Optimizing Taxes Over A Lifetime

One of the largest expenses most people will face in their life is taxes and for the most part, there just isn’t any way around it.  After all, the old saying claims the only things certain in life are death and taxes.  Fortunately, the taxes that must be paid over the course of a lifetime are highly in your control and can be reduced significantly with a little bit of planning.  This is doubly true for anyone who saves a large portion of their income at a young age in order to retire early and live off of their investments, primarily because the type of income most heavily taxed is “Earned Income”.  Earned income is essentially any money worked for such as wages, tips, or self-employment income, which comprises almost all of the average person’s income.  The other types of income that don’t fall into this category includes interest, dividends, and retirement income.  This non-earned income is the vast majority of an early retiree’s financial strategy and is treated much more generously in the tax code.

Everyone probably knows a trick or two to reduce their taxes any given year, but rarely do people look at the bigger picture.  By looking beyond simply reducing your taxes for the current year and creating a rough sketch of your potential lifetime taxes, you might find some large opportunities to reduce that lifetime taxes paid number.  As a person seeking financial independence at an early age, I’m particularly interested in both reducing my taxable income now AND in the future.  In order to answer important questions such as Roth vs. Traditional and whether or not to max out retirement accounts, one MUST look beyond the current year in order to make an informed decision.  An early retiree’s lifetime tax path can be broken down into three distinct parts, each with their own tax considerations.  Let’s take a look at each of these three stages and go into the different tax details that make each one unique.

Stage 1: Accumulation

The accumulation phase is the one that everyone starts in, but not everyone starts at the same level.  Whether you enter the working world with significant debt, zero net worth, or a financial head start, the goal of this stage is the same, spend less than you make and start building up investments (potentially paying off any debt first).  The length of this stage can be reduced by lowering spending, increasing income, or ideally both, but regardless, you will probably end up paying the majority of your lifetime taxes along the way.

There are two reasons the tax burden in the accumulation phase ends up being significant.  First, almost all of the income in this stage will be Earned Income, which has less tax benefits compared to other types of income.  Second, it’s quite likely that the annual income earned during this stage will be the highest in your lifetime.  This won’t be the case for everyone, but if you are saving a high percentage of your income now, there’s a good chance you don’t plan to jump your spending right back up once you retire early.  These two things combine to make the accumulation phase one of the most costly when it comes to taxes.  Luckily, there are several moves you can make to both reduce taxes now and set yourself up for little to no taxes in the future.

Reducing Taxes During Accumulation

As the accumulation years are likely the highest overall income years, they are also the years with the highest marginal tax rate.  This encourages us to reduce and defer any taxes possible to later years, because any reduction at that highest marginal rate will pay out much nicer than a similar size reduction later in  life.  The best way to reduce taxable income during the accumulation phase is through retirement accounts such as 401k’s and IRA’s, each of which come in both a Traditional and Roth variation.

For early retirees, a good rule of thumb when deciding between Roth and Traditional retirement accounts is to look at your marginal tax rate now versus your average tax rate in the future.  This is because any tax delayed via the use of Traditional retirement accounts will reduce your tax burden at your current marginal tax rate, while withdrawing that same money in the future will start at the lowest tax rate and build up from there.  This rule works best for early retirees because of the extremely beneficial tax years between retiring and starting social security payments, but will not work quite as well for the traditional retiree who has very few or none of these in-between years.  For most people seeking early retirement, Traditional will win out over Roth because of the power to significantly reduce or even eliminate the deferred taxes on that income during Stage 2.

In addition to 401k’s and IRA’s, many other accounts exist that can also help to reduce or defer taxes such as 457’s, 403b’s, FSA’s, HSA’s, 529’s and more.  Each of these has their own rules and benefits and aren’t available to everyone, but be sure to check into ALL the accounts you might be able to gain tax benefits from.  The FSA and HSA accounts for example even let you avoid paying FICA taxes!  Be sure to pay attention to which accounts give the MOST benefit if you aren’t able to maximize them all.

Aside from reducing taxable income via retirement accounts, it’s also important to avoid adding any additional income that can instead be delayed to later years.  A good example of this is capital gains, which can often be deferred until later years when cashing them in will possibly invoke less taxes.  On the other hand, harvesting capital losses can be a good way to reduce taxes during the accumulation phase when you still have that high marginal tax rate.

The primary consideration during this phase should be to reduce taxable income while ensuring you have enough money accessible to last until the traditional retirement age when retirement accounts fully unlock.  Keep in mind there are several ways to access retirement accounts early though, so don’t think you need tons of money outside of retirement accounts to make it work!  Read up on Roth ladders to learn a common strategy for doing so.

Stage 2: Early Retirement

Once you accumulate enough assets and investments to live off of for the rest of your life, you can choose to enter stage 2, early retirement.  The rule of thumb for the magic number which makes you financially independent is when your spending is equal to 4% of your investments.  Some people choose to stay more conservative and try for 3% or even less, but in general, an investment pile of 25-30 times your annual spending will put you in a very favorable position to quit your job and live off of the interest indefinitely.

This phase is extremely beneficial when it comes to taxes because the Earned Income that made the last phase so expensive just vanishes.  The money needed to sustain annual spending simply comes from savings accumulated during Stage 1.  This can include a cash reserve, interest, dividends, selling stock, and even accessing retirement accounts before the stated retirement age (59.5 in most cases).  As the amount withdrawn only matches spending, you will already be in a lower tax bracket, but on top of that, withdrawing from some of the sources won’t have any tax impact at all!

The tax burden in this stage is extremely controllable if your investments are spread across multiple types of accounts.  For example, any cash or Roth contributions withdrawn have no tax impact at all and won’t even show up on your taxes.  Any investments sold out of a brokerage account will only have the gains taxed (at a reduced rate compared to Earned Income) while all of the contributions sold go straight into your pocket.  The only income that will be fully taxed is the amount withdrawn or converted from tax deferred accounts such as Traditional IRA’s and 401k’s.  By paying attention to where your income is being pulled from, you can control exactly what amount of your money will be taxable and in what way.

The best strategy to reduce taxes in this stage will highly depend on where your money is currently stored, so I won’t try to dive into specifics here.  If you really plan it out and control your withdrawals carefully, you might be able to pay $0 in taxes on a significant amount of “income” any given year.  Both Go Curry Cracker and Root of Good have great posts on the subject and I plan to copy their strategies to some extent in my own Early Retirement phase.

Stage 3: Traditional Retirement Age

Once you start reaching the traditional retirement age, several things change from the Early Retirement stage, some which simplify withdrawing your money and some which complicate it.  If you’ve made it this far with the early retirement mindset, you probably have a good handle on your finances, but I’m going to list out a few things that change once you start reaching your 60’s and beyond.

Age 59 1/2: Retirement Accounts Open Up

Up until age 59 and a half, it is necessary to get creative in order to access the funds in IRA’s or 401k’s without penalty, such as through the use of Roth Ladders or SEPP withdrawals.  Once you reach this magic age though, they open up completely for withdrawal without any penalties tacked on.  Traditional accounts will still require taxes to be paid on the withdrawals, so you will still want to stay mindful of tax brackets and different impacts of the income you take any given year.  Roth accounts on the other hand open up completely and you can withdrawal at will without any tax implications, it will no longer be necessary to track contributions versus gains or any rollover timing as the early withdrawal penalties no longer apply.

Overall, this simplifies the withdrawing of funds and you will want to apply many of the same principles from the Early Retirement stage to reduce your tax burden.

Age 62-67: Social Security

The exact ages are subject to change and have been slowly moving back for the younger generations, but the impact stays the same.  On the early end, it’s possible to start taking Social Security payouts at a reduced “early retirement” benefit rate, but it is also possible to delay payouts until the later end of the years to receive “full” benefits.  Whenever you choose to start receiving benefits, the income received may be subject to taxation and will also shift any additional money withdrawn from Traditional retirement accounts to a higher tax bracket.  Both of these impacts need to be planned for if you want to continue paying little or no in taxes.

Age 65: HSA Becomes More Flexible

If you had access to an HSA during your earning years, it has always been possible to withdraw funds towards medical expenses with no penalty.  Accessing the funds for non-medical expenses before age 65 has multiple penalties that make withdrawing for regular spending impractical in all but the most extreme cases.  The good news is that once you turn 65, the money in the account can essentially be treated as a Traditional IRA’s funds.  That means any withdrawals are subject to taxation, but there are no penalties regardless of what the money is used for.

Keep in mind, it is still possible to withdrawal towards medical expenses with no tax impact, so that is the smarter move if possible.  At age 65 and beyond, there’s a very good chance you’ll be able to empty out the account entirely towards medical expenses, so I recommend looking to other sources of money first before the HSA when it comes to non-medical expenses.

Age 71 1/2: Required Minimum Distributions

If you’ve made it to age 71 and a half and still have money in Traditional retirement accounts, the IRS is going to start requiring you to withdraw it via Required Minimum Distributions.  Depending on how much you still have in the accounts, this could force you to withdraw much more than you actually need to cover expenses and everything withdrawn becomes subject to income taxes.  The practice makes sense because they want you to pay taxes on the money you previously deferred them on, but may become a major inconvenience if you didn’t plan for them.

Required minimum distributions make shifting as much money as possible from Traditional accounts into Roth accounts during Early Retirement and even the years before 71.5 even more advantageous.

Putting It All Together

I touched on 3 distinct stages for an early retiree’s path and the different tax implications to keep in mind at each one.  It’s important to look beyond the current year and even the next few in order to put together an optimal tax plan for your lifetime.

The Accumulation stage comes with a lot of Earned Income by necessity and probably includes an early retiree’s top earning years, so deferring taxes and maximizing certain deductions becomes top priority.  Look at current marginal tax rates and future expected average tax rates when deciding between Traditional and Roth accounts.

The Early Retirement stage comes with a lot of tax advantages because Earned Income becomes heavily reduced or goes away completely.  Using standard deductions and exemptions along with capital gains tax rules to shift money from Traditional accounts to Roth accounts and realize gains allows for legal avoidance of a lot of taxes previously deferred.

The Traditional Retirement Age stage comes with a few changes such as easier access to retirement accounts and additional income from Social Security, but also makes reducing your tax burden potentially more difficult.  Any money still contained in Traditional retirement accounts eventually becomes subject to required distributions, so planning ahead to reduce the tax impact is important.

Overall, each stage has it’s own benefits towards saving money and reducing taxes and it’s important to consider them all if you want to optimize your lifetime tax plan.  Most people can’t avoid taxes completely, but almost everyone can reduce them by planning ahead and taking advantage of various tax-advantaged rules and accounts.

4 thoughts to “Optimizing Taxes Over A Lifetime”

  1. Great article. But I’m having a hard time understanding the benefits of maxing out your HSA. If you aren’t planning to need all that money for medical expenses, then you’ll end up paying the withdrawal penalty + taxes right (unless you are 65+)? So is the assumption that your taxes will be lower at that point in life than now because of lower income (since you’re retired)? So you end up in the positive. What am I missing?


    1. If you’ve saved enough across several different funds, you shouldn’t have to touch an HSA at all before you are 65 and even then should be able to direct most if not all of it towards medical expenses tax and penalty free. So worst case, it’s a Traditional IRA that avoids FICA taxes. Best case, it’s a completely tax-free investment that grows while you’re young and can be used towards medical expenses (gains and all) later on in life. Either way, it can be extremely beneficial to max out if available. Check out the links below if you want more details.

      I went into a little more detail at the bottom of this article:

      And a bit more here in comparison to other retirement accounts:

      Thanks for reading!

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