Early retirement offers many benefits. The obvious benefit, of course, is . . . well, retiring early. But perhaps a less obvious benefit would be the tax advantages available to early retirees. The advantages are often hidden behind the complexity of the tax code.
A quick Google search claims that the U.S. tax code is a whopping 70,000 pages long. A tax attorney writing for Slate fact-checked this. He found that it is actually only “about 2,600 pages.” Even this was an estimate, though, because the book “starts at page 100, and then skips 500 pages in its numbering.” Confusing enough?
Luckily, we don’t have to know everything in the tax code (or even its true number of pages) to develop an effective tax plan. There are only two key principles that you need to understand if you want to retire early:
First, tax deferral allows you to pay considerably less taxes in your working years. You can then recognize your income over many years at lower rates, potentially as low as 0%.
Second, investment income is taxed much more favorably than earned income. This is also a huge advantage to early retirees who will live primarily off of investments for the majority of their lives. This basic understanding of tax law can allow you to retire far earlier than you may have thought possible.
These principles can best be demonstrated with an example. Let’s consider a couple earning $160,000/year who submit their taxes as married filing jointly. They choose not to live up to their means. Instead, they elect to have a very high savings rate. They live a comfortable, but not extravagant lifestyle on about $40,000/year. This allows them to save well over half of their income, even after taxes. This would allow them to achieve financial independence in about 10-15 years.
Resource: This calculator estimates when you can retire early based on your savings rate
(Note: These numbers were chosen for simplicity of demonstration. The principles and not the exact numbers are important. The principles work regardless of income. For further simplicity, we will ignore inflation and use 2016 values throughout the example.)
Principle 1. Tax Deferral Is Your Friend
Many people are confused as to why you would use tax deferred investment accounts such as a 401(k) or IRA. You may ask, won’t I just owe taxes later? The answer to that question is yes… unless you don’t.
To understand this concept, one first must understand the difference between marginal and effective tax rates. Your marginal tax rate is the rate paid on the last dollar that you earn in a given year. It is the highest rate you pay on any of your income. Your effective rate is determined by dividing actual tax paid by total income. The numbers are quite different. Let’s break it down:
In 2016, the standard deduction for a married couple is $12,600. Everyone is then entitled to a personal exemption of $4,050. For two people this is $8,100. Therefore, their first $20,700 (12,600+4,050+4,050) is free of federal income tax. The remaining $139,300 is taxed as follows:
- The first $18,500 is taxed at 10%, equaling $1,850.00
- The next $56,750 is taxed at 15%, equaling $8,512.50
- The last $64,050 is taxed at 25%, equaling $16,012.50
This couple’s total federal income tax bill is $26,375. Their marginal tax rate is 25% and their effective federal income tax rate is 16.48% ($26,375/$160,000), if they pay all taxes in the year they are earned.
However, they can choose to defer some taxes. By maxing out two 401(k) contributions at $18,000 each, the couple can defer taxes on the last $36,000 they earned. All $36,000 would have been taxed at the marginal rate of 25%. Thus only $28,050 (64,050-36,000) is now subject to the 25% tax.
This reduces taxes by $9,000 from $26,375 to $17,375. Their effective tax rate is reduced from 16.5% to 10.85%. They now have the extra $9,000, plus all of the compounded dividends and interest, working for them in investment accounts for years.
Read About 3 Money Rules That Will Guarantee an Early Retirement
When it comes time to spend their tax deferred money in retirement, the couple will owe federal income tax on this money. There are multiple ways to access money from retirement funds early. Because they live on $40,000/year their tax bill would look like this:
- The first $20,700 falls into the standard deduction/personal exemption and is tax free
- The next $18,500 is taxed at 10%, totaling $1,850
- Only the last $800 is taxed at 15%, totaling $120
The total tax on $40,000 in retirement is $1,970. Their income was shifted from a 25% marginal tax rate to a 15% marginal tax rate. More importantly, the effective tax rate on these dollars, the amount they actually pay, is reduced from 25% to only 4.9% ($1,970/$40,000).
That is a pretty impressive savings. However, I mentioned above that an early retiree may pay no taxes at all on this deferred money. To understand this, we must next understand the second principle.
Principle 2. Not All Income Is Taxed Equally
Our example couple had a very high savings rate. Even after maxing out tax deferred accounts, they were still able to save substantial amounts in Roth IRAs and taxable accounts in their working years.
Any money contributed to a 401(k) or Traditional IRA is taxed as ordinary income when taken from the account, because the tax was never paid at the time it was earned. However, any money contributed to a Roth IRA or taxable investment account already was subjected to income taxes. Therefore they are not taxed as ordinary income a second time.
Learn More: Leveraging Both a 401(k) and a Roth IRA for Retirement
In retirement, money can be taken from Roth IRAs free of any further taxation. Money contributed to taxable investment accounts (cost basis) is also free from further taxation, because it was already taxed. You will owe capital gains taxes on increases in the value of your investments when you sell them.
Currently, capital gains are taxed very favorably for those with low incomes (i.e. most early retirees). According to IRS Topic 409: “The tax rate on most net capital gain is no higher than 15% for most taxpayers. Some or all net capital gain may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets.”
Related: The Pros and Cons of After-Tax 401(k) Contributions
Taxable income for a married couple filing jointly could reach $96,000 before they would be pushed above the 15% marginal tax rate. As you can see from our example couple above, they easily fall into the 15% marginal tax bracket living off of $40,000/year. This gives them 5 options to pay no federal income tax in retirement.
- They can take their first $20,700 (standard deduction + personal exemptions) in income from tax deferred money tax-free. Then, they can take the other $19,300 from Roth IRAs tax-free.
- They could use money from tax deferred accounts as above tax-free. Then, they could utilize taxable accounts. This taxable money would consist of a combination of tax-free basis and taxed long-term capital gains. Since long-term capital gains for those in the 15% marginal tax bracket is taxed at 0%, it is also tax-free.
- All $40,000 could be taken from Roth IRA accounts tax-free.
- All $40,000 could be taken from taxable accounts. Since this money would be taxed at 0% due to their low income, it would essentially function as a Roth IRA.
- They could use any combination of the tax-free options.
Why Early Retirement Offers Such Tremendous Advantages
There are a three key factors that make the tax advantages so great for early retirees. The first factor is developing a high savings rate as required to build wealth for early retirement. This allows using a timing strategy, shifting income from years when it is earned but not needed to years when it is needed and taxed at far lower rates. If you spend every dollar that you earn, you lose this ability to defer money or control when, and at what rates, it is taxed.
The second factor is having a long time period over which to recognize this income. Spreading the income over many years allows it to be recognized in the lowest tax brackets. Those with a traditional retirement have a shorter time frame to recognize tax deferred income. During the majority of a traditional retirement, the retiree will receive social security and be subject to required minimum distributions. This income can push the income into the higher tax brackets and negate much of the advantage of the tax deferred saving.
The final factor is the relatively low cost lifestyle that allows saving large amounts of money enabling early retirement. This low cost lifestyle also allows people to pay very little tax in retirement. The sweet spot is to keep living expenses in retirement low enough to stay in the 15% marginal tax bracket. This allows money in tax deferred investments to be recognized at low tax rates and investment income to be tax free.
Putting It All Together
Early retirement requires living below your means during your working years. The relatively low cost lifestyle required to retire early also allows for tremendous tax advantages in retirement. This gives early retirees several excellent and completely legal options to greatly reduce taxes in their working years and then further limit or even eliminate taxes in retirement.
The post How to Save Money on Taxes By Retiring Early appeared first on The Dough Roller.
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