As we wrap up the year and head into tax season, it’s a good time for those looking ahead to early retirement to assess your finances.
Many people assume (wrongly) that when you hit retirement, your money and taxes go into autopilot mode. But depending on how your finances are structured, there are many considerations for your taxes — and therefore your money — that you need to keep in mind, especially if you’re retiring ahead of the Medicare threshold of age 65.
Tax status
If you are retired (unemployed) and also have income that’s considered “earned,” the IRS considers you a sole proprietor by default, meaning you own a sole proprietorship business, and your earned income is business income. In addition to standard employment, earned income is any income derived from active tasks like working one-off jobs, consulting, or owning rental properties if the IRS considers that a business. If you have a combination of earned income and unearned income — income earned primarily from investments, including capital gains and dividends — at a minimum your taxes could get or stay complicated, but you could also face other considerations that don’t apply while working in a standard W-2 job. On the plus side, this new sole proprietorship status may give you the opportunity to deduct business expenses that weren’t deductible before you were considered self-employed. (Consult a qualified tax specialist for guidance specific to your situation.)
Quarterly taxes
When you’re employed by someone else, it’s usually their job to withhold income taxes for you. However, when you’re self-employed, as many retirees are considered even if that self-employment consists of one or two short-term gigs a year, then you must pay self-employment tax, including estimated quarterly taxes, or face late payment penalties come tax time. You don’t have to pay estimated tax on capital gains or dividends, but you do have to for your other income. And these taxes are much higher than the withheld taxes that you might be used to paying while employed, because a self-employed person has to pay both the employer and employee portions, as well as the usual rates for Medicare and Social Security.
Healthcare premiums and deductions
I’ve learned that many would-be early retirees have not fully researched healthcare costs in the years before they qualify for Medicare, and are therefore unprepared for how expensive they can be. Logon to Healthcare.gov or your state’s healthcare exchange to see the plans and prices available to you, based on your expected retirement income and household composition so you have a better sense of current costs, and well as to understand how those prices might change with a higher or lower income. If you’re planning to retire before age 50, also plug in your same information with future ages of 55 or 60 to get a sense of future costs. By law under the Affordable Care Act, insurers are allowed to double premiums when those covered turn 50.
Healthcare is expensive for those earning a higher income, but the good news is that there are hefty tax credits available to those with modest incomes to offset premium costs, and health insurance premiums for exchange-purchased plans are considered a deductible business expense if you’re self-employed for tax purposes, which reduces your taxable income on the front end.
Everyone can count health insurance premiums as tax deductions, but non-self-employed people can only get a tax benefit if the premiums and other medical expenses exceed 7.5% of adjusted gross income. Many early retirees also rely on complicated tax strategies like Roth conversion ladders, and it’s important to understand how taking the taxable income hit of a Roth conversion will affect your healthcare premiums, because the increase in premium cost might more than wipe out the tax benefit of the conversion.
Charitable deductions changes
Many retirees who were once high earners are used to their charitable contributions earning them big tax deductions, but once those same folks retire, they often find that it’s advantageous to claim a standard deduction rather than itemizing deductions, especially now that the standard deduction is $25,100 for a couple and $12,550 for individuals. Taking the standard deduction means no more tax benefit to charitable giving. It’s important to factor this in, but another solution is to open a donor-advised fund before retiring and making a large contribution to that you can write off of your taxes. That way, you get the tax benefit while earning more, but then have money available to donate for many years to come regardless of your financial status in retirement.
Mortgage math changes
For home-owning folks who once itemized deductions but later take the standard deduction in retirement, the math may change on a home mortgage. (The math might also change for those weighing renting vs. buying a home.) Because you can no longer deduct mortgage interest without itemizing, it may make sense to pay off a mortgage in retirement or before retiring, rather than continuing to pay interest and make a hefty monthly payment. Paying off a mortgage, even if it reduces your overall investment savings, has the benefit of lowering monthly expenses dramatically and may even mean getting much cheaper health insurance because health insurance premiums prior to Medicare eligibility at age 65 are tied to income. Needing less investment income because there’s no mortgage payment to make can mean health insurance premiums that are thousands of dollars cheaper per year. When you’re estimating your healthcare costs, run different scenarios with and without a mortgage to get a sense of the cost difference. And before you buy or pay off a home, make sure you’re considering the climate change risks where you live.
Property tax impacts
Depending what state you live in, if you own your home, you may be able to take advantage of different property tax rules that can benefit your finances. But you might also need to pay closer attention to rising property tax costs.
Some states allow you to designate a property you intend to stay in for the long-term a “homestead,” which can come with tax benefits. Others allow you to transfer the assessed value of a property to another home one time if you meet certain requirements, often age- or income-based, so that your taxes don’t go up dramatically if you move after having spent a long time in a different home. But even before the current period of high inflation, property taxes have frequently outpaced inflation by a factor of three or more, a fact that can harm your financial stability if you’ve only factored in a standard rate of inflation across all of your expenses. (Healthcare and expenses like higher education also outpace inflation significantly, and it’s important to plan for those increases.) Before you pull the plug on work, make sure you have a thorough understanding of your options where you live as well as a plan to tackle costs that rise 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 the Our Next Life blog.
