[Video] Tax Efficiency - Tax Loss Harvesting & Step-up in Basis — Peoria, IL Fiduciary, Financial Planner

Tim expertly covers the three main types of accounts individuals may possess and their corresponding tax implications with capital gains. He also talks about tax loss harvesting as a way to offset gains and reduce tax liability with caution.

Finally, he explores the potential tax burdens of passing on money in different types of accounts to beneficiaries.

So far my taxes in retirement series has included a little bit about retirement tax bombs and things to look out for, taxes 101, taxes 201, and different things for when you approach retirement or are in retirement, and things that are educational for any stage of our life because they are things that you're going to have to deal with as you're retiring.

3 Types of Accounts

But today I want to start with some stuff that might be able to have an immediate impact for you and your retirement tax situation when you're thinking about how to turn your nest egg into a tax efficient income stream retirement. So to start, when you save up a nest egg, you might have a pension, Social Security, or different types of income that come in from whatever your employment history may be.

Then you're going to come to a point where you have basically three different account types:

Pre-tax accounts, such as your 401(k)s, IRAs, 403(b)s and anything like that;
After-tax accounts, which would be stuff like your individual accounts, joint accounts, anything that if you sell something and have a gain or loss, then that creates a taxable taxable event;
Roth IRAs, which are your best accounts because they are after tax money and any growth that you get in those accounts is going to grow tax free. So we love Roths at my firm. Sometimes there are reasons that you might not have a Roth, but generally, if you can get your money into a Roth, that's a good thing.

Whether you know it or not you've been making a decision all along in your career. If you're doing a pre-tax account or a Roth or whatever you're contributing to, that's a tax decision.

A lot of times people don't think about that. They only think about investments in terms of just investment risk or growth or fixed income or equities or so on and so forth.

But do you lay the tax code on top of your situation? Or do you think about where should I hold the specific assets?

Capital Gains in a Pre-tax Account

The best way to illustrate how your taxable accounts are going to work is this: let's say we're going to buy ABC stock. Where do we buy that stock? And why do we buy it? Because we think it's going to go up in value, right?

So let's say we buy the stock in a pre-tax account. Then let's say that it goes up and later we decided we're going to sell it, and let's say for hypothetical sake that it has gone from $10 to $100.

Now, if you buy this in a pre tax plan or an IRA, when you take that out it's going to be taxed at your own income tax rates because you haven't paid income tax on that. Unfortunately, Uncle Sam wants his share of the money, so you're going to get taxed on it, but it's going to be at the rate that you are in retirement.

A lot of times people think, they are going to have a lower tax rate in retirement, and sometimes that's the case and sometimes it's not. This is stuff you need to start thinking about. So that's coming back at your seven buckets or seven brackets.

Reminder: Ordinary Income vs. Long-term Capital Gains

Remember, our seven-bracket or seven-bucket system is what our regular income is taxed at. And those rates go from 10% all the way up to 37%. And it's marginal, so that means that you only pay that rate on the income that falls in that bracket like 10% and then only the amount that goes over that goes to 12% and then 22% and so on and so forth.

And of course, recall that our three bucket or three bracket qualified dividends and long-term capital gains brackets are preferred to our regular income seven income tax brackets because of the rise and run of each bracket is much larger, and they're lower rates for much larger amounts of money.

And they only have a 0% bracket, a 15% and a 20% bracket, so they're much preferred to our seven income brackets that go from 10% all the way up to 37% and the rise and run up each bracket is totally different but much smaller.

Capital Gains in a Taxable Account

Then let's say you buy it in a taxable account like your joint account or individual brokerage. So let's say you buy the stock at $10 and then it goes $100. Well, if you hold it over a year, then that's going to be taxed at the preferable three bucket system of long-term capital gains and dividends, which is preferable because the rates are a lot better than the seven buckets of ordinary income tax.

Capital Gains in a Roth Account

So then, of course, if we buy something in a Roth account, and it goes from $10 to $100, it comes out tax free at the end because you've already paid tax on that money. And the great thing about a Roth account is that if it grows that much, it's coming out tax free. So that's why we love Roth accounts at our firm.

Tax Loss Harvesting (Taxable Accounts)

So what happens if ABC stock goes down? Well, being in your retirement accounts like your IRAs and your Roth IRAs, there's not a whole lot of difference there. You're IRA withdrawals are still going to be taxed at your ordinary income tax rate, and then your Roth withdrawals are still going to come out after tax.

But if the money is in your taxable or your individual or your joint account, then there's this thing we can do this called tax loss harvesting. Now I know a lot of people out there in taxes are speaking of the advantages of tax loss harvesting, and it can be a good thing to help you mitigate your lifetime tax liability.

But I don't like to tout it as a big thing. It is something that we use as a tool. It's another arrow in the quiver that we can use, but the reason I don't like it is because you've lost money. So tax loss harvesting is not going to help you recoup what you've lost. And it may be more of a bandaid when you needed a tourniquet or a cast.

I have a personal story here as an example. So in 2022, you know, the markets went down and my personal stuff went down as well. I sold a bunch of stuff in January at the beginning of 2022 that had gone up quite a bit in years running up to this, so I sold some stuff because I wanted to switch some stuff around. Then December rolls around and we had to have losses for the year. My gains from when I had sold earlier in the year we're going to put me in a tax bracket that I did not want to be in.

So I said, I can switch out of this and I want to invest in this now anyway, so I want to make some changes. So I sold all that stuff at a loss that happened in 2022 in December, and then that created losses in my account, so that kept me from being in a tax bracket that I did not want to be in.

So that is tax loss harvesting. Like I said, it's not something that we try to sell a lot on other people out there because again, you've lost some money. Nobody likes it. It happens, and when it happens, we take advantage of that tax wise, but it's still more of a band aid instead of a cast.

Inherited IRAs

Another question that we get all the time is let's say you pass on, what happens to the money in these different types of accounts?

Well, first your pre-tax money, that money is going to go to your beneficiaries, and whenever they take it out, it's going to be taxed at their income rates just like it would have happened if you had taken it out when you had it, but now it'll be taxed at their rates, not yours.

Unfortunately, the SECURE Act did away with the stretch IRA. This is very frustrating because what happens is statistically let's say you are parents, you've built up a nice pre-tax account and then you pass away and it goes to your kids or your legacy, whatever your beneficiaries are, it goes to them. Statistically, they're going to be in their 50s and 60s in their highest earning years. So now they have to take out that pre-tax money in their highest earning years. And that's stacked on top of their income in their highest earning years.

They've got to take that money out within those 10 years, and that creates a tax bomb for them because the SECURE Act says you have to take it out in 10 years. The stretch IRA used to let beneficiaries inherit and then extend over their own lifetime how much required minimum distributions they had. Now they're required to pull that all out within 10 years, typically at their peak income years.

So that ends up really creating a tax bomb for your beneficiary. That's another thing to consider when you're thinking about your pre-tax accounts and what's going to happen, and if you haven't looked at your estate plan since 2020, when this went into effect, you definitely need to look at that because you might need to adjust.

Step-up in Basis (Taxable Accounts)

So what happens taxable in joint account or your taxable account? This is actually pretty good. So let's say you have a stock that you bought at $10 and it goes to $100. And it's in your taxable account. Well God forbid you pass away and you still own that stock. You will leave that to your beneficiaries just like they bought it at $100. So that's called step-up in basis.

A step-up and basis is still a really good thing, and still there and we use that for tax planning. We can do that in certain situations if we know somebody is terminally ill or probably not going to last a lot longer. We can do some tax planning around that. Nobody likes to talk about that because nobody likes to consider their own mortality, but there are definitely tax planning opportunities they can do.

So basically, like I said, we bought the stock at $10 and it goes to $100 and you pass away and then when you leave that to someone, it's like they just bought it $100. They could sell it the next day at $100 and not pay any tax. So that is step-up in basis.

So then what happens if you have the money in Roth. Well, it's tax free account and if that goes to your heirs, that money still has to come out within 10 years because of the SECURE Act because it's still an IRA, but you've already paid tax on that, so it doesn't create a tax bomb.

As I mentioned, Roths are the most beneficial account and you want to leave the money in there as long as you can if you are a recipient of an inherited Roth IRA because it's still a Roth and it will grow tax free.

So that wraps up tax loss harvesting and step-up in basis in the three different account types for retirement income.

Other videos in this series:

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[Video] Tax Efficiency - Tax Loss Harvesting & Step-up in Basis