Opinion: Are you considering taking early retirement? Watch out for these tax traps

As we wind down the year and head into tax season, now is a good time for those considering early retirement to assess their finances.

A lot of people (wrongly) assume that when you retire, your money and taxes go on autopilot. But depending on how your finances are structured, there are many considerations for your taxes – and therefore your money – to keep in mind, especially if you are retiring before Medicare’s 65-year threshold.

Tax status

If you are retired (unemployed) and also have income that is considered “earned”, the IRS defaults to you as a sole proprietor, which means you own a sole proprietorship and your income earned is business income. In addition to standard employment, earned income is any income from active tasks such as one-off jobs, consulting, or owning rental property if the IRS considers it a business. If you have a combination of earned and unearned income – income from primarily investments, including capital gains and dividends – at a minimum, your taxes could become or remain complicated, but you could also face challenges. ‘other considerations that do not apply when working in a standard W-2 job. On the plus side, this new sole proprietorship may give you the ability to deduct business expenses that were not deductible before you were considered self-employed. (Consult a qualified tax professional for advice specific to your situation.)

Quarterly taxes

When you are employed by someone else, it is usually their job to withhold income taxes for you. However, when you are self-employed, as many retirees are taken into account even if that self-employment consists of one or two short-term gigs per year, then you have to pay self-employment tax, including quarterly taxes. estimated, or face late payment penalties come tax time. You don’t have to pay estimated capital gains or dividend tax, but you do have to pay it on your other income. And these taxes are much higher than the withholding taxes you might be used to paying while in employment, as a self-employed person has to pay both the employer’s and the employee’s part, as well as the usual health insurance and social security rates.

Health care premiums and deductions

I have learned that many applicants for early retirement have not done extensive research on health care costs in the years leading up to Medicare eligibility and therefore are not prepared for their cost. Log on to Healthcare.gov or your state’s healthcare exchange to see the plans and prices available, based on your expected retirement income and household makeup so you have a better idea. current costs and to understand how those prices might change with higher or lower income. If you plan to retire before age 50, also enter your same information with future ages of 55 or 60 to get an idea of ​​future costs. Under the Affordable Care Act, insurers are allowed to double premiums when covered people turn 50.

Healthcare is expensive for those with higher incomes, but the good news is that there are significant tax credits for those with modest incomes to offset the costs of premiums, and insurance premiums. sickness for plans bought on the stock exchange are considered a deductible business expense if you are self-employed for tax purposes, which reduces your taxable income initially.

Anyone can count health insurance premiums as tax deductions, but non-self-employed people can only get a tax benefit if premiums and other medical costs exceed 7.5% of adjusted gross income. Many pre-retirees also rely on complex tax strategies such as Roth conversion scales, and it’s important to understand how taking the hit from the taxable income of a Roth conversion will affect your healthcare premiums because the increase in the cost of premiums could more than wipe out the tax benefit of the conversion.

Changes to charitable deductions

Many retirees who once earned high incomes are used to their charitable contributions earning big tax deductions, but once these same people retire, they often find it beneficial to claim a standard deduction rather than to detail the deductions, especially now that the standard deduction is $ 25,100 for a couple and $ 12,550 for individuals. The standard deduction means that there is no longer a tax advantage for charitable donations. This is important to take this into account, but another solution is to open up a donor-advised fund before you retire and make a large contribution that you can write off your taxes. This way you get a tax advantage while earning more, but then you have money to give for many years, regardless of your financial situation in retirement.

Mortgage math is changing

For homeowners who have already itemized the deductions, but then took the standard deduction in retirement, the math may change for a mortgage. (Calculations may also change for those who value renting versus buying a home.) Since you can no longer deduct mortgage interest without itemizing it, it may make sense to pay off a mortgage in retirement. or before retirement, rather than continuing to pay interest and make a big monthly payment. Paying off a mortgage, while it cuts your overall investment savings, has the benefit of drastically reducing monthly expenses and may even mean getting much cheaper health insurance because health insurance premiums come before Medicare eligibility. at age 65 are income related. Needing less investment income because there is no mortgage payment to be made can mean health insurance premiums that are thousands of dollars cheaper per year. When estimating your health care costs, run different scenarios with and without a mortgage to get an idea of ​​the cost difference. And before buying or paying for a home, be sure to consider the risks of climate change in your place of residence.

Impacts of property tax

Depending on the state you live in, if you own your home, you may be able to take advantage of different property tax rules that can be beneficial for your finances. But you may also need to pay more attention to rising property tax costs.

Some states allow you to designate a property in which you intend to stay for the long term as “property,” which may come with tax benefits. Others allow you to transfer the assessed value of one property to another home just once if you meet certain conditions, often based on age or income, so your taxes don’t go up dramatically if you move. after spending a long time in a different house. But even before the current period of high inflation, property taxes often exceeded inflation by a factor of three or more, a fact that can hurt your financial stability if you only factor in a rate of interest. standard inflation for all your expenses. (Health care and spending like higher education also significantly outpace inflation, and it’s important to plan for these increases.) Before you disconnect from work, make sure you have a thorough understanding of your options where you live as well as a plan to deal with them. costs that grow faster than your retirement savings grow.

Tanja Hester is the author of Wallet Activism: How to Use Every Dollar You Spend, Earn, and Save as a Force for Change and Work Optional: Retire Early the Non-Penny-Pinching Way, host of the Wallet Activism podcast and creator of Notre Next Life blog.


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