As this historic bull market grinds ever-higher, some commonly-used axioms seem apropos to stock investors. “Patience is a virtue.” “Don’t miss the forest for the trees.” “Good things come to those who wait.” But the phrase “hindsight is 20/20” also applies. Few investors were confident about stocks in the frantic days of October 2008, when the financial markets seemed to be collapsing on themselves. But those who remained invested have been rewarded handsomely for their fortitude, as stocks recovered all those losses and have gone on to reach new heights.
This is fantastic news for those nearing or already in retirement. As is often the case, the devil is in the details when it comes to how this affects retirement cash flow strategies. The bull market has generated substantial capital gains in taxable accounts. For most people, these gains become taxable when the stocks are sold. These tax implications must be considered in order to confidently assess the portfolio’s ability to generate cash flow.
Ignoring this potential tax liability could provide a false sense of security. The need to sell stocks to fund living expenses often leads to larger tax bills. Writing these checks in retirement can be uncomfortable for retirees adjusting to life without a steady paycheck.
So it stands to reason that we need to review these devilish details. A solid approach combines a mindset, math, and methods, which together help manage what would otherwise be an unpleasant tax-time surprise.
Mindset: Shift Perspective on Capital Gains Tax
In the normal course of portfolio management, capital gains will be generated. Similar to pruning a tree, an effective investment strategy requires trimming and selling existing holdings, and the infusion of new holdings. This can generate capital gains, and given the market’s massive rally over the past decade, most investors can expect realized gains to increase as a result.
Having to incur capital gains tax should come as no surprise. The IRS has its fair share of obscure and bizarre regulations, but it has always made crystal clear that capital gains taxes will be owed when taxpayers sell an asset for a gain in a taxable (non-retirement) account.
But this tax is often seen as something that can be altogether avoided rather than what it truly is: a deferred tax liability. Investors should view unrealized capital gains as a very real tax liability, whether incurred in the current year or down the road. Either way, Uncle Sam will almost always get his cut.
Math: Debunking the “Lost Growth” Theory
Some investors argue that realizing capital gains is inefficient. In their view, selling appreciated stock and incurring a tax bill of, for example, $10,000, prevents them from benefitting from the growth of that $10,000. In reality, the investor is only “losing growth” of the tax liability itself because the tax liability is already incurred – it’s just deferred. Assuming an expected growth rate of 7%, the investor is only losing out on the growth of $700 ($10,000 capital gains tax bill x 7% expected growth rate = $700).
Taking this one step further, we know all too well markets don’t always go up! If a couple is about to retire, what is the cost of not rebalancing a $2,000,000 taxable account that is 80% stock when a 25% bear market hits swiftly and severely? Most of the time the capital gains tax would be dwarfed by the $400,000 loss of value.
Method: Optimizing the Capital Gains Tax Liability
It’s often difficult to completely avoid capital gains taxes, but there are several methods to employ to minimize the impact. We are sensitive to capital gains and coordinate with clients and their accountants to ensure there aren’t surprises when tax time comes each year. But it’s also important not to allow tax optimization to completely drive our investment decisions. In other words, don’t let the tax tail wag the dog.
Manage the Tax Brackets: Understanding the various break-points in the capital gains tax brackets (which differ from the standard tax brackets) helps manage capital gains taxes. Most notably, if a couple is recently retired, there could be several years of minimal income (prior to taking Social Security) which, if managed properly, could result in 0% capital gains liability! This reinforces the wisdom of being proactive about tax planning with your advisors.
Harvest Losses: Probably the most well-known capital gains tax strategy is known as loss harvesting. Securities sold for a loss offset realized capital gains dollar-for-dollar, reducing the capital gains total. If there are more losses than gains, investors can deduct a maximum of $3,000 per year from income. Any unused losses can be carried over to subsequent years. Special attention must be given to wash-sale rules if and when a security is repurchased.
Leverage Generosity #1: For the charitably-inclined, donating appreciated stock delivers tax advantages relative to writing checks. The taxpayer can deduct the value of the shares, and furthermore will not incur any capital gains tax on the increased value. A Donor-Advised Fund (DAF) can be used to enhance this strategy. Taxpayers can donate to a DAF to optimize their charitable deduction amounts from year-to-year, but make grants to the charities themselves in different amounts and on a different timetable as necessary.
Leverage Generosity #2: In addition, a taxpayer can make gifts of cash or securities valued up to $15,000 per year to any person for any reason. While such gifts can’t be deducted, the recipient “inherits” the cost basis and, assuming a lower tax bracket for the recipient, could sell appreciated securities and incur less capital gains tax than the donor would have owed.
Meet your Maker: Later in life, it’s wise to pause before realizing capital gains, as the cost basis is “stepped up” to fair market value on the date of an account owner’s death. This allows heirs to inherit the assets with little-to-no capital gain embedded. Then, if necessary heirs can sell the securities for little-to-no capital gains tax.
Properly managing capital gains taxes is essential for effective retirement planning. Just as in the working years, taxes are an inevitable and meaningful expense in retirement. Employing the proper mindset, analyzing the math, and using the right methods to manage capital gains can reduce their impact on retirement cash flow.