Year End Withdrawal Strategies

One of the questions I receive quite often is, ‘when we need money from our investments, how do you determine where we should draw it from’?

It’s a very important question and answer that I’d like to share with you because it ties into a year-end tax strategy that I recommend you pay close attention to.

All other variables held constant for a moment, I’m always looking to ‘free up’ funds in the most tax efficient way, i.e. have you pay the least amount of taxes you’re legally obligated to pay in the process.

And, when all is said and done, I recommend maintaining the same prescribed investment allocation post withdrawal.  This is a very important point.

Funds Held Inside IRAs

If you only have funds held “inside” of IRAs, the only variable is ‘when’ you’ll withdraw the money.  For example, one of our Relaxing Retirement members, who has all funds in IRAs, just asked me to free up $60,000 to handle a family issue.

He hadn’t given it much thought, but I asked if he needed to have ALL $60,000 today, or could get $30,000 right now and wait until January 2nd for the second $30,000?

I asked because I know where all of their taxable income comes from each year and withdrawing $60,000 from their IRA in one year (or more to cover taxes) would cause a chunk of that withdrawal to be taxed at a higher marginal tax bracket.

If they were able to withdraw half here at the end of 2013 and the other half in January 2014 instead of all of it in 2013, that would save them a minimum of $3,000 in federal income taxes in the process.

I call this strategy “Income Tax Straddling”.

As it turned out, it made no difference, so they were able to save that $3,000 which will now go toward their upcoming vacation!

Home Equity Line of Credit

Had this couple needed all of the money in 2013, I may have recommended that they withdraw half from their IRAs in 2013 and half from a home equity line of credit.

Then, in early 2014, they could withdraw the 2nd half from IRAs to pay off the line of credit.  This would have the same effect as my first recommendation.

Had the funds only been needed on a short term basis, I may very well have recommended utilizing a home equity line of credit, especially during times like these when interest rates are so low.

Funds Held Outside of IRAs

If you also have funds held outside of IRAs, you have more options available to you because you may be able to pay lower capital gains tax rates, or nothing at all, if you have some current or prior losses to put to use.

As a quick refresher, for investments you currently own outside of IRAs (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $150,000, you would owe capital gains taxes on the growth, i.e. $50,000.

On the flip side, however, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $75,000, you can declare a capital loss of $25,000.

That $25,000 capital loss, while painful to realize, has significant value if handled properly.  For example:

1. You may use it to offset $25,000 of capital gains you realized in the same year, thus eliminating taxes on $25,000 of capital gains.  This saves you between $3,750 and $5,950 in federal taxes in 2013, not to mention state taxes here in MA.

2. If you don’t have $25,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year.  That would save you between $750 and $1,284 in federal taxes this year.

3. You can then carry the unused portion ($22,000) over to next year and continue the same strategy.

  • If you have a $22,000 gain next year, you can offset the entire tax due.  If not, you can offset another $3,000 of ordinary income tax and carry the remaining $19,000 over to the following year.

Tax Efficient Withdrawal Strategy

So that you can determine the most tax efficient withdrawal strategy, here’s the information you want to have in front of you:

1Your 2012 Federal income tax return.  Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into 2013.  And, if so, how much?

2Current Non-IRA Statements:

  • Realized Gains/Losses: Have you sold anything this year thus creating a realized gain in your non-IRA accounts?
  • Unrealized Gains/Losses: What’s the current positioning of each of your current holdings?
  • It’s unlikely that you have many holdings that are worth less than you paid for them, but it’s very possible that you have some, i.e. municipal bonds purchased in the last two years where you haven’t been reinvesting dividends. **Look for any unrealized losses.

3.  Mutual Funds: If you own stock mutual funds, go to your fund company website and you will typically find year-end “internal” capital gains distribution estimates.  Do your best to determine what your short and long term gains will look like.

Armed with this information, look for the combination of holdings you can now sell in your non-IRA accounts that will create the least income tax obligation.

For example, a recent Relaxing Retirement member with balances in IRA and non-IRA accounts needed $85,000.

All of their equity holdings had very large gains attached to them if we sold them except for a municipal bond ETF that was worth slightly less than what they paid for it.  While that’s not necessarily good news, it was for them because we were able to sell it and purchase another quality municipal bond ETF thus creating a ‘capital loss’ to offset some of the gains from selling two equity holdings with large gains.

Because we had copies of their tax return, we knew they some capital losses carried forward from the sale of a rental property several years back, so we were able to use those to offset the rest of the gains realized from sale of those two holdings.

The net effect was we were able to free up $85,000 for their spending needs with no income taxes incurred.  And, we were able to reallocate holdings inside their IRAs in order to bring their investment matrix back to our prescribed mix. (very important as I mentioned earlier)

This is something that’s possible for you, but only if you follow the formula and you have all the necessary information in front of you.

Paying more taxes than you’re legally obligated to pay is not an act of patriotism.  It’s laziness!

Take control in places where you still can!