Early Retirement and Taxes

[recursion49]

Quote:

Originally Posted by Animorph That's pretty much it, with a lot of other tax rules thrown in. It does tie up your money for the half year, so there is an opportunity cost. And there is the tax complications that can be a pain. DW just finished an ESPP period with a big drop in her company stock before we managed to sell (some companies will automatically sell it for you at the final price, but her's doesn't). We made enough to pay for taxes and fees and a few hundred extra by waiting for the stock to rise a little bit again before selling. Not part of our AA, no desire to hold it for a bigger gain.

I think that while it might like a free lunch, because my company sells the stock at 15% below the beginning or ending stock price of a six-month window. However, at the same time, one has to be cautious about the tax implications, because the capital gains taxes might undo whatever discount.

[recursion49]

Quote:

Originally Posted by East Texas In order to reach your goal, you need to understand the basic lifestyle that's allowed most of us to retire early and in reasonable comfort. Live below your means. Support your financial savings and investment plans before you splurge on "gotta have" stuff. Just because you can afford that new car doesn't mean you need it. Also, learn to cook because eating out takes a chunk of money. Think before you buy. It's a lot cheaper to have a good pair of shoes half-soled and heeled than buy new ones. I also brown-bagged my lunch every day except on special occasions. Surround yourself with friends who have similar financial values. Spenders and savers have polarized co-dependent relationships. It's easier for savers to get sucked into the spender's lifestyle than the other way around. DO NOT CO-SIGN for anyone. Never. Carve that line in stone. That means your mother / father/ grandma / favorite cousin / sister / brother / (unmarried) significant other. Anyone who needs a co-signer has (1) already messed up their credit or (2) is buying something they can't afford. It's the easiest way to blow up your financial plan. Your mantra is "I don't co-sign." You don't need to defend your decision. I have a dog-eared copy of The Millionaire Next Door and Dave Ramsey's Financial Peace and I can highly recommend both books. I was just a few years older than you when I decided I wanted to retire at 55. And I did. Living frugally just wasn't that hard to do.

I agree! I think there's a lot of basic "tips and tricks" that often get overlooked. Living frugally is definitely one of them. I've just borrowed Your Money or Your Life, and Early Retirement Extreme from the local library, which I hope will provide lots of good advice!

[RunningBum]

Quote:

Originally Posted by wzxchange I think that while it might like a free lunch, because my company sells the stock at 15% below the beginning or ending stock price of a six-month window. However, at the same time, one has to be cautious about the tax implications, because the capital gains taxes might undo whatever discount.

You're going to max out at 35% short term capital gains, plus whatever state income tax is. There's no way you're going to totally undo any gains or discount. The only reason you shouldn't do this is if you really can't afford to tie up your money and have to stay in credit card debt for day-to-day living, and if that's the case, you've got other problems. The only exposure is that big drop in the few days between the purchase and sell dates that someone hit.

[recursion49]

I'm sorry, I think I might have made a mistake there! Just realized that, after costs are factored in, the taxes won't hurt any return on stock purchase plans.

[Original Wally]

Quote:

Originally Posted by wzxchange That's a good point. However, I read that an exception can be made for 401(k) if I leave my job before 55 - the 72(t) or something. I do have some assets in nonretirement mutual funds (which I might convert to ETFs).

Don't believe you got this answered yet - the exception to the 10% penalty is for distributions made from an employer plan where you RETIRED AFTER 55. So you STILL have that gap to worry about from ER to 59 1/2. If you retire b-4 55, you STILL CANNOT get money until 59 1/2 w/o the penalty. Watch out for State penalty too (California is ANOTHER 2 1/2%)

***CHECK WITH YOUR PLAN ADMINISTRATOR***

[scrabbler1]

Wzxchange, as someone who has already ERed at 45 (I am 49 now), I can tell you what I did. I separated my assets into two parts - one to get me to age 59.5 and the other to get me passed age 59.5. It is the first part which will be more of a challenge but also the one I pay more attention to. I actually now have 2/3 of my investments in taxable accounts because it is my only source of investment income to get me through the next ~10 years. After that, I have access to the first of my "reinforcements" which is unfettered access to my TIRA, being able to collect my frozen company pension, and Social Security.

[samclem]

Quote:

Originally Posted by AWeinel If you retire b-4 55, you STILL CANNOT get money until 59 1/2 w/o the penalty.

If you retire before age 55, could you not simply roll the funds over from the 401K to a traditional IRA (T-IRA) and then do 72t withdrawals without paying a penalty? You'd also have the advantage of much broader (and probably cheaper) investment options. The withdrawals would be limited in size and unlimited withdrawals can't start until 59 1/2 with the IRA (vs 55 with the 401K), but it's something. As a bonus, starting these withdrawals earlier can help reduce taxes later if the RMDs would drive the taxpayer into a higher bracket in later years.
If there's (employer) company stock in the 401k it is generally better to leave it in the 401K rather than move it (the tax treatment is usually better).

[scrabbler1]

Quote:

Originally Posted by samclem If there's (employer) company stock in the 401k it is generally better to leave it in the 401K rather than move it (the tax treatment is usually better).

With company stock, you may be able to cash it out (like I did) as NUA - Net Unrealized Appreciation - and cash it out at long-term cap gains rates and avoid the 10% penalty that way (except on the cost basis).

[recursion49]

Quote:

Originally Posted by scrabbler1 Wzxchange, as someone who has already ERed at 45 (I am 49 now), I can tell you what I did. I separated my assets into two parts - one to get me to age 59.5 and the other to get me passed age 59.5. It is the first part which will be more of a challenge but also the one I pay more attention to. I actually now have 2/3 of my investments in taxable accounts because it is my only source of investment income to get me through the next ~10 years. After that, I have access to the first of my "reinforcements" which is unfettered access to my TIRA, being able to collect my frozen company pension, and Social Security.

I was wondering if anyone has advice regarding an ideal nonretirement/401k/IRA proportion? I know each has its own advantages, but I can't really decide if I'd prefer to increase my 401k past the maximum for employer matching, or retain the funds and place them in a nonretirement/IRA.

Then, there's also the issue of having a HSA to hold into the future, which would provide pretax health spending, and can be converted into an IRA later on to further boost my savings.

My current savings "trajectory" would leave me to roughly 50% in nonretirement, 25% in Roth 401k, and 25% in a Roth IRA, which makes me wonder if I'm overdoing the 401k. As my income grows, I intend to start contributing to a traditional 401k, to reduce my taxes.

Any suggestions would be helpful!

[scrabbler1]

Wzxchange, I can't say I have any magic formula regarding an ideal ratio of non-retirement to retirement investments. But I would ask you if you have reinforcements like those I have such as a pension or other asset (i.e. cash balance) you can access when you hit a certain age. You have enough credits to be eligible for Social Security, right? The more goodies you have waiting for you later, the less you need to save up for later.

In my years of working, I added some after-tax dollars in my 401(k) in the 1990s and a little more after-tax dollars going to my 401(k) for a few years before I focused more toward my ER in 2007.

[samclem]

Quote:

Originally Posted by wzxchange I was wondering if anyone has advice regarding an ideal nonretirement/401k/IRA proportion?

As you note, much depends on the expected future cash flow in retirement and how that gets "hit" by future taxes. IMO, for most people it'll be useful to have a mix of assets tax-favored and after-tax "pots" to allow some flexibility to adapt to changes during retirement.
If you haven't tried it yet, you might get some value out of ORP. Don't expect to learn much just by entering the numbers into the form, but spend a few hours digging into the results and trying "what-if" entries to understand the impact of the tax laws and you'll be much better prepared make allocation decisions. You're decades from needing the money and tax laws/rates are sure to change in the meantime. While it may be impossible to know exactly how the laws might change, it might be worthwhile to at least ask 3 questions to help decide what the future might hold and what you might do to meet the challenge:
1) Is the government likely to take more money or less money to fund govt operations, entitlements, etc in the future?
2) In retirement, will you likely be in a group of persons taxed at a high level to meet these expenses?
3) If "yes" to Q2, which present tax avoidance/reduction methods are most likely to remain available in the future? (a tough one)

[grasshopper]

Ms G and I are are 50/50 taxable to deferred or free. Retired 6 years and the taxable is still accumulating after expenses. At least this past week.

[RunningBum]

Quote:

Originally Posted by wzxchange Then, there's also the issue of having a HSA to hold into the future, which would provide pretax health spending, and can be converted into an IRA later on to further boost my savings.

Why would you convert an HSA to an IRA? If you don't have enough medical expenses, you can just withdraw from an HSA just like you would from an IRA, but you aren't subject to RMD rules. I'm just keeping receipts for all my HSA-eligible expenses, and at some point I'll start pulling money out tax-free using those expenses.

[ziggy29]

Quote:

Originally Posted by RunningBum Why would you convert an HSA to an IRA? If you don't have enough medical expenses, you can just withdraw from an HSA just like you would from an IRA, but you aren't subject to RMD rules. I'm just keeping receipts for all my HSA-eligible expenses, and at some point I'll start pulling money out tax-free using those expenses.

Not to mention that you can't convert an HSA to an IRA anyway. For all intents and purposes an HSA can be used like an IRA once you turn age 65, but without the RMDs. So really if you have other IRA funds, you can withdraw from those until age 65 and then withdraw the HSA funds for income starting at 65.

[pb4uski]

Quote:

Originally Posted by wzxchange I was wondering if anyone has advice regarding an ideal nonretirement/401k/IRA proportion? I know each has its own advantages, but I can't really decide if I'd prefer to increase my 401k past the maximum for employer matching, or retain the funds and place them in a nonretirement/IRA. Then, there's also the issue of having a HSA to hold into the future, which would provide pretax health spending, and can be converted into an IRA later on to further boost my savings. My current savings "trajectory" would leave me to roughly 50% in nonretirement, 25% in Roth 401k, and 25% in a Roth IRA, which makes me wonder if I'm overdoing the 401k. As my income grows, I intend to start contributing to a traditional 401k, to reduce my taxes. Any suggestions would be helpful!

I think you need to redefine the buckets as taxable, tax-deferred (t401k and tIRA) and tax-free (Roth 401k, Roth IRA and HSAs).

From my ER experience I think the ideal mix depends on when you plan to retire, your living expenses when you retire, any DB pension benefits that can be started upon retirement, etc. If your target retirement date is before age 59 1/2, you need to have sufficient resources to cover living expenses from the target retirement date to age 59 1/2 (or some way of funding those years unless you want to pay the 10% penalty). In most cases, I think taxable investments is the best way to cover that period.

FWIW, I focused more on tax-deferred savings in the earlier years and taxable investments toward the end of my career (which happened to be my peak earning years and I was maxing out on tax deferred so it happened naturally).

I never saw much sense to making after-tax investments in my 401k, but I recently learned that it might be possible to transfer after-tax 401k money to a Roth, and if that is the case in retrospect I would have made more after-tax contributions to my 401k and then transferred them to the Roth upon leaving mega.

While my HSA was only available to me the last few years of my career, I viewed it as a pseudo Roth IRA; a place that I could invest for retirement tax free. I maxed my contributions and then paid for medical expenses out of my take home pay but have kept track of my medical expenses so I could always withdraw an amount equal to my past medical expenses if I needed to.

[ziggy29]

Quote:

Originally Posted by pb4uski I think you need to redefine the buckets as taxable, tax-deferred (t401k and tIRA) and tax-free (Roth 401k, Roth IRA and HSAs).

HSAs are only tax-free when used for medical expenses. After age 65 it also functions like a tax-deferred conventional IRA in that distributions for non-medical purposes are taxed as ordinary income but no longer subject to a penalty.

Nit aside, I'm a big fan of diversifying assets across all of these three categories as well. It makes it a lot easier to "engineer" your income in a way that avoids higher tax brackets. For example, using current brackets one might choose to drain 401Ks and TIRAs until they've almost used all the 15% bracket, then switch to tapping taxable and Roths (and HSAs for medical expenses) for additional income without tripping the 25% bracket.

[pb4uski]

Quote:

Originally Posted by ziggy29 HSAs are only tax-free when used for medical expenses. After age 65 it also functions like a tax-deferred conventional IRA in that distributions for non-medical purposes are taxed as ordinary income but no longer subject to a penalty. .....

In the back of my mind my HSA is a crude form of LTC funding, but I'm keeping all my medical receipts anyway.

[Animorph]

In all the playing I've done with my retirement calculations, it always tells me to max out the pre-tax 401k while DW is still working and our taxes are relatively high. Then convert to Roth during ER when our income is very low. Adding to a taxable account instead of the 401k now results in less value during retirement for me. Even though we'll run out of taxable funds for living expenses and Roth conversions before SS kicks in. Even though the RMD's are going to force us into a higher tax bracket when we don't even need that money. So I think maxing out the tax deferred accounts while you are in the higer tax brackets, then Roth, then taxable, is advisable.

[Mulligan]

Quote:

Originally Posted by pb4uski In the back of my mind my HSA is a crude form of LTC funding, but I'm keeping all my medical receipts anyway.

I like that idea. I hope to have a nice pile of cash in my HSA by the time I am 65 assuming the government doesn't change the rules. Since I will never buy long term care insurance, I could use that. If I am unfortunately still alive after that money is gone, I can just change the direct deposit on my pension check and have it sent directly to the nursing home instead.