Counting large tax bills in SWR

[outofratrace]

OK so I'm 45 and ERd. I have large stock positions with large capital gains. My cap gains rate is 23.8%. Usually I count all spending including taxes in my SWR. But if I sell a large amount of stock to rebalance, my taxes could be a large amount. How should I account for taxes if I have a extraordinary year where I rebalance a lot? I could generate a huge tax bill upon rebalancing in the range of 4% of portfolio or even much higher.

 

[papadad111]

Counting large taxe bills in SWR

I am a contrarian on here in that I only count property tax as expense.

Any form of cap gains or dividend driven income tax is counted as a reduction in portfolio balance, not as an expense.

I estimate the tax liability of my total portfolio based on both asset class and account type. dividends, for cap gains its short term. Long term. For Tax deferred it's an estimated future fed and state - Basically those tax estimates reduce portfolio balance and what's left is what I compare to expenses and base my SWR on ...

In this way, I know my 401k is actually worth about 70 percent of its total book value (due to future tax liability). Same for cash accounts. I know how much tax will need to be paid on the "gain" portion of the portfolio.

 

[Done]

Wow, that's a high tax bracket for someone ER'd. Are you referring to long-term cap gains rate, meaning income is north of $413K? That's a time to consult a professional tax advisor before selling anything. The 2015 tax brackets are at at http://perspective.schwab.com/mobile/article/7574/Taxes-Whats-New

I would only give the usual suggestions:
- rebalance in tax-deferred accounts whenever possible;
- wait for a down market or low-income year to change taxable holdings, minimizing taxable gains or possibly even harvesting losses;
- avoid selling short-term holdings (in taxable accounts) when rebalancing;
- sell incrementally in taxable accounts so as not to push yourself into an even higher bracket for the year (but this may not apply if you're already in the max bracket);
- minimize income, no Roth conversions, maximize deductions such as IRA and HSA contributions;
- hold bonds and REITs in tax-deferred accounts per the bogleheads recommendations.
http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement

In my own taxable account, I have an equities fund I'd like to change because of its high expense ratio but it just hasn't been worth the capital gains hit. I'll sell some incrementally each year or wait for a market crash to change to another equities fund. In your case, if you are rebalancing stocks to bonds, and tax-deferred accounts are already all bonds, you'll have to bite the bullet.




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[audreyh1]

I sold a bunch of company stock close to and after retiring, and only counted the after tax proceeds for calculating SWR. Since, I have been able to limit my tax liability from income and rebalancing to under 1% of total portfolio, and sometimes under 0.5%.

I think you should count your initial low basis stock post-tax to calculate SWR. As you sell chunks, the reinvested proceeds will have a much higher basis and taxes can be handled as part of the annual expenses.

 

[pb4uski]

If it is possible that you will be in the 15% capital gains tax bracket in the future? If so, then I would wait if that is possible.

Quite candidly, I would be more concerned about the risk of the lack of diversification than capital gains taxes. Think Enron and WorldCom.

You could incorporate it in your planning by reducing your portfolio by 23.8% in your calculations as if you bit the bullet all at once, not that I would recommend selling all at once.

 

[RunningBum]

I would only give the usual suggestions:
...
- wait for a down market or low-income year to change taxable holdings, minimizing taxable gains or possibly even harvesting losses;
...

Really? Sell low to avoid taxes? No, don't let taxes dictate a plan. Better to make gains and pay taxes than to make nothing and pay no taxes. Rebalance when an asset class is high. If you wait for it to drop, it no longer needs rebalancing and you've missed a chance to sell high and possibly buy back low.

As far as accounting for the tax expense, I'm with papadad, and I know we're in the minority. I find it easier and more consistent to deal with my accounts and holdings in post-tax value.

 

[mpeirce]

I am a contrarian on here in that I only count property tax as expense.

Another contrarian here too.

In my spreadsheets I always track the after tax value of my investments. Whenever I sell I always set aside the taxes due apart from the funds used for living expenses. E.g. sell $10K of stock, set aside $1900 for taxes (say 15% feds + 4% state), and send the remainder into the spending pipeline. The $1900 gets fed into quarterly estimated taxes as they come up.

Each fall I meet with the CPA for tax planning and look around at where things stand. I decide how much to sell resulting in capital gains balanced with how ROTH conversion makes sense.

 

[mpeirce]

> harvesting losses

I've never ever do this. I hold stocks and mutual funds for long periods of time and so it's more a matter of managing capital gains for low tax rates.

 

[jebmke]

Really? Sell low to avoid taxes? No, don't let taxes dictate a plan.

Down markets are the best times to sell. I harvested losses like crazy in 2008-09. The money went right back to other equity investments so my net equity position didn't change (except the extra that I bought to rebalance).

 

[Done]

Really? Sell low to avoid taxes?

I agree this only makes sense if you don't need to sell now. For example if you are exchanging equities to similar equities, you may be able to wait for the right market conditions. If you have to rebalance assets to stay on plan, you shouldn't wait. Near the end of the year, you still may be able to stage the trades over two tax years if it keeps you in a lower bracket.

 

[RunningBum]

Down markets are the best times to sell. I harvested losses like crazy in 2008-09. The money went right back to other equity investments so my net equity position didn't change (except the extra that I bought to rebalance).

If you want to exchange within an asset class, that's fine. The OP was talking about rebalancing, which I take to mean going from one asset class to another. Waiting for equities to drop before selling them to buy bonds is just absurd.

 

[jebmke]

True. OP may have been too young to have losses carrying over from 2008-09 to use as an offset. Probably should go ahead and rebalance if long on equity.

To the original question. The tax is what it is -- part of the spending.

 

[marko]

Really? Sell low to avoid taxes? No, don't let taxes dictate a plan. Better to make gains and pay taxes than to make nothing and pay no taxes.

+1

I've found that playing the tax game usually means a lot of wrangling around for relatively minor gain, percentage-wise. You do the best you can but sometimes it's just not worth the extra hoop-jumping to gain a .05% tax advantage.

I view taxes on gains as a distasteful, but good problem to have.
There's even a financial advisor group (forget which) who's pitch is: "let us get you into a higher tax bracket".

 

[NW-Bound]

If this is a move to diversify from a concentrated holding, then it is an infrequent move. I would simply accept that tax burden, and reset my net worth to reflect the lower after-tax value, that "friction" of 4% of total portfolio that the OP mentioned.

Now, if that is a recurrent annual tax bill, heck, I would not mind having that kind of capital gain year after year. Would you?

Lemme see. A married couple would pay 23.8% cap gain tax if income is over $464,850, but that is only for the amount over that threshold. So, I could be just above it, and pay only 18.8% for most of the gain. That means I keep 81.2% of that $464,850, or $377,458 every year. I can live well on that annual income.

 

[outofratrace]

Thanks for the replies. I retired several years ago and used a starting SWR of about 3% (or less) of my starting portfolio value adjusted yearly for CPI. Up till now I have always included taxes in my annual spending. So when encountering a once every 5-10 year unusual large tax bill I was afraid I am not sticking to my plan. Maybe just a emotional thing. Taxes do seem to be hard to predict year by year when almost all my investments are in taxable accounts. I have very little space in a small IRA (less than 10% of net worth)

 

[RunningBum]

Just remember if you aren't going to include those taxes as part of your yearly expenses, you ought to reduce your net worth by the future tax liability when calculating your SWR, or how much to pull out yearly based on a SWR. You do have to account for the taxes one way or another.

 

[audreyh1]

Thanks for the replies. I retired several years ago and used a starting SWR of about 3% (or less) of my starting portfolio value adjusted yearly for CPI. Up till now I have always included taxes in my annual spending. So when encountering a once every 5-10 year unusual large tax bill I was afraid I am not sticking to my plan. Maybe just a emotional thing. Taxes do seem to be hard to predict year by year when almost all my investments are in taxable accounts. I have very little space in a small IRA (less than 10% of net worth)

Why is your tax bill large every 5 to 10 years a long while after retiring? If it is because you are selling a chunk of some low basis asset from long ago, I think you should use the after tax value to calc your SWR.

Anything else, you just have to take the tax hit as part of the funds withdrawn.

We pay for each years taxes out of our annual withdrawal. Yes, it varies a lot as we are mostly after tax accounts. We are careful with rebalancing so as not to incur excess taxes if possible.

 

[audreyh1]

Just remember if you aren't going to include those taxes as part of your yearly expenses, you ought to reduce your net worth by the future tax liability when calculating your SWR, or how much to pull out yearly based on a SWR. You do have to account for the taxes one way or another.

Exactly!

 

[jebmke]

Just remember if you aren't going to include those taxes as part of your yearly expenses, you ought to reduce your net worth by the future tax liability when calculating your SWR, or how much to pull out yearly based on a SWR. You do have to account for the taxes one way or another.

I agree with your statement but I consider this method inferior. It tends to treat the future taxes (at least mentally) as a foregone conclusion rather than an expense to be managed.

 

[Ed_The_Gypsy]

Safe Withdrawal Rate applies to the survival of the portfolio, not how you spend it (i.e., pay taxes, eat, etc).

IIRC, the beginning asset allocation is more important than rebalancing.

In taxable accounts, I can imagine a good case for not rebalancing. Better to just take the dividends as they come and sell a little stock when it grows out of balance.

Taxable accounts have always been a headache for me. Taxable events sold me on buy-and-hold.

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[RunningBum]

I agree with your statement but I consider this method inferior. It tends to treat the future taxes (at least mentally) as a foregone conclusion rather than an expense to be managed.

I know there is disagreement on this and CPAs might cringe at this method, but for some of us it makes perfect sense. I used to have a large potential net worth in unexercised stock options, and it was better to think of it in terms of how much it would be in post-tax dollars. From there it started making sense to think of everything in post-tax dollars.

If I convert 100K from a tIRA to a Roth and paid 20K out of pocket in fed/state taxes now rather than probably the same 20% later if I'd have taken tIRA distributions later, I really didn't change my financial state even though I now have 20K less in my account totals to show for it. I find this method is good for treating tIRA, Roth IRA, and taxable accounts with cap gains (or losses) on the same ground.

Also, while I'm mindful of managing taxes, I don't want to make choices just to limit my tax expense to some budget. I can't keep all my cap gains under the 15% bracket. If I have reason to sell something and take a large cap gain at 15% one year, I'm going to do it. Rather than have an uneven budget skewed by the occasional sale, I just keep the cap gains and conversion taxes out of my expense budget and instead treat them as a future liability on my balance sheet. I calculate my withdrawal rate on my assets minus the future tax liabilities.

I honestly don't see how this method is inferior. I may be able to manage some of my capital gains to be taxed at 5% (state only) rather than 20%, but I view the 20% reduction as being conservative. I can't be 100% accurate on that tax liability, but neither could I be 100% accurate in budgeting the future tax as an expense either, if I treated it that way. Just because I mentally and on paper took 20% off those gains doesn't mean I won't try to do better with managing it. I mean, if I'm house shopping I may plan on 300K for a house, but if I find one that suits me well for 250K I'm not going to pass on it because it's under budget, or insist on paying 300K because that was my foregone conclusion of what I'd spend.

 

[mpeirce]

I know there is disagreement on this and CPAs might cringe at this method, but for some of us it makes perfect sense. I used to have a large potential net worth in unexercised stock options, and it was better to think of it in terms of how much it would be in post-tax dollars. From there it started making sense to think of everything in post-tax dollars.

This is exactly how I came to my thinking as well.

If one does have large unexercised stock options, it's very important to think in terms of after taxes on these. Non qualified stock options (the kind I had) are taxed at regular tax rates. If you hope to FIRE, you need to exercise these before leaving the company. Roughly half of the value of those options goes to taxes (depending on your state and how big they are) so if you think about the entire amount as your "worth" your in for a big surprise.

And once going through that exercise, you realize that: that $100K in one account isn't really worth the same as the $100K in that other account because, say, one has no accumulated CGs and the there does. Likewise, I like to keep in mind that IRA money is only accessible after a (possible large) tax bite, vs that money sitting in a CD which isn't.

Neither view is absolutely "best", but one viewpoint might make sense based on your situation.

 

[jebmke]

I know there is disagreement on this and CPAs might cringe at this method, but for some of us it makes perfect sense. I used to have a large potential net worth in unexercised stock options, and it was better to think of it in terms of how much it would be in post-tax dollars. From there it started making sense to think of everything in post-tax dollars.

If I convert 100K from a tIRA to a Roth and paid 20K out of pocket in fed/state taxes now rather than probably the same 20% later if I'd have taken tIRA distributions later, I really didn't change my financial state even though I now have 20K less in my account totals to show for it. I find this method is good for treating tIRA, Roth IRA, and taxable accounts with cap gains (or losses) on the same ground.

Also, while I'm mindful of managing taxes, I don't want to make choices just to limit my tax expense to some budget. I can't keep all my cap gains under the 15% bracket. If I have reason to sell something and take a large cap gain at 15% one year, I'm going to do it. Rather than have an uneven budget skewed by the occasional sale, I just keep the cap gains and conversion taxes out of my expense budget and instead treat them as a future liability on my balance sheet. I calculate my withdrawal rate on my assets minus the future tax liabilities.

I honestly don't see how this method is inferior. I may be able to manage some of my capital gains to be taxed at 5% (state only) rather than 20%, but I view the 20% reduction as being conservative. I can't be 100% accurate on that tax liability, but neither could I be 100% accurate in budgeting the future tax as an expense either, if I treated it that way. Just because I mentally and on paper took 20% off those gains doesn't mean I won't try to do better with managing it. I mean, if I'm house shopping I may plan on 300K for a house, but if I find one that suits me well for 250K I'm not going to pass on it because it's under budget, or insist on paying 300K because that was my foregone conclusion of what I'd spend.

I don't think it is inherently inferior except to the extent that it lulls some (maybe not you) to just view the taxes as not within their control.

I had a different approach on my NQ options -- I ignored them entirely until it became time to start converting them to cash. My situation was a bit tricky because I was an insider and had limited ability to just dump them. But, when it came time to liquidate large blocks, I also transferred from our taxable account, appreciated shares equal to about 15 years of our normal charitable donations to a DAF. I was able to shift the deduction from a 15-25% rate to a 35%+ rate and drive the after-tax yield from the NQ exercise up.

I do agree that you can't always (and shouldn't always) manage finances just for tax purposes. But I can tell you from having prepared over 1000 tax returns over the past few years that many people have this perception that taxes are inevitable and not controllable. When I explained tax loss harvesting to a couple of seasoned tax preparers in 2009 they looked at me as if I had invented the wheel.

 

[audreyh1]

I built my retirement portfolio as I divested company stock, and always calculated my potential SWR on the after tax amount I had set aside in that portfolio. This solved the initial capital gains taxes on a lump sum problem.

Once you divest company stock and build an investment portfolio for annual withdrawal, it should be no problem to keep the income taxes of the portfolio well below 1% of the portfolio, and thus below the SWR.

 

[RunningBum]

Safe Withdrawal Rate applies to the survival of the portfolio, not how you spend it (i.e., pay taxes, eat, etc).

IIRC, the beginning asset allocation is more important than rebalancing.

In taxable accounts, I can imagine a good case for not rebalancing. Better to just take the dividends as they come and sell a little stock when it grows out of balance.

That's all rebalancing is. If stocks have a big run you might have to sell more than just a little stock, but probably not too much if you don't defer rebalancing. Actually most of my rebalancing is done by taking my living expenses out of the asset class that is overweight.

Taxable accounts have always been a headache for me. Taxable events sold me on buy-and-hold.

Maybe this is an advantage to my method. I treat taxes as a given, not a headache. I also buy and hold, but now that I'm FIRE'd I'm having to take some out to live on and I don't have any qualms about taking the tax hit since I've already accounted for it, both on paper and mentally. I will try to limit the taxes by selecting which shares to sell but I won't throw my AA further out of balance by choosing to sell a depressed asset class just to limit the current tax hit.