Good tax and financial strategies are sometimes counterintuitive, and it takes strategic thinking combined with years of experience to find the best solutions.
I want to share a real client story with you. (The names have been changed to protect the client’s privacy.) Bill had a large 401(k) with his company. As a loyal employee he had invested a sizable amount – $200,000 – into his company stock and an additional a few hundred thousand in other investments. Fortunately for Bill, the company stock was worth $800,000 and the other investments were worth $500,000 the day he retired.
Through a little known and under-utilized tax law maneuver, we moved the other investments into a new IRA and moved the company stock into a brokerage account in his personal name. The tax law allows Bill to pay taxes only on the $200,000 cost of his stock using this technique called net unrealized appreciation (NUA).
Bill had to pay $50,000 in taxes right away. Oh no! Why would he do that? Here’s how Bill prospered through this decision:
First of all, Bill is in a high tax bracket for federal and state taxes. If and when he starts selling the company stock, he would have to pay capital gains taxes on the difference between its value and the cost of $200,000. But he receives a favorable 15% capital gains rate for federal taxes and around 7% for his state, which is a lower tax rate than his current tax bracket of 35%. However, there is nothing forcing him to sell his stock, so he can pick and choose when this will occur. If he finds himself in a low tax bracket one year, the special capital gains rate could even be zero. If he never sells the stock and gives it to his wife or kids when he dies, they would escape capital gains taxes all together.
Secondly, (and this is where the real benefit starts), Bill just turned 70 ½ and is now required to take distributions from his IRA. The company stock is now worth nearly $2 million. Bill does have a required minimum distribution (RMD) on the funds in the IRA which are now worth $500,000. He has an RMD this next year of $18,181 – to be taxed fully at 35%. If the company stock had been rolled to his IRA instead of using the NUA strategy we proposed for him, then his RMD would be another $69,000 larger and the tax would be an additional $24,000. Every year RMDs grow larger and larger, and he would be paying $24,000 and more for the rest of his life. If Bill would die before he had paid taxes on all the funds, his wife or kids would inherit the privilege of paying the rest of his tax bill. By choosing to prepay two years of tax, Bill will now break even in two short years, and then he has the rest of his life to avoid paying income taxes.
Sometimes it’s just plain smart to pay your taxes early. But I must warn you not to try this technique alone; there are lots of ways you could get this wrong.
Personally, I find a lot of joy in helping my clients to both invest their nest egg wisely as well as to minimize their taxes.
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]
