Tax Efficient Investment Considerations for People Retiring Early

by Miranda Marquit · 4 comments

Many people have a dream of retiring early so they can enjoy their time away from the grind. However, it is important to realize that there are some very real drawbacks to early retirement. The main issue is that you can’t begin taking distributions from your tax advantaged retirement account, penalty free, until you are 59 1/2. That means that early retirement can really puts your saving ability to the test. There are some strategies you can employ, though, to help you as you get ready for early retirement. Here are a few for those thinking about taking the leap one day.

Creating an Early Retirement Portfolio

While you want to make sure that you are taking full advantage of the tax advantaged retirement accounts available to you, you should also create another retirement portfolio that can build value (also known as a taxable account). Though you won’t get the full benefit of avoid taxes on gains, here are two options for your early retirement portfolio that will help in that regard:

  1. Bonds: The interest earnings from some bonds are taxed. However, there are some bonds that are exempt from taxes. Many municipal and state bond earnings are free from federal income tax. On top of that, some states offer exemptions on bonds to residents of the state.
  2. Dividend Paying Stocks: You can also look into dividend paying stocks. Right now, the top rate on dividend earnings is 15%. Plus, if you sell the stocks, you will be capped at 15% as well (for now) on long term capital gains. Even if the tax rate on long term capital gains goes up, it is unlikely to come close to approaching the top tax rate. Dividend stocks — especially dividend aristocrats — are known as great value investments, and earnings are likely to go up.

It’s true that neither of these choices are going to offer huge gains; bonds and dividend stocks aren’t exactly “get rich quick” choices. However, they do provide relatively stable returns that can be counted on during an early retirement. The key is to build up the portfolio now, over time. That way, when you are ready for your early retirement, you might even have a solid income stream.

Remember that your early retirement investment portfolio doesn’t have to last you your entire life; it’s main purpose is to provide you with a way to bridge the gap between the time you retire early, and the time that you can access your “regular” retirement accounts without incurring the penalty. (Plus, with more time to grow, your more traditional retirement accounts will grow larger.) Indeed, with the right planning, you can put together a tiered plan that also allows you to put off taking Social Security until you are older, making your benefits that much larger.

Bottom Line

Even if you plan to retire early, it’s important to consider your options, and put together a plan to keep your taxes as low as possible. The use of certain bonds, as well as dividend paying stocks can help you achieve the best possible tax efficiency, while still providing you with the money you need to enjoy retirement before 59 1/2.

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  • fredjohnson says:

    I think you are preaching to the wind with this article. You’re talking to people who want to retire BEFORE age 59.5(excluding the ones with govt, union pensions, etc). So, they can’t touch the retirement plans and therefore must have a big taxable savings account somewhere. Vast majority of folks don’t have both. They may have lots inside of a 401k, IRA, etc and little else. Even if you could take out 4% of your non-retirement savings you’d need $2.5 million just to take $100k a year—before taxes. Who’s got $2.5 mill laying around in taxable accounts in addition to their retirement accounts? Not many.

    • Richard Cabeza says:

      Fred. The 4% number assumes withdrawals from 30+ yrs. The author here is referring to the gap btw early retirement and 59.5. At age 50 for example, to have $100k/yes, you’d need $900k. Not chump change, but doable. Your post also begs the question of why $100k. That’s a lot of income per year. If this is say 80% of your paycheck, you’ve been earning enough to sock away a lot of savings. Finally, a Roth ladder approach (not mentioned in article) would require much less – perhaps $500k per your case.

  • Patrick R. Carlson says:

    Like asset diversification (where you buy different classes of investments, like stocks, bonds, etc., to reduce overall volatility and risk in your portfolio), you should also engage in tax diversification. Tax diversification examines and evaluates the various tax regimes applicable to investments, and then distributes your investment dollars among various tax strategies. For example, you may have some investments in income tax deferred accounts (like 401(k)s or IRAs), some in taxable bonds or stocks, some in tax exempt bonds, some in real estate investments, etc.

    Like the poster suggested, having all your retirement assets in an income tax deferred account (like an IRA, 401(k), etc.) may not be the best option if you have plans to retire early or need the money prior to age 59 1/2. Tax diversification between those qualified plans or IRAs and non-qualified investment accounts, like dividend stocks, tax-exempt bonds, regular bonds, real estate, etc., is probably a good idea for many people. It might give you the ability to retire early and also provide you with the flexibility if you have pre-retirement expenses, like buying a vacation home, RV, plane, boat, etc.

  • Rich says:

    You must have passive income of some sort otherwise you will be eaten alive by taxes.

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