2 Retirement Tax Planning Strategies To Save THOUSANDS In Your Retirement Portfolio!

 

How would you like to save hundreds of 1000s of dollars potentially in taxes in retirement? Well, these two strategies I’m going to go through today, when combined together have the potential to do just that. Now, if you don’t qualify for net unrealized appreciation, because you don’t have company stock inside your 401 K, you can still qualify for 0% taxes on your long term capital gains and dividends. So when we combine these strategies together, it creates a very powerful tax and income planning tool that you can use for your retirement.

As you can tell, I’m pretty excited about this video, because we’re going to discuss two tax planning strategies, the net unrealized depreciation, which I’ve not yet done a video on the YouTube channel about, and also the 0% taxation for long term capital gains and dividends. And you’re going to want to stick around until the end of the video where I incorporate these two strategies into a real life financial planning case. Now, unless you’ve searched “net unrealized appreciation” to find this video, there’s a pretty good chance you’ve never heard of net unrealized appreciation. So in its most basic form, it’s when you have company stock that’s been issued inside your 401 K, you have the option of rolling that money outside of your 401k, not into an IRA, but rolling it out only paying income tax on the basis that’s been distributed, and potentially pay long term capital gains tax on the appreciation. So that appreciation from where it was issued to where it is, whenever you roll it out and retire, or sever from service or become 59 and a half. That’s what’s called your net unrealized appreciation.

We’re here in Houston, Texas, where we have a lot of clients that worked at Exxon Mobil, or Chevron or some of the other big oil and gas companies. We also have clients from all over the country that work for other companies that can take advantage of this net unrealized appreciation strategy.

Exxon Example

So I’m going to use Exxon because we come across this plan a lot. We’re very familiar with the Exxon retirement plan. And I want to illustrate how this concept works. And there’s some nuances here. And there’s also some financial planning considerations and of course, tax ramifications that we’re going to go through. But if I worked at Exxon, let’s say from 1995, to 2020. And as part of my compensation, I receive shares of stock each year over the course of my employment. So these numbers are not historically accurate, but I want to convey the principle here. So in the beginning years, if XR was trading at $20, then I received 100 shares. And then next year, maybe I received them at $22 per share, and $25 per share. And over time, as I’ve received more shares as part of my compensation package, the value has typically increased the price at which you were issued those shares, and the year you receive them is what’s called your cost basis. So if we do this annual a rollout, that’s the amount that you’ll have to pay income taxes on. But it’s a really cool opportunity here, because over time, most stocks appreciate in value, Exxon today is at $116 per share. So the concept of anyway, is if I was issued stock at $20, a share and I keep it in the IRA, and now it’s at $116 a share. That’s a massive amount of capital appreciation. And if I roll it to an IRA and distributed at that point, or at some point in the future, I’m going to have income taxes, and that can can lead to a pretty big tax liability. Now we’re down the road when I need income. But as stocks depreciate over time, we typically have a mixed cost basis when it comes to the amount of shares that we’ve received from the company.

Cost Basis Breakdown

So first thing to know here and first thing to ask your company is do you guys provide a breakdown of the cost basis on an annual reporting period? Or do you take the average cost basis, so we come across some companies here that they will provide you the information of the exact cost basis and the amount of shares that you’ve received in each year. And that case, we can really cherry pick which shares we want to roll out and really take advantage of this strategy, because typically, we’re going to take the lower cost basis ones. Some companies don’t allow you to cherry pick based on the lower basis shares that were issued, they calculate an average cost basis for all the shares issued. So this is not nearly as advantageous as being able to cherry pick, sometimes it can still make sense, especially if it’s an older 401k. Or if it’s a stock that has really, really appreciated since those shares were issued. In the average cost basis is down. So this video, my primary purpose is to help educate you are on the financial planning considerations of the annuity rollout. So I’m not going to cover all the rules and regs surrounding it. I’ll do that in a later video though. But a couple things you should know, this becomes an opportunity whenever you sever from service or typically when you’re entering retirement. There are some other qualifications but we’ll cover those later.

Now, if you sever from service prior to age 55, you will be subject to a 10% penalty on the amount you distribute. So just be aware that if you’re under the age of 55, you’ve severed from service you have company stock inside your 401 K that that 10% penalty. If early distribution still applies, we have Exxon does 401k here, so the total value is about 1.5 million in this hypothetical example, the shares the tote and totality the shares have been issued over the course of the working career equals about a $600,000 cost basis. So I’m going to use the example here where we can cherry pick the individual shares. So the next question becomes, which shares should I consider doing the anyway rollout because I don’t have to roll all 600,000 bases out in the real world. Typically, this 1.5 million of fair market value may also be comprised of mutual funds, such as growth, funds, income, etc, within the 401k. For the purpose of this example, Exxon stock is valued at $1.5 million. The cost basis of those Exxon shares within the 401k is 600,000. Just want to point out in the real world, typically everyone does not have all their money invested in their company stock. But I’ve I’ve absolutely seen that over the years. So the question becomes which shares do we want to take advantage of the annual a rollout with the general rule of thumb is the lower cost basis shares are more attractive, and that’s determined by the value of the stock today, anything above 50% cost basis to fair market value, typically, we don’t want to consider for anyway, now there are some extenuating circumstances sometimes with financial planning considerations that it may make sense. But when we do the math, we extrapolate out looking at the value that you would have in the IRA versus paying taxes on the basis now, annual taxation for growth, dividends, etc. The break even point isn’t that attractive when we look at these shares that are above 50%, cost basis to fair market value, I personally like to see them around 20, or 30%, really tops. So whenever you have shares that are 10, 15, 20, 25% cost basis to fair market value, those are typically very attractive opportunities. And in some situations 3035 40% could possibly make sense, it just depends on the overall financial plan that you’re putting together in other circumstances.

 

So this is a tax analysis. So you may want to reach out to your CPA for help or assistance in doing this, or your financial advisor if they’re qualified and skilled enough to help you make these determinations. I want to run through some numbers now. So let’s assume for whatever reason, this person decides to do the whole annual a rollout. So just so we understand the how this functionally works, the 600,000 rolls out of the 401 K into a non IRA account income tax is due on that $600,000, you’re probably looking at about a 2728, maybe 30%, effective tax rate will go with 30. So $180,000 of income taxes would be due on the basis being rolled out. But in this scenario, you’re not just rolling out 600,000, that’s the basis, you’re actually rolling $1.5 million out of the 401k and only paying income tax on the basis. Now, if you sell it immediately, the net unrealized appreciation is the difference between the basis and the fair market value. So you have $900,000 of gain there. So if you sell that 900,000, you’re looking at the more preferential long term capital gains tax, that would be a pretty big tax steal. So the question becomes the are what planning considerations? Should we hold on to this stock? Do we feel comfortable having this much in one company? What is our other wealth? What if we break it out over a few years. So this is what we’re really going to dive into. Now, I just want you to understand how this actually works. In regards to the functionality, okay, let’s cover how this actually works. So we take the Exxon stock, the basis is 600,000, but the full value is 1.5 million. So if in this example we decide we want to do at all, we would roll the full 1.5 million out of the 401k it will go into a non IRA account, but you only owe income taxes on the basis the 600,000. If you sell the stock immediately, you will owe long term capital gains tax, which is a more preferential rate than income taxes. It this level of income, the difference between the basis in the fair market value or 900,000. There, but you don’t have to sell it right away. If you don’t sell it right away. And then you sell it six months later, there’ll be subject to short term capital gains tax because your holding period rules take take into a place or take into effect if you don’t sell it immediately.

Financial Planning Considerations

But if you wait 12 months after the distribution date, 12 months in one day, then you qualify for long term capital gains tax treatment. So some of the financial planning considerations are now what are the income taxes do? What is my income and tax plan year one year two year three of retirement how does this fit into that overall tax and income plan? And how do we optimize how do we reduce the total taxes we pay while maximizing the value that we retain if we have to pay income taxes on $600,000 You’re looking at an effective tax rate, they’re of about 2728, maybe 30%. So 30% on 600 is 180 grand, so you’d write that check to Uncle Sam. And you would have 1.5 million outside of the 401 K in the more preferential tax environment of long term capital gains and dividends. Now, you would have annual taxation on these dividends. So that’s something else we need to consider. And we also need to consider future tax rates and make assumptions with what we think income tax rates are going to be in the future long term capital gains, and dividend rates, all of these things go into the analysis. But for now, this is the logistics of how it works, we roll it all out pay income taxes on the basis, we can either sell it immediately and pay long term capital gains on the differential, or we can hold it. And if we hold it past a distribution date, sell it within 12 months short term capital gains, sell it post 12 months, long term capital gains, okay, so I want to dive deeper into the two options, we have just high level. So Option A is we roll everything to the IRA, we do not take advantage of the annual a rollout eligibility, things that we have to consider here is future tax rates, RMDs other income sources and the secure Act. Now this is not an exhaustive list.

These are just some of the big ones. We have to take into consideration future tax rates, because when everything is inside that tax-infested IRA, when you distribute it in the future, you have to pay income taxes, you’ve given up the ability to take advantage of long term capital gains and dividend taxes, which are typically preferential rate RMDs forced distributions from your retirement account. And when added with other income, we often times see people who did not plan for this have 150, 200, 250 even more of income because of required minimum distributions and their other income. So when doing this analysis, we have to extrapolate out and look at these factors to help make the decision today secure act, I threw this in here because it forces distribution of your retirement accounts. If they go to a non spouse beneficiary that’s more than 10 years younger than you full distribution of the retirement account within 10 years. So if you have kids, and it’s important to leave this money to your children, if they have income, and they’re working, and now your retirement account has to be fully distributed within 10 years, that could be a massive amount of income going on top of their income, which now 3040 50 60%, potentially, of your retirement account is gone to Uncle Sam, if you live in a state with income taxes, that could be an issue as well, inheritance taxes. So a lot of issues here rolling everything into the IRA, you can be hit with pretty big income taxes down the road, option B is we do take advantage of the annual a rollout either wholly or in a partial anyway, rollout, how that works is we would take the shares that we do decide to take advantage of the strategy and we roll them into the non IRA accounts, some things to consider there. Is that what our long term capital gain rates now

what are they possibly going to be in the future, but also we have annual taxation of the dividends. And if we’re buying and selling inside that account, whatever we do not roll into the non IRA account with the strategy, the rest of the funds from your 401k go into the IRA. And then of course, whatever’s left here, we have the same considerations that I went through over here. So now there are financial planning considerations here. Let’s say I was at 35% cost basis to fair market value. So I’m kind of right there where mathematically, it may not make sense. But how much non qualified money do I have? How much? Essentially I’m saying how much do you have outside of your retirement accounts. Because if you’re entering retirement and all that money is inside that tax infested 401k, then you don’t have any ability to manipulate what goes on your 1040 your tax return by manipulate I mean, we determine which accounts we’re withdrawing income from to manage our taxable income that we report to the IRS. If we pull from our non qualified accounts, think your bank account, well, you don’t have to report that. So if you need 100,000 A year, we pull 50 from your bank and 50 from your IRA, you get your 100,000. But only 50,000 goes on the tax return. That’s how we can manipulate that. So how much non qualified money do you have? If you don’t have much, we may want to consider doing a little bit higher annual a rollout because even mathematically, it may not make sense when we just compare that decision in isolation to do or not to do the annual rollout. But when we now look at the other benefits that we’re receiving, such as the ability to do Roth conversions, the ability to manipulate what goes on our 1040 the ability to possibly qualify for a health care subsidy. If you retire before the age of 65. By managing the reportable or taxable income that’s reportable, we can qualify for a subsidy.

Marrying Investment Management and Financial Planning

So this is why we’re so big on financial planning because as you can see, it’s not just about investment management in retirement, that’s important. Absolutely. But when we tie in financial planning with investment management, we can create some really optimal scenarios where we’re creating a ton of value and helping you have more income, pay less tax and ultimately have more value throughout the course of your retirement. Okay, this is the part I’ve mentioned in the beginning of the video where we’re going to tie into kind of a real world planning case. So we laid the groundwork for what anyway is and some of the considerations that you have to make in order to determine if it makes sense for you to do the annual rollout. So what I want to point out here is the tax and income plan for retirement years one, two, and three, for someone who takes advantage of the annual rollout. Because the question becomes, when do we sell that stock, if we have 30-40-50% of our entire net worth in our company stock, it’s pretty risky to hold on to that position, just so we don’t pay more in taxes.

So here’s where we’re going to tie the financial planning considerations of the real world application and decisions we have to make on the annual a rollout with years one, two, and three of someone just entering retirement, one of the big risks is if we roll it out the company stock and we decide not to sell it because we don’t want to pay the long term capital gains immediately. If we hold on to that concentrated equity position, we have increased our risk. Now there are investment strategies that can be used, such as buying a put option, or what we call an equity collar. But I want to just talk about the tax and income plan here. So in this scenario, client rolls out the new way. So they have a large concentrated equity position. And they’ve paid income tax on the basis but do not want to sell the company stock yet. So as part of the tax and income plan, what I want to show you is we could break this up. So your two, your three, and even your four possibly depending on the size of the concentrated equity position, company stock, where 0% taxes essentially, so we have total income here of 120,000. So what this is the tax and income strategy where we’re generating income, year two of retirement, not year one, because in year one, you’ve done the the annual a rollout, you have a big tax liability from paying income taxes on the cost basis of that company stock. So the here’s your two. So your two, the tax and income strategy is don’t take anything out of the 401k No Roth conversions, we’re going to sell the company stock that we previously rolled out take advantage of anyway. And we can have $120,000 of income here as long as it’s all capital gains and dividends, your total tax liability $458.

Now, what I’ve done here is assume $20,000 of dividends because if you have company stock, and you rolled it out, it probably paid some dividends. So 20k there and 100,000 of long term capital gains we’re realizing we’re recognizing, so this is darn near 0% on $120,000 of retirement income. And we’re divesting from that company stock. Now again, some risk management strategies, we could have an equity collar or put option helping to support downside volatility of that concentrated position.

But just tax and income planning wise, I want to show you how this can work out. So here now I’ve added $125,000 of long term capital gains with $20,000 of dividends total AGI 145,000. That total tax 4208 and 145k of income 2.9%. So again, we’ve divested so maybe this is year two of retirement or year three, we’ve divested from the company stock, we’ve reduced our risk, we’ve provided the income that we needed for retirement, and we’ve done so in a way that’s tax advantaged. Same thing goes on. Now I wanted to point this one out. Because I’ve here I’ve thrown in the same 20,000 of dividends 125,000 of long term capital gains, so we’re selling the stock again. But now we also take advantage of a $20,000 IRA distribution. So this is which accounts do we pull income from in retirement? How do we generate income? What’s the tax plan? Total AGI comes up to 165. The total tax is 7000 208. But here’s the cool part, the IRS ordering rules for how you pay tax on income based on where that income is generated. The distribution from the IRA is actually tax free. But what happens is, when you take money out of the IRA, it brings some of those long term capital gains into taxation.

 

So I did a video not too long ago, where we talked about adjustments and Social Security and Ira distributions and Roth conversion taxes. The tax code is filled with these where if we take one more dollar of income, it brings one other item into now a taxable state such as Social Security or long term capital gains or dividends. So just just be aware of that, I guess. 165,000 of income $7,208 in income taxes representing a 4.4% tax rate. So now 1,2,3,4 years into retirement, we’ve divested the concentrated stock risk, we provide an income and a very tax advantaged manner. We still have that IRA with a lot of money in it to deal with. But once this is done, we would probably at that point start down the Roth conversion path.

 

Now every situation is different but hopefully these topics and ideas and considerations when it comes to risk management, income planning, tax planning and retirement will help you have a better retirement.

 

If you want to learn in more detail how to potentially pay 0% in long term capital gains and on your dividends, click here to watch a video I did a couple years ago where we do a deeper dive into the special tax advantage.

 

Do you have a retirement plan that goes beyond allocating funds to truly fit your needs? Click here to contact us – We can help you create a retirement life plan customized for your retirement vision and legacy.