Gain harvesting is where investors in the 15% tax bracket or lower can sell taxable investments with long-term capital gains and not owe capital gains taxes. For 2016, you must have taxable income below $37,650 if single, $75,300 if married filing jointly and $50,400 if head of household to stay in the 15% tax bracket. Any long-term capital gains above this taxable income threshold will be subject to the regular 15% tax on long-term capital gains, while the gains below the threshold are tax free. Income is often much lower in retirement, especially before taking the required minimum distributions from retirement accounts at age 70.5, so many retirees have room to realize gains without tax consequences.
So what’s included in taxable income?
Taxable income is the total of your sources of income, which includes earned income, investment income, retirement distributions, the portion of social security that is taxed and pension income. Once these sources of income are added up, you can then subtract deductions and exemptions to arrive at your taxable income.
If you’re receiving Social Security benefits and filing jointly with a combined income between $32,000 and $44,000, then 50% of your Social Security benefits is taxable. If your combined income is above $44,000, then 85% of your benefits is taxable. Combined income is your adjusted gross income, plus nontaxable interest (municipal bond interest), plus half of your Social Security benefit. If this amount is above $44,000, then 85% of your Social Security benefit is included in calculating your taxable income. If 85% of your Social Security benefits is not already included in your taxable income, be aware that realizing capital gains may increase the taxability of your Social Security benefits, effectively pushing you into the 25% marginal tax bracket. To remain in the 15% tax bracket, you may need to reduce the amount of capital gains realized.
Why sell something that has increased in value?
At times it can appear counterintuitive to sell investments that have significantly increased in value to buy investments that have fallen in value. However, more often than not, those investments have grown to be a significant part of one’s portfolio, thereby reducing overall diversification and increasing portfolio risk. In other words, gain harvesting provides a tax-efficient way to rebalance your portfolio to long-term targets. It also allows you to free up cash to cover expenses or gifts without incurring any capital gains taxes.
As an example, consider a retired couple, both age 66, living off of Social Security benefits, retirement account distributions, and dividends and capital gains from their taxable investment account. This couple has a $1 million taxable investment account with $400,000 in long-term capital gains. As you can imagine, their portfolio has probably drifted out of balance due to the significant capital gains. To move their portfolio back to its long-term targets for their risk tolerance, they want to sell enough stocks to rebalance their portfolio with minimal tax consequences, if any.
The following scenarios illustrate the tax implications of this couple selling investments in their taxable investment account for a gain with varying levels of taxable income.
The couple has taxable income of $40,000. They can realize $35,000 in long-term capital gains without owing any capital gains taxes.
The couple has taxable income of $70,000. They can realize $5,000 in long-term capital gains without owing any capital gains taxes. Any gains realized above this amount are subject to the 15% long-term capital gains tax.
The couple has taxable income of $100,000. Their taxable income is already above the 15% tax bracket, so they are not able to realize any capital gains without owing capital gains taxes. Long-term capital gains realized above this point will owe 15% capital gains taxes.
Since taxes can eat away a significant part of the value and return of your portfolio over time, taking advantage of benefits in the tax code in years where your income may be lower, whether in between jobs or in retirement, is a prudent move. This is especially important when your portfolio has drifted away from long-term targets.
Even though they first became available in 2003, health savings accounts (HSAs) paired with high-deductible health plans are becoming more popular and are being offered by more employers. These accounts receive a unique triple-tax advantage, whereby contributions are made pre-tax (federal, most states and payroll taxes), can grow tax free and can be withdrawn tax free for qualified medical expenses at any time. Unspent funds aren’t forfeited at the end of each year like a health flexible spending account, so they can be accumulated and invested during your working years and spent in retirement to cover healthcare expenses.
A recent Fidelity study estimated healthcare costs for couples in retirement is $245,000, and this figure doesn’t even include the cost of long-term care. Rather than drawing down cash reserves or taking retirement account distributions to cover healthcare costs in retirement, why not accumulate and invest the funds in an HSA to spend tax free later?
So what is a high-deductible health plan paired with an HSA?
Similar to other health care plans, where you have an annual deductible that can be anywhere from $250 to $10,000, a high-deductible health plan has an annual deductible of at least $1,300 for an individual and $2,600 for a family. Contributions limits to an HSA for 2016 are $3,350 for an individual and $6,650 for a family, and those 55 or older can contribute an extra $1,000. Many employers contribute the deductible on your behalf and permit you to make contributions to reach the contribution limits. And, maximum out of pocket expenses are $6,550 for individuals and $13,100 for families. Once you reach this maximum, your health insurance provider will cover all remaining costs for the year.
You can’t make contributions to an HSA once you enroll in Medicare. However, if you’re still employed after reaching age 65 and want to stay on your employer’s health plan, you can postpone enrolling in Medicare and continue to contribute to an HSA. Keep in mind that you must enroll in Medicare within eight months after you retire and/or lose group health coverage to avoid paying any penalties.
What can the account be spent on?
The account can be spent tax free on out-of-pocket qualified medical expenses. You can also use an HSA to pay for a portion of your long-term care insurance premiums (based on your age), continuation coverage through COBRA, and Medicare premiums, except Medigap. You can’t use an HSA to pay for regular medical premiums, though, unless you’re unemployed and receiving federal/state unemployment benefits.
Investing an HSA
HSAs often have investment options similar to a 401(k). Some of these plans may carry high expenses, so be mindful of fees when reviewing options.
If not needed for health care costs in retirement, HSA funds can be used after turning age 65 for non-medical expenses; however, withdrawals will be subject to ordinary income tax. Funds withdrawn for non-medical related use before 65 are subject to a 20% penalty plus ordinary income tax. They can also be rolled over to a new employer’s HSA.
A high-deductible health plan paired with an HSA can provide the best overall value of any health insurance option, especially if invested during your working years to cover medical costs in retirement tax free.
Deciding how to best prioritize your savings can seem overwhelming, and the decisions you make can lead to very different long-term outcomes. It’s especially difficult to know where to start with all of the different account types and savings vehicles available to you. As with all goals, developing a plan you believe in and can consistently apply will greatly improve your success rate.
Use the following steps as a starting point for prioritizing your savings. If a step doesn’t apply to you, simply move on to the next step.
Step 1 – Contribute enough to your 401(k) to receive the full employer match
This is one of the few places in life where you can receive money by simply participating. Some employers require you to contribute 3% of your salary to receive a 100% employer match. This means your contribution is effectively doubled, at no extra cost to you. A few plans will match 50% up to 6% of your salary. In other words, you have to contribute 6% to receive their 3% matching contribution. Contributing this amount from each paycheck can put stress on a tight budget, but there’s no better alternative.
Step 2 – Pay down your highest interest rate credit cards
With the sky high interest rates charged by credit card companies, it makes sense to attack these debts before moving to the next step. Since credit card interest rates can be anywhere from 12% to 24%, it’s unlikely you will find an investment that can earn a return anywhere in this ballpark, let alone while taking on outrageous risk. Consolidating your credit card debt and even seeking help from a debt counselor may be appropriate if it’s a problem.
Step 3 – Build up at least three months’ worth of emergency cash
When you have unexpected expenses, like those associated with a job loss or a major house repair, an emergency fund can help fill the gap so you don’t have to turn to credit cards or withdraw from a retirement account. Holding three months’ worth of expenses in an emergency fund at the bank is a good start. For some, it may be necessary to have three months’ worth of your take-home pay or six months of expenses.
This fund should be increased over time as your income and living expenses grow.
Step 4 – Max out health savings account (HSA)
If your employer offers an HSA, this is an amazing savings vehicle used to pay medical expenses now and in retirement. These contributions are not subject to federal and state income taxes, or payroll taxes and withdrawals for medical expenses are tax-free. The excess cash in the account, usually balances in excess of $3,000, can be invested and grown over the long term. Considering this recent Fidelity study, which found that a couple in retirement spends $245,000 on healthcare, not including the cost of long-term care, saving in tax-advantaged accounts for these expenses is a must.
Think of an HSA account like any other retirement account. To accumulate the necessary funds to cover medical expenses in retirement, it makes sense to pay out of pocket for reasonable healthcare expenses while still employed to allow the HSA account to grow.
Step 5 – Contribute to a Roth IRA retirement account
Since contributions to this account grow and can be withdrawn tax-free in retirement, contributing to a Roth IRA makes a lot of sense. This is especially true when you consider the impact of compound interest over long investment periods for those earlier on in their career.
You can also withdraw Roth IRA contributions tax-free for an emergency or for a house down payment, and this can be done at any age. Be careful, however, to avoid touching earnings since they lead to tax consequences. Lastly, keep in mind that if your income is above IRS limits, your ability to contribute to a Roth IRA may be reduced or eliminated.
Step 6 – Save for house down payment
The number of first time home buyers is starting to pick up. Having at least a 5% down payment saved up in addition to your emergency fund is a good starting point. If you plan on buying a home in the next three years, keeping these funds in cash versus investing in stocks is a prudent move.
Once you own a home, increasing your emergency fund to six months expenses will be necessary as roof repairs and miscellaneous expenses that always seem to come up as a homeowner can quickly eat into your savings.
Step 7 – Pay extra toward your student loans
Since many are graduating with significant student loans these days, paying extra toward these loans can lead to significant savings. This is especially true with unsubsidized government student loans and private loans that have interest rates greater than 6%. Since there isn’t a guaranteed 6% plus return available, prioritizing paying off these student loans is a must.
Step 8 – Max out 401(k) plan
Being able to contribute the maximum consistently without jeopardizing your finances or being at risk of having to take an early withdrawal pays off long-term. Not only will you receive the tax-deduction up front on any contributions, the funds will grow tax-deferred throughout your career, providing a greater balance to draw from in retirement.
Step 9 – Contribute to a 529 College Savings Plan
If you have children or expect to have children, there’s never a better time to start saving in a 529 plan. The funds in the plan grow and can be distributed tax-free for college and graduate school expenses. This article discusses the benefits of 529 plans further.
Because your children might receive grants or scholarships to cover their higher-education expenses, we always prioritize retirement savings first.
Step 10 – Invest in a non-retirement account
Now that you’ve maxed out your tax-advantaged accounts, excess savings can be invested in a taxable account. These funds can be invested and used to accomplish a long list of long-term goals. Whether you’re saving toward a future vacation home, early retirement or a child’s wedding in five years, these extra savings can make a big difference.
This list isn’t a one size fits all, but it can provide a framework for developing a long-term savings plan that you can expand upon each year. The earlier you can progress through these steps in your career, the better chance you have of being financially fit and having a high probability of success when you retire.
So you’ve accepted a job offer at a new company, but you want to take some hard-earned time off before you start. The problem is that your current employer will only pay your medical premiums through the end of your last month on the job, and you’re starting the new job in the middle of the following month. So what do you do for the two weeks in between?
COBRA, short for Consolidated Omnibus Budget Reconciliation Act, bridges this gap by providing workers and their families with continued group health benefits during this transition. Once you leave an employer, your plan administrator will send you information regarding your rights under COBRA, stating that you have 60 days from whichever of the following happens last: receiving this notice, the last day on the job or the last day of health care coverage at the end of the month. If elected within the 60-day window, the coverage becomes retroactive.
If you have a medical claim during the two weeks before you start with your new employer, you can elect for coverage after the fact within that 60-day window and pay one month’s worth of medical premiums to receive insurance coverage. Note that this could cost as much as 102% of the cost of the medical premium that was previously split between the employer and you. Still, this is much cheaper than paying thousands of dollars in medical expenses if you’re not covered. One suggestion is to put off any non-emergency medical visits for your family until after this two-week period.
It’s also important to know when your medical coverage for the new job starts. Many employers start these benefits on your first day, but some may have a 30-day waiting period.
Other COBRA Scenarios
Continued coverage under COBRA also applies in the following situations.
- Leaving a job voluntarily
- Becoming eligible for Medicare
- Having a dependent child who loses dependent status
- Having the number of hours you work reduced
- Death of the covered employee
- Divorce or other big life events
For a termination or reduction in hours worked, you and your family will be eligible for 18 months of continued coverage under COBRA, while the other scenarios qualify for 36 months of coverage. More information can be found on the Department of Labor website.
Your son has just turned age 18. The difference between ages 17 and 18 is that if your son has a medical emergency and is incapacitated, you can’t make a medical decision on his behalf or even speak to his doctors about his condition. Even if your son still lives with you and is a dependent, you don’t have the authority to call the shots since he’s now considered an adult. You’ll need to seek court approval to act or even be informed about your son’s medical condition.
To remedy this situation, children between the ages 18 to 25 can sign a medical power of attorney (POA) authorizing parents to act as their agent or proxy in medical decisions. This allows you to step in if they are disabled or incapacitated. This is even more important for kids leaving for college or taking a gap year to travel abroad.
Medical power of attorney documents can be created relatively inexpensively by estate planning attorneys. In most cases, an attorney can draft a medical POA à la carte, and you won’t have to revisit your entire estate plan. When drafting this document, it’s important to name an alternate medical POA in case you can’t be reached. This could be a relative in your son’s new college town or a close friend who is traveling abroad with him. What’s important is that someone with your son’s best interests at heart can act if your son were to become incapacitated.
If your child subsequently gets married, the medical POA should be updated. You don’t want a situation where the spouse has one desire but the parents, who have medical POA, have a different perspective.
Joe grew up in a financially relaxed household. Money came easily to his parents and when they needed something, it was there. He wasn’t spoiled, just well taken care of. Lucy was just the opposite. Money was scarce. Choices had to be made.
When Joe and Lucy got married, their two very different financial tracks had to merge. Much like Joe and Lucy, all of us have stories about what money was like growing up. As we enter into and manage relationships, merging those financial stories is a crucial element to the relationships’ long-term success. The following points provide guidance on how to do so.
Set expectations around your goals
Funding your children’s schooling is a classic example. For the Joe-like individuals, the answer seems obvious – their parents paid for their schooling, so they feel obligated to do the same. The Lucy answer is starkly different. Whether it’s paying for schooling themselves, or getting some kind of scholarship, they need to have some skin in the game. Whatever the outcome, being proactive with a plan is what matters.
Couples at or near retirement can face equally difficult crossroads. One person may be under the impression they’re going to downsize the home to buy a small condo and spend their time traveling. The other person is completely attached to the home they’ve lived in for 40 years and has no intention of selling it. They want to stay closer to their family and the community relationships they have built. Wow! Sounds like fireworks. Again, plan ahead. Don’t wait until your last day of work to have this discussion. Have it now.
If your goals align, great. If not, tweak them to arrive at a compromise. Goals, plans and circumstances change, so continue to have the conversation. I suggest an annual check in. That way things can evolve naturally and you’re not stuck dealing with a dramatic change 20 years down the road.
Who manages the finances?
It’s completely natural for one person in the relationship to gravitate to the finances. In our example, it’s typically the Lucy types – those that had to make choices about how to spend their money. Over time, that person comes to know their finances like the back of their hand. So what happens if that person is suddenly no longer around? Financial relationships can often live on a teeter totter. One person carries the weight, and the other is left suspended in air. Once the weight is gone, the other person may land pretty hard. Neither person in the relationship wants this, so it’s best to take steps to ensure both people have a baseline understanding of the household finances.
Tip: If you’re working with professionals (CFP®, CPA, etc.), make sure the non-financial person attends all meetings. This allows all parties to increase their plan acumen steadily over time and establish relationships with the professionals.
Be honest with yourself and with your partner about your financial habits. Until recently, I’d never encountered a “secret bank account.” In this case, someone siphoned money into a bank account their spouse was completely unaware of. The intention was to create a pool of money that could continually fund their spending habits. A secret like this is a ticking time bomb. It’s probably one of the primary factors behind the statistic that finance-related issues are the number one cause of divorce. Divorce is much more catastrophic than a secret bank account. Again, it’s best to have full disclosure.
Review your various account statements – bank, investment, credit cards, loans, etc. I know it’s easy to toss them into the shredder with the envelope still sealed, but most of us need to be aware of what we spend, so it’s good to get in the habit of reviewing the statements. Twenty minutes a month is all it should take. The intent is for you to get a rough baseline of where your money is going. Knowledge is power. Understanding the big picture of your spending and savings habits is crucial to your long-term success.
Like Joe and Lucy, we all come from different financial backgrounds. The above discussion topics will help those looking to merge paths as well as those who are on an independent path. Start with setting the expectations and defining goals together. From there, ensure that all parties have a baseline understanding of the financial picture. Move to full disclosure – for most of us, this should be nothing more than getting all of the information on the table. Before you know it, you’ll have a mutually agreed upon plan. Day by day and week by week, you’ll live this plan so you can accomplish all that is important to you.