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Episode #564 - Retirement Year End Planning: Tax-Loss Harvesting
Roger: The show is a proud member of the retirement Podcast network.
Welcome to the show dedicated to helping you not just survive retirement, but to have the confidence because you're doing the work to really lean in and rock it. Day after election day, hopefully we are all at peace and can get on with building a great country. Continue that journey.
Today on the show we are going to begin to explore year end action items from an optimization perspective. We're going to talk about tax lost harvesting today with Erin Coe, a planner on our team. She's awesome. Her first time on the show. In addition to that, we're going to answer some of your questions.
Tomorrow we are going to have a live event online about should you do a Roth conversion or not? How do you think through that in an organized way? If you're listening to this on the day of the release, Wednesday, you can go to livewithroger.com or even Thursday because it's Thursday night, we're going to do this. If you can't make it live, but you do want to have access to it, sign up for our 6-Shot Saturday email. You can do that at rogerwhitney.com or sixshotsaturday.com we'll send a replay of it.
In addition to talking about Roth conversions tomorrow we are opening an enrollment to the Rock Retirement Club. Our last open enrollment for this year and also the last time it's going to be offered at this cost. It's going to go up in 2025. In the Rock Retirement Club, we've organized all of the resources, the financial planning tools, the education and the worksheets for you to be able to build your retirement plan of record following the Agile process.
In addition to that, we put together a group of coaches and some professionals to have a safe place for you to ask questions and empower you to rock retirement. So, you can check all that out at rockretirementclub.com with that said, let's get on with tax lost harvesting.
PRACTICAL PLANNING SEGMENT
Now that we're into tax season, we're going to do a primer on tax lost harvesting, and to assist me in this is Erin Coe, an EA, which is an enrolled agent. She's a tax geek and she just recently completed all of your CFP curriculum. How long ago did you do that?
Erin: That was actually completed in 2021.
Roger: Oh, so it's been a while.
Erin: Okay, it's been a while. Working on those experience hours.
Roger: Yeah. So how does that work nowadays? Experience hours? You passed everything, but you can't use it.
Erin: The marks, can't use the marks until you get all the experience hours in. There are two separate paths for that. One's an apprenticeship and one is just the regular path. So, it's either 4,000 hours or 6,000.
Roger: Okay. So, there's a pretty high bar to be able to use the CFP marks. That's pretty cool.
Erin: There is. Yeah.
Roger: I like that. You have recently started on our advisory firm and have been a rock star. So, thank you. Although you can't take that nickname. That's Nichole's nickname.
Erin: I haven't been given a new nickname.
Roger: The nicknames just come to us. We can't figure it out intentionally.
Erin: It will be an organic process for sure.
Roger: Troy is T dog. Tracy is Mrs. T. I'm whatever. So, we'll figure out your nickname at some point. Now today you're going to help guide us through tax lost harvesting, which is one of those year-end items that should be looked at from a tax management perspective.
Erin: Certainly. Yes.
Roger: Yeah. So, what exactly, we're going to build this from the first step. What exactly is tax loss harvesting?
Erin: Tax loss harvesting is the act of intentionally selling capital assets at a loss in an effort to reduce your current or future tax burden. So, first of all, you need to know what a capital asset is. It's property that you own. You use it for investments. In this case, it would not be personal property. We're not talking about your house or your couch or your car or anything like that. It could be collectibles like baseball cards, stamps. But today we're just going to talk about stocks, ETFs, things that would be in your portfolio.
Roger: Okay. Just as a side question, so I have these two lots in Colorado that I purchased and initially had the intent of building. When I sell one or both of them, will I have a capital gain or loss on those?
Erin: Was it held as an investment?
Roger: How is that defined? You could argue yes or no now that I'm not building. I guess they are.
Erin: You could ask your auditor.
Roger: It's up to me to present it as this is an investment vehicle and I lost money in it and then they would argue no, that was personal use. So that's an area of negotiation if it ever came up and if I got audited.
Erin: Correct.
Roger: Okay. Okay. So, let's define what a loss is. Give me a basic example.
Erin: An example would be you buy ABC stock for $10, that's your basis in it, that's what you paid for it, and you sell it for $8, after it's lost some money, you have a $2 capital loss on that stock per share.
Roger: So, in practical purposes, you know, it's been great markets the last couple years from an equity standpoint. But when you look at your portfolio, if you have some fixed income investments, whether an individual bond or a bond fund, you are likely to have some losses on the books, depending on how long you own them, because bond prices have come down over the last year and a half. That would be an example of that, right?
Erin: Yes.
Roger: If I have a loss on, let's say, ABC bond fund, let's say a loss of $10,000, if I sell it, even though I want to have a long-term position, if I sell it, I'm going to realize a $10,000 loss. How does that help me or how does that impact taxes?
Erin: It can impact them in several ways. So, the first way would be if you were to say, harvest $10,000 worth of gains that year, they would net each other out. So, you would not have any capital gains that year because they'd be offset by your losses. You'd be getting money in your pocket, but you wouldn't actually be taxed on that. The second way is you take a $10,000 loss and you have $5,000 in gains. Now you've got $5,000 left. Over $3,000 of that can be used to offset other income.
Roger: Okay. Whatever happens to the other $2,000, so.
Erin: The other two are carried forward to the next year. So, the next year if you have capital gains, you can use that again. Or if you don't have capital gains, you can deduct that against other types of loss or other types of income.
Roger: Okay, so if I sell lot number one, that's an investment for a million-dollar profit. That's all going to be taxed long term, the difference will get taxed at capital gains, but if I sell lot two at a million-dollar loss, they will offset each other and I'll have no net capital gain. Because they offset each other.
Erin: Correct, they will offset each other.
Roger: So that's unlimited on the upside of offsetting. But you can only deduct up to $3,000 per year just off of any income after you've done that reconciliation.
Erin: Right. Against ordinary income, usually.
Roger: Okay. Then that loss that I can't use in a given year because that $3,000 cap can be rolled over for next year.
Erin: Can be rolled over for next year, and if you don't use it all, it can be rolled over again and again and again until you die. It cannot be passed on to your spouse or heirs or even to your state.
Roger: Even to your state.
Erin: Yep, it dies with you.
Roger: So why are we even talking about this? What are we trying to do from a tax perspective?
Erin: Well, your basic intent anytime you do this is to reduce your taxable income, which reduces your tax liability. Your strategy might be different. Your strategy could be to reduce your income this year and that's it. It could be to generate a $3,000 loss this year, or it could be to generate large losses that you can carry forward for many years to come.
It can also have side effects when you do this. By reducing your taxable income, you are lowering your overall capital gains rates, you could reduce or eliminate NITM, which is net investment income tax.
Roger: That's one of those sneaky taxes for higher income earners that we don't even think about. But it's what 3.8%?
Erin: 3.8%. Yeah.
Roger: It's a lot.
Erin: Yeah, it adds up. Yeah.
Roger: Okay.
Erin: You can also reduce the amount of your Social Security benefits that are subject to taxation because that increases with income. You might reduce or eliminate IRMAA surcharges and stay under one of those hurdles. You could possibly increase your eligibility for or the amount of your premium tax credit if you use ACA subsidies. And you know, you could increase your eligibility for other tax credits that are subject to income phase outs.
Roger: It's a lever to have to help control these downstream impacts to all these other things that get calculated in adjusted gross income.
Erin: Correct? Yeah, exactly.
Getting good data is also hard when preparing your taxes
Roger: So how do you gauge the intent of this or, the impact of this actually?
Erin: I mean, so the impact is, first of all, did your strategy meet your intent? Like, did you actually offset all of your capital gains or did you actually create a $3,000 loss or a $3,000 deduction against other ordinary income? Did you actually create this carry forward, or could you check and see if you got any of those ancillary benefits?
The way you want to do that is you can either create a spreadsheet or put those numbers together yourself. There are some online calculators out there that will calculate some of this information for you. Or you can use a website like Dinkytown to kind of create a fake tax return and then make another copy of it showing those losses and it'll show you the difference.
Roger: What was the name of this website?
Erin: Dinkytown. You don't know Dinkytown?
Roger: I am familiar with it, but I always laugh when I hear the name. What is it?
Erin: Everybody's going down to Dinkytown.
Roger: Okay, that's their tagline, obviously. What does it do?
Erin: So Dinkytown lets you play with a bunch of different tax scenarios and see what kind of impact it would have.
Roger: Okay. We'll have a link to that in 6-Shot Saturday. I'm assuming if you're using a Turbo tax, you can also play with, well, what if I have an extra loss or what if I don't? How often, if you're using the actual tax software like a TurboTax or other options, do they have enough releases out in order to do your taxes? Are they good on the release date? Can I use a 24-tax return?
Erin: You could do a 2023 tax return right now with say Turbo Tax, and it would probably give you a pretty good idea, a pretty good estimate. However, that software is not officially updated until tax season begins. Honestly even then, releases roll out. If there's legislation that's late coming, if there's certain IRS rules that haven't been fully shaken out, you know, it could be January. I've seen it in February releases. You're not going to get a perfect estimate until it's time to do your taxes.
Roger: We're just entering in our practice doing tax estimates for year-end decisions like Roth conversions and qualified distributions and so forth. We're using software that's relatively up to date. It's pretty good software. Erin, you've been a big help in building the standard operating procedure for this. There's just a lot of gaps, right, because we don't know exactly how much interest we're going to get. I think we found one the other day where someone was getting unemployment insurance for a period of time and that is a factor. Getting good data is also hard, even if you're on top of this.
Erin: It can be really hard to get good data. Even if you know everything that's happened year to date, I mean, how many times do you see a mutual fund in December throw off a Christmas surprise? Suddenly, we've sold a bunch of things and you have capital gains now.
Roger: The better companies will forecast it, but that doesn't mean it's correct still. It's difficult. Leave some buffer room to be careful on tax cliffs, says Seneca. It is difficult.
Erin: Leave yourself some buffer room.
Roger: That is the key there. Leave some buffer room to be careful. A good example would be IRMAA surcharges. Certain surcharges like IRMAA, which is the extra you'll pay for part B and part D for Medicare if you're above certain limits. There's a tiered structure, it's just $1 and then you're all in on the other limit. It's not progressive. That can have a material impact.
Erin: That's right. Those are cliffs, and you want to avoid those cliffs at all costs. Don't get too close to the ledge on them.
Roger: Just like driving. Don't tailgate the IRMAA limit.
Erin: That's right.
Roger: So, I'm thinking about this. Let's go back to that bond example. I'm assuming we have to do this in taxable accounts, not IRAs or 401ks first off, right?
Erin: Exactly, exactly. It doesn't work in a 401k or an IRA or any of those qualified accounts because those are treated differently for tax purposes. Those don't experience any capital gains, they just come out as income.
Roger: So, I have a bond fund as part of a broader portfolio. In my after-tax account, I have let's say a $10,000 loss on that bond fund, but it fits in with my asset allocation. So, I don't want to sell it because I want to have a bond allocation. But, ooh, I sure could use that $10,000 loss.
The default would be that it's part of my long-term portfolio, so I'm going to do nothing. But another strategy I want to talk about is I could sell that bond fund ABC and buy bond fund XYZ and capture that loss. But there are some problems there as well. What are my options in harvesting this loss but not losing my allocation?
Erin: So, what you're talking about there is the wash sale rule. That means that you can't sell a capital asset and claim that loss and then repurchase it within 30 days either way of the sale of that. 30 days prior, day of, 30 days after, it's a 61-day window. Although the IRS doesn't really get clear on what you can do, they've outlined things you definitely cannot do so you cannot sell that position in one account and then go purchase it in another. So, you can't sell it in your brokerage, go buy it in your IRA. That is a wash sale violation. You can't sell it in your account and purchase it in your spouse's account. That violates the wash sale rule.
Say it's a stock, you can't sell that stock and then go buy an option on that stock. That would be a violation, and you can't buy what they call substantially identical.
Roger: So, define that very specifically for me.
Erin: Wouldn't it be nice if the IRS did?
Roger: Essentially if I have a bond fund that is tied to, I call it the Lehman Aggregate Index, it's probably the Barclays somebody. That's the bond index, the S&P 500 of bonds, we'll call it. If I sell ABC bond fund, that is a tied to the Lehman Aggregate Index and I sell that, capture the loss and I buy XYZ Bond fund that's tied to the Lehman Aggregate Index. Totally different fund companies or ETF providers, et cetera, that is a wash sale. They're substantially equal.
Erin: They may be considered substantially identical in this case. You want to avoid those situations that are kind of walking the line.
What you can do is say you're holding Coke, you want to get rid of that and buy Pepsi, that's fine. They're a totally different company, they have different management. Those are not going to be substantially identical. If you hold, say AstraZeneca and you want to sell that and buy a biotech ETF, you know, those are going to move in very similar patterns. Not exactly, but that would not be substantially identical. You do start to get a little questionable when you have said an S&P index that's offered by Vanguard and you sell that and you go get a Schwab S&P index, you're mimicking the same thing that.
Roger: Probably will violate that rule.
Erin: I would think there's some gray area which is a big reason why this is not tax advice. You want to speak with your tax professional about that. There are still many different ways you can hold a similar enough position in your portfolio that it's not going to drastically change things until such time as you can go back after that 30-day period and repurchase your particular fund or stock if you choose to.
Roger: An example of this is, let's go back to ABC bond fund that mimics the major bond index, the Barclays aggregate or Lehman aggregate if you're an old school guy. If you sell that and buy a high yield bond fund that is focused on the high yield segment of the market or a short-term duration bond fund or a Treasury bond fund, they likely will act 80, 90% of the way there. But they're different.
The problem with this I think, Erin, is that this is all self-reporting on the tax return and really only comes up if the IRS is asking questions if they're going to audit you.
Erin: Correct. This is where I have to tell you that as an EA, I am not supposed to comment on the odds of being audited or anything like that.
Roger: It's a self-reporting thing, like with almost all the tax information and you walk the line to wherever you want to walk the line on these nonspecific rules. But if it gets audited and they ask a question about it, you're going to have to deal with it and you're going to have to explain your stance.
If you violate a wash sale rule, it's not the end of the world. I'm trying to use a kid analogy because they're always the best for these things like this. It's a little bit like a cockroach. They came just innocently asking a question and if they see a wash sale in auditing, that is S&P to S&P, just different providers. Everybody knows what's going on there. That's a cockroach, and when you see one cockroach, Erin, what do you normally see?
Erin: There's a lot of cockroaches.
Roger: So maybe I need to go dig deeper, and I've dealt with this as a CCO and back in the day our firm was audited by the sec. A lot of it is around showing that you're trying to be a faithful actor within the realm.
Erin: Right, exactly.
Again, there's so many alternatives out there that it can easily be argued that whatever you did would not be a violation of a wash sale rule. I think that it's easy enough to stay away from that line, so it shouldn't be a problem. But you know, if you do violate a wash sale rule, it's not the end of the world that that loss is disallowed temporarily. It gets added to the replacement holding and then when you do eventually sell that in a non-wash sale violating kind of way. That loss will be captured there.
Roger: Yeah. Okay, so that's the severity of it going wrong. correct.
What are some gotchas that we need to watch out for when evaluating portfolios, because the goal of this is that we should evaluate our portfolios every year to just look for the low hanging fruit to use things as productively as possibly. So, but what are the gotchas in thinking?
Erin: Well, the biggest one is that wash sale rule. You don't want to run afoul of that.
Another one we touched on, that capital losses die with you. So, if you're 102 and you're like, I'm going to go harvest a whole bunch of losses, might not be the best time if you're not going to use them all up in that year. Those carry forward and it's easy to bank those and use them productively in a different way.
Roger: Let's hit on that one really briefly because I encounter situations, generally it's in real estate or other private type of investments, where there'll be people that will come in with substantial loss carry forwards in the six, sometimes seven figure range. It's easy to want to bank those and use them productively, but they die with you. They go away. You can tell you're a tax person when that's sad to you. But if you have half a million dollars in a tax loss carry forward, that means you can go earn or realize a half a million dollar gain tax free. Right?
Erin: You're resetting your basis. So why wouldn't you go ahead and use it up?
Roger: I just want to make sure we hit that point. Okay, what are some other gotchas?
Erin: That $3,000 maximum limit that we talked about, that can be applied to just ordinary income, other types of income, that's $3,000 whether you're married filing jointly or single. But if you are married filing separately, it's only $1,500. That's another one of those penalties that hit the MFS crowd. So, if you are married filing separately, be cognizant of that.
Another problem is those carry forwards. If you have a carry forward loss every year, you have to put that amount on your tax return and just kind of keep track of it whether you're using it or not.
Say you generate a big loss, $10,000 loss in the year 2006, seven years go by, you haven't harvested any gains, you haven't touched that loss, so you haven't been putting it on your return. Maybe you switched CPAs ®. You forgot to tell the new guy, whatever 2011 you have gains that you do want to count it against. Well, the IRS came out and said sorry, you can't. That's gone. You haven't provided the information on that. Be careful. Make sure you're always recording those. Make sure if you change CPAs ® that they get a copy of your tax return last year. Make sure you're filling out that tax organizer. They don't just have you do that because it's a fun activity.
Roger: It's not.
Erin: They need that information. That's not the most fun activity.
Roger: Well, that's why I love people like you, Erin. So, because you put it on one tax return, you have got to keep putting it on. There is the point.
Erin: Yep. If you want to keep moving that forward to be able to use in future years, you have to keep make sure it shows up on your tax return each year.
Roger: Okay. What else? Any other gotchas?
Erin: We need to think about the mutual funds, they're not so much a gotcha as they can be a surprise at the end of year. Again, that's why we want to kind of leave ourselves buffers, things like that and know that these are estimates, they're not written in stone until your tax return is actually done.
Lastly, related party transactions for any people that thought they'd get sneaky and you know, oh, I'm going to sell this to my brother, my sister, my kid, my grandparent. Related party transactions are not eligible for capital loss treatment.
Roger: Okay, now a couple areas where you can use this and we'll talk about some closing behaviors. One is obviously we're thinking about this near the end of the year, tax year end accounting of looking at how we can use some losses productively.
Another time to think about this and this is one that a lot of us forget, Erin, is during market stress. A good example would have been the COVID bear market, which was a very quick bear market in hindsight. It happened in a month or so and it was drastic. We were relatively on the ball during that, the only selling we did during that COVID bear market which happened I believe in March, April, was to actively harvest losses and purchase other non-substantially equal assets in March to book the losses. When you're under a market stressor, it could be just the general stock market but it could be the fixed income market, it could be any asset.
I think those are the two big opportunities and when things are really stressful in the markets, meaning they're going down substantially very quickly, that's a time that, oh, maybe I make some lemonade, still maintain roughly my position, but within enough margin that you're not worried about the IRS and just book the loss because then you can use those in later times.
Erin: That's right. Tax loss harvesting is not just a December activity, it is a year-round sport.
When you see a big pullback like that, if it affects your portfolio, consider harvesting those losses. If you have certain holdings that have just been turned to dogs and you know you just don't even want to keep them, harvest those losses. If you want, some people even set up like a set parameter, they say, you know, if I have any holdings that drop 10% or more, pick whatever number, I'm going to harvest losses. Just don't let your emotions drive the decision. Make sure that you have a well thought out plan for when you're going to do this and why you're doing it.
Roger: Yes. There's a lot more opportunities with individual stocks for sure, you know, Intel. I'll use Berkshire Hathaway. When Warren dies, that stock will go down. If you're a believer in Berkshire Hathaway, regardless of Warren or past Warren, you could sell it, reset your basis lower, buy it back or buy something relatively similar, but it's a productive thing to have.
This was a great detailed discussion, Erin. I love that you're on our team and I love, love, love that you love taxes.
Erin: Well, I love that you invited me on to talk about them. Thanks Roger.
LISTENER QUESTIONS
Roger: Now it's time to answer some of your questions. If you have a question for the show, go to askroger.me to get it on.
GREG’S QUESTION ABOUT ROTH CONVERSIONS WITH AN OLDER RELATIVE
Our first question comes from Greg related to an optimization question for his older relative.
So, here's the tit. His older relative is 77, has 2 million in his pretax IRA type accounts, he does not have and has never had a Roth account. Greg's question is, if he were to start a Roth account today, via a Roth conversion, would he be subject to the five-year rule? He's trying to figure out if converting some of his IRA to a Roth is a good idea at his age.
All right, Greg, so let's think through this.
First off, whatever he converts is going to be taxed as ordinary income. Realize that he can't use his RMDs to be part of the conversion. He's already taking required minimum distributions. He would have to take those distributions and then choose to convert some pretax assets in addition to the RMD. Then next year his RMD would likely be lower because he would have lower amounts in the pretax assets.
Understand that at his age he meets one of the two requirements of what we call the golden rule, which is number one, he is over 59.5. He hits that, he's 77, but he doesn't hit the second part of it. He's not had at least $1 in a Roth IRA for at least five years, so he doesn't meet that part of the rule. Which means if he were to convert, let's say $100,000, he would pay tax on that $100,000 in the year that he did it. Then that hundred thousand dollars would start the clock on the five-year rule and he would have to wait at least five years to make a qualified distribution from his Roth account.
What does that mean? It doesn't sound like he really needs to draw money from the Roth account. So that's a good thing. Who cares? It's five years. It's really for legacy. But what if he did want to draw money from the Roth account prior to 5 years? How would that work?
Well, if he were to take, let's say $50,000 out of his Roth IRA after he converted $100,000 prior to the five-year rule, he's not going to have any tax and penalty because it's less than what he converted initially. You can always take the money you put in out once you exceed your contributions or conversions. Then the five-year rule starts to apply in terms of either the early withdrawal penalty, which he's not going to hit, or taxes on the growth.
Worst case scenario here, Greg, is that he converts $100,000, he pays the tax on that, and then if he takes out more than the conversion within the first five years, there's going to be some tax implications as a result of that. So, in the situation that he's in, will he be doing that? Will he actually be taking money out because he has got to hit that five-year clock in order to take out any of the earnings or growth on the conversion. But it's calculated on a first in, first out. So, they're assuming the first money's coming out of the contribution or the conversion in this case, which is not going to have any tax consequence.
Now here we are towards the end of the year as we're thinking about Roth conversions. Greg. So, if he were to do a Roth conversion in 2024, the five-year clock starts January 1st of this year even though we are in November because it's done on a calendar year basis.
Some things to consider as you're doing this Greg, with your relative is one, by doing a conversion, is it going to impact IRMAA, the Medicare surcharge for 2024?
IRMAA surcharges start if he's single, if he makes over 103,000 as a single filer or over 206,000 and one dollar as a joint filer, if he's still married. These IRMAA levels are cliffs. Let's assume he had zero income. If he converted $300,000 you would calculate the modified adjusted gross income and that may kick him up into an IRMAA bracket, meaning he'll pay more for Medicare Part B and D potentially. We'll include the 2024 Important Numbers Worksheet that has all of these brackets and the tax brackets and the capital gains brackets in our 6-Shot Saturday email. In fact, Nichole's listening to this. She drafts 6-Shot Saturday and writes it. Nichole let's include the end-of-year worksheet and the important number worksheet as links in all of our 6-Shot Saturdays this month that way people can have access to this quickly as we talk about questions. Greg, understand that you could have second order consequences of IRMAA and different tax brackets that he might go up into.
Ultimately the question Greg comes down to, what is the intent of doing a Roth conversion? What is his intent for this because we're a little late in the game and is this for his heirs? Is this for him to reduce future RMDs because he's worried about tax rates? The better you can define what the intent is for this, the better that you'll get to a solution. Perhaps you would want watch the replay for our live session tomorrow and that will give you a more fleshed out version of how to think through this logically.
STANLEY’S QUESTION ABOUT HIS WIFE’S TAXABLE MULTI-YEAR GUARANTEED ANNUITY (MYGA)
Our next question comes from Stanley related to an MYGA, which is a multi-year guaranteed annuity.
These were pretty popular as a tactical step when interest rates were extremely low and now, they're starting to come due.
Stanley says,
“My wife is 75 and she has a taxable MYGA, multi-year guaranteed annuity which has a basis of $36,000, an estimated end value of $50,000 that is maturing.”
So, these work a little bit like a CD in that they have a maturity date where the interest rate is guaranteed and at maturity you have some choices. Your choices are either to exchange this to a new annuity, whether it's a fixed annuity or any other kind of annuity, or take a distribution from it, surrender it, and in this case, in a multi-year guaranteed annuity, all of the growth is taxable because it's in a tax deferred vehicle. That gain from 36,000 to 50,000 has been growing tax deferred. So, if they surrender this annuity, it'll become taxable income, but if they roll it into a new annuity, it will not. It'll be deferred.
“We have a sizable taxable liquid asset. I have a $80,000 pension. We have Social Security. All of our essential spending and most of our fun and wish spending is covered by our guaranteed income sources. I have two other annuities, one in an IRA, and the other in a taxable account with guaranteed lifetime benefits.
We are gifting our children parts of these annuities annually and either spending or saving the rest, we don't really need the guaranteed income, as you see. But I loathe simply taking the lump sum and paying taxes on it, probably at the 22% tax rate, what would you recommend? Take the lump sum payout, take some form of annuity income, or roll it over to another MYGA annuity or something else.”
That's a great question, Stanley.
Actually, I can't give you a recommended idea. I don't know you. I can't give you a recommendation but let me summarize this.
You have annuities now. You have ample income for anything that you want to do based on great life wants and wishes. This $50,000 in this annuity is excess money that you don't necessarily need. If you were to take the money and pay tax on it in the 22% bracket, which is not a bad bracket. All of this money is going to be taxed at some point, Stanley, and that's important to remember. It's just a matter of when you decide to have it taxed. Understanding that helps reframe it a little bit. You're not avoiding taxes, if you were to roll it over into another multiyear guaranteed annuity, you're just deferring the taxes to another day. The question really becomes, is it better to pay the tax now, have the money, or defer the tax and either I or my heirs deal with it later? That's really the question.
Some of this has to do with what the tax bracket will be that you or your heirs will be in when this tax is getting realized. Is 22% good now? Because you could go with option one, have the annuity surrendered, which would give you a $14,000 gain, which would be taxed at 22%, which means you'd have almost a $3,100 tax bill, which means net after taxes you would have $46,900 in your hand that you could use to gift to your children. That may be the best use of this money. 22% isn't a bad rate, depending on what your situation looks like.
This is why multiyear tax planning is important. Figure out what intent you have for this money. If you have a plan of record, this is excess capital that can either grow for the future or be given to your heirs, grow for the future for your own use, or perhaps start to distribute to your family. I would think that surrendering it and distributing the money to your family might be a good use
When you get into some of these tactical questions, it starts to get very multifactorial, that's why it's hard to answer these questions in a black and white manner on a show like this. I only have limited information on the qualitative and the quantitative side.
Given what you said, I probably would not lock in more guaranteed income. It sounds like you have enough. I would probably lean towards just in this moment, surrendering it, paying the tax and either investing it in after tax assets because that will get a step-up cost in basis, or start to distribute this to the kids in this moment. There may be some other options that come to mind later. I guess one other one that comes to mind is you could look at exchanging this into another annuity that has some estate multiplier. Some annuities will have features where they have a death benefit that has a multiplier attached to it. That might be an interesting thing to consider. It would take some more bespoke planning to see if those options would make sense for your situation. An example of one of these would be that you put $50,000 into a new annuity, but it has a multiplier that if you were to die, it pays $100,000 or whatever it is. You'd have to search to see what is available out there, but that might be an option to consider as well.
JAY ASKS ABOUT THE PIECAKE VERSUS THE BUCKET APPROACH
Next is Jay on timing.
“Hey, Roger.
My question is about the pie or bucket approach. We put five years’ worth of savings into our first pie slice that we have in safe vehicles like CDs.”
Check. I take it that as you spend it down, you replenish it from the next slice for funds needed more than five years. That's going to come from investors in bonds and equities, et cetera.
“Do you suspend moving funds from the growth or upside bucket if there's a market downturn? If so, how and when do you resume moving money from one slice to another?”
Essentially the question is that he has his structure in place, he has a contingency fund. He has his next five years of spending prefunded in CDs and then he has upside portfolio that's more growth oriented.
Jay, if I understand the question correctly, what happens if the market is down 20% this next year? Do I refill the bucket? If so, how?
The answer is maybe, Jay.
Option one is you just hard refill the bucket. You do that as part of your reallocation within your upside portfolio. An example might be, in your upside portfolio, if we have a really bad bear market, not all of the assets in that asset allocation are going to go down. Let's just assume stocks and bonds, let's assume stocks go down and bonds stay the same. Well, now your reallocation if it was 50/50, is not 50/50 anymore. Maybe it's 60% bonds, 40% stocks, because the stocks went down in value. You're going to want to maintain a relatively close asset allocation, which means you would sell bonds and buy stocks, and that would get your upside portfolio back to the allocation that you had predetermined.
Well, another way to do that is just to sell some of your bonds, not sell the stocks, and that gets you back to your 50/50 allocation. Then you peel off some of that money to pre-fund the outer years of your five-year layer. That's one option.
Another option, Jay, is that you do not refill the five-year income floor, that you go through a year of a bear market and you say, okay, now I have four years of spending, I'm going to choose not to refund it and just maintain a four-year income floor in order to allow the sea to calm. Year two, we have another bear market. Maybe you choose not to refill and now you have a three-year cash reserve in order to let the sea calm. That is an option that you have. That is a legitimate option.
One thing that we forget, Jay, as we're making these decisions in an agile way, we're recasting what our spending actually is. So, year one of the bear market, not only are you going to look at the value of your portfolio, you're also going to look at what your actual spending is on your base great life, wants and wishes, because when you build out that five year income floor, you have to decide, am I just going to pre fund my base great life or am I going to add in some of the extra spice of life in terms like the extra trips and the extra purchases and am I going to pre-fund that as well?
If we get through a bear market after year one, part of the decision is, well, what is my actual spending? Because we're in turbulent times, maybe we batten down the hatches and not do some of the extra spending, the extra travel, or we moderate some of the extra spending and extra travel, which actually would extend the income floor a little bit more because you're moderating. Very similar to when we have our steak salads here at the house. Shauna will buy steak, well, with inflation, she doesn't buy filet anymore. She buys other cuts of meat because she's making a swap to try to manage expenses during a time when food inflation is particularly high. God willing, that will subside so that I can have fillet again. It's a little bit more dynamic than just simply tweaking the portfolio because maybe you're just naturally spending less than what you estimated. It's always a moving target.
The important point of all of this exercise, Jay, is the intentionality of systematically paying attention to it because you're also going to be testing at the end of the bear market, you're going to be testing your feasibility again to say, how impactful was this bear market to my long-term feasibility of my current spending plan? If it was not very impactful, then maybe you don't refill the bucket. If it was impactful, well, you have some other negotiations that you need to do on your portfolio but also on your spending side. So, it's a very dynamic thing and it changes every year. The important part is being intentional about it and getting ahead of the curve.
For some perspective, back in 2008, that vintage of Roger as a retirement planner went through all of 2008 with his clients having about two years cash reserve and navigated a 50% peak to trough drop in equity markets and we came out just fine. I didn't have any crash and burn moments. We moderated spending a little bit more than perhaps we could have had. We had built bigger buffers there.
I don't know how much you have to pre-plan this, Jay. I think running the feasibility will help guide you as well as what your life situation looks like at the moment when you are at a decision point.
Now let's get and set a smart sprint.
TODAY’S SMART SPRINT SEGMENT
On your marks, get set,
now we're off to set a little baby step you can take in the next seven days to not just rock retirement, but rock life.
This is going to be a tactical step in the optimization pillar and that is to review your after-tax accounts looking for unrealized losses.
Likely it's going to be in the bond portion of your portfolio. Look at unrealized losses and start examining whether you can use those productively, either by selling them and realizing the loss, or by doing a sale of the loss and buying something somewhat similar, but not too similar to the investment in order to maintain your investment position in order to realize the loss to offset gains. See if that is something that tactically is going to help enhance your plan and provide literally a dollar payoff by saving dollars in taxes.
I want to thank the team that puts all of this together. Erin, Nicole and Allison and Troy, Scott, and Graham. See, when I start naming names, it's getting so big it's hard to remember everybody. We have such an amazing team that works to put all of this together. Tracy and oh, everybody, thank you so much. Hope you have a wonderful day. We'll talk to you next week.
The opinions voiced in this podcast are for general information only and not intended to provide specific advice or recommendations for any individual. All performance references are historical and do not guarantee future results. All indices are unmanaged and cannot be invested in directly. Make sure you consult your legal, tax or financial advisor before making any decisions.