Starve the Tax Monster: My Early Retirement Income Tax Strategy

I like to apply a title to my projects and plans. It’s my way of adding a little fun. My 2017 Early Retirement Income Tax Strategy is named “Starve the Tax Monster”. I know that it’s the season for thanks, charity, worship, family, and friends. But this is a great time of year to review our personal finances for this year and the next.

Starve the Monster: My Early Retirement Income Tax StrategyPlease don’t get me wrong. I do love the celebration of everything that is good and decent in the world during the holidays. But I still take a little time now before the year comes to an end to assess my financial stuff and especially taxes.

By doing this I have time to make adjustments and this year I’m glad that I did.

You may find similar issues in your own tax situation.

Tweaking My Early Retirement Income Tax Strategy

Step 1- Set Income Tax Goals

I believe the first step is to identify one’s tax strategy goals. My goals are simple.

Stay in lower tax brackets. I will do this through establishing threshold base taxable income limits to keep my taxes as low as possible. I fund my lifestyle with a combination of taxable and non-taxable income. My income tax efficiency goal is to be in the 15% tax bracket or lower.

Keep things simple-No shady strategies. I will have no complicated schemes or maneuvers and I will pay my fair share but nothing more. I don’t want to do anything that would be difficult to defend or puts my name on an IRS auditor’s desk. It is all about flying below their radar.

Never withhold so much that it causes a large tax refund. In fact, my goal is to NEVER get a refund and always owe some tax at tax filing time. There’s no reason to give the government an interest free loan.

Step 2 – Run the Numbers

At this time of year I have all my income projections and tax withholding details. I keep track of these things along with my budget so I don’t need to wait for any W2s or 1099s to do this.

I use tax software each year to prepare my taxes so I just set up a test tax return on the last tax filing year’s software and plug-in my end-of-year numbers. In the old days I did my taxes by hand. I would simply print out the tax forms to do this.

Even though there will be small changes in Standard Deductions and Personal Exemptions for the following year this is close enough. Since we are mortgage free we don’t have enough deductions to go Schedule A so we use the Standard Deduction. When I was still with a mortgage I would use the previous year’s numbers which worked out well enough for this exercise.

This test tax return’s result will let me know whether I am on track with my income tax goals and give me an estimate of what I will owe or be refunded.

This year I screwed up big-time and I have over $2000 in Federal Tax refund projected. I never saw it coming so it is good I found out now.

Step 3 – End of Year Income Tax Efficient Options- This Year

Most people would be happy to see a $2000 refund to look forward to. But I hate the idea that I will file a return and then wait for the Government to send it to me when they feel ready to pay me back.

I like to look at my options and long-term retirement funding goals. Part of which is my future efficient Social Security tax strategy of which Roth IRAs are critical.

Action to take- Based on my test income tax results I’ve decided to eat up the refund with Roth Conversions which are a huge part of my early retirement tax efficiency moves.

I reran my numbers through the tax software test return and found I can convert $17,000 to a Roth IRA and the increase in what I will owe in my State taxes won’t be too bad. I was planning on doing a smaller Roth conversion this year anyway.

Step 4 – Income Tax Efficient Tweaks for the Upcoming Year

The fist thing I did after seeing the test tax return results was kick myself and then figure out what happened.

Early in 2010 after my first early retirement I started my lifestyle funding with a SEPP (72t) Substantially Equal Periodic Payments to sidestep the early withdrawal penalty. I also set it up to withhold 10% for Federal income taxes from each monthly distribution.

This arrangement serves me well when I’m doing my “retire early and often” thing. This year I only had a 3 month craft beer-tender gig for a couple of four-hour shifts a week. Our taxable income of less than $35,000 for 2 people means my 10% tax withholding from my SEPP (72t) income was too much.

Action to take- I have notified my financial planner who handles my SEPP (72t) to decrease the federal withholding from 10% to just 2% for next year. This way I will owe just under $500 in Federal income taxes once I file my taxes in the future. At this time I have no plans for beginning another encore career. But if I land a sweet paying gig aligned with my passions and interests I will make withholding adjustments.

(Update Jan 2017: My CFP informed me that they can only withhold 0% or 10%. I have it set for 0% now and then in October will have it changed to 10% for the last 3 months of the year)

Other Tax Issues To Look At

This is a good time to look at any non-retirement account investment-dogs you might want to unload to take the investments losses.

If you use the long form with Schedule A to file your taxes then look to see if instead of waiting whether a well-placed charitable contribution or paying for other deductible expense before year-end will improve your tax situation. Same goes for any business or rental property related deductible purchases. That is if the move makes sense.

If you find that you underpaid your taxes by far too much and worry about under-payment interest/penalties then make use of the time now to adjust your tax withholding up for the rest of the year.

In Closing

I blew it tax-wise this year and overfed the monster. Politics aside, I use the term monster because it will happily over-eat without squabble but will hunt you down and destroy you if you don’t feed it what it thinks you owe.

I have to pay the tax monster something to keep it off my back but not more than I have to pay. It’s better that I manage my money than trust the monster with it.

Everything considered, my discovered tax oversight isn’t too bad. My Early Retirement Income Tax Strategy tweaks will have me add to my Roth IRA holdings before year-end. I will also be giving myself an 8% early retirement funding raise without increasing my taxable income. Sweet!

Even though I can make a Roth conversion for this year up to the tax filing deadline, I like to keep things in the same year when I can. I am very happy to have taken the time during this holiday season to get a head-start and make the necessary income tax tweaks.

What’s your tax strategy?

18 thoughts on “Starve the Tax Monster: My Early Retirement Income Tax Strategy

  1. I was just about to suggest “do a Roth conversion”…but then you focused on that.
    The focus on 15% tax bracket seems to be the answer for most folks. Have you considered making sure you pay at least 15% -via Roth conversions-so that down the road with Social Security and other higher taxes income you might get bumped into an even higher tax bracket?
    I bought my QLAC. I am doing Roth conversions. I even bought asset based LTC for me and my lady -another tax shelter opportunity. And I just wrote an ebook on retirement planning on kindle to flesh out my ideas. Merry Christmas

    James

    1. Thanks for the comment James. I too have a plan to be more aggressive with Roth conversions for the very reason you mention. The Social Security taxable thresholds are very low. I have been converting for a while and this conversion I am doing covers my last available IRA and some from my wife’s accounts. The only other IRA I have left is tied up for another year in my SEPP 72(t) account. Just waiting to hit the young age of 59 1/2 to Roth convert yearly until starting Social Security while staying in the 15% bracket. That is if taxes/SS stays the same structure as now with the new administration. Once I turn 60 I will begin to explore my QLAC options. It is something I have a big interest in.
      Tommy

      1. Tommy

        But if you have converted most of your IRA to a Roth then the 25% to go into a QLAC will be less. Unless of course after conversion you have at least $500,000 in the IRA. Because of that I bought the QLAC before I began major conversions…(I just got off a QLAC education call with…an insurance company.)

        1. James,
          A very good point to bring up. My SEPP IRA is over $500K. Its just hands-off until I fulfill the 72(t) 5 years or age 59 1/2 (which ever is longest) requirement. That is met at age 59 1/2 for me and shortly afterward we will look at our QLAC and Roth conversion options before making any moves.
          Tommy

      2. I have the same challenge: draining sizable IRA prior to RMDs to avoid Social Security tax torpedo. Especially when limiting income to avoid ACA cliff. Thanks to age 55+ rule can access former 401(k) without penalty to carry me to 59.5 for IRA.

        As you said elsewhere, SS can increase twice as much as other income to trigger equivalent taxation. Another good argument to delay for max benefit. Surprising how few blogs or columnists catch this. Also helps most states don’t tax SS. Those that do usually provide exemptions.

        Defined benefit pensions also have the equivalent of RMDs. You must start by April 1 of the year following the year you turn 70.5. Known as the Required Beginning Date. This also gets too little coverage.

        1. Thanks for the comment Steve. I wasn’t aware of the Pension required beginning date issue. Seems logical given the Gov wants to see taxes paid at sometime. The 401K age 55 early withdrawal penalty exception is one few people know about. I know someone who mistakenly rolled their 401k into an IRA at age 56 and killed their option to easily access it before age 59 1/2.
          Tommy

  2. Great,

    great read. I thoroughly enjoyed reading about . Love this post!!
    It’s so interesting to see the statistics of a lifestyle we are trying to make work for us.It sounds as
    if you have worked yourself to where you want to be . Congratulations and continued good fortune!

  3. Wow, great post! Definitely some very helpful info an tips. It can also be best sometimes to consult with a professional for help with taxes. Thanks for sharing!

    1. Thanks for the comment Selene. I agree. As a former tax adviser myself I know taxes can be very complicated. Even if our tax situation doesn’t seem to go beyond what can be handled by today’s off the shelf tax software,sometimes just running some numbers or plans by a seasoned tax professional can help.
      Tommy

  4. I really like your thoughts outside the box as far as early retirement. I am totally agree which you required to have some income in non retirement accounts to get you to 55.13 or beyond. We are selecting to do that with my rental property, but are taking some aside in non-retirement accounts as well.

  5. If you have other sources of income then a portion of social security is likely to be taxable. The pension person with income is subject to 85 percent tax on the social security benefit.

    1. Thanks for the comment M Nasir. You are correct that anyone collecting Social Security would need to include its low allowable income thresholds when developing their own Starve the Tax Monster plan.
      Tommy

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