MAXIMIZE YOUR RETIREMENT GAP YEARS
It has become a popular option for young people to celebrate graduating high school or college by taking an extended break, before continuing with “real” life. This concept is referred to as taking a gap year, and is typified, by young twenty somethings traveling Europe, or volunteering with the peace corp. While there can certainly be a good amount of maturity, and life experience gained from taking a gap year like this, some find that they return home feeling behind as their peers have already moved on with life.
There is another kind of gap that most people don’t talk about. Most people have never even thought about it. They gap I am referring to is not just one gap year, but potentially as many as ten years. I call them the retirement gap years, and they occur from the time you stop working until, you turn 70. With proper planning, and a tailored strategy, these gap years can be one of the most powerful wealth building, and tax reduction tools you have.
Remember all of the advice you have heard about how you will be on a lower tax bracket in retirement? It probably isn’t true. At least, without proper planning, it isn’t. Your retirement gap years can be thought of us a window in time, to get all of your account cleaned up, prior to turning 70, and especially prior to turning 72. The reason those two ages matter; social security and required minimum distributions. If you haven’t planned ahead, turning on social security at 70 could result in an income as high as $4,500 a month. If you did a good job of saving into a 401k and have a big balance when you turn 72, required minimum distributions could kick in and start forcing you to withdraw a significant portion of your account pushing your income even higher. Those two factors combined, can push people as high as the 24% tax bracket. While that may not be higher than your current bracket, it is almost certainly not lower.
The overall concept with retirement gap years, is to take advantage of the years where your employment income has stopped, and you have not yet turned-on social security. This keeps your income (as far as the IRS is concerned) very low and allows you flexibility to make moves that can dramatically lower your lifetime tax bill.
To make the most of retirement gap years, there is a foundation that needs to be laid prior to retiring. Let’s Start there.
Pre-Retirement
The foundation for maximizing retirement gap years is a diversified pool of savings to draw from. Now, when I say diversified, I am not referring to the kinds of investments like bonds, stocks etc., I am referring to the location of your savings. A good foundation will consist of a healthy mix of pretax (IRA, 401K etc.) tax free (Roth IRA) and taxable (regular investment accounts). To build that foundation, here are some things you should consider.
Contribute to a Roth IRA
This one is the simplest. You need to be maxing out a Roth IRA every year. The earlier you start, the more beneficial this will become. Because you are limited to $6,000 per year ($7,000) if over 50) it is important that you start these contributions early and make them often. If you are a married couple each of you can have your own Roth IRA thus doubling your contribution limit.
Contribute to Employer Retirement Plans
While these are not as powerful as Roth accounts, they still offer a great option for saving retirement money. Depending on your employer you may even be eligible to have them match a portion of the money you contribute. Some employers even offer Roth 401k accounts, and if they do you should use that, just note that even though your contributions will go into a Roth account, your employer’s portion will still go into a pre-tax account.
Invest in a Taxable Account
This is the broadest umbrella of the bunch. There are no limits to the amount you can put into this account, and you can invest in almost anything. You could have a taxable account that invests in crypto. You could have a taxable account in stocks, real estate, or bonds. These accounts get no special tax treatment from the IRS, but they exist in the capital gains world, so the gains will be taxed much better than income is. If you want to take this strategy a step, further consider opening an account with a financial advisor who can help you engage in tax loss harvesting which can serve to reduce the overall tax bill of this account.
The final type of account to utilize if it is available is an HAS account. These accounts are connected to high deductible health insurance plans. There are two important things to remember with these. First, they offer triple tax advantage, which means money is not taxed prior to going into the account, it is not taxed while it is growing, and it is not taxed if withdrawn to pay for medical expenses. The second thing to remember is that HSA accounts can be invested just like a 401k and you need to be doing that.
Any combination of the above account will help to create a foundation for gap years. In an ideal world, you would just have one giant Roth account prior to retiring. But since that is not going to happen, focus on trying to have a fairly even mix of the three main account types, with the biggest HSA you can accumulate on the side.
Maxing the GAP
The reason for setting up that foundation, is that having savings in various buckets will give you the flexibility to reduce your earned income, which in turn gives you the flexibility to begin making Roth conversions, realizing capital gains in a zero tax bracket and positioning yourself to enjoy a relatively tax free retirement.
The first step in reducing your income is simple. Stop working. This would also be considered the initiation into retirement. Give yourself a pat on the back for getting here. Enjoy the moment. But when your brother-in-law tells you that you should file for social security early DON’T. You just got your income down to zero when you quit your job, so don’t go and immediately change that by listening to bad advice.
The very first thing to do after retirement is a small move, but one that very few people realize they can do. That is to do a rollover out of an IRA or a 401k into your HSA account. It is capped at 7,300, and you can only do it one time so this is not going to be a game changing move. But, proper tax planning is best described as a series of small moves, that when all done in conjunction create massive results. This move, will mean that $7,300 that would have been taxed, will never be taxed, as long as it is used on medical expenses. And trust me, as you go through retirement, you will have PLENTY of medical expenses.
Rather than claiming social security, your plan is to live off of your savings. Specifically, your taxable investment accounts, and your Roth IRA, while using your HSA to cover the bevy of expenses it can be used for tax free.
Having zero income, but a healthy pile of savings is a beautiful thing. It allows us to do three things. First, you can delay taking social security until you are 70. The longer you wait, the more your eventual payments grow. To the tune of 8% per year in fact. It is the only guaranteed 8% return on investment you will ever find, so take advantage of it. Secondly, have zero income means you can claim a large portion of capital and pay absolutely no taxes. The third thing it sets the table for is Roth conversions.
Many planners advise their clients to do Roth conversions first in their gap years, but it will actually work out better for you if you start by realizing capital gains in your taxable account. Realizing capital gains means you actually sell the investments, and the taxes become due.
The reason my clients start with this step rather than Roth conversions is because they typically reach this stage with some fairly substantial capital gains accumulated. Since maxing gap years relies on living on the money generated by selling investments in a taxable account, it makes sense to clean up any large capital gains while in a zero tax rate, prior to liquidating them to be used for living expenses. Once the capital gains are dealt with , the next phase is where the Roth converting begins.
Roth conversions are the process of moving money from a traditional IRA or 401k into a Roth IRA and paying the taxes immediately. Some people (my father included) cringe at the thought of paying taxes before they have to, but stay with me here. Because your income is $0, you will have the ability to convert up to $80,000 ($40,000 if you’re single) and pay only a 12% income tax rate on the transaction. Admittedly, that is not zero, but is a historically fantastic tax rate and you should take full advantage of moving your money out of pre-tax accounts at that rate.
You can take this plan even a step further by utilizing tax planning strategies like bunching deductions. To do that you would intentionally save all of your impending medical/dental work, charitable contributions, mortgage interest and other deductions, and load them into the same year to create a large pile of itemized deductions. Every additional dollar that you can deduct, is another dollar that you can convert into a Roth IRA for only 12 cents.
Depending on how much you have in pre-tax accounts, and how young you are when you retire, you may have a chance at converting ALL of your pre-tax dollars prior to turning 70. If you do that, you will avoid the dreaded tax bomb of RMDs. If you weren’t able to do it, there is still hope for you by utilizing qualified charitable distributions and some other planning strategies.
While it not a simple process, maxing retirement gap years has the potential to save you thousands of dollars in taxes. Not only will this strategy save you huge amounts of money, it can also prevent your children from being left dealing with income taxes on RMDs in inherited IRAS.
If you work with a financial advisor, and they have never introduced you to this concept; or if you ask them about it, and they have no idea what you are talking about, it is time to find a new financial advisor. In 2021 simply helping you invest your money is not enough value to justify paying a financial advisor. The reason Balanced Capital places such a huge focus on tax planning, is because the strategies outlined above, if executed properly will save our clients, 3-4 times the amount they will pay us in fees over their lifetime. In other words, tax planning is what makes a financial advisor worth the fees they charge.