Case Study: Bob and Carolyn Whitehall, retirees
When Bob Whitehall retired from a regional bank in 1997, he’d accumulated a comfortable nest egg of $1.8 million. A third of his savings was in the common stock of his employer; the bank offered an employee stock purchase program that allowed him to invest in the stock through payroll deduction. The stock had done well over the years, paying cash and stock dividends, which Bob reinvested while he was working. After retirement, Bob began to take the dividends in cash and used them to supplement his income.
In early 2008, Bob and Carolyn reached their mid-70s, and they came to me for an evaluation of their investment portfolio. I found it was still worth $1.8 million. One third of it was invested in three rental properties; another third was still in the bank’s 401(k) plan Bob never rolled over; and the remaining third was invested in various stocks, mutual funds, and bank certificates of deposit (CDs). Bob also still had $500,000 invested in the bank stock that was divided between the 401(k) and the taxable accounts.
Despite only taking modest distributions over the years, the portfolio hadn’t appreciated at all. The bank stock had done poorly since his retirement, but Bob refused to sell it because he hated paying capital gains tax. The stock had a very low cost basis because he’d accumulated it over many years, and stock dividends aren’t taxable until the shares are sold. Still, Bob thought he was being savvy by keeping the stock and not paying capital gains tax.
The reality is the purchasing power of his nest egg had shrunk to $1.3 million because of inflation. Allowing this to continue would eventually reduce Bob and Carolyn’s standard of living. If one or both of them ended up in a nursing home, they could see the entire nest egg wiped out in ten years.
Fortunately, there was an answer that helped even someone like Bob who hated to pay capital gains tax. Today, ordinary income tax rates for individuals ranged from ten percent to thirty-five percent. As I mentioned above, certain capital gains and qualified dividends (i.e., adjusted net capital gains) are taxed at fifteen percent for taxpayers in the twenty-five percent bracket or higher and five percent for taxpayers in the fifteen or ten percent brackets.
Through federal legislation, the five percent rate drops to zero percent from 2008 through 2010. In 2011, all of these rates revert back to the levels prior to 2001 unless Congress acts to extend the law, which is highly uncertain. This allows us a three-year window to take advantage of the zero percent rate.
My strategy for Bob and Carolyn was to reposition the portfolio to place most of their income-producing assets into their tax-deferred accounts. This significantly reduced their taxable ordinary income, which allowed us to sell more of the stock at the zero percent capital gains rate. We sold the bank stock in the 401(k) that had no tax implications and used the proceeds to buy CDs and other fixed income assets, so they could maintain a balanced investment strategy when investing in the tax-efficient investments in the taxable accounts.
Read from Chapter Three – ‘Roth Accounts for Younger People’
