Planning liquidation of investments in retirement.
Most retirees have spent their entire working years saving and investing for retirement. Savings can be accomplished by investing in a collection of taxable and tax-deferred accounts. Retirees can save tax dollars by carefully planning when to (1) take distributions from tax-favored retirement accounts, (2) begin receipt of Social Security and (3) liquidate investments in taxable accounts. This article discusses some of the best strategies for liquidating investments under various scenarios.
Many individuals approaching or starting retirement agonize over the various options available in taking Social Security benefits. The longer one waits to start receiving such benefits, the larger the payments. Also, the income tax on the payments will vary, depending on the level of a retiree's adjusted gross income (AGI).
Generally, under Sec. 86(a), the Social Security included in a retiree's gross income is the lesser of one-half of (1) die annual benefits or (2) the excess of the retiree's "provisional income" over a base amount. The base amount is $25,000 for retirees filing single and $32,000 for those filing jointly. For retirees with provisional income in excess of $34,000 on a single return or $44,000 on a joint return, up to 85% of their Social Security may be included in their gross income. Provisional income generally equals the retiree's AGI plus all tax-exempt interest, and one half of the Social Security benefits.
Retirees who receive Social Security benefits at the earliest possible time may wish to delay selling appreciated securities in taxable accounts. By doing so, they will be reducing their provisional income, thereby reducing the tax burden on the benefits. In addition, if they do not need the proceeds from sales of their investments, they may die still owning those securities. Their heirs would get the benefit of a basis step up and thus, no income tax will be paid on the appreciation of those investments (up to the date-of-death value).
As a result of the Economic Growth and "Fax Relief Reconciliation Act of 2001, there will be a limited basis step-up for heirs who receive property, from decedents dying after 2009. Under Sec. 1022(a), the basis of property acquired from a decedent is the lesser of the decedent's adjusted basis or the property's fair market value (FMV) on the decedent's date of death. The basis of inherited property can be stepped up in the aggregate by $1.3 million, but not in excess of the property's IFMM In addition, under Sec. 1022(c)(2)(B), a spouse is entitled to an additional basis increase of $3 million, not to exceed the property's FMV.
Retirees who have a regular IRA and who start receiving Social Security at the earliest date possible may want to postpone taking IRA distributions until they reach age 70 1/2, because of a three-fold benefit: (1) the regular IRA will continue compounding on a tax-deferred basis; (2) provisional Social Security income will not be increased by the receipt of IRA distributions; and (3) a greater amount of the IRA will be left to heirs.
For Social Security purposes, full retirement age is 65 years, four months. Individuals under full retirement age who have a significant amount of earned income should consider postponing the commencement of Social Security benefits. If not, $1 in benefits will be deducted for each $2 in earned income above the annual limit ($11,640 in 2004). (1) In the year the recipient reaches full retirement age, the payments will be reduced $1 for every $3 earned over a different limit ($31,080 in 2004), until the month full retirement age is reached. (2) After that, the individual can earn unlimited income, without any reduction in Social Security benefits.
Retirees who are younger than full retirement age and already receiving Social Security should consider deferring the receipt of earned income, because they will (1) be able to maximize the benefits they receive and (2) reduce their provisional income.
For instance, retirees may be entitled to deferred compensation from their employers, a large bonus to be paid shortly after retirement or renewal commissions. By deferring these payments until full retirement age, retirees will maximize the Social Security benefits to which they are entitled. In addition, in the years prior to receiving deferred income, their Social Security benefits to be included in gross income will be reduced.
Example 1: In 2004, X is retired, but will not reach fun Social Security retirement age for three years. However, he qualifies to receive $15,000 of benefits. In addition, he receives $10,000 in interest income. He is also entitled to receive $20,000 of deferred compensation, which he can elect to receive in any of the next five years. He files jointly and uses the standard deduction. As shown in Exhibit 1 on p. 166, if he elects not to receive the deferred compensation in 2004, he will pay no Federal income taxes. If X does elect to receive the deferred compensation his Social Security benefits will be reduced by $4,180 (($20,000-$11,640) x 50%), resulting in the receipt of reduced benefits of just $10,820. In addition, Iris Federal income tax bill will be $1,656.
Retirees who cannot postpone receipt of earned income should consider receiving as much earned income as possible in the year before the first year they receive Social Security payments. First, the benefits will be larger when eventually received, because there will be no reduction due to excess earned income. Second, when benefits are received, provisional income will be smaller, lowering the taxable amount of benefits.
In addition, by waiting later in retirement for the commencement of Social Security payments, it is likely that other sources of income will be reduced, resulting in a lower income tax bracket. As an individual progresses beyond normal retirement age, he or she is likely to give up a full- or part-time job and will have consumed some income-producing investments.
Regular and Roth IRAs
Retirees who own both regular and Roth IRAs should consider delaying taking Social Security, and withdrawing from the regular IRA first. By delaying the start of benefits until the regular IRA is partially or completely exhausted, the regular IRA distributions will have a lesser effect on their provisional income. The tax burden on the benefits will be minimized for taxpayers who are not in a high income tax bracket. Once they have partially or completely exhausted their regular IRAs, they can start taking their benefits, along with distributions from their Roth IRAs. Distributions from the Roth IRA will not increase their provisional income under Sec. 86(b)(2), and the regular IRA will be partially or fully exhausted, minimizing the benefits subject to taxation.
Typically, individuals who are about to retire from companies with pension plans have various payout options. Generally, for married individuals, a pension payout over joint lives is mandatory; if the employee's spouse consents to a payment over the employee's single life, the pension payout will be higher, but the payments will stop when the employee dies.
Depending on the assumptions made, it is often more advantageous to take pension payouts over joint lives when the employee's spouse is younger; psychologically, it is comforting to know that the surviving spouse will be "taken care of" for the remainder of his or her life. Also, under the joint lives option, the pension payments in each year will be lower, because they are being spread over more years. Thus, the couple's provisional income will be less and a smaller amount of Social Security benefits will be included in their gross income. After the first spouse dies, the benefits (as well as the pension payments) will be somewhat decreased, resulting in reduced provisional income for the surviving spouse. In determining how much of the benefits are included in gross income, the base amount is disproportionately higher for a single person than for a married couple; thus, it is likely that a lesser amount of the benefits will be included in the surviving spouse's gross income. If either spouse has a regular IRA, delaying IRA distributions as long as possible or choosing the distribution option that results in the lowest amount withdrawn, means that the surviving spouse can receive greater IRA distributions with mini mal adverse effect on the taxation of Social Security.
Investments in Taxable Accounts
As a retiree goes further into retirement, he or she will deplete income-producing assets and reduce provisional income, resulting in less tax on Social Security benefits. In addition, for retirees who reach full retirement age in 2004 and delay the receipt of Social Security benefits, their benefits will increase by 6.5% or 7% a year for each year of the delay. (3) That rate gradually increases, until it reaches 8% a year for people reaching full retirement age in 2008 or later. If retirees do not think that their investments will increase at the rate of 6.5-8% a year, it would be better to deplete their own investments before starting to receive benefits. Thus, delaying Social Security benefits should be considered a relatively good investment in a tax-deferred account.
Example 2: For Social Security purposes, H reaches full retirement age in 2004. If he starts to receive his benefits in 2004, he will be entitled to receive $15,000 a year. If he waits four years to commence receipt, he will be entitled to receive $19,662 a year. If he decides to postpone the commencement of benefits, he will probably liquidate his investments at a greater rate than if he had started to receive benefits earlier. Thus, when he does start to receive benefits in 2008, the income from his investments will be reduced (because he liquidated some). As such, his provisional income will be smaller, resulting in less of his benefits being included in gross income.
An individual may want to consider how much time it takes to make up for delaying the receipt of Social Security. If an individual is in excellent health, and has a family history of longevity, there is a strong probability that delaying receipt will also result in a greater amount received.
Both Series EE and I savings bonds (savings bonds) have interesting tax and financial features. Many retirees have invested in them for safety and/or patriotic reasons. Under Sec. 454(a), interest earned on savings bonds does not have to be reported until the bonds are redeemed. Because most retirees have not reported the yearly interest on their tax returns, they have, in effect, elected to report interest income in the year the bonds are redeemed. Accordingly, most of the planning focuses on timing the redemption. Redeeming savings bonds is a very critical event, as these particular bonds may have several years of accrued interest that will substantially affect a retiree's income tax return in the year of redemption.
It may be worthwhile to delay bond redemption as long as possible. By waiting to redeem, the retiree will benefit from a tax-deferred accumulation of interest. If a retiree delays redeeming the bonds until later in retirement (after he or she has used up other income-producing property), there will be less investment income from that property. Moreover, at that point, there is a greater chance that he or she will be completely retired, and thus, have no earned income. As such, the reported interest from savings bonds would not increase income taxes as much as it would have earlier in retirement.
The redemption timing also depends on the built-in capital gains and/or losses that retirees have in their individual stock portfolios. From an estate tax standpoint, if retirees have substantial unrealized capital gains, they may want to redeem their savings bonds prior to selling stocks. At death, a stock's basis will be stepped up to some extent in the heirs' hands. In contrast, savings bonds are considered income in respect of a decedent (IRD) under Sec. 691(a) and, thus, will not be stepped up.
For retirees with stock portfolios that have unrealized capital losses in taxable accounts, they should liquidate the stock portfolio before redeeming their savings bonds. Selling stocks with unrealized losses can produce up to a $3,000 annual deduction against ordinary income. However, when the retiree dies, the capital loss carryover is extinguished. (4) Thus, the sooner a retiree sells stocks with an unrealized loss, the better the chance that the capital loss carryover will be used before death.
Another motive to defer the redemption of savings bonds is the security that they offer. Most retirees would prefer to have their retirement assets in the safe environment of savings bonds, rather than high-tech stocks. However, there are a couple of cautions. First, once savings bonds reach maturity, no additional interest is paid; thus, savings bonds should not be kept beyond maturity. Second, they should be kept in a safe place known to either or both of the estate's executor or heirs. Unlike mutual funds or a brokerage account, there are no quarterly statements indicating the value of these investments. If the location of the savings bonds is known, they can be found and cashed after the retiree's death.
Another viable option is to convert Series EE or I savings bonds into Series HH savings bonds, which pay interest every six months. Under Sec. 1037(a), owners of Series EE or I savings bonds may convert them into Series HH savings bonds without reporting any of the accrued interest on the original bonds. This works well for retirees who own bonds that are approaching maturity, and do not necessarily need the redemption proceeds.
After conversion, they will receive semi-annual interest payments from the Series HH bonds, which must be included on their returns. Conversion allows retirees to receive some interest income (from the HH bonds) without having to redeem all the Series EE or I savings bonds and their accrued interest. It may also allow retirees to postpone selling appreciated investments in taxable accounts to pay bills. Of course, if retirees never need to sell their appreciated investments in taxable accounts, their heirs will receive a stepped-up basis in these investments at the retiree's death. This step-up may be either a full step up or a partial step-up in basis, depending on the year that the decedent dies and the heir's relationship to the decedent.
In considering various strategies that retirees should undertake in financing their golden years, their personal residence could play a large role. Some retirees may want to move into a smaller home, a condominium or an apartment. Selling the home may be a great source of retirement funds. If a retiree has used a home as a principal residence for two years in a five-year period before the date of sale, he or she can exclude up to the first $250,000 of gain under Sec. 121 ($500,000 if he or she files jointly). (5) For retirees with unrealized capital gains in their taxable accounts or savings bonds with many years of accrued interest, selling a principal residence will accomplish two objectives. First, the sale proceeds can provide a great source of tax-free retirement funds. Second, rather than liquidating investments with unrealized capital gains or savings bonds with accrued interest, retirees can use the sale proceeds and allow the unrealized capital gains and accrued interest to continue to grow on a tax-deferred (or partially tax deferred) basis. At death, the basis of any appreciated investment that is not IRD will be stepped up to some extent, depending on whether the decedent died before 2010 or after 2009.
Widows and widowers often live in homes that are too large for them, because their children have left. If they would like to "downsize" by moving into a smaller home or condominium or an apartment, it is preferable to sell a principal residence rather than to sell appreciated securities or redeem savings bonds. If they die still owning their homes, their heirs will get a basis step-up. However, when the heirs eventually sell the homes, they will not be entitled to the home-sale exclusion, unless the house has been their principal residence for two of the last five years.
Retirees who do not want to move should consider a reverse mortgage. Although there are several ways to remove equity from a home, the main point is that there are no tax implications in obtaining a reverse mortgage (i.e., the funds received are tax free and the loan does not have to be paid until the retiree sells or dies). For retirees with stock portfolios with a substantial amount of unrealized capital gains, a reverse mortgage can help delay "tapping into" these investments until later in retirement. If a retiree does not have to sell these investments to pay bills, his or her heirs will get either a partial or full basis step-up in the appreciated securities.
Retired IRA Owners
Retirees between 59 1/2 and 70 1/2 have a great deal of flexibility in taking distributions from their regular IRAs. It is not unusual for individuals to take "early" retirement at about the time they reach 59 1/2 and to start withdrawing IRA funds. In addition, it may be tempting for them to start withdrawing funds that they (and perhaps their employers) have been setting aside for years in a Sec. 401(k) and/or pension plan. Such retirees may do freelance work and move in and out of the workforce. Retirees between 59 1/2 and 70 1/2 may choose not to take a distribution from their regular IRAs in a year they earned a relatively high amount of income. In such case, a retiree would be better off to let the account grow on a tax deferred basis for that particular year.
Retirees who are philanthropically inclined and whose heirs are in a higher income tax bracket may want to receive IRA distributions and donate the proceeds to charity. Such a distribution will have a negligible effect on their Federal income taxes, depending on whether they itemize and the types of itemized deductions they have.
Two notable provisions cause a reduction of tax benefits derived from itemized deductions. First, under Sec. 68(a), for individuals who file jointly, if their 2004 AGI exceeds $142,700, their itemized deductions otherwise allowed are reduced by the lesser of (1) 3% of the excess of their AGI over $142,700 or (2) 80% of the amount of itemized deductions otherwise allowed. Second, under Sec. 67(a), individuals can only deduct their miscellaneous itemized deductions to the extent they exceed 2% of AGI. As joint taxpayers with AGIs in excess of $142,700 withdraw amounts from their IRAs, their AGIs will increase, diminishing the tax benefit not only from the charitable contribution, but also from their other itemized deductions.
From a state income tax standpoint, the strategy of taking IRA distributions and contributing them to charity may cause a modest increase in state income taxes, depending on the types of exclusions or credits available for retirement income in the state in which the retiree lives. Such a contribution would, however, reduce estate tax.
Liquidation of IRAs and Taxable Investments
A very important decision to be made by retirees between 59 1/2, and 70 1/2, is whether to liquidate their regular IRAs or taxable accounts first. The focus is on three attributes in their taxable accounts: (1) the amount of appreciation, (2) the character of the income generated and (3) the tax efficiency of the investments.
Retirees who have a significant amount of appreciation in their taxable accounts and will not exhaust all of their investments before they die should withdraw from their regular IRAs before their taxable accounts. At death, this will result in an undepleted, appreciated taxable account and a substantially depleted IRA. Benefits: If the investments in taxable accounts produce long-term capital gains, the tax burden on the taxable accounts will not be that great. Moreover, if taxable accounts are invested in tax-efficient investments, the tax burden, if any, will be minimal. In addition, at death, the heirs will receive a basis step-up (to some degree) for the investments in taxable accounts. Unlike inheriting an IRA, they can continue to hold the investments in the taxable accounts without having to take withdrawals (which would generally be the case for inherited IRAs). If an IRA is inherited, there is no basis step-up and any income received by the heirs is ordinary. When the heirs liquidate the taxable accounts, the appreciation will be subject to the long-term capital gain rate. Burdens: If an IRA is liquidated first, the retiree loses the benefit of tax-deferred growth.
If a retiree has invested in mutual funds that are not tax efficient, the unrealized appreciation will probably be negligible, resulting in a lower basis step-up at death. In that case, it is better to liquidate investments in a taxable account before taking IRA distributions; the tax-deferred growth in a regular IRA will outweigh the benefit of a step-up at the retiree's death.
Determining which investments to liquidate in retirement is a critical decision, to be made alter analyzing many variables. For individuals nearing retirement, consideration has to be given to when to commence receiving Social Security benefits. Depending on the amount and character of income received during retirement, a higher or lower amount of benefits should be received and taxed. Individuals should analyze all of the sources of retirement income to which they are entitled, including Social Security, so that they can develop a harmonious plan that will maximize their net retirement payments.
Savings bonds and personal residences have some interesting tax characteristics that should be considered in deciding the order in which assets will be liquidated to finance retirement. Retirees who own regular IRAs and are between 59 1/2 and 70 1/2 should choose whether they want to take distributions, depending on their financial and tax situation; this issue should be examined annually.
Exhibit 1: Deferred compensation Alternative 1: Delay receipt of deferred compensation Amount of Social Security included in gross income: 50% of Social Security $ 7500 Interest income 10,000 Provisional income 17,500 Base amount 32,000 $ 0 Lesser of the two $ 0 Taxable income Social Security $ 0 Interest income 10,000 Gross income 10,000 Less: standard deduction (9,700) personal exemptions (6,200) Taxable income $ 0 Federal income tax $ 0 Alternative 2: Receive deferred compensation Amount of Social Security included in gross income: 50% of Social Security $5,410 Interest income 10,000 Deferred compensation 20,000 Provisional income 35,410 Base amount 32,000 Excess 3,410 x 50% $ 1,705 Lesser of the two $ 1,705 Taxable income: Social Security $1,705 Interest income 10,000 Deferred compensation 20,000 Gross income 31,705 Less: standard deduction (9,700) personal exemptions (6,200) Taxable income $15,805 Federal income tax $ 1,656
(1) See www.ssa.gov/OACT/COLA/rtea.html.
(3) See www.ssa.gov/OACT/ProgData/ar_drc.html.
(4) See Rev. Rul. 74-175, 1974-1 CB 52.
(5) The exclusion is up to the first $250,000 for taxpayers filing single. For a discussion, see Dilley, "Tax Planning for the Sale of a Principal Residence (Parts I and II)," 35 The Tax Adviser 30 (January 2004) and 35 The Tax Adviser 90 (February 2004).
* Retirees should plan when to start receiving Social Security and when to receive or defer other taxable and nontaxable income, such as IRAs, pensions savings and other investments accounts.
* A retiree's personal residence can play a large role in devising strategies for financing his or her retirement.
* Retirees between ages 59 1/2 and 70 1/2 have a great deal of flexibility in taking IRA distributions.
For more information about this article, contact Prof. Fink at PFink2@UTNet.UToledo.Edu.
Philip R. Fink, J.D., CPA
College of Business Administration
University, of Toledo