Smart Tax Tips for Early Retirees

Considering early retirement? Congratulations! Get ready for a life of freedom where you get to call your own shots and do what you want. Oh, and say hello to a fixed income living off all of those savings you have spent an entire lifetime earning.

Yes, living off of a fixed income presents its own challenges, but you can help reduce them by managing how much you pay in taxes on your fixed income sources. Here are some tips to help you do that:

Tip #1: Before You Retire, Mix Your Investments.

This is Tip #1 because it is something you should consider long before you ever contemplate retiring, early or otherwise. As you consider investing for your retirement, you should always think about diversification. Most employers offer some type of 401(k) plan which allows you to deduct money from your paycheck and contribute it to a retirement plan.

However, do not let the investing end there. Look at saving in other investment vehicles as well. For instance, money market accounts, which tend to be far less volatile than 401(k) plans.

You should also consider investing in a Roth Individual Retirement Account (IRA) plan. Companies such as Scottrade offer them, as do other brokers. Roth IRAs offer several interesting differences from traditional IRAs. The most notable one is that, because you contribute post-tax earnings into them, their earnings are not taxed.

If you have diversified, when you retire, you will have a good mix of cash, taxable earnings from traditional IRAs (which most 401(k)s tend to be), and your Roth IRA.

Tip #2: Minimize the Amount of Money You Withdraw before You Are 59½. 

Any money you take out of your IRA before you turn 59½ is subject to a 10 percent early withdrawal penalty. Even if you have officially retired, you still have to pay an additional 10 percent tax on all monies taken from a 401(k), IRA, or other retirement plan until you reach 59½. Therefore, the less you tap these sources, the less you will have to pay in early withdrawal penalties.

However, tapping into your IRAs may be unavoidable, but there are ways you can be smart about lowering the taxable amount. For instance, you can withdraw money from a Roth IRA under certain conditions which do not incur the early withdrawal penalties. Try to pay for those conditional expenses with early pulls from your Roth IRA and spend your non-IRA money on other expenses.

Tip #3: Take Control of Your Investments. 

Your retirement investments are likely going to be your biggest source of income. Therefore you need to control them and understand how they are being managed.

Once the remains of your retirement party are cleaned up, you should be rolling your 401(k) into a brokerage account you control. Doing this is a good way to control where the money is being invested and, typically, a brokerage account gives you far more investment options than a company 401(k).

Tip #4: Consider Taking Advantage of the Penalty Free Withdraw Period.

When you are rolling over your 401(k), you do not have to reinvest all of that money. If you have quit your job or retired and you are between the ages of 55 and 59½, you can take money out of a 401(k) and avoid the 10 percent early withdrawal period from an IRA. That money will still be taxed as normal, but you won’t have to pay the penalty if you want to pull it out later.

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