Tax Strategies for an Early Retirement

While some say it can be done, the chances are slim that you will be able to have a tax-free retirement. Still, financial planners and tax experts identify steps you may take to minimize your tax burden in retirement. Some that you may take while you are still dedicated to your 9-to-5 job could help you reach the promised land of leisure a little early.

“If the ‘average Joe’ plans properly and maximizes these three strategies, he can surely keep his retirement income taxes very low, or even have tax-free golden years,” says certified financial planner, Michael Hardy.

Planning is the key element of a burden-free retirement.

Michael Hardy, a certified financial planner and partner with Amherst, New York-based independent financial planning firm Mollot & Hardy Inc., notes a few options about which he typically advises working-class clients. They include Roth IRAs and profits from the sale of the principal residence.

“A Roth IRA will provide tax-free income at retirement,” Hardy said. “Currently, as long as one falls under the maximum income limit as stated by the IRS, he or she can (contribute) up to $5,000 this year, plus another $1,000 for those 50 and over.”

In regards to real estate, Hardy says a couple filing joint taxes may realize a tax-free gain of up to $500,000 on the sale of their home.

Parents often lecture children about the importance of saving a few pennies here and there whenever they get a little money. Those pennies can add up, children are told.

A Roth IRA allows you to practice such saving on a much larger scale. A Roth IRA is a retirement account funded by after-tax contributions. Qualified distributions of contributions and earnings are not taxed. Experts say taking full advantage of a Roth IRA or a Roth 401(k) is among the best ways of mitigating some of the tax burdens in retirement.

“A Roth IRA can be set up by any financial institution and can hold a multitude of investment options,” said Nick J.D. Olesen, a private wealth manager with the Philadelphia Group in King of Prussia, Pennsylvania. “I do not recommend investors open up any account through a bank or credit union, as those institutions mainly recommend CDs for the investments and do not have access to other investments.”

Roth accounts allow retirees to withdraw income completely free of taxes after the later of attaining the age of 59 ½, or a five-year holding period for the first contribution.

“This obviously can help one plan for being within a certain tax bracket in retirement if they are able to access income from their investments that doesn’t get eaten up by Uncle Sam,” said Kasey Gahler, a certified financial planner.

Gahler, of Austin, Texas-based Gahler Financial, adds that most tax-advantaged accounts, such as IRAs, do not allow investors to access funds prior to the age of 59 1/2 without a 10 percent penalty.

He explained, however, that there are several ways around that stipulation including the Substantially Equal Periodic Payments (SEPP) calculation. It allows the account holder to withdraw funds before the stipulated age, granted the same amount is taken annually until the later of five years or attaining the age of 59 1/2.

The Internal Revenue Service has outlined three ways to calculate the SEPP amount, Olesen said. Each is based on the investor’s age and either the interest rates or Required Minimum Distribution tables.

Other ways which allow investors to access funds from tax-advantaged accounts, such as IRAs, prior to the age of 59 1/2 without a 10 percent penalty include:

• Distributions to the extent the individual’s unreimbursed medical expenses exceed 7 ½% of his adjusted gross income
• Qualified higher education expenses of the taxpayer, spouse, child or grandchild
• First-time home purchases (no home ownership in prior two years) limited to $10,000
• Disability or death

In addition, a one-time tax and penalty-free transfer can be made from an IRA to a Health Savings Account (limited in 2011 to $3,100 for self-only coverage and $6,250 for family coverage).

Will you really need that five-bedroom house with the huge backyard once you have stopped working and all your children have moved out? Probably not. That is why experts say downsizing early can equate to rewarding benefits later.

“Another privilege that one could easily take advantage of is the tax-free gain on the sale of your primary residence,” Gahler says, noting that owners may walk away with up to $250,000 if single or $500,000 if married and filing jointly.

“Having your home paid off prior to retirement can be a major advantage not only in monthly cash flow but also if you plan to move and/or downsize in retirement,” Gahler said. “You are able to take those gains and could use them to supplement your retirement income if needed, or simply allow them to grow in your portfolio.”

Given the complexities involved in most long-term financial strategies, Sean Dowling, president of the Dowling Group, a Stamford, Connecticut-based financial planning firm, said it is important to consult with a tax professional or certified financial planner, as a good understanding of the nuances of the Internal Revenue Code is required. Mistakes could be extremely costly, he noted.

“These are fantastic opportunities available to those that are looking for them,” Dowling said. “Anyone who is interested in pursuing these types of strategies would be wise to seek out competent professionals who can work with them and integrate their tax, retirement and estate planning.”

You have worked most of your life and paid a lot of taxes. Must you really worry about Uncle Sam getting his share of your retirement income? Austin, Texas-based certified financial planner Kasey Gahler says yes.

“There are a number of tax burdens to be aware of in retirement,” Gahler said. “For more retirees, a large majority of their savings is usually in pre-tax accounts such as 401(k)s or 403(b)s.”

Gahler said all of these dollars are taxable as income in retirement — meaning taxed as if you’re working when you are really not.

Another tax to consider, he said, is the potential taxation on Social Security benefits. “Whether or not your benefits are taxed depends on the amount of other income derived from investments, pensions or even part-time work one is bringing in during retirement years,” Gahler said.