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Maximize the Tax Opportunities of the ‘Bridge Years’

Published on: Nov 01 2022

Many retirees and pre-retirees go through a period called the “bridge years” but don’t take full advantage of the tax reduction opportunities of that period. The bridge years are a period when a person is phasing into or is in the early years of retirement.

Income is lower, because the person no longer is working or is working reduced hours and probably not yet receiving Social Security. The retiree is younger than age 72, so required minimum distributions (RMDs) aren’t being taken from 401(k) s and IRAs. Often, there’s a substantial decline in the tax bracket because income is lower than during the working years.

But in a few years, income levels and the income tax bracket are likely to increase because of RMDs and the beginning of Social Security benefits. Someone with a high employment income is likely to have a substantial 401(k) or IRA that will generate high RMDs beginning at age 72, pushing you into a higher tax bracket and triggering the Stealth Taxes.

The higher your income was while working full time, the more your income tax rate is likely to drop during the bridge years, and the greater the tax planning opportunities that could be created. Some people stop working or reduce working hours in their late 60s. They have only a few bridge years.

People who stop employment or reduce their work hours in their early 60s can have a bridge period of 10 years or longer. Many retirees who don’t take advantage of the opportunities of the bridge years find that their income tax rates, and tax bill increase at age 72 and beyond.

In addition, the higher income of those years is likely to trigger the Stealth Taxes, such as the Medicare premium surtax, inclusion of Social Security benefits in gross income, and others. People who expected taxes to decline as they age find their income taxes and tax rates increasing. The bridge years can be used to accelerate taxable income from future years.

Pay taxes at today’s lower tax rates to avoid the higher income tax rates and the Stealth Taxes that could be triggered in later years if action isn’t taken during the bridge years. Taking advantage of the bridge years is especially important today, because the 2017 income tax cuts are scheduled to expire after 2025 if Congress doesn’t take action to extend them.

Failure to take action during the bridge years is likely to cause higher income taxes later in any case, but the taxes are likely to be even higher if Congress allows the 2017 tax cuts to expire. The first step is to determine the income tax bracket you’ll be in during the bridge years, your estimated annual income, and the top income level of your tax bracket. You also can estimate what your income is likely to be in future years after Social Security benefits and RMDs begin.

You might have other sources of taxable income that won’t begin until later years. Then, take action to increase income enough that you take full advantage of your current tax bracket. Increase income enough to take your taxable income to the top of the bracket but not push you into the next higher bracket. But if you’re in one of the lowest tax brackets, you might want to recognize enough income during the bridge years to put you in the next higher tax bracket to keep that income out of an even higher tax bracket in later years.

Consider these strategies. Take distributions from traditional IRAs. You need income during the bridge years, and the best source might be traditional retirement accounts. Many people want to begin Social Security early to start that cash flow. They’ve been trained during the working years to build up the retirement account balance and not touch it for as long as possible.

But as I showed in my book, “Where’s My Money: Secrets to Getting the Most out of Your Social Security” (Regnery Capital; 2021), you’re better off in the long run by delaying Social Security benefits and drawing from traditional IRAs and 401(k)s for a period of years. Your nest egg will last longer, and you’ll be able to spend more during the retirement years.

If you want a steady flow of income during the period before Social Security benefits begin, consider using a portion of a traditional retirement account to purchase a short-term annuity that will pay monthly income for a few years. When you’re age 65, buy a five-year annuity and delay taking Social Security until age 70. Delay Social Security. A key to retirement security is not to claim Social Security benefits early. The longer you delay them, the better off you and your spouse will be in the long run.

Though delaying them until age 70 is ideal, the real key to retirement security, as several studies have shown, is to avoid taking benefits before your full retirement age. That’s why I say it’s better to take distributions from traditional retirement accounts during the bridge years. Delay the Social Security benefits so they increase by 8% each year. And take advantage of the lower tax rate during the bridge years by taking those fully taxable traditional retirement plan distributions to pay your expenses.

That increases the after-tax value of your retirement plan distributions, because you have more after-tax money to spend than if you took them later when you’re in a higher tax bracket. The strategy also increases the amount of your Social Security benefits. In effect, you’re purchasing an inflation-indexed annuity at low cost by using retirement plan distributions to delay Social Security benefits.

IRA conversion. Consider converting part of a traditional IRA or 401(k) to a Roth IRA. You’ll include the converted amount in gross income as though it were distributed. But future distributions from the Roth IRA would be tax free (after the five-year waiting period).

In addition, a Roth IRA doesn’t have RMDs for its owner. You take distributions only when you want or need the money. We’ve discussed IRA conversions in detail during past issues, including all the factors to consider before deciding to do a conversion. See the September, March and February 2022 issues for details.

Review your taxable accounts. Investments in taxable accounts might have tax losses you can recognize. You take losses now and build up a balance of loss carryovers to be used in later years when you are likely to be in a higher tax bracket. Another strategy is to recognize some gains while you’re in the lower tax bracket. You pay the taxes at to- day’s low rate.

Then, you can repurchase the investments later and establish a higher tax basis for them. That will reduce the amount of taxable gains when you sell them to generate spending money in later years when you’re in a higher tax bracket. We discussed these and other strategies in more detail in the October 2022 issue. Reconsider charitable giving strategies.

Because the standard deduction was doubled in the 2017 tax law, many people no longer deduct charitable contributions. Charitable contributions are deductible only as itemized expenses and only when your total itemized expenses exceed the standard deduction.

A minority of taxpayers itemize expenses now. One strategy to consider is to bunch several years of charitable contributions into one year when you’re in a higher tax bracket. You can do this during the working years or after the bridge years are over.

You could donate a large amount to a donor-advised fund (DAF). You deduct the full amount of the contribution in the year it is made to the DAF. But you can direct how the DAF invests the money (within the DAF’s limits) and make contributions over time just as you would have if the DAF weren’t used. See our May 2021 issue for details about DAFs.

Another strategy is to use qualified charitable distributions (QCDs) to make some charitable contributions after age 70½.

In a QCD, you direct that money be transferred from a traditional IRA to a charity. This counts toward your RMD for the year, but it isn’t included in your gross income. You can’t take a charitable contribution deduction for the QCD. See our July 2022 issue for details about the QCD.

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