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I know, long title… but I wanted to fully describe the content of this article, which is to answer the following dilemma: I have a sizable IRA and a sizable taxable account that holds appreciated stocks. I am in need of additional funds (above any RMD required from the IRA) – so which account should I draw the additional funds from?
Taxable account!
There is one school of thought that says you should take the additional funds from the taxable account, because at today’s capital gains rates you will save a bundle in taxes.
The capital gains on your appreciated stock will at most be taxed at 20% under present law. But quite likely your rate will be less at 15%, and could possibly even be zero. When you compare this tax rate to the ordinary income tax rates, which top out at 37% for 2023 (same as last year), this is a bargain. This also assumes that you’ve held the stock for at least 12 months, otherwise your gains would be taxed at your marginal ordinary income tax rate.
It’s a no-brainer, you should always take this extra money from the taxable account, right? No, not always…
IRA account!
There is another school of thought that says, since appreciated stock receives a step-up in basis at your death, you should leave those funds alone if you can and plan to leave them to your heirs. This way the appreciated portion is never taxed.
So when you consider the concept of paying ordinary tax on your IRA distribution and zero tax on the taxable account (assuming you never need to use those funds) versus paying capital gains on the taxable account and potentially leaving your heirs with a fully-taxable IRA (because IRA funds never receive a step-up in basis), this method seems to make a lot of sense.
Conclusion
In the circumstance where you know you’re going to need most or all of the funds from both accounts, it probably doesn’t make much difference in the long run. But you would likely come out better, at least in the short run, using the taxable funds at today’s low capital gains rates first. This will hold true until changes are made the the capital gains tax rates that might make this method less desirable.
But if your holdings are large enough in either account to cover your needs for the longer term, with some planning of your distributions you might come out better with the second method. Or rather, your heirs will come out better in the long run, since the step-up rule is unlikely to change anytime soon. (Now watch Congress make a change to the step-up rule!)
You could also vary your strategy and use IRA funds in one year, and capital gains accounts in another year, “stacking” the ordinary income versus the capital gains income. You might even use the difference (in the capital gains year) to convert some of your IRA money to Roth.
Sterling Raskie, MSFS, CFP®, ChFC®
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Excellent points Jim! A few of additional thoughts:
For some, the cap gains rate could include the 3.8% Net Investment Income Tax. This might change the calculus for a few people.
Those considering the issue of step-up basis should also consider the real marginal income tax rate of their heirs. At one extreme they could have a sole heir in the highest brackets or their beneficiary could be pushed into them, via a large tax-deferred inheritance and the SECURE Act’s 10-year divestment rule. At the other extreme, if they are charitably inclined and have no heirs, their beneficiary can be a charity and no tax will be paid.
If selling appreciated assets, the investor must be sure they understand their broker’s default selling order rules and be sure they sell the appropriate lots; otherwise, they may turn what they think is a LTCG rate situation into an income tax situation.
Thanks for all of your educational content!
Excellent points all around, Scott. Thanks for sharing!
Since most folks aren’t high net worth and in the 37% tax category, there are other matters to consider as well. By keeping taxable income and AGI lower they can both manage tax liability and IRMAA exposure. Which account to draw from, traditional IRA, Roth IRA or taxable investments should be carefully examined to keep payments of taxes and penalties within bounds if at all possible.
Right on!
Great post, Jim
I agree with you conclusion that generally speaking, it’s better to take appreciated assets out of a taxable account at capital gains rates.
Of course, with the current uncertainty with estate taxes and the unknown about future income and capital gains tax rates, this could all change quickly and not necessarily for the better.
Absolutely right, Russ – the great unknown is just what Congress will do
for usto us.