You’ve done it. All that smart saving and investing has brought you to your final year of work. But before you plan that first trip around the world, there’s a few nifty tactical planning moves you can make. If you want to save lots of money in your early 60s, here are five homework assignments for your final career year.
Partial Year 401(k) MAX
If you are deferring income to an employer-sponsored plan (like a 401(k)), some percentage of each paycheck is probably going into your account. For example, if you’re over 50, maybe $1,083 leaves every paycheck and 24 paychecks later – you’ve hit the maximum ($26,000 in 2021). Let’s say you retire in June. That means you will have deferred only half of what you could have ($13,000). If your federal and state tax bracket combine to around 40%, that means you failed to avoid $5,200 of taxes.
Change your deferral election to be a larger percentage of your income so that you can reach the maximum allowable contribution before your employment ends. Assuming you can cover your needs from some other source (bank reserves or other investment account), it’s well worth it, right? Who doesn’t want an extra $5,200 in their pocket?
The Tax-Saving Cash-Out Refi
One of my favorite preemptive tax strikes is for a pre-retiree to look ahead 5 to 10 years and see where their cash flows will come from. If you are going to fully retire in your early 60s, you’ll have many years before you start collecting social security (usually age 70) and are required to take IRA distributions (age 72). So where’s your cash flow going to come from until then?
If you have a sizable non-retirement account balance, you can draw from there. But if most of your net worth is tied up in your home and retirement accounts, you may want to pull some equity from your home to meet some (or all) of your cash flow needs. This lets you delay those fully taxable IRA withdrawals a while and could greatly reduce the taxes you pay over your remaining years.
This is an especially attractive move if you eventually plan to sell your home and downsize / relocate. The tax-free withdrawal of equity acts like an advance on the house proceeds you’ll eventually get when you sell. If you apply for a cash-out refinance while you’re still working, qualifying for the loan should be easy since mortgage lenders can use your current income to qualify you (they don’t ask if you are planning to retire soon). If you wait until after your career ends, there is a workaround as long as you are at least 60.
Many mortgage lenders will view a single account distribution (withdrawal) as part of the “monthly income” requirement they use to qualify you, as long as they get some form of documentation that they are expected to continue. For example, if they want to see $10,000/month as taxable income to qualify you for a mortgage starting in February at $3,000/month, and you can produce evidence of a single $10,000 IRA withdrawal in January, they’ll count that as monthly income. And if you are considered “of retirement age” they may let you use a non-retirement account to meet this requirement. Just be prepared to ask your advisor to produce a letter stating these distributions are currently set up to be recurring.
Frontload the DAF
If charitable giving will be part of your annual budget in your post-career life, you’ll want to seriously consider opening a donor advised fund (DAF) and frontloading several years of future gifts now. This will secure your deduction at a higher tax bracket when it’s worth more to you. For example, if your federal and state tax brackets combined at 40%, you’ll get 40% of your donation back. A donation while your combined tax rate is 20%, means you only get 20% of your donation back.
Let’s say you budget giving away $10,000 per year to charity and your combined federal and state tax rate is 40% now, but will drop to 20% once you stop working. If you donate annually, you’ll get back $22,000 ($4,000 in the first year and $2,000 for the next 9 years). If you frontload the DAF, you’ll get $40,000 back all at once ($10,000 x 40%). That’s an extra $18,000 in your pocket.
I find people are typically comfortable contributing 5 to 10 year’s worth of giving to the DAF now, but you may wish to do a smaller or larger amount. Talk to your tax advisor to understand how the deduction rules will apply to you, and talk to your financial planner to ensure your long-term plan allows whatever gift you wish to make.
Medical Coverage for the Bridge Years
Early retirees used to fret about how to get medical coverage if they left their job before Medicare kicked in. Times are different. Cobra medical coverage is technically coverage, but it’s expensive since you’re on the hook for the portion of your plan’s costs your employer paid. You’ll want to have other options that can take effect as soon as your employment ends.
Based on your expected income, you may be shocked how low your costs can be if you enroll in a plan through the Health Insurance Marketplace. If you live in California, play around with the Covered CA calculator to get a sense of your costs. The period between your early retirement date (say, 60) and age 65 (when you enroll in Medicare) can be one of extremely low income taxes – assuming you don’t have other big sources of passive income. But even if you think your income will be too high to qualify for credits, the American Rescue Plan now caps your health care premiums at 8.5% of income.
Now Get Ready to Roll
The vast majority of people wrapping up their careers roll their plans into an IRA rollover account. This usually gives you and/or your financial planner a wider range of investment options and strategies for reducing overall portfolio taxes. At Abacus, for example, each account in a client’s household is not a mirror image of the other. We specifically place the most tax-inefficient holdings in the retirement account(s) and vice versa for accounts subject to taxation (individual, joint, trust, etc.). In other words, the left arm works with the right arm to rebalance and manage a portfolio regarding taxes.
When you do your rollover, be sure the funds go into an “IRA Rollover” account, not a traditional IRA. If you’ve had 10 jobs with 401(k) plans in your life, all of those can end up in a single IRA Rollover account. But do not commingle money that originated from an employer plan with money from a traditional IRA (an IRA that received contributions directly from you). Rollovers that trace back to ERISA-governed plans, like a 401(k), should continue receiving the highest level of creditor protection.
If you are over age 59 1/2 and your employer lets you do an in-service distribution, you can perform the rollover while you’re still employed (assuming you and your advisor agree this is in your best interests). Otherwise, just be ready to do the rollover as soon as you retire from your career.
Remember, the bridge years between early retirement and age 72 come with plenty of financial opportunities and challenges. You’ll want to make sure your estate plan accurately reflects your wishes and that you’re prepared for the unexpected costs that can accompany aging, especially long-term care.