Should You Downsize Now if You are Thinking of Retiring Early?

A lot changes when you retire, from your daily routine to your expenses. Your children are likely to move out during this time as they become adults and are unlikely to return home. Socializing may also decrease as you get older. Moreover, with a relatively tighter budget than during your working years, you may want to cut back on some expenses, including your home. Downsizing is a common strategy adopted by many retirees. However, it is not as straightforward as it may seem, and it is essential to understand whether it is a good idea to downsize for your personal and financial needs.

A financial advisor can help answer all your questions about downsizing. This article will discuss the pros and cons of downsizing, and the essential considerations to remember while making this decision.

Is it a good idea to downsize in case of early retirement?

Downsizing is a subjective strategy that can work for some people but not for others. Ideally, downsizing can be suitable in the years preceding or after retirement. This is irrespective of your age but more aligned with your retirement age and other factors. For instance, if you plan to retire early in your 40s but your kids are still young and living with you, downsizing will not be ideal as you need a bigger space. However, if you retire in your 60s and your kids have moved out, downsizing can help you get rid of clutter and live in a house that is more aligned with your age and needs.

Apart from this, there are several other factors to consider when downsizing.

Below is a list of the pros and cons of downsizing that can help you arrive at a decision:

Pros of downsizing

1. Frees up money

The most apparent reason to downsize is to free up cash. Selling a larger house and purchasing a smaller space can generate funds. Under existing tax regulations, if you sell your primary residence at a profit, you could potentially exclude up to $250,000 as a single tax filer or $500,000 as a married couple filing jointly of that capital gain from your taxable income.

The freed-up cash from downsizing can be instrumental in shaping various financial goals. This money could be channeled towards increasing your retirement savings, thereby providing you with a more secure financial future. Alternatively, you can direct the funds towards funding a child’s higher education and ease the financial strain associated with tuition fees and other education-related expenses. Investing the proceeds from downsizing can be another viable option to potentially generate higher returns and contribute to your long-term financial stability.

2. Earnings can be used to pay the mortgage

This strategy holds particular merit for those nearing retirement or recently retired with an ongoing mortgage. This way, you can effectively eliminate all your liabilities at once and enjoy peace of mind and financial stability as you enter a new phase of life.

Carrying debt into retirement is generally discouraged. Paying for debt from your retirement savings can erode your nest egg over time. Ideally, debt should be eliminated before you retire to ensure lifelong financial security.

If you still have an outstanding mortgage, it can be wise to use the profits from downsizing to pay it off. This will remove a significant financial obligation, reduce your ongoing retirement expenses, and allow for a more secure and comfortable retirement.

3. Cuts down long-term maintenance expenses

In addition to the costs associated with buying or selling a house, there are numerous other expenses tied to homeownership. Larger homes typically incur higher expenditures. For example, utilities like electricity and water tend to be pricier. Moreover, maintaining a larger space involves more extensive tasks, such as checking for mold and handling potential infestations, which can lead to increased expenses. Maintenance costs also escalate with larger homes, and tasks like cleaning become more challenging as you age. These potentially require you to hire costly help for both indoor and outdoor upkeep, such as gardens, pools, driveways, and garages. Moving to a smaller house can help lower or even eliminate some of these expenses. For instance, a smaller apartment can be easier to maintain than an independent bungalow.

Furthermore, larger homes generally require higher insurance coverage, which results in higher insurance costs. Downsizing to a smaller residence typically means lower insurance premiums as the property value and number of items covered decrease. This translates to reduced homeowner’s insurance premiums as well.

4. Helps save tax in case of relocation to a new city

Downsizing could be a smart move if you are considering relocating to a state with minimal to no tax on your income. Taxes are a persistent expense in retirement, and eliminating or reducing them before you retire can lead to significant savings over time. While there may be initial expenses associated with relocating, the long-term savings can outweigh these costs.

Here’s what you should keep in mind:

a. States like Alaska, Florida, Georgia, Mississippi, Nevada, South Dakota, and Wyoming either have no state income tax, no tax on retirement income, or offer substantial tax deductions on retirement income. Additionally, these states also have favorable property, estate, and inheritance tax rates.

b. Colorado, Arkansas, Oklahoma, Pennsylvania, Illinois, Kentucky, Louisiana, Delaware, Idaho, Michigan, New Hampshire, Alabama, South Carolina, Tennessee, Texas, Virginia, Washington, and West Virginia do not tax Social Security income and often provide an additional deduction on retirement income.

c. States like Arizona, Indiana, New Mexico, New York, Maryland, Massachusetts, Missouri, Iowa, Kansas, Montana, New Jersey, the District of Columbia, Hawaii, North Carolina, North Dakota, Ohio, Oregon, Utah, and Wisconsin offer lower deductions on retirement income.

d. California, Connecticut, Maine, Minnesota, Nebraska, Rhode Island, and Vermont offer minimal to no retirement income tax benefits.

Considering these factors can help you make an informed decision about downsizing and relocating to a tax-friendly state in retirement.

5. Makes life more comfortable

Downsizing can significantly enhance your retirement lifestyle. Retirement is about relaxation, and a smaller home contributes to that by reducing the amount of work needed around the house. With less maintenance required, you can take things at a slower pace and focus on enjoying your newfound freedom. Many retirees also prioritize travel, and a smaller home is easier to manage while you are away. Finding a house sitter is simpler, and people are more willing to care for a smaller home due to its simplicity.

Smaller houses, especially those on a single floor, are more elderly-friendly. You do not have to take multiple stairs every day, which can become increasingly challenging as you age. Additionally, smaller homes can be easier to monitor and secure from a security standpoint, which can provide peace of mind during your retirement years.

6. Save on property tax

Property taxes are fees you pay to the government based on the value of your property. Taxes can differ a lot in value depending on where you live. Different cities, counties, and states have their own rules and rates for property taxes. So, someone living in one area might pay more or less in property taxes compared to someone living in another location, even if their properties are similar. For example, taxes for condos or townhouses are often lower compared to single-family homes because you are typically responsible for a smaller piece of land and fewer exterior maintenance costs.

Property tax is usually calculated based on the size of your property. The government appoints an assessor who examines your property and estimates how much it is worth. This includes both the land your house sits on and the building itself. After that, you get an assessment, which tells you the value of the property. In some places, they use a percentage of that value to calculate your taxes, while in others, they just use the exact value they came up with. So, depending on where you live, you might pay more or less in property taxes even if your property’s value is the same. Downsizing to a place that is more favorable for property tax can help you save money.

Cons of downsizing

1. Tax exclusion can only be claimed under specific conditions

While the IRS offers tax exclusions on the sale of a house up to a specific limit, there are some conditions to this. You can use these tax exclusions on multiple sales, but you can only do so once every two years.

Additionally, the IRS uses two tests to determine your taxability – the ownership and use tests. According to the ownership test, you must have owned the house with the property in your name for at least two years, or the property should be jointly owned for a minimum of two years before the sale. As per the use test, you must have lived in the house as your primary residence for at least two out of the last five years up to the date of sale. However, the two years of residency do not have to be consecutive. As long as you have lived in the home for a total of 24 months out of the five years before the sale, you meet the requirement.

There are exceptions to these rules. For instance, the IRS may allow you to adjust the exclusion if you need to move before owning the home for two years due to a job change. The same applies in the case of natural disasters and if you get divorced. However, if you go through a divorce after living in the home for just one year, you would only be entitled to 50% of the exclusion.

It is also important to consider that higher-valued homes that may exceed the $250,000 or $500,000 exclusion limit will be subject to taxation. So, if you do not meet any of the criteria mentioned above or if the value of your house is more than the tax exclusion limit, you will pay tax on the profit exceeding these thresholds. In this case, downsizing may not be suitable as you could lose money rather than making a profit.

2. Sense of loss and nostalgia

While downsizing can offer financial benefits, it is essential to acknowledge the emotional aspects of such a significant life change. Many individuals feel a sense of loss when they shift homes, especially if they have resided in the same house for numerous years. Selling it can be emotionally challenging if your children grew up in that home. Moreover, neighbors play a significant role in fostering a sense of community and leaving them behind can intensify feelings of loss. The connections and memories built within the neighborhood can be challenging to part with. Transitioning to a new area may not provide the same sense of belonging. This can further complicate the adjustment process.

3. No guarantee of profits

Downsizing does not always guarantee profits. The money you make from selling your home largely hinges on real estate prices at the time of sale. Additionally, the location of your property significantly impacts its selling price. A smaller house in a highly sought-after area can sometimes get you a higher price than a larger home in a less desirable location.

Furthermore, your profits are influenced by your tax situation. The goal is to maximize your earnings by minimizing tax obligations. This means you need to consider strategies that help you retain as much of your profit as possible instead of seeing it diminished by taxes.

To conclude

Downsizing can be a helpful strategy, but it is crucial to fully understand its pros and cons and how they apply to your situation before making a decision. This move can affect your entire family, so it is advisable to seek their opinions and consent as well. Moreover, downsizing is not limited to selling a larger house and buying a smaller one. It can also involve selling a home and renting another if that makes financial sense. Consulting a financial advisor can be helpful in determining whether downsizing is the right move for you.

Use the free advisor match tool to connect with vetted financial advisors who can answer all your retirement planning-related questions about downsizing. Simply answer a few questions about your financial needs, and our match tool can match you with 2 to 3 advisors suited for guiding you toward your financial goals.