savings in the year money is earned.

Let’s apply this concept to our example couple earning $200,000. They could save the maximum amount allowed in two 401(k) accounts ($19,000/person in 2019) and a health savings account (HSA) ($7,000/family in 2019). This means they could avoid paying taxes on $45,000 of their most heavily taxed money.

Their marginal tax rate, the highest rate they are taxed, decreases from 24% to 22%. Far more importantly, their effective tax rate, the percent of tax they actually pay, decreases from 15.2% to 10.2%. This translates to a tax savings of over $10,000 in a single year. Let’s break it down again.

Earned IncomeIncome Tax RateIncome Tax Owed
$45,0000% (Tax Deferred Saving)$0
$24,4000% (Standard Deduction)$0
$200,000 (Total Income)Effective Rate =10.2%$20,449 (total)

If you spend every dollar you earn, you lose the ability to defer taxation of income and control when and at what rates it is taxed. Developing a high savings rate works greatly to your advantage when tax planning. This is a great incentive to lower your cost of living and develop a high savings rate.

Timing Strategies

Conventional thinkers say you are not really saving all this money in taxes. You are simply deferring taxation and will have to pay later.

Part of developing the high savings rate that enables early retirement means developing a lower cost lifestyle. Retiring early means we have many years with little or no earned income. This combination allows spreading out taxes over long periods of time at lower tax rates, possibly as low as 0%.

Let’s return to our hypothetical couple, who shifted taxation of $45,000 that would have been taxed at 22-24%. This saved them $10,044 in the year they took this action. This also allowed them to invest the tax savings where it could go to work for them for years or even decades, rather than watching the money disappear to the tax man.

Assume with a paid off mortgage to minimize housing costs, they could live comfortably on $45,000 per year in retirement. If they took the $45,000 they deferred when working and used it to meet retirement spending needs when they had no other income, their taxes would be $2,084. This is a real tax savings of $7,960. No fancy tricks and no advanced knowledge are required. Let’s look at it in table form again.

Earned IncomeIncome Tax RateIncome tax Owed
$24,4000% (Standard Deduction)$0
$45,000Effective Rate =4.6%$2,084 (total)

Having a high savings rate allows for dramatic tax savings in the year money is earned, accelerating the journey to financial independence with simple tax planning. This enables an arbitrage opportunity, shifting taxation of those dollars from high rates in the year they are earned to much lower rates when you need the money and don’t earn income.

Roth IRA

To this point, I’ve focused on the advantages of investing in tax-deferred vehicles. Tax-deferred accounts allow you to defer income in the year it is earned, allow investments to grow without annual taxation, then pay taxes when the money is taken from the account. Tax-deferred saving is advantageous if you anticipate being in a lower marginal tax rate when you will need this money.

But there are advantages to Roth accounts as well. A Roth IRA gives tax diversification and more flexibility when developing strategies to withdrawal money.

Roth accounts require you to pay tax in the year money is earned. Investments in these accounts then grow tax free forever and are withdrawn without further taxation. Low wage earners paying little or no income tax may benefit by using a Roth IRA rather than tax-deferred accounts.

After filling up tax-deferred savings options such as work sponsored retirement accounts and health savings accounts, you still have the opportunity to utilize a Roth IRA. This is simple if you’re income is below the IRS limits for Roth accounts. Even if you have a higher income, you can still utilize a Roth IRA by adding one step. This is known as a backdoor Roth contribution.

Taxable Investments

The next principle is that not all income is treated equally by the IRS. Earned income from a job is taxed most heavily. The more you earn, the less friendly the tax code is. As we shift from earned income to income created by investments, the tax code shifts further in our favor.

For now, let’s focus on paper investments consisting of stocks and bonds. I favor holding these investments in low cost index funds or exchange traded funds (ETF) in large part because they are simple and tax friendly.

Most investment income (qualified dividends and long-term capital gains) is taxed at only three rates: 0%, 15%, and 20%. The tax rate is 0% for those with incomes roughly equivalent to the top of the 12% marginal tax rate. Interest and short-term capital gains are taxed at your marginal tax rates.

This tax structure gives further incentive to learn to live well for less, allowing you to pay little or no tax on investment income.

Living Better for Less

The US tax code is friendly to early retirees. Even if you don’t desire a traditional retirement, strategies like semi-retirement, cutting down to part-time work or having one spouse retire before the other when you can live on a lower income can allow you to earn income with greater tax efficiency.

Keeping taxable income in the lowest marginal tax brackets produces a low effective tax rate, and it allows most investment income to be taxed at 0%. Some people can get hung up on the idea of living on a “low income,” so it is worth exploring what that means in relation to the tax code.

Without doing anything to lower your taxable income, a married couple with no kids could earn or take distributions from tax-deferred accounts up to $103,350 utilizing the standard deduction in 2019, before reaching the top of the 12% marginal tax bracket.

According to the most recent US Census data, the average American household income is $59,039. Being able to live on over $100,000 with little tax liability allows you to live far better than most, even if your spending looks like everyone else’s.

When you don’t have to earn an income, you can drastically reduce income taxes and eliminate payroll taxes. Once you’re financially independent, there is little need for life or disability insurance. A retiree can eliminate the costs of working such as commuting, work clothing, etc. Many people choose to pay off the mortgage before retiring as well.

This allows a large portion of retirement spending to go towards items like travel, entertainment or anything else you value. You can live better than most people, while spending far less. Not needing a large income enables you to pay little or no taxes.

Tax Benefits for Higher Spenders

Some people desire a lifestyle of higher spending in retirement. You could spend well over $100,000 each year by supplementing taxable income. Saved cash, basis on investments (the amount contributed prior to growth) and money from Roth IRA accounts can all be withdrawn completely tax free. This tax diversification allows you to use income from a variety of sources to keep your tax burden low.

Lower spenders can utilize these sources of income in combination with tax-deferred income or earned income up to the standard deduction to completely eliminate income tax once they cut their earned income.

Save Without Sacrifice

You can use tax advantage investments to pay less tax while working. You will pay little to no income tax once you cut back paid work. This crushes one of the largest expenses most people have throughout life with absolutely no sacrifice … unless you enjoy paying taxes.

Further Reading

If you want to explore this topic further, my tax avoidance strategies were heavily influenced by Brandon, aka the Mad Fientist. You can read through his full archives on the topic here.

Darrow has written on this blog about why he doesn’t fret about taxes. He’s demonstrated how low his taxes are in early retirement, without applying much effort to reduce them. Check out his posts from 2014, 2016 and 2018 to see how low his effective tax rate has been.

Others have a different take on the topic. For those who want to optimize retirement taxes, Jeremy writes at Go Curry Cracker how to never pay taxes again. He then summarizes how he’s actually accomplished it in his first 5 years of early retirement.

Portions of this post are excerpted from my upcoming book, Choose FI: Your Blueprint to Financial Independence. The book explores lessons from a variety of people who have achieved financial independence quickly to demonstrate key principles that you can adapt to your own life.

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