Tax Planning for the Year You Retire Early: A CPA's Guide

By Tom, CPA · Updated October 25, 2026

TL;DR: Your retirement year mixes a partial year of wages with your first retirement moves. Front-load 401(k) contributions before you leave, think about when severance and bonuses are paid, avoid Roth conversions that stack on top of high wages, and use the rule of 55 if you separate from service in or after the year you turn 55.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

The year you quit is the year your tax return does parkour. Your W-2 shows wages for part of the year, maybe a severance package and a vacation payout, and possibly some stock compensation. Your brokerage statements start to look like a retiree's. And next year looks completely different.

That mix creates opportunities and traps. This guide walks through the decisions that matter most, with 2026 limits from the IRS.

CPA Warning Label: Severance, unused vacation payouts and final bonuses are wages. They're taxed and withheld as wages, and they can push you into a higher bracket than you expected for a year you only half worked.

Partial-year income math

The federal income tax is annual. It does not care that you only worked until June. Six months of a $180,000 salary is $90,000 of wages, taxed at the same brackets as a full year of $90,000.

That has two consequences. First, if you retire early in the year, your retirement-year tax rate may be quite low, leaving room in the 12% or 22% bracket for Roth conversions in the same year. Second, if you retire late in the year, your wages may already fill the brackets, and conversions should wait until January.

Illustration. Assumptions: married couple filing jointly, 2026. One spouse retires on March 31 after earning $45,000 in wages for the quarter; the other was already retired. Other income: $10,000 of qualified dividends.

• Wages $45,000 minus 401(k) deferrals of $20,000 (front-loaded before leaving) leaves $25,000 of taxable wages.
• After the $32,200 standard deduction, ordinary taxable income is zero, and $2,800 of the deduction spills over to the dividends.
• Room to the top of the 12% bracket: they can add about $107,000 of Roth conversions ($25,000 + $107,000 = $132,000 of ordinary income, just under $133,000) for about $11,480 of tax on the ordinary income. But the $10,000 of dividends would then sit above the 0% band and add $1,500 of tax. Trimming the conversion to about $96,000 keeps taxable income at $98,800 and the dividends at 0%.

Compare a spouse retiring December 31 with $180,000 of wages: their 2026 conversion room is in the 22% or 24% bracket, and waiting a few weeks to convert in January 2027 cuts the rate roughly in half.

Severance and PTO timing

Severance, unused vacation and sick-pay payouts are taxed as wages and subject to Social Security and Medicare taxes. Employers usually withhold federal income tax on supplemental wages at a flat rate unless they combine them with regular pay. Flat withholding may be too high or too low compared with your actual tax.

If you have any control over timing, think about which year the payment lands in. A severance paid in January of the following year may be taxed in a year with no other wages, potentially at a much lower rate. Some employers allow you to choose, and some deferred compensation plans fix the timing years in advance. Once you have a legal right to the money, you generally cannot postpone it just by not cashing the check.

Severance can also affect ACA premium tax credits if you buy marketplace coverage for part of the year, because the credit is based on annual household income.

Max out accounts before leaving

For 2026, the 401(k) elective deferral limit is $24,500, plus an $8,000 catch-up if you are 50 or older, or $11,250 instead of $8,000 if you are 60 to 63 (IRS IR-2025-111). Deferrals must come out of your paychecks, so once you leave, you cannot contribute. If you plan to quit mid-year, raise your deferral percentage early so you reach the limit before your last day. Check that your employer match is not "per pay period," or you could miss part of the match by front-loading.

You can still contribute to an IRA after you retire, but only if you have earned income for the year at least equal to the contribution. A partial year of wages counts. The 2026 IRA limit is $7,500, plus $1,100 catch-up at 50 or older. If you have a spouse with earned income, a spousal IRA can also be funded.

HSA contributions depend on months of HDHP coverage; if you keep HDHP coverage after leaving work (through COBRA or a marketplace HDHP), you may still contribute for those months.

The rule of 55

Distributions from a 401(k) or other qualified plan are exempt from the 10% early distribution tax if you separate from service during or after the year you reach age 55 (age 50 for qualified public safety employees), according to the IRS. The exception applies only to the plan of the employer you leave, and it does not apply to IRAs.

That has a big implication for your retirement year: if you are 55 or older and plan to use the rule of 55, do not roll the old 401(k) into an IRA, or you lose access to penalty-free withdrawals until 59½. Leaving at 54 in December does not work; leaving in January of the year you turn 55 does.

Distributions are still subject to regular income tax, and many plans withhold 20% from cash distributions.

Deferred comp and RSU timing

Restricted stock units are taxed as wages when they vest. Unvested RSUs are usually forfeited when you leave, unless your plan has retirement provisions. If a large vest is scheduled shortly after your intended departure, compare the value of staying a few more weeks with the tax cost of receiving it in a high-wage year.

Nonqualified deferred compensation is paid on the schedule you elected years ago. Lump-sum payouts can land in your first retirement year and use up the low brackets you hoped to use for conversions.

Stock options often must be exercised within a short window after leaving. See the employee stock options guide for details on ISOs and NSOs.

Health insurance in the transition year

Leaving an employer plan means choosing between COBRA and a marketplace plan. Marketplace premium tax credits are based on annual income. A spouse who retires in March with $45,000 of wages might still qualify for a credit for the remaining months; one who retires in October with $150,000 probably will not. As of Oct 2026 the enhanced credits have expired, so household income above 400% of the federal poverty level ($84,600 for a two-person household for 2026 coverage, per CMS) gets no credit at all.

Withholding and estimates in the transition year

Your employer withheld tax on your wages, but conversions, capital gains and dividends after you leave have no withholding. If your wage withholding was generous, it might cover the whole year. If not, use the safe harbors: pay at least 100% of last year's tax (110% if last year's AGI exceeded $150,000), or 90% of this year's. In the year you retire, last year's tax is usually high, so the 90% current-year test may be easier. See estimated taxes.

Setting up next year's plan

1. Estimate next year's spending and where it will come from.
2. Decide which bracket you will fill with conversions, and check subsidy and IRMAA lines.
3. Look for 0% capital gains room.
4. Set up quarterly estimates or IRA withholding.
5. Update beneficiaries on all accounts.
6. Document cost basis in taxable accounts while statements are easy to find.

Frugal Fran's retirement-year spreadsheet had 14 tabs. Lavish Larry celebrated with a boat and a December Roth conversion on top of a full year of wages. Fran's tax rate was 8%; Larry's was 24% on the conversion. Both enjoyed the boat, on different days.