For many people, the idea of stepping away from the workforce can evoke similar feelings to a child standing beside a pool. You see your friends swimming and want to make the leap, but the anticipation brings mixed feelings of fear and anxiety about jumping into a new situation. In a similar way, standing at the edge of a decision to step away from a dependable paycheck can be scary, even for those with a solid plan and a strong safety net of savings.
Whether you are transitioning to retirement, taking a strategically planned mid-career break, or navigating an unplanned layoff, the idea of not having earned income can feel unnatural and unsettling. In many cases, knowing you have a plan to handle current cash flow and minimize future taxes can also allow you to fully enjoy the non-financial opportunities that accompany a break from work or the start of a new retirement chapter. With intentional planning, these gaps in taxable income can be manageable, and can even create valuable tax planning opportunities that aren’t available in high-income years. Understanding these opportunities makes it easier to take the leap.
A New Chapter
A typical career often entails a series of successive jobs over several decades, with the end goal of settling into retirement. During your career, you earn a regular paycheck; you allocate some to retirement savings, then you spend on housing, food, and other needs. It can feel straightforward. However, life is rarely simple or linear, and it’s not uncommon to experience a planned or unplanned gap in income at some point.
In recent years, more workers have embraced the idea of a sabbatical as career shifts have become more common and burnout more of an issue. Some companies are starting to offer this as a benefit for long-tenured employees, while other people intentionally plan for time off between jobs or as part of a career transition. While sabbaticals can be as short as 1 month for some, they often range between 12 to 24 months. Many workers have found that sabbaticals offer a unique opportunity to focus on their well-being, gain valuable perspectives on life outside of work, and reset mentally.[1] This planned gap in the middle of a high-earning career provides a much-needed break and can open up new tax opportunities while income is temporarily lower.
Making the leap into retirement often creates an even larger gap in taxable income that can similarly bring mixed feelings of excitement and opportunity alongside anxiety and trepidation. Even with all the preparation and savings that lead up to the retirement decision, the thought of not having a predictable stream of income, and needing to pull money out of your savings, can be a daunting adjustment. Regular income from Social Security is on the horizon, but deferring benefits until age 70 often means waiting several years post-retirement. Additionally, RMDs (Required Minimum Distributions) from IRAs, 401ks, or other retirement accounts add more taxable income, but new laws don’t require those to start until age 73. This means there is usually a dip in taxable income in the years immediately following retirement, and opens up some interesting opportunities for intentional planning.
It is important to recognize that sometimes we don’t get to choose when we jump in the pool; we just get pushed in. Layoffs and other unexpected job losses are another reason that people find themselves in a period of low taxable income. The first step in these situations is to make sure that cash flow can be covered by emergency savings and other resources, and that health insurance and other important coverage is properly taken care of. Assuming that these safety nets are all in place, these same strategies to take advantage of a low-income year can be relevant, even if the experience of an unplanned job loss feels different than the excitement of a planned sabbatical.
Minding the Gap
The basis of good tax planning is simple: defer income when your tax rate is high, and ‘generate’ income during gaps when your tax rate is low.[2] During working years when taxable income is high, maxing out retirement contributions or funding charitable giving plans are common strategies to reduce taxes. However, when income is low in a given year, there are ways to trigger certain taxable events to take advantage of your lower tax brackets during those years.
- Trimming Highly Appreciated Stock: Low-income years can be an opportunity to trim specific parts of your portfolio or individual stocks that have grown significantly over time. This strategy can help with diversification, reduce your future tax burden, or free up needed liquidity.
- Exercise Stock Options: For employees who have been granted stock options, exercising them often feels like stacking more taxes on top of high income. A lower-income year can provide a unique opportunity to minimize taxes while also creating liquidity. Careful planning can help determine how many shares to exercise, and how the timing of sales can minimize your taxes over the long term.
- Roth Conversions: This strategy involves the transfer of retirement assets from a tax-deferred account into a Roth IRA. Converted funds will be considered taxable income, and you gain the ability to make tax-free withdrawals from the account in the future. Adopting this strategy in a low-income year will result in paying less taxes on converted IRA funds. As an added benefit, these conversions will also reduce the size of future RMDs from traditional retirement accounts.
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Accelerated Distributions from an Inherited IRA: Following recent updates to the law, anyone who inherits an IRA account needs to distribute the full balance within a 10-year period. This can create a hefty tax burden when stacking income on top of your work earnings. If you expect to have an income transition, whether a sabbatical or shifting into retirement, then strategically sequencing these IRA distributions can dramatically lower the amount of taxes you pay over the 10-year period.
There is a lot to consider when turning your retirement or sabbatical dreams into practical reality, and there is no one-size-fits-all strategy for these major shifts in household income.
Moving Forward with Confidence
The decision to step away from a steady paycheck is complex, and it is unlikely that everything will play out as expected. An unplanned gap in income is even more stressful. This is why it’s essential to have a strong financial plan in place, guided by thoughtful “what if” scenario analysis that not only helps you guard against risks, but also helps you take advantage of opportunities that arise during these temporary gaps in income. Our team at North Berkeley helps clients evaluate these decisions and formulate a plan that is unique to their situation and needs. If you know ahead of time where you stand financially, you are better positioned to dive into your next chapter with confidence.
Resources:
[1] Research: The Transformative Power of Sabbaticals HBR
[2] Broadening the View on Taxes North Berkeley Wealth Management