Comprehensive Sabbatical Finance Planning Guide

Previously, we delved into budgeting for your sabbatical and shared eight essential tips for saving money. We're elevating the game with this guide, focusing on financial planning. Specifically: investment and tax optimization.

This installment is particularly valuable if you're navigating stock investments in taxable accounts and 401ks. We'll reveal how strategic financial strategies can significantly reduce your tax liabilities and enhance your savings. These actionable steps will yield you substantial financial benefits during your sabbatical.

Why Financial Planning is Crucial for Your Sabbatical

Taking a sabbatical often means a temporary stop in earnings, making it crucial to watch your spending. But here's a twist: with five steps, you can use this period of lower income to your advantage. This guide is split into two parts: first, we discuss investment techniques; second, we dive into the art of tax optimization.

Strategic Investment Moves for Sabbatical Planners

Lower Expense Ratios: Move from 401K to TIRA

Transitioning from an employer-sponsored 401K to a Traditional IRA (TIRA) can save you money from lower management fees. Typically, 401K plans have higher expense ratios, which are fees that cover the costs associated with managing your investments. For instance, data shows that 401(k) plan participants paid an average expense ratio of 0.36% in 2021. By rolling over to a TIRA with providers like Vanguard or Fidelity, you often find lower expense ratios. For example, some Vanguard funds have expense ratios as low as 0.09%! Plus, they have a wider range of stocks, giving you more control and flexibility for things like rebalancing your portfolio.

For each $100,000 in 401K rolled over into a TIRA, you can save up to $270 a year. This might seem small, but it can significantly impact your long-term savings because of the effect of compounding. This difference can lead to substantial savings and is particularly valuable during a sabbatical when every financial decision counts.

Harvest Capital Gains Strategically From Taxable Investments

Who doesn’t like free money? Harness the power of your low-income bracket during your sabbatical and potentially save up to $47,025 in taxes with capital gain harvesting. This approach allows you to reset the cost basis of your investments, reducing your tax liabilities in the future. Here's how it works:

1. Understanding Capital Gains and Taxable Income:

• Capital gains are the profits you make from selling an investment for more than you paid for it. The IRS taxes capital gains, but the rate depends on your taxable income. For instance, in 2024, single filers with a taxable income of $0 to $47,025 are eligible for a 0% capital gains tax rate.

2. Calculating Taxable Income for Capital Gains:

• Your taxable income includes wages, interest, dividends, and capital gains, minus deductions like IRA contributions and standard deductions.

3. Case Study - Paul's Scenario:

• Paul, a 30-year-old single individual, has $100K in stocks (VTI), purchased for $70K three years ago, amounting to $30K in long-term capital gains.

4. Capital Gain Harvesting Steps for Paul:

• Paul can strategically sell his stocks during his sabbatical to realize the $30K in gains. Since he didn't earn any income in 2024, he's in a low-income bracket (0% capital gains tax rate). He won't owe taxes on these gains.

5. Avoiding Wash Sales:

• To avoid triggering a wash sale, which can disallow the capital losses, Paul can buy a different but similar investment, like SCHB, immediately after selling his original shares.

6. Resetting Cost Basis:

• By doing this, Paul resets the cost basis of his investment (from $70K to $100K). If his investment grows from $100K to $125K in the future, he'll only owe taxes on the $25K gains, not $55K.

By understanding and harvesting capital gains, you can effectively use periods of lower income, such as a sabbatical, to lower future tax liabilities on long-term capital gains.

Invest in Retirement Accounts During Sabbatical

Understanding why and how to invest in retirement accounts like Roth IRAs and Traditional IRAs (TIRAs) during a sabbatical is vital. Even when not actively earning, contributing to these accounts have long-term benefits and potential tax advantages. However, it's important to note that your ability to contribute, particularly to a Roth IRA, is influenced by your income levels during the sabbatical. Let's consider two scenarios to illustrate this:

Paul’s Sabbatical Year: The Roth IRA Advantage

Paul, on a full-year sabbatical, has no income, placing his Modified Adjusted Gross Income (MAGI) at $0. This makes a Roth IRA an ideal choice for him. The Roth IRA offers tax-free withdrawals upon retirement, allowing Paul's portfolio to grow tax free. With no income, Paul can fully utilize this opportunity by maxing out his $7,000 contribution limit.

Jerry’s Mid-Year Sabbatical: Navigating Income Levels

Jerry's case is different. He takes his sabbatical mid-year and his taxable income exceeded $146,000, and isn’t eligible to contribute to his Roth IRA. In Jerry's case, contributing to a TIRA becomes a viable option. One might question why Jerry should opt for a TIRA over a taxable brokerage account, especially when the tax treatments appear similar. Here's why:

• Tax-Deferred Growth: TIRA contributions allow for tax-deferred growth. While investments in a taxable brokerage account might incur taxes on dividends or capital gains annually, TIRA investments grow tax-deferred until withdrawal.

Understanding the nuances of IRA contributions during a sabbatical is key to effective retirement planning. Whether you're in a no-income situation like Paul or navigating limited income like Jerry, each scenario requires a strategic approach to ensure your retirement savings continue to grow efficiently.

Optimizing Taxes During Sabbatical

Maximizing Your Tax Refund

For those who've quit mid-year, there's free money waiting for you. Initially, the IRS bases your tax rate on your annualized monthly income, effectively assuming a full year's earnings. But when your actual income for the year turns out to be just a portion of this due to your sabbatical, you’re likely eligible for a tax refund.

Here's a tip to boost that refund by up to $1,000: consider harvesting losses, explained below. By selling off investments that are at a loss, you can decrease your taxable income. This maneuver not only cushions the financial impact of your sabbatical but also lowers your tax obligations.

Lowering Taxes With Tax Loss Harvesting

Let's revisit at Jerry's scenario. He steps away from work mid-year, having earned $150,000. Without any realized capital gains for the year, Jerry can harvest up to $3,000 in investment losses. This strategy reduces his taxable income by the same amount, which, at a 24% tax rate, translates to a $720 reduction in his federal tax liability (i.e. his tax refund increases by $720 next year!).

It's a straightforward yet effective way to manage your taxes during a sabbatical, turning a period of lower income into a tax-saving opportunity. The intricacies of tax loss harvesting can be extensive – I might delve into this topic in a separate guide.

Lower Taxes With A Roth Recharacterization

Story time: at the start of the year, not knowing when I would start my sabbatical, I made a routine contribution to my Traditional IRA, maxing out at $6,500. Little did I know that I stepped into a unique financial situation as the tax year drew to a close.

Here’s the picture: I had initially contributed to my TIRA last year because my annual income made me ineligible to contribute to a Roth IRA. And I preferred to contribute to a TIRA rather than a taxable brokerage to take advantage of the tax-deferred growth. Having left in April, my taxable income (under $146K) meant that I was eligible to contribute to a Roth! My TIRA contribution wasn’t going to be tax-deductible due to my income levels and retirement plan coverage. Effectively, I had made a post-tax, non-deductible, contribution to my TIRA.

In hindsight, I realized that I should have contributed to a Roth IRA instead because it offered tax-free growth and withdrawals. If I had left it in the TIRA, sure, it would grow tax-deferred, but eventually I’d have to pay taxes on the withdrawals. Moving it to a Roth IRA meant leveraging my already taxed contribution for tax-free growth and withdrawals in the future.

Ultimately, I was able to recharacterize my TIRA contribution to a Roth IRA. I will explore the nuances and how-tos of Roth recharacterization in a separate deep dive.

Wrapping Up: Key Takeaways on Sabbatical Finance Planning

Our journey through the intricacies of sabbatical financial planning has covered a vast landscape, from strategic investment strategies and capital gain harvesting to the nuances of retirement account contributions and tax optimization. We've seen firsthand how a sabbatical doesn't just mean a break from work but also presents unique financial opportunities.

• Optimizing Investments: The shift from a 401K to a TIRA can lead to substantial savings, thanks to lower expense ratios. This, coupled with the strategy of capital gain harvesting, can significantly decrease your tax liabilities and enhance your savings.
• Roth IRA Contributions: For those with lower or no income during their sabbatical, contributing to a Roth IRA can be a wise decision. It offers the advantage of tax-free growth and withdrawals, making it a valuable tool in your retirement planning arsenal.
• Tax Efficiency: We explored how maximizing your tax refund and leveraging tax loss harvesting can turn a sabbatical into a period of financial gain rather than just a hiatus from earnings.
• Roth Recharacterization: The flexibility of being able to switch contributions from a TIRA to a Roth IRA is a powerful tool, especially when your financial circumstances change unexpectedly.

This guide is just the beginning. Your personal experiences, insights, and strategies can add immense value to this discussion. So, I encourage you to share your tips, stories, or questions in the comments below!