2020 was a massive year of change, especially for retirees, but with change comes opportunity. Retirees should review their situation carefully – the old rules have changed, understanding the new ones and how you can take advantage will be important.
Many retirees in the US live primarily off a combination of Social Security, pension, and Required Minimum Distributions (RMDs) from qualified retirement accounts. Amidst all the changes we are living through [financially speaking] the CARES Act has been the most dynamic piece of legislature affecting individuals so far this year. While the CARES Act touches multiple areas, one huge change for retirees is the ability to forgo RMDs from qualified accounts in 2020. While there are some retirees who need to withdraw their RMDs to fund their general living expenses, many who take their RMD every year don’t spend it. They withdraw it because they are mandated by the IRS, but their general living expenses are primarily covered by a combination of Social Security and pension. For these people, their annual RMD just results in higher taxes!
We’ve noticed that people who aren’t big spenders are usually big savers. These big savers generally have significant investment positions in their taxable brokerage accounts due to positions being invested over such a long (and positive) period of time. To paint a better picture – these are the investors who bought or inherited a couple thousand dollars’ worth of Microsoft (or Apple, or insert almost any big stock) in the 90’s and now the holding has grown so large they aren’t entirely sure what to do with it. Since the stock was purchased in a taxable account, selling it causes a large capital gains tax, and even a possible Net Investment Income Tax. Taxes are clearly problematic.
Investment-wise, from an asset allocation perspective, these large, outlier holdings can cause a skew in your overall portfolio and investment strategy with too much dependence on one (or a select handful) of specific companies. You may hear these types of holdings referred to as “legacy” positions. A strategy to add diversification to your portfolio would be to sell some (or all) of these legacy holdings and spread out the proceeds among many different investments but, again, we return to the problem of tax constraints.
Since retirees are able to forgo their 2020 RMD, and if they choose to do so, they might reap the benefit of significantly lower taxes for the year. This could be an opportunity to sell some of these legacy positions and add diversification to your portfolio. For 2020, there is a 0% tax on long-term capital gains for total taxable income below $40,000 for a single filer and $80,000 for married filing joint. Let’s look at an example of someone this strategy could benefit:
Erin and Ron are both 74, file their taxes jointly, and claim the standard deduction. As of prior year-end, Erin has $800,000 in her IRA and Ron has $500,000. Based off these values, Erin and Ron’s total RMDs for 2020 would be over $54,000. Erin and Ron have a joint taxable account where one of their holdings is Intel stock with a value of $100,000, $70,000 of which qualify as long-term gains. Erin collects an annual pension of $10,000 and Social Security benefits of $30,000. Ron does not collect a pension but does collect Social Security of $15,000. They have $150,000 in the bank.
In prior years, Erin and Ron have been well above the $80,000 threshold for total taxable income due to the required distributions from their qualified accounts. Because they are above this threshold, in years past, they would be required to pay capital gains tax of either 15% or 20% on any realized gains inside of their taxable account. Specific to 2020, if Erin and Ron forgo their 2020 RMD, their taxable income would be greatly reduced and put them in a position to realize up to $59,000 in long-term capital gains. This would allow them to significantly reduce their exposure to the legacy holding, and consequently, to funnel the proceeds into more diverse holdings thus strengthening their global investment strategy.
While this scenario seems rather straight forward, the analysis is more complicated. It will be important to understand where your taxable income will fall in the current year – this will define how much space you’ll have to realize capital gains. Capital gains realized could also increase how much of your Social Security benefits are taxable. Depending on your level of income, up to 85% of your Social Security benefits could be reported as taxable income. If you already withdrew your RMD for 2020, there is a chance you can move it back into your IRA and still utilize this strategy. The IRS has extended the traditional “60-day rollover” period for any RMDs already taken this year until August 31st, 2020. Because of the many variables and everyone’s unique circumstances, it will be important to talk with a tax professional to determine what is the ‘Goldilocks,’ amount of capital gains to realize in your personal scenario – not too much, not too little, but just right.
This strategy can be very useful but there are other things to do with highly appreciated securities and, depending on your unique circumstances, they may be better utilized by being left alone and incorporated into your estate or charitable plan. A financial planner who is thoroughly familiar with your situation can help you determine if it is best to donate, sell or keep the highly appreciated securities and how you can take advantage of the current environment.