Saving For A Sabbatical Using Retirement Accounts

[moda0306]

Being a tax guy, I've been constantly pontificating the benefits of certain tax-vehicles, scouring their rules/benefits, and deciding to what they can be used even as a mechanism for short-to-medium-term saving without risk of large penalties worsening your scenario.

Long story short, I believe a Traditional IRA/401(k) retirement account might be a great savings tool for periods that they're not traditionally ascribed for.  Yes, liquid taxable funds and Roth funds (you can pull your principal out tax/penalty-free) can help as well... but one shouldn't have to get too hung up on keeping things uber-liquid for a sabbatical in most instances... for the reasons I highlight below.

Here's my take on saving for a definite or possible future period of living off of your wealth but not earning income:

A Traditional 401(k) or IRA can be viewed as a Roth 401(k)/IRA with what I call (probably inappropriately) a tax-arbitrage element to it.  For instance, if you are in a 30% combined bracket at the date of contribution, and a 30% combined bracket at the date of distribution, you will have the exact same net-wealth having contributed to a Traditional retirement account as you would have from a Roth retirement account.


Obviously, the next conclusion to come to is that if you can contribute at a higher rate than you distribute at, you've "arbitraged" your way into a higher net-realizable wealth than you could have accomplished with a Roth.  For instance, if you put $10,000 into a pre-tax (traditional, not roth) account at the 30% bracket when you're 59, retire, and distribute that money at 60 in the 20% bracket, you put in a net-$7,000, and distributed a net-$8,000.  $1,000/$7,000=14.3% automatic gain!

Now people intuitively avoid putting too much money into retirement accounts because of penalties that need to be paid at distribution... but I think this deserves some re-analysis.

Assuming you're merely in a 30% combined tax bracket, you'll be able to contribute a certain amount every year at that rate.  Suppose you've decided after 5 years of working for the man that you want to take a year off and see the world, but you haven't saved more than a few thousand $$'s in your taxable savings account... But you have $40k sitting in a tax-deferred retirement account that will cost you penalty at distribution.  Let's examine for a second whether this person would have been better off putting this $40k of savings into a taxable account, adjusted for the tax-cost of doing so.

This person, in putting $40k into a retirement account, really only lost $28k, since it was all done over the years in the 30% combined tax bracket.  So let's assume the second scenario as being that this person set-aside $28,000 into a savings account.  For simplicity, let's not even factor in gains/income... though this would probably aid the case for the retirement account.

We'll now view these 2 individual scenarios on sabbatical.  Let's say it's a 1-year sabbadical that will cost the full $28,000 in cash savings (no idea if this is realistic, but this is just for purposes of illustrating a point to build on with peoples' individual scenarios).  This also assumes that the sabbatical starts on January 1st of a year, also for simplicity.  Lastly, this taxpayer has no other income sources, and files with the standard deduction, not itemizing.

One person will have $28,000 of liquid cash to spend without tax-consequence, and the other will have $40,000 to spend but with taxes AND penalties.

Let's look at what happens to that individual with $40,000 in oh-so-awful penalized 401k Distributions:

The first $9,500 comes out completely income tax-free, but with a 10% early-withdrawal penalty... Cost: $950

The next $8,500 is taxed at a 10% federal rate, and a (hypothetical) 5% state rate, plus the 10% early withdrawal penalty.... Cost: $2,125

The next $22,000 is taxed at a 15% federal rate, a (hypothetical) 5% state rate, plus the 10% early withdrawal penalty... Cost: $6,600

Total Tax Cost: $9,675

Amount realized out of $40k retirement account: $30,325.  That's another $2,325 of spending-fun during your sabbatical, or an 8.3% increase over your $28,000.

So as you can see, by contributing for years at your highest tax-rate, even with the penalty, you can fund a lot of fun in your lower tax rates.  Especially if this guy had a pile of Roth or taxable-account cash to help keep from taking funds out in the 15% federal bracket, he could have benefitted immenseley from the tax-diversification.  So this isn't even a case of very efficient retirement fund usage.

The point of this is to show people to not be so afraid of the apparent permanence of retirement accounts.  Ironically, pre-tax retirement accounts are one of the best mechanisms for saving for long periods of low income during the pre-retirement years.  I would definitely supplement the spending at the time with Roth principal and taxable savings accounts, but don't let a 10% penalty scare you out of enjoying your life, or contributing to accounts that you can use to your benefit later on if you simply know how to work around the tax code.

EDIT: See TripleB's idea below... instead of distributing from the traditional account, do a Roth basis distribution, and then do a Roth Conversion from tradtional account to Roth.  More detail in the posts following TripleB's observation.

[moda0306]

Keep in mind, one can also substitute the word "sabbatical" with "job loss".

If you lose your job for long enough (6-months or longer), you'll start plummeting in marginal tax bracket from where you used to be.  At this point, you might also be running low on liquid savings to finance your unemployment.

The retirement account can work in the same way... giving you distributions at a much lower tax rate than you contributed at... yes, it might hurt to look at the "penalty" you paid on your 1040, but look at the forest through the trees... if you've beaten or tied the arbitrage, you've BEATEN a Roth IRA or taxable account.  Who cares if they call it a penalty!! To you that was the best place to put your money at the time... even in hindsight!


I think the real risk with shoving too much into retirement accounts comes not in the instance of an income emergency (job loss), but an expenditure emergency (medical expenses, uninsured loss).

This is where accessing retirement funds could come at a high cost.

Of course, for things like this, I would recommend being as properly-insured as possible on the high end.  Good health, life, homeowners, liability (for business owners), umbrella, and auto liability insurance is a must not simply as a retirement-fund usage tool but overall financial planning tool.

[lazyboy]

Thanks, moda. When I was working and saving money in my 401K, there was a provision for borrowing from that account without penalty and essentially paying yourself back. If that provision is still in effect, then that might be a way to spend for some need in a relatively painless way, assuming you were going to still be working in the same place.

[moda0306]

Yeah...

If your 401k allows you to borrow AFTER being separated from service, that's a great way to do it... though if you have to pay it back if you're canned that can cause some troublesome problems.

Keep in mind I'm not condoning using money in a whimsical fashion... all this is about 1) deciding where to put funds when saving and 2) deciding which funds to tap while on a long break.

The more fundamental issue, of course, is "can you afford this?"  That's up to you to answer.  I just have found that the retirement accounts aren't nearly as scary as they initially seem, and actually can be manipulated for a huge benefit.

[hoost]

This is an interesting discussion on a topic I've been thinking about a lot lately.  As I finish paying off the last of my debt my savings will ramp up quickly to where this becomes very applicable.

I'm still leaning toward being cautious to not put too much into my 401k (simply get the match and that's it), but thinking about it in terms of marginal tax rates make sense.

I was of the mindset that I wouldn't touch any funds that would be subject to a penalty in early retirement, but thinking of the penalty as just another tax, and drawing from multiple accounts, such as part from a roth and part from traditional to keep your marginal tax rate down is interesting.

I guess where my mind goes next is at what point does this logic break down?  Even with maxing out roth and 401k, I will be able to invest considerable funds in taxable accounts.  I guess you would want the full 25% of gold in your taxable...although, if I had that much in taxable I might not even need to spend from my traditional, so maybe it doesn't matter.

I look forward to reading more of this discussion, as I've been looking for an opportunity to explore both sides of this issue.

Thanks for starting the thread moda.

[moda0306]

In a perfect world, if i could see what my pre-contribution income and tax rates would be for the rest of my life, my goal would be to trim down the highest years as much as possible, and do Roth contributions for low-tax/income years.  This is impossible, but one can do fine, usually, by trimming off the top the whole way with pretax contributions.  Of course, pulling money out is a bit different.  At some point(s) in life you will "dissave," and doing so you should tend to look at the same looking into the future.  If you're doing a sabbatical at 30 years old, and you have $100k in Roth, $300k in IRA/401k, and $100k in taxable, it's probably best to look at your tax rates going forward, and try to see what opportunities exist within the sabbatical year.

Keep in mind, the goal isn't to incur high taxes, but to take on $1 of tax today if it will save you an investment-value-indexed more-than-$1 going forward.

The most efficient thing to do, at this point, isn't to take big penalized distributions out of your 401(k), but instead to spend from your taxable funds, and consider doing a Roth conversion to get you up to a taxable income that you think will keep the arbitrage element working.  Why??  Two reasons:

1) Why take a Distribution at a 10% penalty when you can roll it into a Roth without, since you have taxable funds to fund your sabbatical.

2) Preserving Roth basis is important for future use if available.

Keep in mind that your likely tax rate in retirement is a moving target.  The more Roth funds you have in relation to your total portfolio, the lower your tax rate will be in retirement, and vice-versa.

The last thing to mention is that the way Social Security is taxed adds a big hiccup to the average person's EFFECTIVE marginal tax rate in retirement.  If your income is low enough, Social Security doesn't add to taxable income.  However, as your non-SS income goes up, so does the amount of SS income that is subject to income tax.  This creates a zone where people can be in the 0% tax bracket until an abnormally high income, and then be thrust into a MARGINAL rate of almost 40% VERY quickly.  So if you're approaching retirement and in this zone (if your required income is somewhere between $40k and $70k (MFJ) in retirement you likely should look at this), then it's probably more important than you might think to make sure you have some Roth Funds as a decent chunk of your retirement, because this is the zone where your marginal tax rate goes kablooey... even though you're not making much money, and you'd think you're in the 15% bracket.

[Lone Wolf]

Nice analysis, moda.  Thanks for a new way of viewing these accounts (especially for savers those currently in a higher income bracket.)

I wonder if this might apply best to a true "sabbatical" versus unemployment (since with unemployment, you'll be paying taxes on your unemployment benefits!)  Perhaps this doesn't make much difference.

[moda0306]

LW,

Regarding unemployment benefits, this is valid, but UE benefits are income that may prevent you from having to dissave during a period of unemployment in the first place, and you still might end up in a much lower bracket even still.  In any instance, UEIB is something that will significiantly reduce the need to dissave during UE.  This is a good thing (for the person receiving it), and will likewise reduce the need to have a giant stockpile of non-retirement funds to access.

There's two decision points I like to highlight: 1) Where do I put my money first when saving?, and 2) where do I pull money from when dissaving.  For most financial-minded and non-adventurous people, #2 doesn't happen much until retirement.  I simply try to reiterate that #1 should be looked at differently than most look at it, even if #2 is going to happen at times before 59 years old.

I'd also reiterate that for people with a solid chunk of taxable funds to access WITHOUT penalty, it's probably better to do so during sabbatical/unemployment (assuming that these aren't needed for a large purchase in the near future).  If you find yourself in uber-low tax brackets due to one of those reasons, you can accomplish a better arbitrage by using your non-retirement funds first, and doing a Roth conversion with your 401k/IRA balances to pull you back up near the higher brackets again without going over.  But this is for the person deciding how to dissave to accomplish their non-working-period goals, not the person deciding how to save while working.  The decision of how to SAVE WHILE WORKING is a different one, and for those nervous about long periods of unemployment (unaided by social safety nets to prevent dissaving) or a whim to "sail around the world" 7 years from now, in an odd turn of events, I insist that pre-tax retirement accounts are a wonderful tool to save into.  Of course, this is all in the context of having 3-to-6 months of cash savings built up and maybe some Roth contributions to boot to help add a little cushion to my pushin'. (sorry for that  )

Always keep in mind that you are changing your retirement taxability scenario AS you try to hedge against one scenario or another, so you should keep re-evaluating your accounts, and the income that can be derived therefrom, and comparing them to your cash-flow needs of dissaving periods and the tax code.

[moda0306]

Also, if you want to retire early, the IRS allows you to take your total IRA and split out some of it into a given account, size of your choosing, and take a series of substantially equal payments from it without paying the penalty...

So people shouldn't be too afraid of the 59 1/2 requirement.  It can be worked around, and you don't have to make big commitments with your entire IRA balance, but just enough to spit you out enough income to supplement your other income sources before you turn 59.5.

I'm also a big believer in using debt SMARTLY.  If you're only going to live in a house for 5-7 years, get a 7-year or 10-year ARM.  If you have contribution-capacity in your Roth/Traditional accounts, don't be in a huge rush to pay down low-interest debt, especially if it's tax-deductible... wait until years where you can save well in excess of your retirement contribution limits.

I used to be really averse to debt, and vowed I would pay cash for my next car no matter what, but more and more I realize that it can be used to smooth cash flows over long and short periods, and allow yourself to avoid being horribly bit by taxes, and often in a relatively low-cost way.  It's often not the debt itself, but the lazyness of bargaining that follows that really bites you.  College, new car, new house... all can appear affordible based on payments... $100 here... $100 there.  Some people find that the only way to avoid making dumb financial decisions is to avoid debt altogether, and by no means am I trying to engineer these people to be different... know yourself and how to prevent succumbing to your weaknesses... but if you're relatively confident in where you are putting your money, the decision to use debt where it can allow better use of short-term cash-flows can help us improve our finances.... not hamper them.

[TripleB]

Great analysis Moda!

I'll add a few points that might add value to the discussion:

1) If you're going to do this, it makes substantially more sense to do it from mid-year to mid-year rather than Jan to Dec. Then you can push yourself into a lower tax bracket 2 years in a row rather than 1.

2) The added benefit of Moda's plan is "option value." You may decide not to take a sabbatical, in which case you were better off with the money in the 401k rather than taxable savings (assuming that was an either/or decision and not both), because you can never re-contribute money into the 401k for those lost years going forward.

3) Imagine a slightly modified scenario:

You work out of college earning low wages of around $40k. You max out 401k and Roth IRA because you're in a low tax bracket. You put $5k into a Roth IRA for 5 years but still get tax-deferral from the traditional 401k.

At 5 years, you have $25k in the Roth IRA as a "principal contribution" that you can remove penalty free. You quit your job at the 5 year mark and live off the $25k Roth contributions. At the same time, you convert $25k of 401k into the Roth IRA. Essentially you were able to "access" the 401k money without penalty, because money is fungible. You didn't reduce the value of your Roth, because you converted in exactly what you withdrew. You did reduce the value of the 401k, however you did it penalty-free (albeit not tax-free, and it would follow the same tax calculations Moda did in the first post).

4) Consider SEPP - google it if you don't know. That could work nicely too if you decide to retire early, rather than just 1 year off sabbatical.

5) Consider how you will explain the year off on your resume in a manner that won't make you look bad to future prospective employers. It may be easy; it may be hard. It's worth considering.

[moda0306]

Triple B, you sly f*king dog, you....


To your point #3)

That's perfect...

I'm going to double-check if you can do conversions in the same year as non-qualified (though tax/penalty-free) Roth distributions of basis.

I can't believe I didn't catch that.  That works even better.

Further, once you've initiated a Roth conversion account, I THINK you get 5 years until the basis of THAT account is distributable tax/penalty-free.

I'm going to look at this right after I edit my initial post and give you credit for your input.

[moda0306]

UPDATE:

Ok so here's how these things work:

If you're under 59.5 and don't meet the other odd-ball exceptions, you can obviously take your Roth Basis out, but conversions are different.  With every conversion, you have to wait 5 years.  So "all basis is not created equal."

But this still works relatively well with TripleB's example.  If you have Roth basis, and you're exasperating your taxable funds, doing a Roth-distribution of basis as well as a Tradtional-to-Roth conversion of similar amounts will leave you with what will feel like a retirement distribution without a penalty.  Now you don't HAVE to do the conversion, but it's probably a really good idea to get any money you can at incredibly low tax rates from a traditional to a Roth.  This will also aid in future liquidity, as the Roth basis will eventually switch back to being tax/penalty-free after 5 years from the conversion.

Now it is worth mentioning that this new Roth basis that you're building up is NOT the same as the one you're distinguishing.  If distributed within 5 years you WILL have to pay the 10% penalty (no tax, because it was already paid at conversion).  However, this is penalty that, under my scenario, you would have paid and been ok with it... but you get to DELAY that until later, if you even have to take it at all.

TripleB's example is perfect.  You can move $25,000 of your Traditional to your Roth, and $25,000 of your Roth basis to your "Fun money" account and go sailing around the world or whatever.  Assuming a 5% state rate, this will cost the average individual, in 1 year, about $2,675 in taxes, or less than 11%.

This is money that you were likely getting somewhere between 20% (in TB's example) or 30% (for people making a bit more money) in deduction for.  If the latter, you've just spent $17,500 to fund $22,325 of fun, and that's before any growth/income from the investments... that's a 27.6% ROI cumulative over those savings years.  Not. Too. Shabby.

Now if your trip goes a little long, you can start pulling from your Roth, but at this point you've benefitted a huge amount from your moda/TripleB arrangement, and 10% in taxes at this point is hardly something to freak out about.

Now you have the clock ticking on new Roth IRA contributions that, in 5 years, can be used to fund another sabbatical with our pre-discussed method.

[moda0306]

Regarding TripleB's other points:

1) I don't see a huge benefit to spreading it over two tax-years, because your earnings in both years will be pushing your tax bracket up to moderate (not high) levels, offsetting some of what would have been conversions at VERY low rates (0%-10% federal).

2) Option value: Definitely.  The point of this is to highlight that these accounts, if done right, can work very well both for long-term retirement goals, or even something as foolish as taking a long sabbatical... It was quite the epiphany I had when I realized just how flexible these things could be in combination... and that's before TripleB came and trumped me.

5) I will consider it a personal failure if I ever use what a potential employer might think as the tie-breaker in deciding whether to do something I feel would be a good life experience... but it's an excellent point, nonetheless.