Retirees: Here's The Tax-Free Retirement Paycheck Strategy Early Retirees Miss

Added: 2026-05-10

[00:00:00]Building a tax-free retirement paycheck before Medicare is not as simple as pulling from the right account because in this phase and really only in this phase, you may be dealing with a second layer of tax that most retirees never see coming. It does not show up on the tax bracket chart, but it can still cost you thousands of dollars and that is why the years before Medicare are one of the strangest planning windows in retirement, but they can also be full of opportunity or full of expensive mistakes because before Medicare, the goal is not always to create the lowest income possible. This is the weird part about it. Sometimes you need to keep income down and sometimes you actually need to create income on purpose. So in this video, I'm going to show you the tax-free retirement paycheck strategy most early retirees miss, how to create spending money before Medicare while also managing the income that shows up on your tax return. And to make this real, I'm going to use two common examples I see all the time.

[00:01:01]One couple that needs to be very careful about creating income and another couple that actually needs to create income on purpose. By the way, if you're new here, my name is Rachel Camp. I am a CFP professional and the founder of Camp Wealth and we help people retire before age 65. So let's get into it. All right, our first couple is Jim and Pam Halpert.

[00:01:21]Jim is 62 years old while Pam is 60.

[00:01:24]They just retired and they need $120,000 a year after tax to support their lifestyle in retirement. And here's what their portfolio looks like today. They have 2.2 million across traditional IRAs, $5,000 in Roth IRAs, $70,000 in a savings account, $25,000 in a taxable brokerage account. So all in, they have $2.3 million for their portfolio. They have plenty of assets, but most of their wealth lives in pre-tax accounts. That means they have money, but not a lot of tax flexibility. Now, our second couple is Michael and Holly Scott. Michael is 62, while Holly is 60. They also just retired, and they also want to spend about 120,000 a year after tax. Now, their balance sheet, this is where we differ, this looks very different. They have 1.05 million across traditional IRAs, 510,000 in Roth IRAs, 600,000 in a taxable brokerage accounts, and $140,000 in cash. So, the same as Jim and Pam, all in, they have 2.3 million. So, these two couples are in the same stage of life, same ages, same retirement date, same spending goal, same starting portfolio value, also same social security assumptions. But, what we're going to see is that they have very different paycheck building options. And this is the part that surprises people.

[00:02:48]While these couples appear to have the same amount of money, one of them has far more control over what shows up on their tax return. And before Medicare, that control can be the difference between a tax-free retirement paycheck and a very expensive health insurance mistake. So, let's look at phase one here of retirement. This is the pre-Medicare years. So, phase one in retirement runs from retirement till about age 65, or until each spouse goes on Medicare. And this is usually the most sensitive phase. Not just because of taxes, but because of health insurance. Before Medicare begins, many early retirees get coverage through the Affordable Care Act marketplace. Michael and Jim have 3 years in this phase. Pam and Holly have five. And this is where the tax plan can quietly affect something most people do not think of as a tax at all. That's the cost of health insurance. The marketplace looks at a specific income number from your tax return to decide how much help you qualify for with your premiums. So, the higher that number is on your tax return, the more you pay for health insurance. And this is where people get blindsided. A withdrawal strategy can look perfectly reasonable if you're only looking at the tax bracket chart. But once you factor in lost health insurance subsidies, that same strategy can cost thousands more than expected. So in this phase, the goal is not just to keep taxes low, the goal is to manage the income number that determines your health insurance cost. Now, that number is called your modified adjusted gross income specifically for health insurance, but you don't need to memorize the acronym. What matters is this. Certain types of retirement income can push it up, and when that happens, your health insurance may get more expensive. So keeping that number low can be extremely valuable as you'll see in a minute. That is if it's even possible. And whether it is possible depends on the tax structure of your portfolio. Now, first, we are going to start with a couple that looks very strong on paper, but becomes much more constrained once we actually start building that paycheck. So we're going to start with Jim and Pam. Remember, they want $120,000 after tax for spending. But most of their money is inside pre-tax accounts. So they have 2.2 million in traditional IRAs and only $5,000 in Roth money. And then they have some in a brokerage account and cash savings. So what is the strategy in their first year of retirement? Well, if you remember in phase one, we are first focused on whether they can even qualify for health insurance premium tax credits. Because those credits are a direct reduction in the cost of their health insurance. And this is actually where the second layer of tax starts to show up. I have a really detailed video on all of this, but here's a quick summary. In 2026, we return to the subsidy cliff. The enhanced subsidies have now expired. What this means is if you go $1 over the cliff, you lose all premium tax credits, and you pay the full cost of health insurance. So for Jim and Pam, as a married couple, their cliff this year is $84,600.

[00:05:50]So at $84,601, they qualify for zero dollars worth of subsidies or premium tax credits. But at $84,500, they actually qualify for $18,303 of premium tax credits. That again is a direct reduction of the cost of their health insurance. So the question is with their account structure, can we even get there? Is qualifying for premium tax credits possible when they need $120,000?

[00:06:19]Or do we just give up, pay the full cost of health insurance, and for them should we focus on Roth conversions? Now, let's start by using the most tax-efficient accounts first. That is going to be their cash and brokerage account. So we will assume for their tax return they have about $1,500 in interest for the year. That's going to come from that savings account that has $70,000 in it.

[00:06:39]And we will assume 50% of their brokerage account is unrealized gain. So when we sell the brokerage account, that creates $12,500 of long-term capital gains that has to go on the tax return.

[00:06:50]So right there, they have created $95,000 in spending money with only $14,000 in adjusted gross income. Now, they still need $25,000 in net for spending. So let's see what happens if they take that from their IRA, which is their only option outside of the Roth.

[00:07:06]With this strategy, they get to $120,000 in net in spending. And they only show $39,000 in adjusted gross income. So they have zero dollars for a federal tax bill because the IRA distribution and interest are covered by the standard deduction, and then the capital gains are still in the zero percent long-term capital gains bracket. From a health insurance perspective, $39,000 of adjusted gross income puts them at 184% of the federal poverty level. So it is not so low that they drop into Medicaid, and they are now anticipated to receive $24,437 as a premium tax credit. It's not bad for their first year of retirement. Now, this is where most people would stop and say, "Great, no federal tax." But, before Medicare, that is not the end of the calculation. At this point, because their ordinary income is only 26,500 and the 2026 married filing jointly standard deduction is 32,200, Jim and Pam technically still have 5,700 of standard deduction left. That is tax-free income that they're not using.

[00:08:09]So, we could say that that creates room for a $5,700 Roth conversion, again with no federal income tax due on that conversion. But, here's the trick. That will still increase your modified adjusted gross income for the purposes of health insurance, and that reduces their premium tax credit. So, the Roth conversion itself may create $0 of federal income tax, but it would increase their AGI to 44,700, which would bring their premium tax credit from 24,437 to 23,581.

[00:08:41]So, that is a cost of $856 on the $5,700 Roth conversion, which is an effective tax impact of about 15%.

[00:08:50]And, if Jim and Pam convert more than the 5,700, they effectively start to create a double tax. The standard deduction has now been filled, so they are entering the 10% federal marginal tax bracket, and they're also continuing to reduce their premium tax credits. So, for example, a $10,000 Roth conversion would bring their adjusted gross income up to $49,000.

[00:09:11]The first 5,700 of that conversion is still covered by the remaining standard deduction, as we just talked about, but the next 4,300 becomes taxable at the 10% federal tax bracket, creating $430 of federal tax. And, remember, that's not the only cost because at 49,000 of adjusted gross income, their premium tax credit drops by about 1,525 for the year compared to doing no Roth conversion. So, the real cost of that $10,000 Roth conversion is 1,525 of lost premium tax credits plus 430 of federal tax. So, all in that is $1,955 or an effective cost of 19.55% and this is exactly the type of planning people should be doing in the first phase of retirement when they are attempting to qualify for premium tax credits. We should not just look at marginal tax brackets. We also have to pay attention to lost premium tax credits because before Medicare that can function like another tax. But, the real issue with Jim and Pam is not year one.

[00:10:15]Year one actually ends up working pretty well for them. The problem is what happens after that flexibility is gone because in year two, while they are still in phase one, Jim and Pam's situation looks completely different.

[00:10:27]Their brokerage and cash accounts are now depleted. Even if they were to pull from their Roth, it would not be enough to stay under the cliff amount. So, now they are pulling 100% from their IRAs.

[00:10:37]That means they need about $131,000 from their IRAs to get to $120,000 net for spending. At that point, they may still have some room in the 12% marginal tax bracket to consider a Roth conversion. They may even consider going into the 22% bracket if that makes sense for their broader tax plan.

[00:10:55]But, for Jim and Pam, phase one really gives them one strong year where they can use the tax-free paycheck strategy effectively. After their brokerage and cash are depleted, they no longer have the same ability to qualify for premium tax credits. And you may be asking, if they lose that $24,000 premium tax credit, does that not mean their spending actually needs to jump from $120,000 a year to closer to 144 to cover the additional cost of health insurance? And yes, for the years until Medicare, you have to include the additional cost of marketplace insurance and make sure your plan works with that higher cost, which as we just saw can be very expensive. Fortunately for Jim and Pam, the joint cost of marketplace insurance only lasts a few years until Jim reaches age 65 first. Now, let's compare that with a couple that has the same net worth, same spending goals, same retirement date, but a completely different level of control. Let's look at Michael and Holly in phase one. Now, their accounts are much more diversified from a tax status perspective. They have 1.05 million in pre-tax, 510,000 in Roth, 600,000 in brokerage, and $140,000 in cash. And that changes everything for this first phase. Because Michael and Holly can create spending money without automatically creating the same amount of taxable income. And before Medicare, that flexibility is incredibly valuable.

[00:12:19]With Jim and Pam, we were asking, "Can we keep that ACA modified adjusted gross income low enough to qualify for premium tax credits?" But with Michael and Holly, the question is different. And this is where the strategy flips.

[00:12:33]Because they have so much cash and brokerage money, we are not just trying to keep income low, we may actually need to create income on purpose to avoid dropping down into Medicaid. So, the goal is not simply, "How do we report the lowest income possible?" The better question becomes, "How do we create the right amount of ACA modified adjusted gross income?" And that is the planning opportunity for Michael and Holly. For this first year, let's say Michael and Holly prioritize the cash account for spending. So, if they need $120,000 net, they could just simply pull from the $140,000 of cash that they have on hand.

[00:13:08]That cash withdrawal creates spending money, but it does not create taxable income. So, if they use $120,000 from cash, their only income may be the interest from that cash account. So, we'll assume for them about $4,000 of interest for the year. So, at this point, Michael and Holly have created $120,000 of spending money, but only $4,000 of ACA modified adjusted gross income. And that might sound great at first, but it's actually too low. Because if their ACA modified adjusted gross income is only $4,000, they're not really in the premium tax credit planning zone. They are pushed toward Medicaid, and that is actually not what we want. We are trying to keep them on ACA marketplace coverage and to qualify for the premium tax credits. So, this is the counterintuitive part. Michael and Holly need to create income. And this is where the Roth conversion becomes very useful.

[00:14:01]For Michael and Holly, it is not just a tax planning tool, it is an ACA modified adjusted gross income management tool.

[00:14:07]Again, that's that number that they pay attention to on the return for how much they pay in health insurance. So, for a married couple, the Medicaid expansion threshold is roughly 138% at the federal poverty level. In this example, that means Michael and Holly probably need an income or an adjusted gross income close to roughly $30,000 to stay out of that Medicaid territory. So, with only 4,000 of interest income, they need to create about 26,000 of additional income. A Roth conversion is a great way to do that. And the nice thing is, because they're using cash for spending, they do not need the Roth conversion for their lifestyle. They are using the Roth conversion for planning purposes, and that is a very different kind of control. So, let's say they start with a $26,000 Roth conversion. That brings their income from 4,000 to $30,000 for adjusted gross income purposes. Now, they've created enough income to stay in the ACA marketplace planning range. And because their ordinary income is still below the 2026 married filing jointly standard deduction of 32,200, that Roth conversion creates $0 of federal income tax. But getting above the Medicaid threshold is only the first decision. The bigger opportunity is what they do with the rest of that window.

[00:15:24]Once they are safely above the Medicaid threshold, they still have another question. Should we stop here or should we use this year to convert more?

[00:15:33]Because remember, Michael and Holly's subsidy cliff is $84,600.

[00:15:38]At 84601, they lose all of the premium tax credits, but at 84,500, they still qualify for roughly $18,000 as a premium tax credit. So, if they start with only $4,000 of interest income, they could technically convert about 80,500 and still keep ACA modified adjusted gross income under that cliff amount.

[00:16:00]That is a massive Roth conversion opportunity. But, this is where we have to be careful not to oversell the strategy. This conversion is not free.

[00:16:09]With 84,500 of ordinary income and a $32,200 standard deduction, they would have about 52,300 of taxable income. That first 24,800 is taxed at the 10% rate. The remaining 27,500 is taxed at the 12% federal tax bracket.

[00:16:28]So, the estimated federal tax bill is about 5,780.

[00:16:33]But, federal tax is only one part of this cost. The other cost is the premium tax credit they give up by increasing their ACA modified adjusted gross income. At the lower end, if they only converted enough to bring ACA modified adjusted gross income to about $30,000, they would receive a premium tax credit of 25,612 per year. At 84,500, they still qualify for a premium tax credit, but it drops to 18,303.

[00:17:01]So, the real cost of that larger Roth conversion is 5780 of federal income tax plus 7,309 of lost premium tax credits.

[00:17:10]That is 13,089 total on an $80,500 Roth conversion. That's an effective cost of 16.26%.

[00:17:20]And that might be a very reasonable trade-off because they are moving roughly $80,000 out of pre-tax accounts before RMDs even begin. They're keeping it their income below the subsidy cliff and they're avoiding Medicare territory.

[00:17:34]They're doing all of this while still receiving a meaningful premium tax credit. But they do have to understand within the context of their greater tax plan if that large conversion and that tax rate makes sense for this year. It's also worth noting that this is just federal tax we have been looking at. If you live in a state with income tax, you will need to include the impact of that additional cost as well. But that is the real contrast between the two couples and that's a kind of planning flexibility Jim and Pam just do not have. Jim and Pam had one very good year in phase one. They could use their cash in their brokerage account to keep their income low, qualify for meaningful premium tax credits, and maybe do a small Roth conversion. But after that, their cash and brokerage accounts were depleted. So in year two, they were mostly forced back into IRA distributions. And once they had to use their IRA for spending, they lost the ability to keep their income low enough to qualify for premium tax credits.

[00:18:30]Michael and Holly on the other hand are very different because they have substantial cash, brokerage, and Roth money. They may be able to do this type of planning for the entire phase one.

[00:18:41]And that is a huge planning advantage that they have. This is not just a one-year opportunity for them. They are able to manage their ACA modified adjusted gross income year after year.

[00:18:51]They can decide how much cash or brokerage money to use. They can decide whether to realize capital gains from the brokerage account. They can decide how much Roth conversion to do. And they can measure the true cost of that Roth conversion by including both the federal tax, state tax, and lost premium tax credits. And this is why tax diversification matters so much in early retirement. Because before Medicare, the goal is not just to pull money from the lowest tax account, the goal is to create the right amount of income. And that is the retirement paycheck strategy most early retirees miss. Now, if you want to help thinking through your numbers and how this decision fits into your full retirement plan, click the link below to book a call with my team.

[00:19:33]And if we're not the right fit for you, we're happy to refer you to a trusted partner. In the meantime, thanks for watching and I'll see you in the next video.