One very lucrative way to sequence your distributions in retirement is to take money first from taxable savings and brokerage accounts; leaving the money in your retirement accounts to continue growing tax deferred or tax free (Roth). This is beneficial because taking money from taxable accounts requires you to pay taxes on the gains.
The beauty of having money in retirement accounts, such as 401(k) and IRA accounts, is the ability to defer the tax on the gains until the money is removed from the account, allowing the investment, as well as its earnings, to continue to grow. In some cases, such as Roth accounts, even when you take the money out of the accounts, it will not be taxed.
The longer your money can grow without being subject to taxes, the more your net worth will increase.. Thus the reason to have a taxable savings account that you can draw on first, letting the tax deferred accounts keep growing.
Spending money from your taxable account will generate a tax bill if you sell something that has appreciated in value. But there is a way to sell these assets without paying taxes on the gains.
Taxes owed on gains
Let’s first look at what happens if you sell an appreciated stock or stock mutual fund in a taxable account. For our example we will assume you are married, filing jointly and your budgeted expenses are $200,000 a year. We will also only look at the capital gains without regard to any other part of the tax calculations.
Let’s say you bought Stock A many years ago for $20,000 and today it is worth $200,000. Your spending need for the year is $200,000 so you decide to sell Stock A to generate enough cash to live on this year.
You sell Stock A and now have $200,000 to spend. But since you realized a gain on Stock A, that gain will be taxed. Since you are in the 15% long term capital gains tax bracket, the $180,000 appreciation of Stock A will require $15,000 in taxes to be paid, which is calculated as 0% of the first $80,000 and 15% of the remaining $100,000. The $200,000 you took minus the $15,000 paid in taxes will leave you with only $185,000 to spend. You won’t have enough money to meet your $200,000 annual budget.
Selling appreciated stock requires you to sell more than you need so you can also pay the taxes and still meet your financial obligations.
Tax losses to deduct
Most people want to sell high, not sell low, so selling losers feels like you have locked in a loss. Thus most people gravitate towards selling the winners and paying the taxes. If selling winners costs a little extra in taxes, what would happen if you sold losers instead? Your investment account will drop by $200,000 either way.
Let’s look at another stock in your taxable account, Stock B, which recently suffered a 50% drop in value. You initially paid $400,000 when you bought this stock and due to a recent correction in that industry, the stock is now worth $200,000. If you sell this stock you will have $200,000 to spend on this year’s expenses.
Your sale generated a $200,000 long term capital loss. Since you have no taxable income this year, because you sold for a loss, you will have no gain to deduct the loss against. Therefore, the capital loss will be carried forward to a future tax year.
With this carry forward loss on the books, you could sell an appreciated stock next year and use this deduction against next year’s gain, reducing your succeeding tax burden. But what if you could use that capital loss this year? There is great value in taking advantage of something this year as opposed to sometime in the future.
Tax free money from your taxable account
What if you were to combine the two concepts, long term capital gains + long term capital losses, and sell just enough of the stock that went down in value to create enough write off to cover the sale of a portion of the stock that had a taxable capital gain?
If you were to sell $71,428 of Stock A, which has appreciated such that 90% of the sale was long term capital gains, you would owe taxes on the $64,286 gain.
If you also sold $128,572 worth of Stock B, with a 50% loss, you would generate a long-term capital loss of $64,286.
The sum of the two sales generates the $200,000 you need to live on. It also generates a $64,286 capital gain and an offsetting $64,286 capital loss. Thus your tax bill for the sale of the two stocks would come to zero with zero net capital gains.
This gives you $200,000 worth of cash to spend with no tax to pay. A very efficient way to take your distribution.
All three options drop your portfolio value by $200,000. Only the second two options generate enough cash to live on for the year by not creating a tax bill. The third option balances the gains with the losses to eliminate this year’s taxes owed.
The real world
The above examples were considered in a vacuum just to help you understand this concept. In reality, there are many other calculations on your tax form that will contribute to the actual outcome of total taxes owed. If we take into consideration that taxes are not owed on the first $80,000 of long-term capital gains, then you only have to sell enough of stock B to drop your long term capital gains to $80,000, if capital gains are your only source of income. Also, you can still take your standard deduction, $25,100 in 2021 for married filing jointly, or your itemized deductions, whichever is larger. Each factor complicates the math and makes your CPA’s help much more valuable.
If we added only these two factors, the standard deduction of $25,100 for 2021, and zero long-term capital gains tax on up to an $80,000 gain, then your distributions this year would need to have a combination of gains and losses that total a $105,100 net gain in order to pay zero taxes. The results would look like this:
Sell $146,500 of Stock A and $53,500 of Stock B for $200,000 total cash.
Stock A dollars are 90% gain, so that’s $131,850 of long-term capital gains.
Stock B dollars are 50% loss, so that’s $26,750 of long-term capital losses.
$131,850 gain – $26,750 loss = $105,100 net capital gains.
$105,100 net capital gains – $25,100 standard deduction = $80,000 taxable capital gains.
Tax on the first $80,000 of capital gains is ZERO.
Because these calculations are so complex and very dependent on your exact tax situation, I suggest you use the services of a good CPA to help you arrive at your zero tax goal, when you are living on your retirement income. The complexities of the different retirement plans you have will also come into play. If zero tax is your goal, you might be able to hit it, unless you are fortunate enough to never have any investments that go down in value.
If you keep your total living expenses under $105,100 and only live on your taxable retirement plan money, you should be able to live tax free every year. If you have any Roth retirement products, they will increase your tax free income number even more.
Have you ever used this tax balanced harvesting method to spend your money? I don’t know about you but I prefer not paying extra taxes if I don’t have to. The combination of having losses and gains in the same year is the reason I had a tax bill of zero my first year of retirement. I wrote about the surprising things I learned when I owed no taxes in my article, Tax Surprises My Retirement Year.