Tax optimization - Reduce Earned Income and use Capital Gains

[jdman2]

Hello all, long time listener, first (actually second) time caller.

Looking to early retire here in a few years at 55. Got most of my expenses paid off now, and been doing a lot of planning on withdrawal strategies when the time comes. Got me thinking about my current situation, and think I can save some taxes over the next few years while I am still working.

Married filing jointly, both 51+ years of age.
Gross Salary $150,000 combined
Currently 3% to 401k to get the match.
Puts us in the 22% tax bracket, paying roughly $15k in FIT.

Have $130,000 in company employee stock, that has about 50% growth of capital gains.

Thought is to reduce the earned income by maxing out the 401k's, down to the 12% bracket, and replace that "lost" take home pay by selling stocks at 15% capital gains.

Option 1, contribute to 401k to get to the 12% tax bracket, then sell some stock at 15% capital gains to replace the income that put into 401k.
Gross income 150,000 , 401k Contributions of 17k, taxable income of 100,800 - deduction = FIT of 11,600. Sell 10,000 stock, =$750 CG tax. Saves about 3k in taxes.

Option 2, max out the 401k. Puts us well into the 12% bracket, even allowing some stock sale at 0%. and then some at 15% to replace the income placed into 401k.
Gross income - 150,000, 401k contributions of 65,000, taxable income of 85,000 - deduction = FIT of 5,840. Sell 60,000 stock = 0% CG tax Saves about 8k in taxes.

Am I missing something here? ai says it's a smart strategy. Just looking for some real life critic.
(the numbers aren't exact, but rough idea)

Thanks,
John

 

[SecondCor521]

I thought the maximum employee 401(k) contribution was lower than what you indicate in option 2, so I think you're limited there.

It does look like you'd save on income taxes for maybe two or three years with this technique. You're trading off ownership of that stock, though, which you may see as a bug or a feature. What is the likelihood of the stock going to $150K in two or three years?

If I wanted to divest from the company stock, I'd probably execute the strategy but only enough to get out of the 22% bracket.

This also assumes that you won't be in the 22% bracket or higher later (like in your 70s with SS and RMDs and investment income).

 

[Al18]

I would put your scenarios into the 1040 tax calculator at dinkytown

You plan may work, but note LTCG stacks on top of other income. If you have $3K of qualified dividends plus $5K of interest from CD, then that’s $8K of LTCG that you will pay 15% federal taxes

 

[jdman2]

I thought the maximum employee 401(k) contribution was lower than what you indicate in option 2, so I think you're limited there.

It does look like you'd save on income taxes for maybe two or three years with this technique. You're trading off ownership of that stock, though, which you may see as a bug or a feature. What is the likelihood of the stock going to $150K in two or three years?

If I wanted to divest from the company stock, I'd probably execute the strategy but only enough to get out of the 22% bracket.

This also assumes that you won't be in the 22% bracket or higher later (like in your 70s with SS and RMDs and investment income).

I believe at age 50+, you get the standard contribution limit of 24,500 + 8,000 catch up, x2 for the working spouse = $65,000. I believe I've got my retirement tax planning pretty good to stay in the 12% bracket (at least under the existing tax laws)

I am more a believer of index funds vs individual stocks, but just acquired these as part of my salary. It's a solid company, but I don't really see it going through the roof. It normally just follows the indexes.

 

[SecondCor521]

I believe at age 50+, you get the standard contribution limit of 24,500 + 8,000 catch up, x2 for the working spouse = $65,000. I believe I've got my retirement tax planning pretty good to stay in the 12% bracket (at least under the existing tax laws)

I am more a believer of index funds vs individual stocks, but just acquired these as part of my salary. It's a solid company, but I don't really see it going through the roof. It normally just follows the indexes.

Based on that, then I think I'd do the strategy to the extent of getting out of the 22% bracket and sell enough to meet your cash flow needs until you run out of stock or choose to retire or have some other sort of tax situation change.

The 15% bracket is pretty wide, so unless you really want to get away from your company stock, I wouldn't sell more than that.

With option 2, you're escaping OI taxation at 12% for a combination of 0%/15%. It seems like there might be spots where you don't max out the 401(k) but still end up with the same tax bill. Personally if I had to do it over again I wouldn't mind having more in taxable and less in my traditional IRA, especially retiring early.

I think anywhere between "avoid 22%" and "max 401(k)" is probably not a bad place to be.

 

[engineernerd]

First off, it can be a good idea to sell company stock just to become more diversified, but then again $130k may not be that big a share of your portfolio.

To some extent, whether you end up ahead will depend on your crystal ball. What you'd be doing is essentially two things, deferring taxes from this year to whenever you withdraw the funds from the 401(k), and giving up the 0%/15% tax rates on future returns (CGs and QDs) from the company stock.

If you have a lot of other CGs and QDs in taxable accounts, you'll still be able to play the 0% game in retirement. OTOH, if this company stock is your only taxable holding with big capital gains, maybe you'd get more bang for the buck after retirement by limiting your ordinary income to no more than your deductions, and filling as much of that 0% bracket as your other priorities (ACA subsidies?) allow.

 

[junkanoo]

what are your tax-deferred, Roth and taxable brokerage balances roughly?

I ask because it would helpful to get a sense of your 55+ plan.

I guess my other question is ... why wouldn't you hold off until 55+ to pull from your taxable account? Without your wages, much more of your LTCGs will be at 0 then.

 

[Winemaker]

How is your company stock held? My company stock was in a equity type plan that allowed for capital gains. My brother's company stock is partially his contributions and mostly company contributions, in a deferred compensation type account. His distributions will be taxed a ordinary income tax rates.

 

[jdman2]

Thanks for the replies so far. As was suggested above, I'm really looking to avoid the 22% tax now, because in retirement, I will have flexibility to pull money wherever needed to get into the appropriate bracket. I plan to live at the 12% bracket limit, at least initially in retirement.

As for my current position,
Tax deferred 401k - 2M
Roth - 500k
Company Stock - 130k
Taxable brokerage - 120k
Cash - 100k

At 55, will utilize the Rule of 55 to live off my 401k. Looking for annual income of 120k. Plan to use the 401k, up to 12% tax limit, being conscious to reduce 401k balance to limit RMDs later in life. Whether that be annual withdrawals, Roth Conversions, etc. That's still kind of up in the air as Wife isn't sure how long she will continue to work after I retire.

My stock was acquired as part of my compensation. It's already been taxed as ordinary income.

Yes, the plan was originally to hold onto taxable accounts into retirement, as needed. Actually planned to use them to bridge the gap between 55 and 59.5. But then I found that my company allows Rule of 55 distributions, so I no longer need the taxable to bridge the gap, but will use them just to optimize tax bill.

Here's what got me thinking about this and heading down this rabbit hole. I hate sitting in the 22% bracket, when I could drop to the 12% by contributing more to 401k. So sure, let's drop to the 12% bracket, and use stock w/LTCG to cover the gap. But hey, I hate paying 15% too, so why not increase 401k contribution even more.

Sorry for the rambling. Just trying to get it all out there.

 

[Out-to-Lunch]

FWIW, I doubt that if you limit yourself to the top of the 12% bracket in retirement, that you will make much of a dent in the $2M in tax deferred. I would guess that your RMDs (20 years later) will put you into 22%+ territory. So you might consider going into the 22% bracket with, say, Roth conversions, in early retirement.

 

[Aerides]

Since you'll be retiring at 55, you have two major considerations that might impact where your savings go, and where your income will draw from:

1 - cash/taxable accounts to withdraw to cover before 59.5. If you are looking at the rule of 55, confirm that your plan allows it. Some don't. Be sure you don't reach the finish line at 53, ready to retire, but now you're trapped as everything is non-taxable.

2 - healthcare. ACA premiums require lower income, so a plan that creates capital gains before medicare is one you have to manage...carefully.

 

[OldShooter]

IMO you are at serious risk of having the tail wag the dog.

All you should care about is how much money is yours at the end of the game. It doesn't matter a whit how much you paid in taxes along the way.

 

[junkanoo]

Thanks for the replies so far. As was suggested above, I'm really looking to avoid the 22% tax now, because in retirement, I will have flexibility to pull money wherever needed to get into the appropriate bracket. I plan to live at the 12% bracket limit, at least initially in retirement.

As for my current position,
Tax deferred 401k - 2M
Roth - 500k
Company Stock - 130k
Taxable brokerage - 120k
Cash - 100k

At 55, will utilize the Rule of 55 to live off my 401k. Looking for annual income of 120k. Plan to use the 401k, up to 12% tax limit, being conscious to reduce 401k balance to limit RMDs later in life. Whether that be annual withdrawals, Roth Conversions, etc. That's still kind of up in the air as Wife isn't sure how long she will continue to work after I retire.

My stock was acquired as part of my compensation. It's already been taxed as ordinary income.

Yes, the plan was originally to hold onto taxable accounts into retirement, as needed. Actually planned to use them to bridge the gap between 55 and 59.5. But then I found that my company allows Rule of 55 distributions, so I no longer need the taxable to bridge the gap, but will use them just to optimize tax bill.

Here's what got me thinking about this and heading down this rabbit hole. I hate sitting in the 22% bracket, when I could drop to the 12% by contributing more to 401k. So sure, let's drop to the 12% bracket, and use stock w/LTCG to cover the gap. But hey, I hate paying 15% too, so why not increase 401k contribution even more.

Sorry for the rambling. Just trying to get it all out there.

Not ramblings at all. Those are all pertinent issues and concerns.

Do you have any significant pensions? When do you and your wife expect to take SS?

 

[junkanoo]

IMO you are at serious risk of having the tail wag the dog.

All you should care about is how much money is yours at the end of the game. It doesn't matter a whit how much you paid in taxes along the way.

Well, sure it does. Because what you pay along the way factors into whatever target date accumulations (that are meaningful to you).

 

[OldShooter]

Well, sure it does. Because what you pay along the way factors into whatever target date accumulations (that are meaningful to you).

For example, keeping your money under the mattress is a 100% sure way to avoid paying taxes. But it does not maximize your money at the end of the game.

 

[engineernerd]

Thanks for the replies so far. As was suggested above, I'm really looking to avoid the 22% tax now, because in retirement, I will have flexibility to pull money wherever needed to get into the appropriate bracket. I plan to live at the 12% bracket limit, at least initially in retirement.

As for my current position,
Tax deferred 401k - 2M
Roth - 500k
Company Stock - 130k
Taxable brokerage - 120k
Cash - 100k

At 55, will utilize the Rule of 55 to live off my 401k. Looking for annual income of 120k. Plan to use the 401k, up to 12% tax limit, being conscious to reduce 401k balance to limit RMDs later in life. Whether that be annual withdrawals, Roth Conversions, etc. That's still kind of up in the air as Wife isn't sure how long she will continue to work after I retire.

My stock was acquired as part of my compensation. It's already been taxed as ordinary income.

Yes, the plan was originally to hold onto taxable accounts into retirement, as needed. Actually planned to use them to bridge the gap between 55 and 59.5. But then I found that my company allows Rule of 55 distributions, so I no longer need the taxable to bridge the gap, but will use them just to optimize tax bill.

Here's what got me thinking about this and heading down this rabbit hole. I hate sitting in the 22% bracket, when I could drop to the 12% by contributing more to 401k. So sure, let's drop to the 12% bracket, and use stock w/LTCG to cover the gap. But hey, I hate paying 15% too, so why not increase 401k contribution even more.

Sorry for the rambling. Just trying to get it all out there.

Thanks for the clearer picture of your overall situation.

If you will not have retiree medical and will depend on ACA for health insurance in the years between retirement and Medicare eligibility, I think the money you'd save in taxes in the remaining years before retirement is not worth giving up the ability to tap cash for living expenses with reduced impacts on MAGI (your 50% basis isn't income) after you retire. The ACA premium tax credits you'd get with a MAGI below 400% of the Federal poverty level are likely to be a much bigger deal than the tax savings you're targeting.

If your Roth is an IRA and not a Roth 401(k), then you'll be able to tap your Roth contributions for the same purpose, without being forced to also tap the earnings (which would be taxable if you are not yet 59.5). The rules for Roth-account distributions before age 59.5 are somewhat complicated and I don't remember the details. The thing about that is, you'd be giving up one of the best advantages of Roths, the tax-free accumulation of investment returns over many years.

So I recommend becoming as familiar as possible with ACA in your state and zipcode, and IRS Form 8962, and the rules about taxability and 10% penalty on Roth distributions before age 59.5. Then decide.

 

[pb4uski]

I would do tax deferred contributions to stay out of 22% tax bracket and decare victory. KISS.