Reduce Your Taxes in Retirement by Turning Lemons into Lemonade

Does the current stock market downturn have you on pins and needles?  If so, then you likely have an opportunity to recover a portion of your loss if you act right now. 

While nobody likes to realize a loss on their investments, the great news is you can turn “lemons into lemonade” and recover a portion of any loss if you handle it properly.

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 this year), to reduce your income tax burden each year. 

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 and How to Save Money in Taxes

For investments you currently own outside of IRAs and 401(k)s (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.

That $25,000 capital loss, while painful to realize, 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.
  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.

Your Tax Saving Opportunity

If you sold any investments in the past, thus “realizing” a capital loss, you now have the opportunity to put those losses to use offsetting realized gains this year.

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

Your Tax Saving Strategy

My recommendation for you is three-fold:

  1. Review your most recent 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 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 (what you paid for the investment) 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 instantly with substantially similar investment holdings adhering to the “wash sale rule.”

This is a discipline and exercise we continue to go through for our Relaxing Retirement members each year, especially during temporary market downturns like we’re experiencing right now, and at year-end.   

If you haven’t done so already, take a moment to explore harvesting opportunities right now. 

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When You Retire, 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 when you withdraw funds to support your desired lifestyle.

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 carefully targeted Retirement Bucket™ strategy.

How to Think About 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 right now and the other part in January of next year instead of all of it this year, 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 and the other half temporarily from a home equity line of credit. 

Then, in January of next year, 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 of RETIREMENT GAME PLAN, 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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