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Income Tax Planning in Early Retirement: Strategies for HNWIs

Anyone entering retirement must manage the tax implications that come with shifting their primary income source from their employer to other income streams like social security. But for high-net-worth individuals (HNWIs) with robust portfolios, income tax planning can be particularly complex. Retiring early can complicate the tax planning process even further.

In a recent video presentation, Granite Harbor Managing Partner, Tim Smith, CFP® discussed income tax planning in early retirement, cash flow considerations, and strategies for achieving long-term financial goals. Watch that full presentation below or keep reading to find insights and strategies for effective income tax planning in early retirement and beyond.

Bridging the gap to age 59 ½

Employer-sponsored benefit plans like 401(k) plans are often a foundational element of financial planning for retirement. Unless an individual is 59 1/2 or older, retirement funds usually cannot be accessed without penalty, creating a gap for early retirees. However, there are still ways to access funds and bridge that gap to maintain cash flow in early retirement.

1. 72(t) elections

One way to access funds in retirement accounts before age 59 ½ is to take an election known as a 72(t) election. Sometimes referred to as rule 72(t), this election allows for penalty-free withdrawals from IRAs, 401(k) plans, and 403(b) plans. However, those withdrawals will be taxed at the retiree’s normal income tax rate. Withdrawals are made in at least five equal payments that must continue for a minimum of five years, or until the retiree reaches age 59 ½, whichever is longer. The amount of those payments is based upon the retiree’s life expectancy.

2. 401(k) distributions at age 55 if severed from employment

Typically, early withdrawals from 401(k) plans would incur a 10% penalty. However, the IRS allows penalty-free, premature distributions for those age 55 or older (but under age 59 ½) if they are fired, laid off, or otherwise separated from service after the attainment of the age of 55.

3. Ideal post-tax asset allocation

One key to bridging the gap to 59 ½ is to ensure a retiree’s portfolio has the appropriate mix of equities and bonds to meet cash flow needs in retirement. At Granite Harbor, we typically recommend early retirees have four to seven years of income security based on their post-tax asset allocation. We work with our clients to map out expected cash flow needs throughout retirement and manage portfolio mix to ensure security without compromising future growth opportunities.

Managing taxes efficiently

Tax efficiency becomes even more important for high-net-worth individuals as income streams shift entering retirement. Here are four strategies to manage taxes more efficiently in early retirement:

1. Charitable giving acceleration

Accelerating charitable donations can create tax advantages for early retirees. There are seven types of charitable giving strategies high-net-worth individuals may want to consider:

  1. Donor-advised funds – Allow individuals to place a large amount of money in a charitable giving account and receive a tax deduction in the year the funds were transferred, with donations directed by the retiree over time.
  2. Real estate - Highly appreciated real estate can be donated for significant tax advantages.
  3. Cash – Deductions are limited to 60% of the retiree’s adjusted gross income (AGI).
  4. Highly appreciated stock – Deductions are limited to 30% of AGI but can be an effective tool because assets may have been taxed at a much lower rate when acquired, but donations are made at today’s fair market value of that stock.
  5. Charitable trusts – Charitable lead trusts (CLTs) and charitable remainder trusts (CRTs) are irrevocable trusts that can provide income and tax advantages to retirees, heirs, and charitable organizations both before and after an individual’s death.
  6. Gifting other assets to charity – Retirement accounts and life insurance benefits can be gifted to charity to create tax efficiency.
  7. Private foundation – A popular gifting strategy for those who have accumulated significant wealth.

2. 83(b) elections for vested stock

An 83(b) election allows retirees to pay taxes on stock options at the grant date instead of the vesting date. This strategy can be effective in situations where stock is expected to appreciate significantly over the next few years, or if vesting is expected all in the year of retirement.

3. Minimizing other income sources during the calendar year

Minimizing tax exposure from other sources of income during early retirement can provide significant tax advantages. Some strategies for boosting tax efficiency include:

  • Managing the timing of deferred compensation payouts
  • Maximizing retirement savings accounts
  • Pre-paying or post-paying real estate taxes
  • Managing the timing or collection of passive income
  • Limiting capital gains exposure on investments in year of severance

4. Conservation easement and opportunity zone investing

For individuals who have highly appreciated real estate, conservation easements, and investing in opportunity zones can provide tax advantages. Specifically, opportunity zones are available for investment of after-tax dollars for tax-advantaged treatment of both contributions and future appreciation. Conservation easements allow taxpayers to permanently conserve real property (such as ranch property, family real estate, or green space inside commercial real estate projects) to obtain a significant tax deduction.

Tax diversification strategies

Most high-net-worth individuals use two main “buckets” to accumulate wealth: pre-tax and post-tax. Pre-tax strategies include things like 401(k) or 403(b) plans, pensions, and IRA accounts where contributions are made with pre-tax dollars. Post-tax strategies include brokerage accounts, bank accounts, and real estate holdings where contributions are made with after-tax dollars. But there’s a third bucket of tax-advantaged strategies that offer a blend of current and future tax benefits, including things like Roth plans, FHA, HSA, and 529 accounts, as well as cash value life insurance. At Granite Harbor, we often advise clients to diversify their holdings across all three buckets to maintain flexibility and security from a tax perspective. The key is to work with an experienced firm of financial advisors who can help identify and manage the right mix of assets to achieve individual retirement goals.

Solid tax planning leads to a prosperous future

Income tax planning in early retirement is critical for maintaining cash flow without jeopardizing long-term investments and generational wealth. By thoroughly exploring all the available options and developing an individualized plan based on a retiree’s most important goals and priorities, high-net-worth individuals can enjoy a fulfilling retirement and feel confident their financial future is secure.

Considering early retirement but unsure how that will impact your tax exposure? Connect with Granite Harbor Advisors and we’ll schedule a complimentary consultation to evaluate your current situation and explore income tax planning strategies that can help you achieve your retirement goals.

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