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.
Turning Capital Losses into a Benefit for You
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:
- 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 in Massachusetts.
- 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.
- 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.
Information You Need to Make a Smart Decision
So that you can determine the most tax efficient withdrawal strategy, here’s the information you want to have in front of you:
- Last Year’s 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 tax year. And, if so, how much?
- Current Non-IRA Investment Statements (i.e. individual, joint, trust, etc.):
- Realized Gains/Losses: Have you sold anything this year thus creating a realized gain in your non-IRA accounts?
- 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?
- 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.
Tax Efficient Withdrawal Strategy
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 index 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.
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 tax return from last year, 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 this 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!