Tax Tips for Early Retirees

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Tax Tips for Early Retirees


or big 401k contributions really did spell early retirement. Or your diligent savings strategy has paid off. No matter how you got there, congratulations. Setting yourself up to live life as you see fit is the American Dream writ large.

The one problem with retiring early (besides figuring out what to do with all that time) is that quitting work before age 60 doesn't necessarily make you a retiree in the eyes of the Internal Revenue Service. That's why you need to be tax smart when it comes to managing your retirement accounts. Here are some things to think about....

Should I Roll Over My 401(k)?

In short, yes. Rolling over your 401(k) almost always makes a ton of sense. After all, why would you want your former employer overseeing your account? Taking control of that money will open up a world of investment options.

Your plan probably has at most 20 mutual funds to pick from. A rollover IRA will give you thousands of choices. I assume, since you're ready to retire early, that you have a brokerage account. So if you're happy with that firm, you could just roll over your account there.

Of course, if you want some of that money immediately and you're over age 55 (but younger than 59 1/2) take the money out first and then roll over the rest of the account. Thanks to a handy penalty exception for those who quit or retire between those ages, you can take payouts from company-sponsored qualified retirement plan accounts and successfully dodge a 10% early withdrawal penalty. The amount will be taxed to be sure, but it's better than rolling the money into an IRA and then trying to access it.

When Not to Roll Over: Company Stock

A rollover may not be the best option when your qualified retirement-plan account has a bunch of low-cost stock from your former company. If the current market value of the company shares is high in relation to their cost, you should strongly consider withdrawing the shares now and paying the resulting taxes.

The reason is because your tax bill will be based on the (low) cost of the shares, rather than their (high) market value. If you're under age 55, you'll also owe the 10% penalty. But since the cost of the stock is low, the tax hit will probably be manageable even after the penalty. Why follow this strategy? Because it positions you to pay only the 20% capital-gains tax on the difference between the cost of your company shares and the eventual selling price. Here's an example of how cashing in your company stock could benefit you:

Say you decide to bail out of your job at the ripe old age of 52. Your company 401(k) account is worth $500,000. Of that, $200,000 is invested in company shares that cost only $25,000. If you follow my sage advice, you'll roll over $300,000 tax-free into your IRA. So far, so good. Now withdraw all the company stock and put the shares into a taxable account with your favorite brokerage firm. You'll owe income taxes on $25,000, which is the cost of the stock. Plus you'll owe the 10% penalty (because you're not age 55 or older) on the $25,000. Let's say the total tax hit, including the penalty, is 41% or $10,250 (.41 x $25,000). That's the bad news.

The good news is your company stock now qualifies as a capital asset. So if you sell immediately for $200,000, you'll only owe the 20% capital-gains tax on your $175,000 profit. In contrast, if you roll the shares over into your IRA, your profit will be taxed at your regular rates (up to 39.6%) when you start taking IRA withdrawals.

Things will work out even better if you hang onto the shares for over a year and they continue to appreciate. Now any additional profit will also qualify for that nice, low 20% capital-gains rate. Say you hold the shares for 10 years and then sell out for a cool $600,000. You'll pay only 20% on your $575,000 profit. In this example, the future tax savings from not rolling your shares over could be as much as $112,700 ($575,000 profit taxed at only 20% instead of 39.6%).

One word of caution: To be eligible for the favorable tax treatment I just explained, your company stock must be received as part of a lump-sum distribution from the qualified retirement plan or plans in which you participate. Check with your employee-benefits department to make sure your retirement-plan payout qualifies as a lump-sum distribution. You can then roll over the remaining amount into an IRA.

Tapping your IRA

Unlike a company-sponsored plan, there's no special treatment when it comes to IRAs for people between the ages of 55 and 59 1/2. So if you tap your IRA before official retirement age, you usually get hit with the 10% early withdrawal penalty. There are some penalty exemptions — we've listed them here — but as you'll see, some are decidedly less appealing than others:

  • Annuity-like withdrawals taken over your life expectancy. The withdrawals must be taken at least annually for a minimum of five years or until you turn 59 1/2, whichever is later. To figure how much you could withdraw penalty-free under this exception, call us as there are many methods and our recommendation depends upon age, marital status and investment return assumptions.
  • Withdrawals to pay qualified higher-education expenses. This could be for you but more likely it could be used for your kids.
  • Withdrawals to pay deductible medical expenses (the amount in excess of 7.5% of your adjusted gross income).
  • Withdrawals to help pay for a qualified home purchase (there's a $10,000 lifetime limit on this exception). Again, this could be given to a family member.
  • Withdrawals after death or disability.

Tapping Your Roth

The great thing about Roth IRAs is your earnings can be withdrawn totally tax-free. But that's only true if: (1) the account has been open at least five years, and (2) you are at least age 59 1/2, dead, disabled or use the money for higher education or to make a qualified home purchase ($10,000 limit). If you don't pass both parts of the test, the earnings are taxed when withdrawn.

For withdrawals before age 59 1/2, you'll also owe the 10% penalty on those withdrawn earnings, unless one of the penalty exceptions listed earlier applies. That penalty will also apply if you withdraw "conversion contributions" within five years of the conversion. Conversion contributions are those you made by converting a traditional IRA into a Roth and paying the resulting tax hit.

On the other hand, you generally can withdraw Roth contributions tax-free and penalty-free. Even so, you shouldn't do it. Why? Because taking withdrawals mean you'll have that much less to continue investing on a tax-free basis. And think of it this way: If you need the money so badly that you need to immediately tap your original contribution, you probably ought to keep working for a few more years.

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