At some point, you may find yourself unemployed—either of your own volition or, in the worst case scenario, by surprise. You may need to take time away from work to care for an aging loved one, raise kids, or venture out on a sabbatical. Or, in the wake of an economic downturn or rising inflation, you could be let go without much warning. Whatever the case may be, a break in income can stress out your finances, making it more difficult to maintain progress towards your long-term goals (like retirement).
Below, we’ve rounded up a few ways you can still prioritize preparing for retirement when you’re not working, even if you don’t have extra funds to keep saving.
Prior to leaving, did your job offer a 401(k), 403(b), or similar workplace retirement plan? It’s not unusual for employers, especially larger companies and corporations, to provide an easy and automated way to save. And while a 401(k) is certainly an effective tool for preparing for retirement, it does come with a few drawbacks.
If the majority of your future retirement income is stashed away in a traditional 401(k) or IRA, your future tax bills could be relatively high. Since you deducted your contributions from your taxes, neither the principal amount nor the earnings have been taxed yet. That means when it comes time to withdraw from your retirement account, you’ll be on the hook for paying ordinary income tax on every dollar distributed.
This is also why the IRS imposes annual required minimum distributions (RMDs) for retirees over the age of 73—eventually, it wants its cut of the earnings.
But, during years when your income is lower than usual (say you’re unemployed for part or all of the year), you could use the opportunity to do a Roth conversion and enjoy some future tax savings in retirement.
If you’re unfamiliar with the concept, a Roth conversion transfers the funds from a traditional, tax-deferred retirement account (like your 401(k) or IRA) into a Roth account. Qualified withdrawals from Roth accounts are tax-free, and that includes any earnings.
While a Roth conversion doesn’t necessarily grow your savings for retirement, it does help preserve the value of your existing assets in retirement, since you’re reducing your future tax burden. If you think about it, $500,000 of tax-free income is worth more than $500,000 of taxable income. The less you need to withdraw to cover taxes, the more your money can stay put and continue growing throughout retirement.
The trick with a Roth conversion is that you’ll need to pay tax on the amount converted come tax time—and you’ll want to do it without drawing from the account itself (which may incur penalties plus negate some of the benefits of doing a conversion now).
During this period of lower-than-usual income, consider what additional tax burden you can comfortably cover, and use that to help determine how much to roll over to a Roth account. Keep in mind you can convert as much or as little into a Roth account as you like (as long as you can cover the tax liability without jeopardizing your other financial obligations).
Once you’ve completed a Roth conversion, you’ll need to let the account grow for at least five years before you can start taking qualified tax-free withdrawals (assuming you reach age 59.5 during this period as well).1
In order to contribute to an IRA, you need to have “earned income” during the tax year, according to the IRS.2 But, if your spouse is still employed or otherwise earns income, there’s a bit of a workaround.
Your spouse can open what’s called a Spousal IRA, and both of you can contribute to it on your behalf. You can each contribute to the account up to the annual limit ($7,000, or $8,000 for those 50 and older).3 The contributions, however, can’t exceed the total earned income reported on your joint tax return.
Can you and your spouse swing setting aside a little extra in savings, even during a period of unemployment? If so, a spousal IRA is a simple way to continue building your retirement savings and enjoying some immediate tax benefits (since contributions are deductible).
If you or your spouse are on a high-deductible health plan (HDHP), or you were prior to ending employment, you may have access to a health savings account (HSA). Available only to those on an HDHP, HSAs are, as they sound, savings accounts specifically built to help plan participants cover out-of-pocket medical expenses, including copays, prescriptions, coinsurance, and other healthcare-related expenses.
Each year, you can contribute up to an annual limit ($4,300 for individuals or $8,550 for families) and enjoy triple tax benefits including:4
Unlike an IRA, you don’t have to earn income to contribute to an HSA—making it easier for unemployed individuals to set aside savings in a tax-advantaged way. Another benefit? HSAs don’t have RMDs, like IRAs or 401(k)s do.
The funds in your HSA are yours to keep since anything unused rolls over year after year. During periods of unemployment, especially, having a separate account for medical expenses can help preserve more of your emergency fund or other financial resources.
Once you turn 65, your HSA even allows you to take penalty-free withdrawals to use on any expense, not just medical expenses. Just keep in mind that if you’re using withdrawals on non-medical expenses, you will have to pay income tax.
If you don’t have access to an HSA, but you’re able to continue growing your savings (say you’re earning some rental income on the side), consider funding a taxable brokerage account.
Brokerage accounts offer the most flexibility (when compared to HSAs, 401(k)s, and IRAs), since they aren’t subject to age restrictions, penalties for non-qualified withdrawals, or required annual distributions.
On the other hand, taxable brokerage accounts don’t come with some of the same tax advantages as other accounts. There’s no deduction for contributions, and profits earned are typically taxable.
However, if you hold onto your investments for at least a year after buying them, you can enjoy the long-term capital gains tax rate, which is as low as 0% depending on your adjusted gross income. Selling investments prior to the one-year mark will make your profits subject to short-term gains tax, which is the same as your ordinary income tax rate.
If you don’t have the extra funds to contribute to savings or investment accounts during this time, that’s completely understandable. You can, however, still use this opportunity to plan ahead for retirement.
Think of this time off work as “mini retirement,” or a scenario planning opportunity for the future. Track your spending, find opportunities to cut back, and see what works and what needs tweaking before the real retirement gets here.
You can also use this time to figure out what your routine in retirement could look like—which again, may impact your retirement budget.
With more time on your hands, you may be interested in joining fitness studios or taking classes at the local university, for example. Or, maybe you’re bitten by the travel bug and can’t seem to stay put for too long. Consider how your hobbies and interests come to the foreground when work isn’t taking up 40+ hours a week—and what that may mean for your future income needs.
Along the same lines, living frugally now can help shine a light on what brings you joy, and what, frankly, you can live without.
Right now, you may be naturally scaling back on unnecessary expenses and realigning your spending with your values and priorities. Take note of what those values and priorities may be. Once your income levels rise again, you might want to continue practicing more stringent spending and saving habits—especially if you plan on making up “lost time” with your savings goals.
If you’re forced to cut back now, it can also help you do the opposite: Figure out where in your life you enjoy spending more. Retirement isn’t all about spending as little as possible, but being wise with your resources. You want to be sure that what you’re spending on truly brings you joy. For example, can you do with fewer meals out if it means more weekend trips to the beach?
Remember, the key to a happy retirement is finding fulfillment and a sense of purpose. In many ways, that can be done without spending more money.
Whether you have the extra resources to continue building your retirement savings or not, there are things you can do during a period of unemployment to keep your future retirement needs top of mind. Reassess your priorities, weigh your tax savings opportunities carefully, and if you’re able, consider speaking to a financial professional about your concerns.