Diversification of Divided Assets

Why is it important to involve a Financial Professional in your case?  Here’s a quick scenario that is not all that uncommon.  It is designed around a married couple, but all divorces start with one thing in common, a married couple.  When you start to weigh the assets, it is easy to see how it can affect a person receiving a personal injury settlement, inheritance or going through a divorce.  We ran this past an enrolled tax agent that we work with to make sure our information is correct.  Be sure to consult your own professionals, this is for illustration only.  If you don’t have professionals, call us.

Here’s the basic scenario: In one scenario a famous family gets all their retirement income from 2 sources, their IRA/401(k) and social security.  In the other scenario the family gets the same retirement income from 3 sources: 1/3 from IRA/401(k), 1/3 from a taxable account, and 1/3 from tax free accounts (Roth IRA and life insurance cash value).  

Assumptions:

1. Max Social Security Benefit (SSB) of $45,864/year for Han ($3,822/month).
2. Leia’s SSB is half of Han’s, so she receives $22,932/year ($1,911/month).
3. Filing status: Married filing jointly.
4. Other relevant assumptions:

• All traditional IRA withdrawals are taxable as ordinary income.
• Roth IRA withdrawals are tax-free since they meet the qualified distribution criteria.
• Long-term capital gains are taxed at favorable rates, depending on total income.
• Social Security benefits are taxable based on total income.

Now, let's compare the tax implications of withdrawing $150,000 from a traditional IRA versus $150,000 from diversified sources for Han and Leia Solo, who are both receiving Social Security Benefits(“SSB”).

Scenario 1: Withdraw $150,000 from Traditional IRA

• IRA/401(k) Withdrawal: $150,000 (fully taxable as ordinary income).
• SSB Total: $45,864 (Han) + $22,932 (Leia, we all know she was really the bread winner) = $68,796.

Total Income = $150,000 (IRA) + $68,796 (SSB) = $218,796.

• Taxation of SSB: Since their income exceeds the thresholds for Social Security taxation, 85% of their Social Security benefits will be taxable.
• Taxable portion of SSB: $68,796 × 85% = $58,476.

Adjusted Gross Income (AGI):
$150,000 (IRA) + $58,476 (Taxable SSB) = $208,476. (pro tip: remember this number or be prepared to scroll back up)

• This total income will be taxed at ordinary income rates. A portion of this income may be taxed in the highest marginal tax bracket depending on other deductions.

Scenario 2: Withdraw $150,000 from Diversified Sources

1. IRA Withdrawal: $50,000 (fully taxable).
2. Long-Term Capital Gains: $50,000 (taxable portion after adjusting for cost basis, is presumed $25,000, we’ll use $25,000 going forward as we’re looking at tax consequences).
3. Roth IRA: $50,000 (tax-free).
4. SSB Total: $68,796 (same as in Scenario 1).

Total Income = $50,000 (IRA) + $25,000 (LTCG) + $68,796 (SSB) = $143,796 (plus $25,000 in basis and $50,000 Roth withdrawal, total is the same $218,796).

• Taxation of SSB: Because of their income, 85% of Social Security benefits will be taxable.
• Taxable portion of SSB: $68,796 × 85% = $58,476.

Adjusted Gross Income (AGI):
$50,000 (IRA) + $25,000 (LTCG) + $58,476 (Taxable SSB) = $133,476. (Do you remember that number?… Go ahead scroll back up we’ll wait.)

• Capital Gains Tax: The $25,000 of long-term capital gains will be taxed at the capital gains rate, which could be 0%, 15%, or 20%, depending on total income and tax brackets.
• IRA and SSB: The $50,000 IRA withdrawal and taxable portion of SSB are taxed as ordinary income.

Tax Implications Summary

Key Differences:

1. Higher Tax Bracket in Scenario 1: In Scenario 1, withdrawing $150,000 from the IRA pushes total income significantly higher, leading to higher taxation of Social Security benefits and more of the income taxed at ordinary rates.
2. Favorable Tax Rates in Scenario 2: In Scenario 2, only a portion of the withdrawal is taxed at ordinary rates, and $50,000 from the Roth IRA is tax-free, so we’re not calling it “income” in the taxed sense of the word. The long-term capital gains of $25,000 benefit from a more favorable tax rate, potentially as low as 0% or 15% and the other $25,000 was taxed during the working years.
3. Reduced AGI in Scenario 2: The lower AGI in Scenario 2 results in less overall tax liability compared to Scenario 1.

By diversifying the income sources in Scenario 2, Han and Leia can reduce their taxable income, potentially benefit from lower capital gains tax rates, and lessen the tax burden on their Social Security benefits.

Here’s the payoff:

If Han and Leia only have IRA investments and Social Security they pay $30,386 in federal income tax.  If they diversify, they pay  as little as $7,576 federal income taxes for THE SAME AMOUNT of Money, $218,796.  If you need help talking to your divorce, personal injury or probate client, reach out to us.  We can help with strategies even when people think it’s otherwise too late...  If your head is still spinning give us a call, it’s free.