Part of my plan for retiring early is to keep my income very low so that I remain in the 0% tax bracket. According to the IRS I can earn the following before being bumped to the 10% federal and 4.5% state tax brackets.

$3650.00 - exemptions
$5700.00 - standard deductions
$ 500.00 - if I pay property taxes and don't itemize
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$9850.00 - 0% tax bracket
$2000.00 - if I fund an HSA
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11850.00
+ if I have more than 5700 in standard deductions I could earn even more and remain in the 0% bracket. These are 2009 figures and it may go up some in 2010.

In 1997 I started working for a big company which had a pension plan for it's employees. They froze the plan one year after I started working there. When I retired the company gave me the money that was in the plan. It had grown to a whopping $3906.00. In this situation the pension is treated like an IRA. The fund reserved 20% to pay taxes before passing the money on to me.

If I just spent the money on living expenses I would pay taxes on the money as income and also owe a 10% penalty for early withdrawl. However, if my income with the pension/IRA dispersal is less than the amount to tip into the 10% tax bracket I owe no income taxes on the money.

If I spend the pension/IRA money on medical expenses, including health insurance premiums, dr visits, prescription drugs, lab work, eye glasses etc, I don't have to pay the 10% penalty. There is a caveat on that. You can exclude the amount you paid for unreimbursed medical expenses during the year minus 7.5% or your adjusted gross income for the year. And the IRA/Pension distribution contributes to your gross income. Figuring out the exact amount to withdrawl ahead of time can be tricky unless you know exactly how much you are going to earn for the year and exactly how much your medical expenses will be. I plan to ballpark it in the future and if necessary pay a small 10% penalty on the extra.

So for 2009 I had income including the pension distribution of 7765. My medical expenses were 3140 multiplied by 7.5% means 2558 was exempt from the 10% penalty. That left 1348 to pay the penalty on so I paid $135 in taxes last year and got the rest of my 20% that the fund withheld back as a rebate. To do this you have to fill out form 5329 and select exemption 05. There are only 4 lines on the form so it's not that difficult, plus you don't have to itemize your deductions to do this, you can use the standard deduction, but you do have to have reciepts to back up your claim on how much you spent on medical if the IRS ever asks thru a random audit.

This year I will be withdrawing $5000 from my IRA to pay for medical expenses. This is a ball park figure based on needing to pay $4500 for health insurance and a guesstimate of another $1000 - $1500 in out pocket expenses. My income can be higher since I can open an HSA fund so I shouldn't have to pay income taxes on the withdrawl and the penalty may be anywhere between 0 and less than a $100.

I could take the money from some other funds and not use my IRAs. I know the money gurus always tell you to leave this money till the last, but I have good reasons for doing it this way.

1. Most of my money is in IRAs.
2. Currently I'm in a 0% tax bracket, you can't get lower taxes than that. Taking the money now means less money I will be forced to take out when I am 70 and collecting social security and our government has raised taxes thru the roof to fund all the spending they are doing now.
3. It preserves my other funds, especially my cash for emergencies.

Until I am 59 1/2 and can withdrawl the money without penalty I will try to continue to use this method of funding my health care expenses. That's a little more than 10 years, this could be $50,000 or more preserved in my other funds and money that I won't have to pay taxes on, or very little taxes.

I finished reading my book Beyond the Dark. Supernatural short stories - very good.