If you think you might change your living situation during retirement, let me warn you that many people make mistakes that could cause them to pay more tax than they need to. This will be very useful even if you don’t plan on moving for quite some time, because it’ll show you how to prepare so that you can get ahead of the curve and not be surprised whenever it is time to move in the future.
The Problem with Pre-Tax Money
I spoke to a couple recently that is retiring soon and one of their financial goals is to move to another state. They wanted to sell their current home and buy a new home as well, but they had a problem. All of their wealth was tied up in pre-tax 401k and IRA.
If you didn’t know, when you’re making a house transition you sometimes find the next place before your current place is ready to sell, or there might be some reasons why you have to have two for a little bit of time. This happened quite a bit to clients who were making a move like this or just wanted to buy a second home in retirement and be snowbirds. They’ve got too much tied up in pre-tax monies.
You might have guessed that the negative of this is if you take money out of your pre-tax monies, then it increases what your taxable income is. It may even shoot you up to higher tax brackets the year that you take a big lump sum withdrawal. Another problem retirees run into is if they no longer have a wage, it may be harder to qualify for a mortgage if they don’t have that high income anymore. Also, for many, the first few years of retirement is the Roth conversion sweet spot. If you’re taking withdrawals out of your IRA for lump sums or down payments on houses, that can throw the conversion strategy out of whack, or withdrawals from IRAs can increase how much you’re paying for healthcare costs too if you’re under 65 – those are some of the problems. Let’s get to some of the solutions now.
Five “Out-of-the-Box” Ideas That Could Save You Thousands in Taxes
These may be out of the box ideas for those in a situation where they may not qualify for a big enough bridge loan or a mortgage if they’re in retirement. As always, talk to your financial professionals or tax professionals to evaluate all the options to make sure that it fits your situation before doing anything.
1. 60-Day Rollover
The first is one that I mention to people, but I usually don’t recommend it. If someone’s in the process of selling one house and then buying the next one and they find their new house first and their money is all in pre-tax accounts, they sometimes bring up the idea of doing a 60-day rollover, which is basically taking money out of one account, pre-tax account, and then if you’re able to add that same dollar amount back into another pre-tax account in under 60 days, you shouldn’t have to pay tax or a penalty if you’re under 59 and a half. A 60-day rollover is really meant for 401ks where it’s coming out of a 401k and then getting into an IRA. There’s a 60 day period where you can get it and there’s no tax impact of that, but some people may think about using this as almost like their own bridge loan, where they can get it, buy the second house, and then, hopefully, their existing house sells, they get the proceeds, and then they can add it back to the IRA; to me, that’s risky.
You and I both know that house transitions never go as smoothly as you want and things get delayed, or one party has different stipulations. It’s not worth adding that time constraint to your life, if you can avoid it. If it doesn’t all go according to plan that could mean thousands of dollars that you pay in tax.
2. 401k Loan
Something similar is taking a loan from your 401k to help with part of a down payment of a house purchase or a house purchase. Some 401ks allow you to take out either half of the balance or 50K, whichever is less, but there’s negatives here too. You don’t get the growth in the 401k once you take that money out. If it’s long term money, you’re not getting the growth. You have to pay back the loan, sometimes within five years. There’s different rules for different plans, so talk to your tax and financial professionals before thinking about that, but it’s a time constraint.
3. Taking Systematic Withdrawals Before You Need the Cash
The next solution is if you’re a few years out before retiring, or maybe just a few years out before a house transition, see if you can add to your non-retirement funds or maybe your Roth accounts over the course of a few years. It might be adding to it just regular contributions or it might be withdrawing from pre-tax accounts, but spreading out how much you take out of pre-tax accounts and getting it into the non-retirement accounts over the course of a few years. That way, if you take a big lump sum in one year in the IRA versus spreading it out, you may be saving quite a bit of tax that way. If you’re still working, it may be even funding your non-retirement accounts before your 401k if you’re working now.
This is something you might not think is the normal thing to do, and it’s not. These are just ideas, not recommendations, but when clients get clear on their goals and are able to design that financial plan and see what the future holds, it could make a lot of sense for them.
4. The Debt-Free Option
What about that person who needs to be debt free in retirement? No mortgage, but they don’t have enough cash or non-retirement accounts to pay for the new place. They just got the IRA or 401k. Here’s the idea: what if you went against the plan of being debt free, but only for just a few years? The reason for this – you guessed it – taxes. Instead of taking out a big lump sum from your IRA and paying tax on all of it, what if you only took enough for a down payment so that you don’t shoot up to the highest tax bracket? Then next year, maybe take a little bit more out of the IRA, up to a certain tax bracket (but not to the highest one) and use that to pay off the mortgage in a big chunk. Over the course of four to six years, you could end up paying a lot less in tax than if you were to just take one big lump sum from your IRA. I know the importance of wanting to be debt free, but there might be a way to help save on tax by having a mortgage for a little bit but paying it off more rapidly.
5. Rent Where You’re Moving
The next solution is one that I actually like a lot (even though many people’s first reaction to it is, “I don’t want to do that”) and that is to pay for flexibility by renting in the area that you’re going to be moving to. The reason I like this option is because I’ve seen the positives that have come from this, and I’ve seen the negative things when people just get their new house right away in this new area. So the scenarios that we’ve seen play out when someone buys a house in a new location, they find out, maybe a year later, something is off. It might be that they’re having a hard time creating new social connections in this new area; they didn’t know that might happen or maybe they don’t like the distance from their family back home; the weather isn’t exactly what they thought. Maybe these don’t seem like big things, but it’s enough for people to second guess their decisions after they’ve already bought this house. I asked a bunch of retirees who have moved to a new state for advice and I shared what they said.
On the flip side, we’ve also had clients who moved to a new location and they look for either a short-term rental, six months or maybe a year. That way, they can test the area, make sure it’s the right place and if it’s not right, they can easily look around that area to different communities without feeling tied to stay in that place because they already bought it; moreover, they don’t have to worry about selling the house and paying 6 to 8% after all the closing costs and things of that nature if they were to make another transition.
As always, with each one of these ideas, there are many elements to getting them right. I know I say it all the time, but do talk with your CFP or CPA before making any big financial decisions. Hopefully, you found some value in this, whether it’s something you’ll use now or further down the road. See you next time!
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Disclosures: Securities offered through LaSalle St. Securities LLC (LSS), member FINRA/SIPC. Advisory services offered through LaSalle St. Investment Advisors LLC (LSIA), a Registered Investment Advisor. Streamline Financial Services is not affiliated with LSS or LSIA. LSS is affiliated with LSIA.