Selling Your Business: Managing Taxable Wealth

Below is a transcript of the posted video.

As you watch and read retirement planning articles, most everything shared is about how to manage IRA withdrawals prudently, but there is very little written about how to deal with taxable money.

While not every family has a liquidity event from selling a business, we see everyday business owners frequently that have amassed taxable wealth now trying to figure out how to prudently grow it for the future without giving all of it to Uncle Sam in the process.

As business owners ourselves, we understand larger tax bills are NOT fun, and managing them needs to be a part of growing and preserving your family’s wealth.

So today on Retirement Ready, we’re going to drill into the case of a client who’s just sold their business and talk about some potential strategies for better managing their taxes while growing and preserving wealth into the future. 

Let’s meet John and Jane Smith, both 67 years old. Jane has been a lifetime educator, taking a bit of time when the kids were growing up at home, But Jane managed to amass 25 years teaching school.

John built an industrial business and sold it last year. As a result, last year was a hefty tax year with capital gains, and The Smiths are super interested in how not to have more heavy tax years into the future.

So let’s look at the numbers: John sold the business for $4.5 million after taxes. He also managed to save $1 million in his 401K plan, and he’s now eligible for Social Security as well. His monthly Social Security will be $3800 monthly.

Jane will receive $2400 monthly in state retirement pension for her teaching career, and her Social Security would be $1380.00 monthly, but she’s entitled to one half of John’s security benefit, which is $1900 monthly.

In addition, Jane’s mom passed away last year. Jane had a middle-class upbringing, but her parents were diligent savers and believed that investing made sense. As a result, Jane inherited $1,000,000.

During their working years, John and Jane built a money market account at the bank, where they keep roughly $100,000.

OK, so we know that John and Jane have done fine for themselves; but managing this Wealth is going to take some planning and they’ll need experts to effectively guide this plan into the future.

We’re going to walk through 3 scenarios; 1 through 3 are looking at the money today and reducing taxes, and then as a planning bonus we’re going to add a fourth scenario that Plans well into their 70s and 80s.

OK, Scenario 1, John and Jane invest in a moderate growth portfolio, that is 70% growth and 30% conservative; this means they have a little over $3.8 million in growth, and a little over $1.6 million in conservative bonds. Let’s start with the bonds, which are yielding roughly 5% currently; this amounts to taxable interest of roughly $85,000 annually.

Additionally, John and Jane have roughly $120,000 annually in qualified dividends. The good news is qualified dividends receive a better tax rate, but the bad news is that’s a fair amount of income. Also, Jane has $28,800 in state retirement from teaching, and together John and Jane have $68,400 in gross Social Security. They’ll pay tax on roughly $58,000 of this.

Knowing that John and Jane must manage this taxable money over time, we know there will be capital gains in their portfolio and we’ve assumed roughly 3% annually in capital gains. This would amount to $115,500 which is added to their total income.  Now this too will receive a better tax rate than interest on their taxable bonds for example, but you can see down the page here that at this rate of income they are effectively paying 18.8% on their capital gains, not the 15% that they thought they would have after selling the business and no income from the business.

So All in all in this scenario, John and Jane are in the 22% marginal tax bracket and 17% effective federal along with a 6.5% state tax.  While 22% is better than their tax rate has been in the past, there are ways to bring it down. So let’s examine another scenario.

Here in Scenario 2, we’ve made our first adjustment: we’ve gotten rid of our taxable bond portfolio and instead included municipal bonds, which are going to be Federally tax Exempt. Now it’s important to note that they are at a lower rate, in this case 3% instead of 5% taxable.

One can debate which choice is better, but let’s examine it from a tax return standpoint.  By moving the taxable interest out, we can see that our taxable income drops from $376,000 to $294,000, which is a decrease of $82,000 or 22%.

But here’s the first place the rubber meets the road: our total tax drops from $63,700 to $41,600. That’s not a 22% drop, that’s a nearly 35% drop in taxes paid.

So while you may read the tax free municipals aren’t all they’re cracked up to be in retirement, this math would beg to differ!

Additionally, we are now in the 12% marginal bracket instead of the 22% bracket, which brings other interesting planning tools into the equation.

All right, let’s move into Scenario 3.  Each scenario is building upon the last one, so let’s look at what’s different.  In this scenario we have made one material change, and that is how a portion of the taxable money is managed.

In this scenario, we’ve plugged in a tool that helps us manage our capital gains for the future.  John and Jane have been investing for a long while, but they were surprised to learn that the indexes they’ve heard about for years like the S&P 500 may go up three out of four years, but on average 37% of the stocks in that index are down in any given year and even more than that at some point during the year during a correction.

This fact ultimately allows them to invest a portion of their portfolio to have index like performance overtime, but actually work to harvest the losses in those stocks that are down during the year. What this does overtime is lessen the effect of capital gains, thus improving their tax picture.

You can see in scenario 3 dad John and Jane’s capital gains have dropped from $115,000 annually to roughly $25,000 annually. This has a massive effect on their taxable income.

From where we began, with John and Jane at $376,000 in taxable income, they are now at $203,000 in taxable income. These two planning techniques have reduced their taxable income by $173,000 or 46%.

So what does that mean in taxes paid? Their tax bill is dropped from $63,700 to $23,400.  With nothing exotic but prudent planning, they’re paying roughly 1/3 in taxes that they would had they stuck with scenario 1 and planners who were not proactively thinking about their tax bill in the process of managing their wealth.

While we’re here let me share with you one other very important nugget in the tax code: If you have taxable losses, those carry forward indefinitely to be used in the future against any gains that you have. If for example, John and Jane made over $500,000 on their personal residence and sold it, they would have a capital gain.  Tax loss carry forwards, like what we have illustrated here in scenario 3 carry forward for the sale of real estate, the sale of a business, etcetera. In fact, John was kicking himself for not having the tool described in scenario 3 in his portfolio while he was working, because it would have worked to build tax loss carry forwards that would offset the sale of his business, meaning he and Jane would have taken less of a tax hit last year.

Alright, I promised you a bonus scenario that looks into the future for John and Jane. Since we have reduced their taxable income so much, we have to consider that they still have roughly $1.1 million in IRA money that at age 73 they will have to begin taking required minimum distributions on. They could leave that out of their planning at this point, but doing so would potentially begin to lessen their options in what to do with this money in the future. There would always be the option of giving it to charity in order to avoid taxes, but we have found over time that while benevolence is important, giving wealth away is not the primary goal of our clients.

 What we’ve done in this scenario is we’ve begun to convert some of John and Jane’s IRA’s to Roth IRA’s.  We’ve done this in a way where we solved for how many pennies John and Jane are comfortable paying on the dollar in taxes – as you can see in this scenario we have solved for 15%.

Assuming the tax code does not change, This would allow for John and Jane to convert $60,000 times 5 years or $300,000 in IRA money before they must start taking required minimum distributions at age 73. This is nearly 30% of their IRA balances which would not be taxed again in their lifetimes.

Early in my career I had an older advisor friend, and I asked him how taxes come into play with his clients and managing money for the future?  He said to me, “Chris, I don’t let the tax tail wag the investment dog.” Let me share with you friends, taxes must come into play with decisions you make on taxable wealth. 

If you have a fair amount of after-tax wealth, a financial plan that considers taxes as part of your investment strategy in addition to building and preserving will be important – and you will want advisors that understand this, like us.

If we can help you or your family, please reach out to us today!  Thanks