Recent years have seen significant portfolio income with requisite tax consequences. Here are some strategies for managing this investment reality through the years.
Take Capital Losses at Any Age
Market downturns are difficult to stomach. However, they aren’t all bad. Times of reduced asset valuations offer opportunities for tax savings and investment growth. When securities fall below their cost basis, they may be sold to “harvest” capital losses to offset gains. If the intent is to use the capital loss for tax purposes, the same security may not be rebought within 30 days prior or after the sale. Rebuying the security within that window “washes” away the capital loss in what is called a Wash Sale.
Note that tax-loss harvesting involves risks, potentially including higher costs, portfolio tracking error, and unintended tax consequences. Tax laws may change and materially affect your situation.
The Period Before and During Retirement
In order to reduce exposure to a fund that generates significant capital gains, an investor might consider donating shares of the fund each year to charity. Rather than giving cash—especially if there is little to no tax benefit for the charitable gift due to historically high standard deductions—giving shares of a fund provides a tax benefit by reducing a taxable asset.
Retirees before age 70.5
For those in retirement who are below the current age for required minimum distributions (RMDs), consider relying on dividends and capital gains before taking taxable withdrawals from traditional retirement accounts.
Many people continue to reinvest dividends and capital gains in retirement. That’s fine if the goal is to build greater wealth. If the investor is tax-conscious, consider that these distributions are taxable whether or not they are taken as cash. If they are reinvested, they become part of the fund that is generating taxable distributions. Selling shares from that fund generates even more capital gains. Receiving the cash gives the investor the benefit of the taxable distribution. Since qualified dividends and long-term capital gains are taxed at 15% for most middle-class investors, the investor may get 85% of the benefit of the funds.
Emergency Funds in Retirement
Emergency funds aren’t just needed before retirement. During the working years, emergency funds help to primarily deal with periods between employments. In retirement, they allow us to delay taking funds from investment portfolios during market downturns. During times of reduced valuations, we would have to sell more shares of our securities to meet the same budget as before the downturn. The emergency fund gives us flexibility to manage when and how we take funds from the portfolio. Receiving dividends and capital gains from taxable brokerage accounts can help us quickly build or replace emergency funds when markets recover.
Retirees After age 70.5
Once an investor reaches age 70.5, they can make qualified charitable distributions (QCDs) from their IRAs. Sending funds to charity directly from the IRA bypasses the investor so the investor doesn’t incur taxable income. Consider this common scenario: a taxable IRA distribution is taken as income to the investor. The investor gives money to charity. Most retirees aren’t able to exceed the standard deduction in order to claim a charitable deduction on their taxes so there is no tax benefit for giving to charity. If the investor had used QCDs instead, he would not directly receive the IRA distribution at all and that is equivalent to a tax deduction.
Qualified (IRA) Annuity Income
Annuities are an insurance contract to provide income for a specified period of time or for the remainder of life. These are sometimes used with IRA assets to ensure the investor doesn’t outlive their income. What can be done if dividends and capital gains are meeting most of the investor’s needs but the annuity income continues for life? Find out whether the annuity income may be distributed to an IRA as a non-taxable transfer between the accounts. The annuity would become a lifetime funding source for the IRA. The investor can then manage annual income by deciding how much to take from the IRA or send to charity through QCDs.
As always, financial and tax planning doesn’t happen through emails and newsletters. Discuss specific situations with appropriate financial professionals.
