Early retirement is an aspiration many people hope to achieve. Through unwavering discipline and consistent savings, a fortunate few of us will attain the goal of having enough passive income to sustain our lifestyle. But learning how to save and invest is only half the battle. In order to achieve an early retirement, minimizing taxes is also paramount. Here are five common tax consequences of early retirement:
Avoid the early withdrawal penalty. Many people are concerned about putting too much money away in tax-deferred accounts. Early retirees often fear they will incur a tax penalty by taking money out before age 59½. But there's a provision that allows early retirees to withdraw their money without penalty if they take their distributions as substantially equal periodic payments. Make sure you follow the rules outlined by the IRS, and you will be allowed penalty-free access to your retirement savings before age of 59½ if you set up your withdrawals as consistent distributions throughout retirement.
A partial Roth conversion can lower your overall tax bill. One tremendous benefit an early retiree has is being able to convert a portion of pre-tax money to post-tax money without paying much tax. Due to their likely low income, a retiree who isn't yet collecting Social Security can elect to convert a bit of their pre-tax portfolio to a Roth while staying in a low tax bracket.
Roth contributions can be withdrawn penalty free at any time. There are enormous tax benefits to having money inside a Roth account. One Roth perk is the option to withdraw contributions at any age without penalty. Just make sure you don't withdraw any of the earnings as an early retiree or you could face a 10 percent early withdrawal penalty.
Include taxes when estimating your retirement expenses. Taxes will continue to be a major expense in retirement, especially if you have a significant amount of savings in tax-deferred retirement accounts. Social Security and investment income could also be taxed at different levels than they are now, depending on the political climate in the future. No one can predict exactly what will happen to tax rates, but make sure that an estimate of your tax bill is included in your retirement budget.
Moving to a different state can mean serious savings. Income tax rates differ from state to state, and some states have no income tax. Sales taxes, housing costs, and the general cost of living can also vary considerably by location and could mean the difference between worrying excessively about outliving your assets and a comfortable retirement. Your address can have a big impact on your budget. Early retirees should consider the financial benefits of moving to a different area of the country. There's always the possibly that a place that costs less could also be more enjoyable.
Retiring early is a great achievement. Just make sure you consider the tax consequences before you decide to leave your job.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.