The Secret Superpower of the Mini-Retirement

In this crazy era, filled with work-from-home/e-learning, Covid-19 disruptions, and the Great Resignation, it seems like more people than ever are interested in taking a mini-retirement. The much-touted benefits of a mini-retirement include taking time to relax and decompress from stressful work (and life) situations, maybe doing some travel (when it is safe to do so), or perhaps working on a side hustle/passion project that you never have enough time for when you are working full-time. But there are some major financial moves that can be made in a year with low- or no income that could put thousands of dollars back in your pocket over your lifetime.

As you know, we have a graduated income tax system in the United States. Every dollar that you earn from your job, plus interest from savings accounts and CDs, short-term capital gains, and non-qualified dividends are taxed at “ordinary income” tax rates ranging from 0% (hidden on the tax tables), 10%, 12%, 22%, 24%, and so on. And for qualified dividends and Long Term Capital Gains (when you sell a stock for a profit, after holding it for at least 1 year), those earnings are taxed at the lower Capital Gains tax rates of 0%, 15% and 20% (with some additional taxes due for certain high-income taxpayers). To qualify for the 0% Capital Gains tax rate, your ordinary income tax rate needs to be in the 12% tax bracket or below.

Tax Gain Harvesting

The paragraph above leads to a very easy example of how someone can benefit from reduced taxes when they have a low/no income year. In this example, the mini-retiree has accumulated shares of AAPL (Apple ticker symbol) and held them for the past several years. The basis (ie. the amount the shareholder paid per share for the stock) is $40 per share, but at the time I am writing this post, AAPL trades for $172 per share. There is a potential $132 gain per share that can be “tax gain harvested,” which is where you sell the stocks and pay the taxes owed, and in the case of the 0% Capital Gains bracket, that is zero dollars. If this was done in a year with a normal amount of earned income, the tax due would be $19.80 to $26.40 PER SHARE. If our mini-retiree sells 50 shares of AAPL, that’s a $990 to $1,320 savings in taxes owed.

One more thing about Tax Gain Harvesting, you can still re-buy the same stock right away if you want to; it does not have the same 30-day restrictions in place to avoid a “wash sale” that Tax Loss Harvesting has in place. In this case, you are simply raising your tax basis (again, price paid per share of the stock) and avoiding taxes due on the future sale of the stock because you no longer bought AAPL for $40, you bought it for $172. Let’s say it grows to $200, you would only owe taxes on $28 in Long Term Capital Gains at that future date, rather than the $160 in growth from your original basis of $40 up to $200.

Roth Conversion

Most retirement plans in place in the US are pre-tax retirement accounts. These are commonly called a 401k, 403b, 457b, TSP, Traditional IRA, SEP-IRA, etc. When you contribute to these accounts during your earning years, the amount of the contribution is deducted from your taxable income from the year, thereby reducing your taxes owed. It can be a great way for people to save for their own retirement, but the downside is that all of those dollars still need to be taxed by Uncle Sam, and that happens when you are older, no longer working, and probably need every dollar that you are withdrawing. To add insult to injury, Uncle Sam starts getting impatient about waiting for his cut of your retirement savings when you turn age 72, and demands that you withdraw a “Required Minimum Distribution” starting at around 4% of the account value and going up each year so that he can finally get paid his cut of your retirement savings that you stashed away decades ago. When you add these RMDs to other retirement income like Social Security or some type of pension payments, these older taxpayers can find themselves in very high tax brackets and have no tax flexibility because their income will be high for the rest of their lifetime.

But there’s another type of retirement account, the Roth IRA, which allows you to contribute after-tax dollars and then the account grows tax-free for the rest of your life. This type of account didn’t even exist until 1998, and the Roth 401k became an option in 2006, so many workers and current retirees hold most of their retirement assets in traditional (pre-tax) accounts and not nearly as much in Roth (after-tax) retirement accounts.

The tax code allows you to “convert” money from a Traditional IRA into a Roth IRA, but since those Traditional IRA dollars were not taxed yet, you must pay the taxes due on the amount of the conversion. Money in a Traditional IRA is taxed as Ordinary Income upon withdrawal or conversion, so we’re back to those same 0%, 10%, 12%, 22%, 24% and above brackets that apply to your paycheck. If you make a conversion in a year where you are working, this just adds additional income on top of your already well-deserved paycheck, and could bump you up into a higher bracket, or at the very least you are paying your highest marginal tax bracket on the conversion. I would recommend waiting for a year with low/no-income and making a conversion when you can pay 0%, 10% or 12% (and probably worth it to go to the top of the 24% tax bracket if you have millions in pre-tax retirement accounts). By paying the (lower) taxes during a mini-retirement, those dollars are now the more valuable Roth IRA dollars, which will grow tax free for the rest of your life and can be withdrawn tax-free in retirement. “Seasoned conversions” can also be withdrawn tax and penalty free after the 5-year seasoning period, regardless of your age.

Expiration of Tax Cuts and Jobs Act (2017)

One more thing to consider is that the tax brackets I have mentioned a couple times in this article (0%, 10%, 12%, 22%, 24%, etc) are only temporary. They were lowered starting in 2018 and are set to expire at the end of 2025. Unless Congress passes another costly tax bill, brackets are set to reset to 0%, 10%, 15%, 25%, 28%, etc. so there is a limited window of the next ~4 years to capitalize on these temporarily lowered tax brackets. Each of these lower 4 tax brackets are set to go up by 3-5% when the TCJA expires, so it just makes sense to push money from a Traditional IRA (or similar) into Roth accounts before that deadline passes.

0% tax bracket

While there is not an official 0% tax bracket on all of the marginal tax bracket tables you have ever seen, there actually is a hidden bracket that does not get taxed. That is called the “standard deduction,” which in 2022 is $12,950 for single taxpayers, double that amount ($25,900) for Married Filing Jointly, and $19,400 for Head of Household. That means the first several thousand dollars of income each year are not taxed, and then the 10% bracket and all of the others kick in on income above that amount. This is just another helpful benefit of the tax code for our mini-retiree in a low/no-income year when it comes to making the money moves outlined above.

Conclusion

These steps allow the mini-retiree with low or no income to make massive changes to the amount of future taxes owed, all because they have planned ahead a little bit. This is not “cheating” the tax code – it is making smart decisions and paying only the taxes due and not a dollar more. This does require living off of personal savings and paying out-of-pocket for one’s own health insurance, but it also provides these huge tax advantages and a chance to reset and recover from this difficult period in one’s career/family/life. This move is especially beneficial for people in their 20s, 30s and 40s, because those Roth Conversions can grow tax-free for many decades to come.

What do you think about mini-retirements? Is this truly a superpower? Would you tax a year off in the middle of your career to make some of the strategic money moves outlined above?