A Hidden Window: How Early Retirement Creates a Smart Tax Opportunity

For many retirees, the early years of retirement come with a significant drop in taxable income. This is especially true for those who delay their Social Security benefits and instead live off savings or brokerage accounts. While this may seem like a temporary lull, it creates a unique opportunity for thoughtful tax planning. With a little strategy, retirees can use this window to build a tax-efficient withdrawal plan that could save them thousands over time.

To understand how this works, it helps to know how the IRS treats different types of income. Not all income is taxed the same. Ordinary income includes wages, interest, a portion of Social Security benefits, business profits, and non-qualified dividends. These income sources are subject to the standard progressive tax brackets, which currently include rates of 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. The term “progressive” means that your income fills the lowest bracket first, then moves up in layers, not that all of your income is taxed at the top rate you reach.

The 2025 tax law, known officially as the One Big Beautiful Bill Act, made the standard deduction permanent. It set the standard deduction at $15,000 for single filers and $30,000 for married couples filing jointly. On top of that, individuals over age 65 can deduct an additional $2,000 if single or $1,600 per spouse if married. A temporary bonus deduction of $6,000 is also available through the end of 2028.

These deductions are subtracted from gross income to arrive at taxable income. Taxable income is what the IRS uses to apply the bracket system. The actual taxes owed are based on how much income falls within each bracket, and this creates an effective tax rate that is usually much lower than the top marginal rate.

To see how this plays out, consider a retired couple with $100,000 of gross income. They take the standard deduction of $30,000, leaving $70,000 in taxable income. The first $23,850 of that is taxed at 10 percent, which equals $2,385. The remaining $46,150 is taxed at 12 percent, which comes out to $5,538. Add those together and the couple owes $7,923 in federal income tax. Although their marginal bracket is 12 percent, their effective tax rate is just 11.3 percent. That’s the average rate they pay across all their taxable income.

Now let’s look at another type of income: long-term capital gains. These are profits from the sale of investments that have been held for more than one year. The tax system for long-term capital gains is more favorable, with three main brackets: 0 percent, 15 percent, and 20 percent.

For married couples, the 0 percent capital gains rate applies to taxable income up to $96,700. That means a couple with $70,000 in taxable income still has $26,700 of room in the 0 percent capital gains bracket. They could realize that much in long-term capital gains and pay no federal tax.

But the benefit goes further. After realizing a gain, they can immediately repurchase the investment and reset their tax basis. Suppose they sell an investment for $53,400 that originally cost $26,700. Half the value is gain. By repurchasing the investment right away, they reset their basis to $53,400. If the asset appreciates again in the future, they will owe tax only on gains above this new, higher basis. This move can significantly reduce future tax exposure.  And if the value drops, it can offer a chance to share some of the loss with Uncle Sam.  

This opportunity often goes unnoticed because many retirees don’t differentiate between ordinary income and capital gains. But in this case, the difference creates a powerful planning opportunity. Long-term capital gains stack on top of ordinary income. That means you fill up the ordinary income brackets first, and then long-term capital gains are assessed after that.

Now, let’s extend the earlier example. Suppose the couple needs to sell stocks for living expenses and realizes a $30,000 long-term capital gain. Their total taxable income now increases to $100,000. Since the 0 percent capital gains rate ends at $96,700 for married couples, the additional $3,300 is taxed at 15 percent. That’s $495 in taxes, which is 15 percent of the amount over the threshold.

In return, they now have $60,000 in spending money, which is the full value of the investment they sold. Paying $495 in taxes to access that much liquidity is a worthwhile trade-off. It’s certainly better than taking the same amount from their IRA.

If they had withdrawn $60,000 from their IRA instead, their taxable income would jump to $130,000. That level of income would increase their tax bill to $18,428. The effective tax rate in that case would rise to 14.2 percent. In comparison, the long-term capital gains route kept their tax rate much lower.

Understanding the difference between how various types of income are taxed is essential to building a smart withdrawal strategy in retirement. A well-designed distribution plan always starts with the end in mind. The question to focus on is not just how much you need to withdraw, but how much of that money will be left after taxes. By taking advantage of low-income years, understanding how income stacks across different tax brackets, and making use of the 0 percent capital gains window, retirees can maximize what they keep and minimize what they owe. That kind of planning not only improves cash flow, it also leads to better financial peace of mind.

After all, it’s like the age-old adage: It’s not about how much you make. It’s about how much you get to keep.