Part II: Where Should You Draw Funds From?

In the last edition, I shared my first answer to the question I receive so often from our Relaxing Retirement members, “how do you determine where we should draw funds from when we need money from our Retirement Bucket of investments?”

In my answer, we focused solely on taking “tax efficient” withdrawals from IRAs and using an “income tax straddling” strategy.  (If you haven’t read it, I strongly recommend doing so)

Today, we’re going to focus on situations where you have Retirement Bucket™ funds held inside and outside of IRAs.

If you have funds held outside of IRAs, you have more options available to you because you may be able to pay lower capital gains tax rates (or no taxes at all) if you have some current or prior capital losses to put to use.

As a quick refresher, for investments you currently own outside of IRAs (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, using nice round numbers, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $150,000, you would owe capital gains taxes on the growth, i.e. $50,000.

On the flip side, however, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $75,000, you can declare a capital loss of $25,000.

While painful to realize, that $25,000 capital loss has significant value if handled properly.  For example:

  1. You may use it to offset $25,000 of capital gains you realized in the same year, thus eliminating taxes on $25,000 of capital gains.  This saves you as much as $5,950 in federal taxes in 2021, not to mention state taxes here in Massachusetts.
  2. If you don’t have $25,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year.  That would save you between $750 and $1,302 in federal taxes this year.
  3. You can then carry the unused portion ($22,000) over to next year and continue the same strategy. 
    1. If you have a $22,000 gain next year, you can offset the entire tax due.  If not, you can offset another $3,000 of ordinary income tax and carry the remaining $19,000 over to the following year.

Tax Efficient Withdrawal Strategy

So that you can determine the most tax efficient withdrawal strategy, here’s the information you want to have in front of you:

  1. Your 2020 Federal income tax return.  Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into 2020.  And, if so, how much?
  2. Current Non-IRA Investment Statements (i.e. individual, joint, trust, etc.):
    1. Realized Gains/Losses: Have you sold anything this year thus creating a realized gain in your non-IRA accounts?
    1. Unrealized Gains/Losses: What’s the current positioning of each of your current holdings?  Are any in the “red”, i.e. worth less today than the day you bought them that you could harvest?
  3. Mutual Funds: If you own stock mutual funds, go to your fund company(s) website and you will typically find year-end “internal” capital gains distribution estimates. 

Do your best to determine what your short and long term gains will look like between now and the end of the year.

Armed with this information, look for the combination of holdings you can now sell in your non-IRA accounts that will create the lowest tax obligation.

Using the example I provided last week, let’s assume the Relaxing Retirement members, who needed $120,000 to help their son buy his first home, had balances in their IRA and their non-IRA trust accounts. 

Let’s also assume that most of their stock fund holdings had very large capital gains attached to them if we sold them except for the remaining shares they still own in the company he used to work for (that he nostalgically held on to), and two stock funds which they purchased just before the Covid-19 crash which haven’t recovered completely. 

While that’s not necessarily good news, it would be for them because we could sell those three positions and generate a “capital loss” to offset some of the gains from selling two stock fund holdings with large gains to arrive at the $120,000 needed.

Because we had already reviewed their 2020 tax return, we knew they had some capital losses carried forward from the original sale of the majority of his employer’s stock several years back, so we could use those to offset most of the rest of the gains realized from sale of those two holdings.

The net effect in this case is freeing up $120,000 for their son’s down payment with less than $3,600 in income taxes incurred.  Not bad.  If they had no funds held outside of IRAs, they would have had to withdraw almost $160,000 from their IRAs in order to “net” out at the $120,000 they needed after paying about $40,000 in income taxes.  

Don’t Miss the Final Step

All of this is very encouraging, but if you don’t take the final step, you’re going to leave a gaping hole in your strategic Retirement Bucket™ allocation.

When you buy and sell various holdings in your Retirement Bucket™ of investments in order to free up needed cash, your carefully thought out target allocation is then out of balance because you likely didn’t sell a little bit of every holding you have. 

Instead, you sold what was necessary to free up funds while being as tax efficient as possible.

Given this, the final step is to reallocate your holdings back to your prescribed target mix simultaneously. 

The place to do this is inside your IRAs so you don’t incur more taxes. 

All of this is possible for you, but only if you follow the formula and you have all the necessary information in front of you.

As I mentioned in the last edition, paying more taxes than you’re legally obligated to pay is not an act of patriotism.  It’s laziness!

Take control in places where you still can and keep what you’re entitled to keep!

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Where Should You Draw Funds From?

One of the questions I receive quite often is, “how do you determine where we should draw funds from when we need money from our Retirement Bucket of investments?”

It’s a very important question.

All other variables held constant for a moment, we’re always looking to “free up” funds in the most tax efficient manner, i.e. have you pay the least amount of taxes you’re legally obligated to pay in the process.

And, at the same time, we recommend maintaining the same prescribed Retirement Bucket™ target allocation post withdrawal.  This is a very important point that you can’t afford to overlook. 

You don’t want your withdrawal to leave large holes in your strategic Retirement Bucket™ mix.

Funds Held Inside Your IRAs

If you only have funds to draw from held inside of IRAs, the only variable you need to consider is “when you’ll withdraw the money. 

For example, when asked by one of our Relaxing Retirement members (who has all of their funds in IRAs) to free up $120,000 for them to loan to their son for the down payment on a new home, the big question is “when,” not where.

They hadn’t given it much thought, but I asked when the closing for his son’s home was to take place, i.e. did he need the entire $120,000 before the end of the year? 

I asked because I know where all of their taxable income comes from each year and withdrawing $120,000 (“net” after taxes) from their IRA in one year would cause a large chunk of that withdrawal to be taxed at a much higher marginal tax bracket.

If they were able to withdraw part now in 2021 and the other part in January 2022 instead of all of it in 2021, that would save them a minimum of $11,500 in federal income taxes in the process.  This doesn’t count state income taxes.

This strategy is called “Income Tax Straddling”.

As it turned out, the closing was to take place in January, so they were able to follow this lead and save that $11,500 which can now go toward something they really want to spend that money on!

Home Equity Line of Credit

Had they needed all of the money before the end of the year, we may have recommended that they withdraw half from their IRAs now (in tax year 2021) and the other half temporarily from a home equity line of credit. 

Then, in January (2022), they could withdraw the second half from their IRAs to pay off the line of credit.  This would have the same effect as my first recommendation, i.e. Income Tax Straddling.  And, because borrowing rates are at historic lows right now, the cost to do this would be minimal.

Had the funds only been needed on a shortterm basis, I may very well have recommended utilizing a home equity line of credit instead of an investment withdrawal, especially during times like these when interest rates are so low.

Saving $11,500 is something that is possible for you, but only if you ask the right questions and you have all the necessary information in front of you.  Paying more taxes than you’re legally obligated to pay is not an act of patriotism.  It’s laziness!

In the next edition, we’re going to outline how to free up the cash you need in a tax-efficient manner when withdrawing from Non-IRA accounts.

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Annual Tax Loss Harvesting

Before the clock strikes midnight on New Year’s Eve, I strongly recommend taking a moment to review your tax strategy for opportunities.

One of the areas where proper planning can help is tax loss harvesting, i.e. utilizing any unrealized losses or unused capital losses that you have realized in prior years (and potentially earlier this year during the COVID crash), to reduce your income tax burden in 2020. 

While nobody likes to realize a capital loss, the great news is you can recover a portion of any loss if you handle it properly.

Given the market’s resurgence since the COVID-19 crash earlier in 2020, your opportunities will not be as great to realize a capital loss as they were earlier in the year.  However, putting prior realized losses to use to free up needed cash flow is a great strategy you don’t want to pass up.

Let’s quickly review capital gains tax law for a moment so we can clarify where this opportunity lies for you.

Capital Gains Tax Law

For investments you currently own outside of IRAs (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, if you purchased a stock or stock mutual fund for $100,000 and later sold all of it for $175,000, you would owe capital gains taxes on the growth, i.e. $75,000.

On the flip side, however, if you purchased a stock or stock fund for $100,000 and, after temporarily falling out of favor, you sold all of it for $75,000, you can declare a capital loss of $25,000.

While painful to realize, that $25,000 capital loss has significant value if handled properly.  For example:

  1. You may use it to offset $25,000 of capital gains you realized in the same year, thus eliminating taxes on $25,000 of capital gains.  This saves the average taxpayer a minimum of $3,750 in federal taxes, not to mention state taxes here in Massachusetts.
  2. If you don’t have $25,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year.  That would save the average taxpayer approximately $750.
  3. You can then carry the unused portion ($22,000) over to next year and continue the same strategy.  If you have a $22,000 gain next year, you can offset the entire tax due.  If not, you can offset another $3,000 of ordinary income tax and carry the remaining $19,000 over to the following year.

Opportunity

If you sold any investments in the past, thus “realizing” a capital loss, i.e. earlier in the year during the COVID market crash, you now have the opportunity to put those losses to use offsetting realized gains this year after the market’s recovery.

Or, if you have any investments today held outside of IRAs where the cost basis is higher than the current market value, you have an opportunity to lock in a capital loss right now and use it against your realized gains this year. 

Strategy

My recommendation for you is three-fold:

  1. Review your 2019 federal income tax return.  Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into this year.  And, if so, how much?
  2. Determine if you have any realized gains in your non-IRA accounts so far this year: 
    • Have you sold any of your holdings at a gain, thus already realizing gains in 2020 that you may want to potentially offset?
    • If you own actively managed stock mutual funds, go to your fund company(s) website and you will typically find year-end “internal” capital gains distribution estimates.  Do your best to determine what your short and long-term gains will look like.
    • Do you have any stocks or stock funds that you have thought about selling, but you haven’t pulled the trigger because it will carry a large capital gains tax with it? 
  3. Take a look at your unrealized gain/loss positions on your non-IRA account statements:
    • Is the cost basis for any of your holdings greater than the current market value?  If so, this may be due to three situations:
      • The share price is lower today than when you purchased the fund due to market forces, or
      • The share price is lower today because your fund declared capital gain distributions in the past and you have already paid tax on them, thus raising your cost basis above what you paid for the investment, or
      • You have been reinvesting the dividends from your fund to purchase more shares over the years, thus raising your cost basis.
    • If this is true for any of your holdings, you have an opportunity to “realize” a capital loss before year-end (tax loss harvesting) and offset any of your realized gains.

Once you’re armed with this information, look for opportunities to offset this year’s gains with prior losses you’ve carried forward, or with losses you could “realize” this year by selling specific holdings at a loss, and replacing them with substantially similar holdings adhering to the “wash sale rule.”

This is a discipline and exercise we continue to go through for Relaxing Retirement members each year, especially at year-end.   

If you haven’t done so already, take a moment to explore harvesting opportunities prior to December 31st

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Don’t Miss This Tax Saving Opportunity

You would be shocked by the number of missed opportunities I see to pay lower tax rates among those who are introduced to us.

And, the mistake can be solved by taking advantage of the disparity between tax rates on investment earnings.

Let’s walk through some examples to clarify what I mean so you don’t miss the opportunity. 

Assume for a moment that you’ve determined your level of Retirement Bucket Dependence™, i.e. the amount you’re going to need to withdraw from your Retirement Bucket™ of investments each year to supplement your social security and pension income.

You’ve calculated the minimum investment rate of return you now must earn to keep pace with inflation and keep your Retirement Bucket intact.

And, you have carefully positioned your Retirement Bucket to give yourself the best shot at generating the returns you need.   

Now let’s assume that half of your money is in tax deferred retirement accounts (like IRAs, 401(k), 403(b), etc.), and half of it is not, and you’re going to hold stock funds and fixed income funds (bonds and money market funds).   

The missed opportunity lies in where you hold each of these “types” of investments.

Two Different Tax Rates

As I alluded to, there are two different types of taxes on investment earnings, and the tax rates you pay are drastically different. 

Federal Ordinary income tax rates today run as high as 35%

Federal Capital gains tax rates, however, max out at 20%.   

Given this severe disparity, and your potential choice if you currently have investment holdings held inside and outside of an IRA, wouldn’t you rather pay capital gains rates whenever possible?

I would hope so.  Unfortunately, most don’t!

Tax Rate Differential

So, when do you pay ordinary income tax rates and when do you pay capital gains tax rates?

When it comes to your investments, you pay ordinary income tax rates on:

  • Interest you earn at the bank (CD, money market, etc.)
  • Interest or dividends you earn on a bond or a bond mutual fund/exchange traded fund (ETF)
  • Taxable withdrawals from an IRA or an annuity

You pay capital gains tax rates on:

  • Profit from the sale of stocks, stock mutual and/or exchange traded funds, and real estate
  • Internal capital gain distributions from stock mutual funds (even if you don’t sell the fund)

Examples in Practice

Fixed Income Investment (Bond and Money Market Funds):

  • If you earn interest on a CD that you hold outside of an IRA, you pay ordinary income tax rates on that interest.
  • If you earn interest on a CD that you hold inside of an IRA, the tax on that interest is deferred as long as it remains inside your IRA. However, when you withdraw money from your IRA, you then pay ordinary income tax rates on the entire amount of your withdrawal.
  • If you are not withdrawing this interest or dividend income, you’re better off deferring the tax on it inside of your IRA. When you withdraw your interest or dividend income, you’re still going to pay ordinary income tax rates just as you would have if you held it outside your IRA.  But, you’ve benefited from tax deferred compound interest along the way.

Equity Investment (Stock Funds):

  • If you buy a stock or stock fund for $100,000 outside of your IRA, and later sell it for $150,000, you pay capital gains tax rates on that $50,000 gain (maximum 20%).
  • If you bought that same stock inside of your IRA for $100,000 and later sold it for $150,000, there would be no tax on the sale as long as the proceeds remain inside your IRA.
    • However, when you then withdraw that money from your IRA, you pay ordinary income tax rates (as high as 35%) on 100% of your withdrawal, no matter where the money came from.
  • Bottom Line: If you hold your stock investments inside of your IRA instead of outside your IRA, you forgo the opportunity to pay the lower capital gains tax rates.

Two Big Mistakes

There are 2 big mistakes I see too many dedicated savers make in this area:

  1. Most pay no attention to this tax rate disparity and continue to hold their stock or stock fund investments inside of their IRAs

By doing this, it insures that they will never be able to qualify for lower capital gains tax rates on their earnings.  Instead, they pay the significantly higher ordinary income tax rates when they withdraw those gains from their IRA.

Think about it.  On the same $100,000 gain, you could pay $20,000 (20% capital gains tax rates), or as high as $35,000 (35% ordinary income tax rates).  That’s a difference of $15,000 more in taxes on the same $100,000 gain!  Which would you rather pay? 

  1. The second mistake is they are not able to deduct their capital losses. This was especially critical following the market losses in 2008 and most recently at the end of 2018 and during the Covid-19 crash this year. 

Let’s say that you bought a stock for $100,000 and later sold it for $60,000, thus taking a $40,000 loss.  If you purchased that stock outside of your IRA, you would be able to deduct $40,000 against any capital gains you incurred this year. 

If you don’t have $40,000 worth of gains, you can apply a $3,000 loss toward any ordinary income earned that year, and carry the remaining $37,000 realized loss to use in future years.

If you took the same loss on a stock that you bought inside your IRA, you are not able to deduct that $40,000 loss because it was incurred inside of your IRA.

That $40,000 capital loss could be worth as much as $14,000 in tax relief to you!  However, if you incurred the loss inside of your IRA, you are not able to deduct it.  Pretty substantial, wouldn’t you say?

We have Relaxing Retirement members who I met back in 2003 after the dot com crash.  Prior to working with them, they suffered losses in excess of $380,000 inside their IRAs!

They were not very happy to learn that they couldn’t deduct any of those losses.

Simultaneous Planning

Given this, and your available options, don’t miss the opportunity to position your stock investments outside of your tax deferred retirement accounts (IRAs) to every extent possible, and your fixed income investments (bonds and money markets) inside your IRA.

To put this in larger perspective, your big takeaway in this edition is your investment decisions can’t be made in a vacuum, especially during Phase 2 of your financial life. 

Most individuals make decisions concerning their investments separately from their decisions concerning their taxes.

In contrast, your investment planning decisions have to be made simultaneously with your tax planning decisions.  Otherwise, it’s highly likely that you’re going to pay a lot more money in taxes over the course of your lifetime than you are legally required to. 

This is money that could have gone to more vacations for you, or presents for your grandchildren. 

Where would you rather see it go? 

Take the time plan it out ahead of time.

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