By Kevin P. Brosious, CPA, PFS, CFP
Early retirees in their 50s and early 60s have life expectancies that could be another 30 to 40 years. They must plan carefully to ensure their nest egg can support them throughout their retirement, and doing so in a tax-efficient way is critical. Often, retirees have both taxable and tax-deferred accounts, such as 401(k)s, IRAs, and so on. Some may have a pension. Because of their age, they are either not eligible for Social Security retirement benefits yet or don’t want to take the discounted early benefit prior to their full retirement age (FRA). They may have enough cash to support their spending until FRA Social Security benefits, or when they can take penalty-free distributions from their retirement accounts. But is this the most tax-efficient way to proceed?
Since these retirees no longer have earnings from employment, most will be in lower tax brackets. If they are in a low tax bracket, they can use this to their advantage.
Early retirees should consider selling some of their taxable investments and realize a long-term capital gain. Long-term capital gains are taxed at 0% for single filers with income levels below $40,400 and joint filers below $80,800. Consider selling funds or securities up to these income levels, either using the cash to support retirement or simply resetting the basis of those taxable investments and then using this higher reset basis to realize lower capital gains later in retirement.
Early retirees should also consider converting some tax-deferred accounts – such as 401(k), traditional IRA, or 403(b), – to a Roth IRA. They can take advantage of the current low-tax environment and pay tax now instead of a probable higher rate when required minimum distributions (RMDs) are taken at age 72, especially if they are planning to defer their Social Security retirement benefits until age 70. Because the conversion will lower traditional tax-deferred account balances, it will also lower future RMDs. Plus, there will be more money in a Roth IRA, which will grow tax-free and would never have to be withdrawn if the funds are not needed.
Or, instead of doing a Roth conversion, early retirees could take advantage of their low tax bracket and take distributions from their tax-deferred accounts prior to their RMD date to fund their early retirement years. They can take penalty-free distributions from traditional IRAs at age 59 1/2, and as early as age 55 from company-sponsored retirement savings plans. Retirees who happen to be younger than age 59 1/2 or 55 can consider a 72t distribution. This allows substantially equal periodic payments from retirement accounts penalty free. The distribution is based on the retiree’s life expectancy and must continue for at least 5 years or until age 59 1/2.
Other considerations could be exercising company stock options, taking 457 plan distributions, restricted stock sale, etc. The whole point is to identify tax arbitrage opportunities across different categories of income for clients.
Also, consider that the current tax law provides homeowners the opportunity to pocket tax-free gains from the sale of their residence up to $250,000 for single filers and $500,000 for joint filers. If early retirees are considering relocating at some point anyway, they may want to consider moving up their date. Remember, there is no guarantee that this or any other tax break will continue indefinitely.
One note of caution: Be careful of other financial implications when applying strategies that may generate additional taxable income.
For example, usually younger retirees are not Medicare-eligible and must secure health insurance from private sources or via the Affordable Care Act (ACA) insurance exchange. If the retiree is applying for ACA insurance, they may be eligible for a premium subsidy, which is based on modified adjusted gross income, not on assets the retiree may own. The subsidy is a tax credit calculated off income relative to federal poverty levels. Any strategy that generates income would likely also impact any subsidy the early retiree may be entitled to receive.
Kevin P. Brosious, CPA, PFS, CFP, is president of Wealth Management Inc., located in Allentown and Plymouth Meeting. He can be reached at firstname.lastname@example.org.
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