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Early retirement offers many benefits. The obvious benefit, of course, is . . . well, retiring early. But perhaps a less obvious benefit would be the tax advantages available to early retirees. The advantages are often hidden behind the complexity of the tax code.

A quick Google search claims that the U.S. tax code is a whopping 70,000 pages long. A tax attorney writing for Slate fact-checked this. He found that it is actually only “about 2,600 pages.” Even this was an estimate, though, because the book “starts at page 100, and then skips 500 pages in its numbering.” Confusing enough?

Luckily, we don’t have to know everything in the tax code (or even its true number of pages) to develop an effective tax plan. There are only two key principles that you need to understand if you want to retire early:

First, tax deferral allows you to pay considerably less taxes in your working years. You can then recognize your income over many years at lower rates, potentially as low as 0%.

Second, investment income is taxed much more favorably than earned income. This is also a huge advantage to early retirees who will live primarily off of investments for the majority of their lives. This basic understanding of tax law can allow you to retire far earlier than you may have thought possible.

These principles can best be demonstrated with an example.  Let’s consider a couple earning $160,000/year who submit their taxes as married filing jointly.  They choose not to live up to their means. Instead, they elect to have a very high savings rate.  They live a comfortable, but not extravagant lifestyle on about $40,000/year. This allows them to save well over half of their income, even after taxes. This would allow them to achieve financial independence in about 10-15 years.

Resource: This calculator estimates when you can retire early based on your savings rate

(Note: These numbers were chosen for simplicity of demonstration. The principles and not the exact numbers are important. The principles work regardless of income. For further simplicity, we will ignore inflation and use 2016 values throughout the example.)

Principle 1. Tax Deferral Is Your Friend

Many people are confused as to why you would use tax deferred investment accounts such as a 401(k) or IRA. You may ask, won’t I just owe taxes later? The answer to that question is yes… unless you don’t.

To understand this concept, one first must understand the difference between marginal and effective tax rates.  Your marginal tax rate is the rate paid on the last dollar that you earn in a given year. It is the highest rate you pay on any of your income. Your effective rate is determined by dividing actual tax paid by total income.  The numbers are quite different. Let’s break it down:

In 2016, the standard deduction for a married couple is $12,600.  Everyone is then entitled to a personal exemption of $4,050. For two people this is $8,100.  Therefore, their first $20,700 (12,600+4,050+4,050) is free of federal income tax.  The remaining $139,300 is taxed as follows:

  • The first $18,500 is taxed at 10%, equaling $1,850.00
  • The next $56,750 is taxed at 15%, equaling $8,512.50
  • The last $64,050 is taxed at 25%, equaling $16,012.50

This couple’s total federal income tax bill is $26,375. Their marginal tax rate is 25% and their effective federal income tax rate is 16.48% ($26,375/$160,000), if they pay all taxes in the year they are earned.

However, they can choose to defer some taxes. By maxing out two 401(k) contributions at $18,000 each, the couple can defer taxes on the last $36,000 they earned. All $36,000 would have been taxed at the marginal rate of 25%. Thus only $28,050 (64,050-36,000) is now subject to the 25% tax.

This reduces taxes by $9,000 from $26,375 to $17,375.  Their effective tax rate is reduced from 16.5% to 10.85%. They now have the extra $9,000, plus all of the compounded dividends and interest, working for them in investment accounts for years.

Read About 3 Money Rules That Will Guarantee an Early Retirement

When it comes time to spend their tax deferred money in retirement, the couple will owe federal income tax on this money. There are multiple ways to access money from retirement funds early. Because they live on $40,000/year their tax bill would look like this:

  • The first $20,700 falls into the standard deduction/personal exemption and is tax free
  • The next $18,500 is taxed at 10%, totaling $1,850
  • Only the last $800 is taxed at 15%, totaling $120

The total tax on $40,000 in retirement is $1,970. Their income was shifted from a 25% marginal tax rate to a 15% marginal tax rate. More importantly, the effective tax rate on these dollars, the amount they actually pay, is reduced from 25% to only 4.9% ($1,970/$40,000).

That is a pretty impressive savings. However, I mentioned above that an early retiree may pay no taxes at all on this deferred money. To understand this, we must next understand the second principle.

Principle 2. Not All Income Is Taxed Equally

Our example couple had a very high savings rate. Even after maxing out tax deferred accounts, they were still able to save substantial amounts in Roth IRAs and taxable accounts in their working years.

Any money contributed to a 401(k) or Traditional IRA is taxed as ordinary income when taken from the account, because the tax was never paid at the time it was earned. However, any money contributed to a Roth IRA or taxable investment account already was subjected to income taxes. Therefore they are not taxed as ordinary income a second time.

Learn More: Leveraging Both a 401(k) and a Roth IRA for Retirement

In retirement, money can be taken from Roth IRAs free of any further taxation. Money contributed to taxable investment accounts (cost basis) is also free from further taxation, because it was already taxed.  You will owe capital gains taxes on increases in the value of your investments when you sell them.

Currently, capital gains are taxed very favorably for those with low incomes (i.e. most early retirees). According to IRS Topic 409: “The tax rate on most net capital gain is no higher than 15% for most taxpayers. Some or all net capital gain may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets.”

Related: The Pros and Cons of After-Tax 401(k) Contributions

Taxable income for a married couple filing jointly could reach $96,000 before they would be pushed above the 15% marginal tax rate. As you can see from our example couple above, they easily fall into the 15% marginal tax bracket living off of $40,000/year. This gives them 5 options to pay no federal income tax in retirement.

  1. They can take their first $20,700 (standard deduction + personal exemptions) in income from tax deferred money tax-free.  Then, they can take the other $19,300 from Roth IRAs tax-free.
  2. They could use money from tax deferred accounts as above tax-free. Then, they could utilize taxable accounts. This taxable money would consist of a combination of tax-free basis and taxed long-term capital gains. Since long-term capital gains for those in the 15% marginal tax bracket is taxed at 0%, it is also tax-free.
  3. All $40,000 could be taken from Roth IRA accounts tax-free.
  4. All $40,000 could be taken from taxable accounts. Since this money would be taxed at 0% due to their low income, it would essentially function as a Roth IRA.
  5. They could use any combination of the tax-free options.

Why Early Retirement Offers Such Tremendous Advantages

There are three key factors that make the tax advantages so great for early retirees. The first factor is developing a high savings rate as required to build wealth for early retirement. This allows using a timing strategy, shifting income from years when it is earned but not needed to years when it is needed and taxed at far lower rates. If you spend every dollar that you earn, you lose this ability to defer money or control when, and at what rates, it is taxed.

The second factor is having a long time period over which to recognize this income. Spreading the income over many years allows it to be recognized in the lowest tax brackets. Those with a traditional retirement have a shorter time frame to recognize tax deferred income. During the majority of a traditional retirement, the retiree will receive social security and be subject to required minimum distributions. This income can push the income into the higher tax brackets and negate much of the advantage of the tax deferred saving.

The final factor is the relatively low cost lifestyle that allows saving large amounts of money enabling early retirement. This low cost lifestyle also allows people to pay very little tax in retirement. The sweet spot is to keep living expenses in retirement low enough to stay in the 15% marginal tax bracket. This allows money in tax deferred investments to be recognized at low tax rates and investment income to be tax free.

Putting It All Together

Early retirement requires living below your means during your working years. The relatively low cost lifestyle required to retire early also allows for tremendous tax advantages in retirement. This gives early retirees several excellent and completely legal options to greatly reduce taxes in their working years and then further limit or even eliminate taxes in retirement.

Author Bio

Total Articles: 24
Chris is a father, husband, and adventure seeker who loves to seek new challenges and continue to learn. He became a personal finance junkie obsessed with DIY financial planning to figure out how to retire by age 40. He wants to leave the rat race to fully pursue these things that he is most passionate about.

Article comments

Ben says:

Thanks for the article Chris. I had no idea the personal exemption existed. I usually use tax act to file my taxes and don’t remember it coming up. Is there some trick to getting it?

Chris Mamula says:


Thanks for reading. I’m not sure I understand your question. I don’t know what tax act is, but I would think any tax software should show you what your deductions and exemptions are depending on your filing status and # of dependents. Hope that helps.


Jim Buchanan says:

Chris, some great tax examples! I am thinking that in lieu or, or in conjunction with, such an extreme savings rates during your working years, wouldn’t it also be valid to pay for things during your working years that will reduce living expenses in the future, such as: paying off any mortgage fully; installing solar panels and heavy insulation to keep utilities low; if desired, purchasing a value-minded timeshare or vacation home or RV instead of costly annual vacations; and where offered, lifetime memberships or subscriptions for things you already purchase annually; perhaps installing a producing vegetable garden, and so forth ?? (Some of these things can be enjoyed before retirement even begins…)

Similarly, I know a few folks who have bought a long-lived vehicle (like a pickup truck) somewhat in advance of retirement…)

Chris Mamula says:


You make great points here. Where this becomes really important is if purchasing health insurance and relying on Affordable Care Act (Obamacare) subsidies. These subsidies are CURRENTLY based on your income and do not factor in any means testing. I was going to include this in the article, but felt it was a better topic for a separate post as it is fairly complicated.

Also, the danger with any of these strategies is that tax laws are subject to change. I feel that the advantages to the planning strategies outlined in the post are so great that it would take a complete overhaul of the system to not come out ahead. With the ACA being such a hot button political issue, I feel much less confident planning based on things there staying the same.

Hi Chris

Very informative article. I would add one possible wrinkle; the Roth option in the 401(k). Yes, while I understand that not every plan offers this option, it is growing in acceptance by plans.

Today, an increasing number of employers offer a Roth 401(k) as part of their 401(k) retirement plan. The Vanguard Group – one of the largest providers of retirement and investment plans – indicated that 56 percent of the 1,900 employers offering a 401(k) plan through Vanguard now offer a Roth option. That’s up from 42 percent six years earlier in 2010. More than 2.3 million employees have access to a Roth 401(k) through Vanguard, yet only 14 percent are using it. That’s a small, but increasing percentage. Six years ago, just 9 percent were using a Roth as part of their 401(k) retirement account.

I think the Roth is a great option for people. Most folks are likely to invest more in their company’s 401(k) than in their own IRA primarily due to the higher contribution levels, but also due to corporate matches and the automatic contributions.

If you can invest your money — granted, post tax money — into a Roth 401(k) for say 30 or 40 years, you could easily be looking at a 7-figure nest egg… and the best part, if it’s in a Roth, it’s not subject to taxation when you withdraw it in retirement.

Source: http://dollarbits.com/how-does-your-401k-stack-up-and-other-bits/

Chris Mamula says:

Tax planning is very specific to your personal situation. It involves knowing where you are now, projecting where you will be in the future and the amount of confidence that you have that the laws will not change drastically.

All that said, I think this is one case where the advantages are very clear and even if your projections are off by say 50%, you will end up ahead if you max out tax deferred plans before worrying about Roth options because the advantages are so great for early retirees. While I can not advise others what to do, we always max out tax deferred savings options first.

For those with relatively high incomes and low expenses, after maxing out tax deferred retirement accounts and HSA’s there is still the option of funding Roth IRA’s (conventionally or back-door) and then utilizing taxable accounts as well. This will give flexibility to recognize income in the most optimum way once in retirement.

Dave says:

A lot of good information packed into one article. However if we are talking about early retirement you need to factor in the penalties for early withdrawal from any tax deferred accounts such as IRA’s or 401k’s taken before the age of 59 1/2.

Chris Mamula says:


This is a common objection to this strategy which I disagree with for several reasons.
1.) There are ways to access retirement accounts penalty free. I linked an article in the post that explains Roth conversions and 72T SEPP’s. While somewhat complex, they are options.
2.) A portion of early retirement planning is planning a conventional retirement (+ funding the early portion). This strategy could be fully implemented for a full decade from ages 60-70 without penalty and with full control of when and how income is recognized if SS is delayed and before RMD comes into play.
3.) Look at the example in the post. Even if they would pay the full penalty (10%) plus the full 4.9% tax in retirement, they would still pay a total of 14.9%. 14.9% < 25% which is what they would have paid if not deferring the taxes. Plus they would have this money working for them for years rather than never having it if paying the taxes the year it was earned.

Hopefully some food for thought and I welcome any objections to this way of thinking.

Stephanie Colestock says:


Be sure to check back here on Thursday — we’re covering this exact concern!


Lauren says:

Chris, thank you for this article… Avoiding taxes by pulling funds from different accounts each year is what we should all should do in retirement.

I have read too many times that we should deplete taxable investments first and leave tax deferred and Roths til last, clearly NOT the right thing if you want to limit tax liability every year throughout retirement, and don’t want to leave Roths (tax free) to heirs.

Are the income levels and corresponding marginal tax rates announced by the IRS at the beginning of the tax year so we can execute this strategy? Hopefully they won’t change them mid way through the year!

Chris Mamula says:


I agree with your thought process completely.

Typically marginal tax rates are announced near the end of the year prior to being implemented with occasional changes to the law and inflation adjustments . While changes in tax law are the biggest risk I can think of with the strategies I’ve outlined, I don’t think they’ll ever change things up in the middle of a year (though I guess anything is possible?!?)


Baste says:

Chris, this is an awesome article! I am 35 yrs of age and I have option to take an early retirement at age 55 in my company with projected 6k monthly pension. In addition, I am also contributing to our voluntary contribution which will yield to an additional 2k monthly annuity or I can take it as lump sum. My wife is in similar income situation.
My concern is if it will be advantageous to open another tax deferment account account that is offered in my company or will I pay end up paying more taxes in the future. I am not sure how are pension and annuity are taxed.
Also, my plan is to retire at 50 at the latest! Do you have any suggestions on how can accomplish that?

Chris Mamula says:

Thanks for the positive feedback Baste. It sounds like you have put yourself in a very favorable position and are fortunate to have the pension and annuities. Assuming the structure of the tax code stays the same, the primary consideration for the strategies I have outlined is whether your income is greater now than in retirement (better to defer and pay lower rates later) or higher in retirement than now (better to pay up front). For most people in a position to retire early it is a no brainer to defer when possible. Your unique situation with the pension and annuity may make you an exception and so you may want to sit down with a tax professional for a consultation.

Best of luck!

Roger says:

Sometimes using a low cost tax prep software program will show the individual(s) what would happen, tax wise, if they withdrew funds from their retirement accounts. Also what tax, if any, would be due should the individual(s) begin to receive social security income in addition to the retirement account distributions.
A useful tool indeed!

Chris Mamula says:

Agree that sounds very useful. Are you aware of specific programs with this feature?

Mike says:

Great Article not the usual run of the mill. I am 60 years old with 1.5 million Total (670K in Cash & Investments, 630K in IRA’s, & 200K in Roth IRA) with 140K in my house & SS when the time comes. (13% Cash, 12% Bonds, 10% in 3 different REITS, & 65% Stock Mutual Funds). I feel by putting so much in IRA’s when I was younger and in a lower tax bracket that now it will put me in a higher one as I am older. I want to move some IRA money into the Roth IRA over the next 3+ years and start slowing down now to do the things I can in my 60’s. Any thoughts would be greatly appreciated. Mike

Chris Mamula says:


I think that the first key question is whether you want to cut back now for lifestyle reasons. I would not let the tail wag the dog by trying to make less just to pay less taxes. However, if you are looking to cut back anyway, without knowing all of your details it seems that you have put yourself in a pretty nice financial/tax situation. You could have a full decade to recognize income in a very purposeful way while limiting taxes now and later by converting portions of your IRA accounts to Roth IRAs before you would need to start RMDs and taking SS later. It would likely be worth your while to sit down and consult with a tax professional and SS expert with all of your details to make the optimal decision. Best of luck with your decisions and thanks for taking the time to comment.