Retirement Planning and Basis
This article obviously will not/cannot cover all the issues regarding investments, asset allocation, etc. But I believe it can properly focus on another bad area of planning that few retirees address properly. Be aware however that the commentary reflects only those people who intend to leave assets to beneficiaries. If you are going to spend everything, then the following discussion has less impact- though the tax aspects of investing properly is still viable and can still make you money.
Assume you are retired and have $500,000 of assets existing in a 401(k) plan and $500,000 in five pieces of real estate. You anticipate needing only the assets and income of one of the assets for your retirement and expect to leave the rest to your children.
Many people have been told and do recognize the fact that if you can leave assets to grow in a non taxable environment, they will provide a larger sum later on than those assets that are taxable on an ongoing basis. But that is not a complete analysis. What is missing is two fold. It's not the BEFORE TAX number that is as important as the AFTER TAX number. Secondly, some assets in a "taxable" account do not really incur that much in tax annually- assuming you know how to invest.
Let me tackle the last issue first. Assume you owned a mutual fund in a non taxable/tax deferred account and it grew at 10% annually for 15 years. If you started with $25,000, It would then be worth $104,000 (rounded). Nonetheless, if your beneficiaries received it through an estate, they would retain the requirement of ordinary income taxation and, at a 35% rate, would net $67,600.
Now let's assume that this mutual fund was in a taxable personal account and had a 75% turnover rate and was sending out a 1099 form each year with $2,000 of income and capital gains that you had to pay tax upon. If we assume a 35% rate and that most of the distributions were short term gains and ordinary income, you would incur a taxable event of $700. That would radically reduce the amount of assets in 15 years. I'll dispense with a technical long analysis but simply reduce the net return to 7% annually. That's only $68,975. But should it be left to your beneficiaries, it would have a full step up in basis and incur no further tax.
When compared, the net results are effectively equal so no difference to become "concerned about".
But check this out. Assume you had used an Index fund in your taxable personal account. These have almost a nil turnover rate. I will use 5%. So, again using a simplistic analysis, the index fund will incur only about a $44 annual tax bill versus the $700 above. In essence therefore, an investor's return stays high and the end result after 15 years I will say is $100,000.
You still appear to be a little ahead with the tax deferred account but we have a BIG difference as far as the beneficiaries are concerned with the NET non taxable versus the taxable accounts- $67,600 versus $100,000. That's a 48% increase and due to the taxable account having a FULL STEP UP IN BASIS AT THE DATE OF DEATH. Now what do you think??? Admittedly an index fund is not perfect, etc., etc. but a $32,400 potential increase in retained funds in only 15 years is a major consideration.
Assuming you see the validity of the argument, take the retirement situation above to a logical conclusion. If you sold the real estate to live on, you would incur long term capital gains rates at perhaps 20% but you would have left the 401(k) asset to grow for 15 years until your death where it would then be worth $2,000,000 (rounded). The estate tax is $780,000 leaving $1,220,000 (actually less due to the income tax filing by the decedent). However, the remaining sum is FULLY TAXED AS ORDINARY INCOME resulting in another reduction of $427,000 (assume distributions over a period of time to allow a 35% tax bracket). That leaves $793,000 to the beneficiaries.
Assume, on the other hand, that you took distributions out of the 401(k) during retirement. Admittedly you incurred an ordinary income tax rate on the distributions- which are higher than capital gains- and this requires identification.
However, all the real estate was left to your children. Assuming the same rate of return to $2,000,000 and the same estate tax, the real estate gets a FULL STEP UP IN BASIS to the remaining $1,220,000. NO FURTHER INCOME TAX. Now your children have netted the full $1,220,000 and an EXTRA $427,000- a 54% increase.
Sure, you can find caveats in the scenarios. But are the caveats enough to offset over $400,000??????