3 Smart (and Not So Smart) Tax Decisions by Retirees

In my blog last week, I talked about how looking at the future of tax policy may be an interesting hobby (especially if you’re a geek like me!), but that it really isn’t all that useful in the present.  But, there are things that are important to look at when it comes to today’s income tax situation.  I don’t want to minimize the impact of paying attention to taxes; it’s just a matter of learning which situations are high impact situations.

In talking with a group of people who are on the verge of retirement (within weeks of their last day), we discovered a few things that can save people thousands of dollars by just applying a little bit of “hey, what would it look like if we did this instead of that” what-if analysis.  Here are a couple of examples of what I’m talking about.

1.  One member of the group was thinking that she would love to pay off her mortgage with a chunk of her pension plan.  She had the opportunity to take a 50% lump sum from the pension and let the other 50% be paid out monthly in the form of pension income.  Her first thought was “I’ll take the 50% lump sum, pay off my mortgage, and then my monthly cash flow will be much easier to manage.”  It sounded great.  In theory.  We put pen to paper to test the theory, it turns out that her 50% lump sum was going to be in the neighborhood of $300,000.  (That’s a nice neighborhood!)  If she took the entire distribution immediately upon retirement, paid the income tax due, and used the balance to pay off her mortgage, the tax due would have been around $135,000.  That was way more than she expected.  We looked at the “what-if” of rolling the $300,000 into her IRA, and taking $100,000 per year over 3 years and making 3 large principal payments that would pay off the mortgage in 3 years, rather than immediately.  The tax bill on that “what-if” turned out to be around $75,000 over 3 years.  So, just spinning that one idea around, and paying attention to today’s tax system, might save her ~$60,000.  She was very happy that we played the “what-if” game!  She is now in the process of converting her fixed mortgage into a home equity line of credit so that when she makes the large principal payments, her monthly payment decreases substantially.  In the end, this is one decision that paying attention to the tax impact paid huge rewards.

2.  Another topic of conversation was about stock options and the impact of taxes there.  One member of the group had options that were exercised about 10-11 months ago.  In that period, the stock has risen about $8/share.  He was considering selling those shares to pay off his mortgage.  Once again, we played a little “what-if” with the tax impact of 2 scenarios.  The $8/share gain, if sold now, would be considered ordinary income and in his situation that would amount to about a 40% Federal and State overall tax bite.  He had a significant number of shares (over 3,000 shares) and the tax bill would have been ~$10,000.  If he holds on to the shares for 6 more weeks, he qualifies for long term capital gains treatment on that gain.  If the stock price remains stable and he can sell at the same price 6 weeks from now (That’s a big IF, though.), his tax bill would be ~$3,750.  The question he has to answer is, “Do I want the money now and am I willing to pay an extra $6,250 in taxes, or do I wait 6 weeks and see what happens to the stock price?”  That’s a question only he can answer.   In real terms, the stock would have to fall by a little more than $2/share to wipe out the tax benefit.  And, if the stock goes up in the next 6 weeks, he not only saves a bunch of money in taxation, but walks away with more money overall.  It’s a tough choice, but at least now he understands the potential upside and the potential risks involved.  I’ll be curious to see which way he goes.

3.  Last week I said that future tax code changes are irrelevant.  This week, I’m singing a slightly different tune (“Oh no, not singing again!“) about taxes.  There is a lot of good that can come from taking a step back and analyzing the tax impact of your big financial decisions.  Never let the tax part be the only reason that you do something.  I’ve seen that cost people a fortune.  Because he didn’t want to pay capital gain taxes (15%), a person I know let nearly $1,000,000 in Borders Books stock evaporate when the company entered bankruptcy.  At first, he didn’t want to sell the stock because of all the taxes he would have to pay (15% of $800,000 gain = $120,000 check to the IRS).  When the stock started to fall, he didn’t sell because he kept hoping it would “bounce back” (Hope is NOT a strategy) and because as an employee who had been there from the start, it would be disloyal to sell.  As it fell faster and further, he didn’t sell because it was worth only around what he paid for it (~$200,000).  At the end, he held on to his shares as a sign of his life’s biggest regret and has the stock certificate framed in his home office.  If he had not let the tax decision drive the decision, he would be so much better off.

If I had to put all of these stories together in one coherent message, it would be that taxes and tax policy are a bit like the Goldilocks story.  Don’t let it totally drive the train or you could make a horrible long term decision because of a short term tax issue.  Don’t completely disregard it (at least not the current tax code, go ahead and disregard all the political posturing related to future tax code “enhancements” until they become real).  Find a middle ground that allows you to consider if there are a few alternate paths when you have a big financial decision to make.  Sometimes just opening your mind to the possibility that there’s another path is all it takes to find a great solution.  I guess that concept works on more than just your taxes, too.

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