Retirement is a time of significant financial change, and it’s important to have a tax planning strategy in place to make the most of your retirement income. Many of our clients have what we call “gap years” in the early years of their retirement before they claim Social Security or start to take their required minimum distributions (RMDs). RMD age is 73 or 75 based on the SECURE 2.0 Act. During this period of lower income, there are several tax planning opportunities to consider.

Tax Planning Strategies for the Gap Years

While most households attempt to lessen their tax bill each year, we look for ways to decrease our clients’ tax bill over their lifetime. And the retirement gap years can be a prime time to do just that. Below are three strategies we help our clients analyze and implement:

1. Consider Converting a Traditional IRA or 401(k) to a Roth IRA

A Roth IRA is a tax-free retirement account. If you convert a Traditional IRA (or 401(k)) to a Roth IRA, you’ll pay ordinary income tax on the converted amount in the year of the conversion. However, once the money is in your Roth IRA, it can grow tax-free, and withdrawals will be tax-free as well. This can be thought of as accelerating or increasing taxable income in years when you may be in lower tax brackets to ensure those dollars are taxed at a lower rate than they would’ve been after Social Security is claimed and/or RMDs start.

Another reason you may want to consider Roth conversions is if you have legacy goals for your children or other heirs. According to current tax laws, if you leave your children a Traditional IRA, they are required to distribute that Traditional IRA in 10 years. This could substantially increase their ordinary income tax liability during their peak earning years.

If you have more than you need in your lifetime and plan to give the excess to your children, for example, you can choose to pay tax on those dollars now at your current income tax rate instead of your children paying tax on inherited dollars later at their potentially higher tax rate. If they inherit a Roth IRA as opposed to a Traditional IRA, they will not owe any ordinary income tax on those dollars. Furthermore, they can keep that money in an inherited Roth IRA for up to 10 years, so the tax-free growth can continue.

2. Take Advantage of Capital Gains Tax Rates

Capital gains tax rates are generally lower than ordinary income tax rates. If a security is sold after being held for at least a year in a non-retirement account, it will be taxed at 0%, 15%, or 20% depending on your level of income. If your income is low during gap years, take advantage of the lower capital gains tax rates for withdrawals to pay the bills, resetting cost basis, diversifying your portfolio, etc.

3. Implement Tax-Efficient Withdrawal Strategies

During gap years when your income is down, you’ll need money to enjoy the retirement you’ve been saving up for. Careful planning of withdrawals from various retirement accounts can help minimize your tax liability. For instance, if you have a combination of taxable accounts, tax-deferred accounts (such as Traditional IRAs or 401(k)s), and tax-free accounts (such as Roth IRAs), you can strategically withdraw funds to optimize your tax situation and allow for the opportunity to use other tax planning strategies. By taking withdrawals from the most tax-efficient sources, you can potentially reduce your overall tax burden and extend the longevity of your retirement savings.

Healthcare Considerations

Healthcare costs are a significant concern for retirees, especially before they become eligible for Medicare. However, if your income is lower during the retirement gap years, you may qualify for certain healthcare subsidies or tax credits. Explore options such as the Health Insurance Marketplace to determine if you are eligible for premium assistance or cost-sharing reductions. These opportunities can help alleviate the financial burden of healthcare expenses during this phase.

Charitable Contributions

Charitable giving can be a great way to enhance any of the tax planning strategies mentioned above. While we don’t encourage our clients to give charitably solely to get a tax benefit, people who are giving to charity should make sure they’re doing so in the most tax-efficient way possible. One option is giving appreciated securities by way of a donor advised fund (DAF). Another way is through qualified charitable distributions (QCDs) after age 70.5.

Be Mindful of Side Effects During Retirement Gap Years

When forming a strategy on when to claim Social Security, whether to perform Roth conversions, and what accounts to draw money from during these gap years, you are really deciding how much income you create in a given year. All those decisions can have unintended consequences. For example, if you have more income, more of your Social Security income may be taxed. You also might trigger net investment income tax (NIIT). Or you might incur Medicare surcharges, aka income-related monthly adjustment amount (IRMMA). Sometimes, accelerating your income during these gap years still makes sense despite these side effects. Just make sure you are aware of and are okay with the results of your decisions.

The retirement gap years — that period between retiring and the start of Social Security benefits or RMDs — offers a unique window of opportunity for effective tax planning, including Roth IRA conversions, capital gains harvesting, tax-efficient withdrawal strategies, and healthcare considerations. Communication between your CPA and financial advisor is very important to make sure these strategies are discussed and implemented properly. If you’re unsure whether you are leveraging these opportunities to optimize your financial situation, contact us to learn more.

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