What is a Bridge Account?
Good tax efficient savings strategies lead many to use HSAs, 401(k)s, IRAs, and 403(b)s as they save for retirement. Unfortunately, these accounts can be challenging to withdraw from in early retirement without triggering significant penalties. By using bridge accounts to fill the gap between early retirement and age 59.5, you can get the best of both worlds.
The Common Conundrum of Retirement Saving
When we assembled the Next Dollar Roadmap, we ordered each step to produce the most optimal outcome for the average Jane or Joe.
This means we recommend making the most of tax-advantaged savings methods like HSAs, 401(k)s, IRAs, and 403(b)s in Milestone 5 of the Roadmap.
Using these accounts can be a significant boost to your lifelong savings goals and provide a welcome leg up in getting to retirement.
To be sure, we’ve shown that consistent investing over time can produce huge wealth building results years down the road. If you start early enough, you could even find yourself in a position to retire earlier than you thought.
There could be one problem with that, however.
The legislation and revenue codes that govern these accounts restrict withdrawals before the age of 59.5.
The reason is noble enough.
The government doesn’t want you to get starry eyed once those account balances start to get nice and fat. They created these accounts so you could have money in your senior years, not for a new swimming pool in your 40s.
There are some exceptions, but for the most part if you try to tap these accounts before you turn 59.5 years old you will have to pay a 10% penalty on each dollar you withdraw.
That’s a significant deterrent from using these funds.
Now, suppose you were disciplined in your 20s and limited your spending for years in order to build a healthy nest egg. In fact, you did so well that you have enough money at age 50 to retire and live comfortably for the remainder of your days.
You’ve budgeted for years so you could shelter as much of your savings as possible from the nasty bite of heavy taxation. Now these accounts are bulging with cash!
Good work!
Now, you’ll just have to share an extra 10% of it with Uncle Sam.
Bridge account to the rescue!
Finding out you have enough to retire, but can’t get to it could be pretty frustrating.
And even though you made the optimal financial decisions over the years, that may be of little consolation if it forces you to delay your retirement by a full decade.
To avoid this restrictive scenario, you should begin building a bridge account to provide income before you tap your tax advantaged retirement savings.
The account is so named because it’s designed to act as a bridge between the time you leave your income producing job and the age at which you can begin withdrawing from your retirement accounts penalty free.
In most cases, a taxable brokerage is used for the bridge account. Any brokerage like Vanguard, Fidelity, or Merrill Lynch will be happy to allow you to open an account and invest with them.
On the roadmap, bridge accounts come in Milestone 6, right after you save 15%-25% of your income in tax advantaged retirement accounts to satisfy Milestone 5.
One reason we say 15%-25% in Milestone 5 instead of calling for you to max-out these tax advantaged spaces is so you can begin building your bridge. However, if you can afford to do both you should go for the max.
In all likelihood, you’ll need time to build your bridge account so it has time to replace multiple years of income, so don’t drag your feet on this if you do want to retire early.
Tax efficiency of multiple savings “buckets”
In addition to the flexibility bridge accounts provide for early retirement, they also have several tax savings features that make them an attractive way to save money.
Capital gains tax vs Income tax
The first feature of using taxable brokerage accounts for savings is the lower taxation of capital gains as compared to income tax.
Not long ago, we put up a post about how income taxes work. In it, we also covered capital gains taxes. No matter your income, capital gains taxes are going to be equal to or lesser than income taxes.
Obviously, this is important to know because it means cash produced in the form of capital gains is taxed less than ordinary income.
No, you probably won’t ever turn down income for the sake of selling off investments and living off that instead.
However, if you’re deciding between continuing to work for earned income vs retiring early and living off capital gains to some extent, then obviously the tax savings is a factor.
Controlling income
We also recently wrote a post about the progressive tax system. In summary, it shows how your income is taxed at progressively higher rates as you produce more and more income.
Thus, the lower your income, the less tax you’ll pay as a percentage of that income.
By having a bridge account from which you can completely control the flow of money, you have more flexibility over how much income you realize in a given year.
For example, let’s say you’re retired and have funds in traditional IRAs (tax deferred), Roth IRAs (tax free or already paid), and a (taxable) brokerage or bridge account.
Depending on your age, any RMDs, and your income needs for the year, you may pull varying amounts of cash from one or all of these options in order to optimize withdrawals for tax efficiency.
These various sources of retirement income are often called “tax buckets” which is just a succinct way of saying they are all taxed uniquely.
Metaphorically, these buckets are like having a healthy variety of pieces in a game of chess. The timely use and application of each could improve your performance in the game.
However, if you only have one or two pieces to play, even if one of them is the queen, you may find your performance is somewhat limited. Having multiple options never seems to hurt.
Roth conversions
A popular tax avoidance strategy in retirement, or even before, is the conversion of traditional 401(k) or IRA assets to a Roth IRA.
By converting traditional funds to Roth, the account holder avoids RMDs and secures future investment growth in a tax-free space.
The conversion of these funds does create a taxable event which means you’ll need some extra cash available to give Uncle Sam his share.
Naturally, you wouldn’t want to sell tax-free/Roth assets to pay to convert money into tax-free/Roth assets.
Most of the time, people use money from their taxable brokerage or bridge accounts to pay the tax bill instead of using traditional or Roth dollars.
It’s wise to do this because of the advantage of capital gains tax rates applicable to the taxable brokerage over income tax rates applicable to the traditional IRA from which the money is being converted.
Note, 401(k) funds need to be rolled into an IRA before being converted to a Roth IRA.
Funds available for irregular and large purchases
In addition to various tax efficiency strategies, you may want a bridge account to save for large expenses like vacations, new homes, or new vacation homes.
This is the account from which you can fund all sorts of dreams, so the bigger it gets, the better.
For example, we’d like to be in a slightly larger home as our kids get older. There’s nothing wrong with the one we have, it’s just a bit tight at times.
We enjoy entertaining and the thought of having a fun hang-out space for our kids to bring their friends to a few years from now is appealing to us. It’s just difficult to do where we are now.
So, we’ve been tossing extra savings into our own bridge account for some time in case the right opportunity pops up.
I don’t know how much we’ll borrow or pay up front, but having more cash could give us more flexibility to approach it however we want when the day arrives.
I’m not going to spend much time making assumptions about your own goals, but whatever they are, I’m confident having more cash available won’t hurt at all.
This is an added benefit of having money in a bridge account.
Giving strategies from taxable brokerages
For those of you who are charitably inclined, you can also use a taxable brokerage account to make tax-efficient contributions to charity.
By donating appreciated shares of stock to a charity in lieu of cash, you can still receive a tax deduction for your gift while also getting a free step up in the basis of your asset without reducing its value at all.
Here’s an example of how it works.
First, let’s say you have $5,000 of XYZ mutual fund in a brokerage account and want to donate it to ABC Charity. $4,000 of the donated amount is principle, the other $1,000 is capital gains.
Instead of writing a check to ABC you call your brokerage and have them send $5,000 worth of XYZ mutual fund directly to the charity.
At the same time, you deposit $5,000 into your brokerage account and buy the same amount of XYZ mutual fund that you donated. As a result, you still own $5,000 of XYZ mutual fund.
Once the shares are sent to ABC Charity, they send you note indicating that they have received your gift and they think you’re just a wonderful person.
On tax day, you get to claim your deduction just like you would have if you had written a check to ABC Charity directly.
They key difference using this strategy is now in your brokerage account you have XYZ mutual fund with a tax basis of $5,000 instead of $4,000. You have effectively shielded $1,000 from capital gains tax by donating shares instead of writing a check directly.
Depending on your tax bracket, that could be a savings of up to $200.
Conclusion
Sparing your income from taxes now or in retirement is certainly a wise financial move, but it can lead to a lack of flexibility if you have aspirations for early retirement.
Creating a bridge account can keep your early retirement options open while providing several additional benefits for you financially.
