Putting it Together: Tax Management in Early Retirement (Phase 1)

This is Part 3a of our Retirement Withdrawal Strategies series.

In Part 1, we looked at when you can actually access your retirement savings, dividing retirement roughly into three phases:

In Part 2, we explored the tax-free buckets that you can use so you never pay US or UK tax again (or at least keep it very low).

Today, we’ll look at how those two elements work together, mixing and matching the accounts that you have available plus their tax implications. We’ll also look at a few of the key points for attention, to ensure long-term success. I’m going to split Part 3 into three sub-parts, one for each phase, so that you don’t have an entire book to read!

Finally, in Part 4 we’ll look at a few scenarios and examples to see how this all might work in practice.

Quick note on inflation: all figures in this series are in 2021 $ and £. I think in terms of real (after inflation) returns, and tax brackets are roughly indexed to inflation. Inflation is real, but we get to ignore it here. I also assume a constant exchange rate of $1.40 to the £ – the principles hold anywhere around that, but if we see major changes (stuff like $1 to the £ or $2 to the £), I’d want to re-check some pieces between US & UK taxes.

Phase 1: Early Retirement

Phase 1 has three main objectives:

  1. Ensure you have enough money to make it to Phase 2, when you get access to all the tax advantaged accounts
  2. Set yourself up for success in Phase 2 and especially Phase 3, when it becomes much more difficult to control your income due to Social Security, State Pension, and/or Required Minimum Distributions.
  3. Enjoy early retirement!

Your options are pretty limited here, which makes things simpler but also more constrained than later on:

Goal 1: Get to Phase 2 Without Running out of Money

In order to meet goal #1, we need to start withdrawing from our accounts, and we’d rather not pay any more tax than we have to – 0% would be nice!

On the UK tax side, it’s actually pretty easy to not pay any tax here – the only account that is taxable is your taxable brokerage account. Depending on the balance here and any gains (potentially offset by capital gains and loss harvesting), you may struggle to fill your capital gains and dividends allowances. After that, it’s all tax free, so you want to look at the US picture to decide how to make up the rest of your spending.

For the US, your taxable brokerage account remains taxable, and your S&S ISA gets treated like another taxable brokerage account. For a modest level of spending, it shouldn’t be difficult to keep capital gains and dividends below the limit, and possibly do some capital gains & losses harvesting in both accounts.

After balancing out your taxable brokerage account and S&S ISA, you may still need more money. Really the only place to get it is from your Roth contributions – you’ll want to be careful not to deplete these too fast, because they don’t go up over time and they can’t be replaced, except through Roth conversions with a 5 year wait.

Setting up those Roth conversions as soon as possible makes sense to be able to get the money before 59.5, but also because of Goal 2.

Goal 2: Set Up for Success

If you have a balance in a Traditional IRA, 401(k), or similar, you need to be planning no later than Phase 1 for how you’ll handle Required Minimum Distributions.

I go into this in detail in my How I Learned to Stop Worrying and Defuse the RMD Bomb post. Quick summary here:

  • Waiting until 72 and just accepting the RMDs will have you paying 20% or even 40% tax in Phase 3
  • Aggressively withdrawing at age 59.5 can keep overall tax to zero if you only start with about £80k ($112k). More than that, and you’re either paying 20% with your aggressive withdrawals, or paying 20% with your RMDs.
  • Roth conversions can keep tax to zero for much larger amounts, depending how early you retire. Even if it doesn’t keep tax to zero, it can probably limit it to 10 or 12% in US taxes except for very large balances
    • Very roughly, if you have more than £800k in Traditional balances at age 55, you’ll probably wind up 20%+ on some of it, but RMDs really only get out of hand and pushing you into 40%+ past £1m or so at 55.

Basically, Roth conversions need to be strongly considered if you have any Traditional balance. Start them as soon as your wage income falls below the US Standard Deduction ($12,400 single, $24,800 married filing jointly), and maybe even if it’s under the 10% or 12% brackets, depending on your overall situation.

Even better, if you are also concerned about the Lifetime Allowance and trying to plan for RMDs and the LTA at the same time, starting Roth conversions early may allow you to take some aggressive Pension/SIPP withdrawals early in Phase 2, helping to manage the LTA without pushing your income into an unfavorable US tax bracket.

Goal 3: Enjoy Early Retirement

That’s really it for the financial side – now enjoy your time! Once you have a plan for Goals 1 and 2, they should be pretty much on autopilot with some occasional attention to handle withdrawals to cash and Roth conversions.

Phase 1 Potential Pitfalls

Some quick notes on a few things that might make Phase 1 a little more challenging:

  • Some people may still have a mortgage at this point, making your spending requirements higher than they will be later in retirement. This can push you into a higher tax bracket, depending on the mortgage payments and the rest of your spending, and curtailing your ability to start Roth conversions. There’s no single right answer here, you’ll want to look at a few scenarios like accelerate repayments, paying off in full, or just planning for the increased cash requirement.
  • If you’re taking more of a CoastFIRE, BaristaFIRE, or FlamingoFIRE route and are still working in some capacity, this can quickly fill your Personal Allowance and push you into the 20% tax bracket (32% with NI contributions). Obviously means you don’t need to draw down investments (or at least not as much), but limits your ability to do Roth conversions to manage RMDs without paying extra US tax up front.
  • The sequence of returns risk is highest just after retirement, so if you get particularly unlucky and are looking at major drops in your portfolio value while also not being able to access much of your savings, things can get tight. There’s no one way of managing this, but things like flexible withdrawal rates, being open to part-time work, and, worst case, withdrawing 401(k), IRA, or LISA money with a penalty may all be options.

Transition to Phase 2

Lastly, Phase 1 ends when you start to get access to your tax-advantaged accounts (Pension, SIPP, 401(k), IRA, etc.). Depending on your age and where your savings are, there may be a substantial interim phase (age 55 to 59.5) where you have access to a UK Pension/SIPP, but none of your US accounts. Because of the way pensions are taxed (75% taxed as UK wages, probably 100% US taxable but maybe with a basis), this can be a slightly complicated period, especially if you wind up relying heavily on your pension because your Phase 1 accounts are largely depleted.

If you’re in that boat, you may want to plan this as a discrete phase with some careful planning to manage taxes as well as preparing for the transition to Phase 2, along with the longer-term planning for RMDs and LTA. In some of my scenarios, this sub-phase is actually pretty useful for LTA management, since you’re drawing substantially on your pension as soon as you can, reducing future growth, but there are drawbacks.

If you’re lucky enough to be carrying a significant balance from your Phase 1 accounts into Phase 2, it’s less critical – may still be useful for LTA management to draw down your Pension early, but the handoff from Phase 1 to Phase 2 doesn’t need to be as meticulously managed.

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