How to Plan for Retirement Gap Years
We're not talking about time off between high school and college, or even perhaps a break between jobs. What we're really talking about are the years prior to two important dates, and those dates are when you take Social Security and when your RMDs will begin. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the place. Hey there, my name is Jacob Duke, and each week I'll be walking through different tips and strategies to help you succeed in retirement.
Jacob:So let's go ahead and get started with today's show. Hey friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke. As always, I'm your host. This week we're talking about gap years.
Jacob:We're gonna answer the question how you can successfully plan for and use your retirement gap years to your advantage to help lower your tax bill either year after year while you're in that period of time or even perhaps lower your tax bill throughout the rest of your life. So we're gonna talk about what those gap years are, how you can use them to your advantage, and maybe you've heard of these gap years before, or maybe this might be a new concept to you. So we're gonna cover what the gap years are. We're gonna discuss what you need to know on how to use them to your advantage. We're gonna walk through a real life example of this in action so that you can get an idea of how this all works together.
Jacob:And I wanna give you my big takeaway there at the end. But before we jump in, let's go ahead and highlight this week's listener review. It comes in from Marley and she gives the show five stars and says, I highly recommend Jacob is very knowledgeable and I've learned so much. Give him a listen. Thank you so much for that review.
Jacob:I appreciate it. I'm glad to hear that, it's been valuable and impactful for you in a positive way. If you are enjoying the show, then I would appreciate if you gave a rating review there on Apple Podcasts or Spotify. Okay. So let's go ahead and jump in.
Jacob:So first things first, we've got to answer what are these gap years? Like what does that mean? We're not talking about time off between high school and college or even perhaps a break between jobs. We're really talking about are the years prior to two important dates. And those dates are when you take Social Security and when your RMDs will begin.
Jacob:So this is the period of time between whenever you retire and whenever those dates would happen in the future. So it could be 60 to 67, let's say if you're taking your social security at 67, or it could be 65 and you take social security at 67. So depending on when you retire and whenever you start your social security or your RMDs would kick in, that is what we're calling your gap year. So you might be wondering, Jacob, why are these years so important? Like what is so important about them?
Jacob:And it really comes down to the fact that most of the time, this is a period of lower taxation for retirees, meaning there's a gap between their income they were earning in the high income years towards the end of a career, but also, before their RMDs would kick in on their tax deferred assets whenever they are forced to take RMDs out and potentially do that at higher income tax rates. So most retirees have accumulated a majority of their retirement savings in their tax deferred accounts such as IRAs or 401ks, but that money has yet to be taxed. So it will be taxed in the future whenever RMDs kick in or whenever you take money out before RMD age. So I guess this creates a problem perhaps, and you're gonna be forced to take and pay income tax on that money even if you don't want it or need it. So that's why we've kinda got a plan for that and see what we can do to avoid that if at all possible.
Jacob:So if you've got more than 1,000,000 or even more than that in a tax deferred retirement account, utilizing these gap years to your advantage is gonna be crucial to lowering your lifetime tax bill. So I've talked about it in the past, about last five, first five. In fact, I've done an episode on this. Basically, this idea of the last five years of your working career and then the first five years of your retirement. These are the really important years that you have to get things right.
Jacob:The first, the last five leading up to retirement, we've got to make sure we're planning, doing everything that we need to do to be ready for all the steps we have to take in retirement. And then that first five, that's when we have to execute. So the first five is really, that's the gap years that we're talking about here. And sometimes it can be longer than five years, it can be shorter than five years, but on average, typically we have this gap of five years before someone starts taking their Social Security after they retire. So these are the gap years, and it's really your chance to optimize your retirement savings and lower your tax bill throughout the rest of your life.
Jacob:So how do we do this? How do you do this? And what can you do during these gap year to help lower your future taxes? The first one is Roth conversions. The second one is tax gain harvesting.
Jacob:And the third one is withdrawal sequence planning. So, where you take money and when you take from certain accounts. So those are the three things we want to talk through today before we walk through an example, and then I want to give you my big takeaway. But let's go back to Roth conversions. Maybe you've heard of Roth conversions before.
Jacob:I'm sure that if you're listening to this podcast, you've heard of them. And in fact, if you listen to me for any length of time, you've probably heard me mention the word Roth conversions. Basically, a Roth conversion is just whenever you move money from a tax deferred account into a tax free account or after tax retirement account. So the way to do that though is we have to pay the taxes on the amount that we convert. So, that's what you can do during your gap years, perhaps at a lower tax bracket.
Jacob:So remember, Roth conversions only make sense if your tax rate is going to be lower right now than it would be in the future. So if you're gonna pay a lower tax right now to convert that money to a Roth account, it might be wise to do that as opposed to if your tax rate's gonna be lower in the future, it might not make sense to do Roth conversions right now. And this fits into your gap years because typically this is a gap between that high income period of your later years of career, but then also the RMDs that might kick in in the future. So this is a great time to do Roth conversions. And doing your Roth conversions during this time will help lower your RMDs in the future, helping you save taxes on the RMD itself, but also potentially saving taxes on social security by lowering how much of your social security will be taxable.
Jacob:We have to remember, not every type of income is taxed the same, and we're gonna talk about tax gain harvesting here in a second on long term capital gains. But just know that not every dollar is taxed the same. So if you pull money from a Roth, it's taxed as 0% technically, it's not even included on your tax return. You pull money from a traditional IRA, it's gonna be taxed as normal income. If you have social security, it's not gonna be fully taxable.
Jacob:In fact, at most, 85 of your social security could be taxable. And so we have all these different kind of ways of being taxed because of the type of income. So we have to piece all that together and remember these things whenever we're building out our plan. Also, another issue that RMDs present here is potentially increasing your Medicare premiums because your income will be going over those IRMAA income cliffs. So we've got to remember IRMAA, which is basically your income related monthly adjustment amount for your Medicare premiums.
Jacob:And if you are above certain income levels, looking two years in the past, whatever your your tax return two years ago said, then you could pay an increased premium on your Medicare Part B premiums. And so we've got to remember that because if your R and Bs are going be so much so that you're going to be in those new IRMA higher income brackets, now you're going be forced to pay perhaps IRMA the rest of your life because you didn't do the planning during your gap years you otherwise could have done. But remember, Roth conversions are not always the best solution for everyone. You should evaluate the benefits of a Roth based on your situation and see if they would be right for you. So Roth conversions are the first way that we can use these gap years to your advantage by saying we're going to shift the income that we would be taking via RMDs in the future out of our tax deferred accounts.
Jacob:We're going to shift that into this window of time where our tax rates are perhaps lower. And because of that, we're going pay a lower overall lifetime tax bill. We're going look through an example of this here in a little bit like I talked about. The second way that you can utilize these gap years to your advantage to help lower your tax rate is by doing tax gain harvesting. Now, maybe you've heard of tax loss harvesting, which is intentionally offsetting some gains in your brokerage account with other losses that you have there in the account as well, so that you kind of wash those out together and there's there's no capital gains tax because you offset the gains with the losses.
Jacob:But tax gain harvesting is intentionally realizing the gains without realizing any offsetting losses. And you might be thinking to yourself, Jacob, why would I do this? Well, the reason is, is so that you can pay a 0% tax rate on those gains. And again, you might be saying, well, what? I thought that I always had to pay taxes on my capital gains.
Jacob:And technically you are paying a tax, but you're doing so at the 0% rate. Here's how. There are three different long term capital gain rate tax brackets. The first one is 0%, the next one is 15%, and the next one is 20%. Which rate you end up paying on those capital gains, remember this is a long term capital gain, not a short term, but the rate that you would end up paying is dependent on your taxable income.
Jacob:So in 2024, long term capital gains are taxed at the zero percent rate up to a taxable income level of $94,000 married filing jointly or $47,000 if you're single. Now, once you are above these limits, your capital gains will be taxed at a 15% rate. Obviously, once you get higher than that, it goes to 20%, but that's well down the road depending on your income. Now, there are some specifics here that I don't want to dive into. I've actually done an episode in the past on tax gain harvesting and how you can use that 0% capital gain bracket to your advantage.
Jacob:I think that was episode 38. So go back and listen to that if you want to learn more about how it actually works and the details of it. But the main thing here is just know that your capital gains actually stack on top of any other income whenever you're trying to figure out which capital gains bracket you fall into. So if you have no other taxable income, you can realize $94,000 of capital gains and pay no here in 2024 if you're married filing jointly. If you have 50,000 of other income, let's say from an IRA distribution or perhaps just normal W-two income, you can realize 44,000 of capital gains at that 0% rate before you get to that $94,000 level.
Jacob:If you go above that, any capital gains above that $94,000 level would be taxed at 15%. So that's a quick overview of how that works. Remember, go back and listen to the previous episode if you wanna learn more. But the idea is that your gap years present this unique opportunity to realize gains at a tax rate that might never be available to you again because your income in the future might be increasing once you add Social Security into the mix or add RMDs to the mix. And so you're not gonna be able to use that 0% capital gain rate perhaps in the future, as opposed to whenever you're in your gap years, you can do that during that time.
Jacob:So if you have large amounts of gains in your brokerage accounts, maybe you bought Nvidia stock, let's say that one's one that's going off a lot right now. Or maybe you have Apple stock or Amazon, anything that's appreciated over time. Maybe you've had this appreciation in your brokerage account and you're wondering how am I ever going to sell this or exit these positions without paying a ton of taxes, Right? And so this might be your opportunity to do it. So one way to think about this is if you're in your 50s and you're thinking, hey, I'm going to retire here at some point in the next maybe five to ten years, I've got all these brokerage accounts with built up gains in them.
Jacob:Think about the future in terms of your gap years and say, going to wait to sell any gains until the future whenever have minimal income, and I can do so at that 0% rate. Even through all of this, you know, the 15% long term capital gain rate is still not bad. It's way lower than your normal income tax rate would be at that same income level. So that's some ways to think about how you can effectively use the gains in your brokerage account and basically turn in your brokerage account into a Roth IRA by doing it this way. So think about that, but use the gap years to your advantage.
Jacob:If you have those large brokerage accounts and you're trying to figure out how to exit these positions without paying a ton of taxes on it, utilizing that 0% capital gain bracket could be beneficial for you. And the final way that you can use your gap years to your advantage is through withdrawal sequence planning. So you can use your gap years to effectively plan out when you take from certain account types. For example, you can do tax gain harvesting, just like I mentioned, You can take your income in the early stages during these gap years of your retirement at a 0% rate because you're pulling money and paying no capital gains tax on those gains. Or you can take money from your tax deferred accounts for your income during these gap years, which allows you to pull income at a lower tax bracket out of your IRAs or 401ks, but it'll also be lowering your RMDs in the future as well.
Jacob:So I like to kind of call this a spend down strategy. So this is often either done in tandem with partial conversions or smaller conversions, or maybe just no Roth conversions at all because you're taking decent chunks out to live on out of your tax deferred accounts. But by doing that, you're spending down those accounts, which means your RMDs will be that much lower in the future. So you're intentionally living on your tax deferred assets in the early stages of retirement, and by doing so, you're reducing those future RMDs. This is typically going to be dependent on how much you have saved in that tax deferred account.
Jacob:But if done correctly, you can lower those RMDs down to whatever you think you would be needing out of the account anyway, so that your RMD is not greater than whatever you would be distributing once you get to RMD age and beyond anyways. And even better, if you're charitable, you can lower your RMDs down to a certain amount That would be however much you were wanting to give to your church or charity. And once your RMDs kick in, and that's where you have to take your distributions, you can start doing qualified charitable distributions in replacement of your RMDs. So just know that there's ways to change how much you're pulling from certain accounts or which accounts you're pulling from during these gap years to help plan out the entire rest of your retirement. So understanding your income needs and kind of your goals throughout your entire retirement, you can use these years to effectively meet those goals and lower your taxes along the way.
Jacob:All of that sounds great, but it's really only theory at this point. So I wanted to share a real life example of this with you to help make more sense of everything. So here's kind of the details of a situation that I'm walking through with a client right now and kind of what their options are, and then we're gonna say, hey, how much they're gonna be potentially saving over the rest of their life by doing what they're going to do. So they've got $1,400,000 total, 50,000 of that is in cash, 175 is in brokerage, they have 1,200,000 in IRAs, which are tax deferred. They're married filing jointly, their house is paid off, and they need about $5,000 a month to do what they would like to do in retirement.
Jacob:And they're both currently 63 and they plan to take their social security at 67. So we got four years before social security kicks in. And at 67, their social security amount combined would be about $66,000 per year. So that's about how much they need in terms of their living expenses, what they're trying to do. They mentioned, hey, we just don't live an extravagant life.
Jacob:We just like simplicity and we don't really travel a whole lot, so we don't need a ton of income. So with all of that information, what are their options? Well, they could do tax gain harvesting in the brokerage account at 0% and live on the IRA for whatever else is needed annually. That's one option. They could do a spend down from their IRAs, meaning they're just gonna spend all their assets down as far as they can out of the IRAs, but that would only take about $240,000 out of their IRAs over the next four years.
Jacob:Remember, they only need $60,000 or so for the next four years to live on to meet their normal income needs. And even on top of that, market growth could replace how much they end up taking out over that time period anyway. Or the third option here is they could do Roth conversions prior to their social security. This would lower their tax deferred balances resulting in lower RMDs in the future. It takes advantage of that 1222% brackets.
Jacob:And remember, these are increasing in 2026. So if we take advantage of that instead of paying 15% in the future or 25%, depending on which bracket we're in, can take advantage of those lower brackets. While we have them. Obviously everything's written in pencil, so who knows what the future holds, but it's just what we know right now. They can choose to live on cash in the brokerage account during these gap years while doing the conversions, or do a combination approach where they pay taxes with cash and brokerage account while living on those IRA funds.
Jacob:So regardless of how we end up going each year in terms of where they get their income from and things like that, they're lowering their future RMDs by doing the conversions. They're building Roth accounts for their grandkids, which I mentioned was important. They wanted to leave something for them, and leaving a tax free account such as a Roth is far more valuable than leaving a tax deferred account. And they wanna lower their taxation on social security in the future. So by doing all those things, they're gonna lower their RMDs in the future, which will make less of their social security taxable.
Jacob:And all of these different benefits that we just talked about by doing the Roth conversions, living on brokerage account or cash, or some combination of those two things, All that adds up to around $300,000 of tax savings and tax free growth moving into the future. So $300,000 over the rest of their life is being either built up tax free or saved on taxes because of the strategy we're doing during their gap year. So that's the total benefit of this strategy. But it could even be more than that depending on how much those Roth IRAs grow over this time period as well. So once they turn on Social Security 67, they're gonna have enough money or income to live the life that they wanna live.
Jacob:Obviously, anything that they can take from their portfolio above that is gonna be additional, meaning they can go have fun and do whatever they'd like to. But the key is they get to choose. They don't have to take all their money from a tax deferred account in the future if they don't want to. They're lowering their lifetime tax bill by upwards of $300,000 And if no action is taken during their gap years, they're gonna have lower taxes during the gap years, yes. So this first four years of their retirement, but they're only building up that larger tax bill for themselves if they do nothing right now.
Jacob:So by the time they get to 73 or 75, whenever their RMDs will kick in, they could have upwards of $2,000,000 in that tax deferred account, which means their RMDs will be much larger, making more of their social security taxable, potentially pushing them into Irma brackets one day where they have to pay more on their Medicare. And so these years, these four years for them are crucial to lowering their tax bill and not having the snowball effect of all these other negative consequences of just kind of sitting on your hands and doing nothing during this prime opportunity. So this is a real example of a client, and hopefully it gives you some context and gives you maybe some hope around how you can use your gap years to your advantage to lower your lifetime tax bill. So here's maybe a big takeaway for you. The thing that I want to emphasize that makes this all work.
Jacob:All these ideas and strategies, they sound good. But in order for them to work, they have to work together. So you can't look at each of these ideas, in a silo or in a vacuum and expect the plan to work out. You have to take a truly comprehensive approach to all of this and make sure you're doing what's best for you based on your situation. Because not all these ideas apply to everyone.
Jacob:Maybe some apply to different people or maybe in a condensed fashion or in a kind of reduced amount. So just make sure that it all applies to you, but the key here is that it has to be comprehensive. All these things have to work together. You can't take Social Security and expect to do Roth conversions to the full benefit of the Roth conversion. You can't take Social Security and expect to do $94,000 tax gain harvesting.
Jacob:Like all these things have to work together and planning that out leading up to your gap years is crucial. And then when you're doing this during the gap years, you gotta execute it correctly. So hopefully this is helpful for you as you continue to navigate your retirement plan and all the things that come with it. So hopefully this is helpful for you as you continue to navigate all the things that you've got to plan out for your retirement. Other than that, I hope you have a great week, and I look forward to talking with you again right here next week.
Jacob:Hey, it's Jacob again, and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at jacobretirementanswers dot net. And I'd love to answer that question for you right here on the show. Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice. Retirement Answers is for educational purposes only.
Jacob:Thanks for tuning into this week's episode. I look forward to talking with you again next week.
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