Real Life Case Study- Strategic Planning and Tax Efficiency for a Retired Widow

Matt Blocki
00:00
Welcome to Ewa’s finlit podcast. Ewa is a fee only RAa, based out of Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. Welcome, everyone, joined here by Chris Pavzik, where we are going to talk about a sample case analysis for someone in retirement that is recently widowed and in their mid seventies with $3 million. So there’s a lot of. A lot of good planning that needs to be done in advance, and then, obviously, after, for someone in that distribution mode. So, Chris, let’s set the stage. So this person had about a million dollars in a.

Matt Blocki
01:02
Well, yeah, about a million bucks in a brokerage account with Merrill lynch, and they also had some retirement money. So give us just a high level snapshot of the retirement side.

Chris Pavcic
01:10
Yeah. So on the retirement side, she worked in the nonprofit sector, so has a 403 b and also a 457 plan on the retirement side. Both of these were approximately 900,000, and then the rest was in brokerage accounts. So you mentioned the one.

Matt Blocki
01:30
Yeah, the one was a Merrill a million and another million at Morgan Stanley, it looks like. So 3 million. So basically, a million. A million. A million. So 2 million in brokerage, a million through the 403 b.

Chris Pavcic
01:43
And those were both pre tax to. No Roth funds.

Matt Blocki
01:46
Okay. Those are all pre tax, I believe, through the. The Orp system in Texas. Right. So all pre tax, similar to. Yeah, all treated as pre tax. The 457 was a governmental plan. That’s important to note, because a governmental 457 can be rolled to an IRA, whereas a traditional 457, you know, you have to take that pretty quickly after retirement. It’s all taxable. Yeah. So, okay, so let’s talk through. So this person needed about, you know, $6,000 a month of spending. So one of the first issues that you brought up the table, Chris, was around tax bracket management and Medicare management. So what happens when someone becomes a widow? They obviously have a year, but after that year is over. Talk about how the brackets shrink.

Chris Pavcic
02:41
Yeah. So this is something in our world known as the widow penalty. They call it because your tax brackets and your Medicare brackets shrink. So almost cut in half. So, for example, the 10% tax bracket, I believe, if you’re married, is up to 22,000 or so, versus if you’re single, it’s only 11,000. Same with Medicare brackets. The amount that you’re paying is based on income. If you show, you can show a higher income if you’re married versus if you’re single, you’re going to pay more.

Matt Blocki
03:14
And those brackets essentially get cut in half once you’re single versus married, 500. Okay, perfect. Okay, so basically, you know, looking at the analysis you did, Chris here, the. If we do nothing, I mean, with between. So there’s going to be an RMD’s of about. So Social Security is. So there’s this TRS pension paying about 50,000 a year. The Social Security is paying about 40,000 a year. So right off the bat, there’s 90,000 of income and that eats up that ten, the twelve, and we’re far into even the 22% rate just with those sources of income that are going to come in no matter what. So then required minimum distributions you analyzed here are just over, you know, about $45,000. So now we’re at a total of about 140 ish, we’ll call it between Social Security, pension.

Matt Blocki
04:12
So obviously she needs about $6,000 a month to live off of. She has more than that coming in right off the bat, just between these three sources, RMD’s, Social Security and pension right off the bat. So talk about the. I see about 8000 a month. So it’s 2000 a month extra. So talk about some of the immediate recommendations that we’re going to do to give more control and more tax efficiency and more Medicare efficiency down the road.

Chris Pavcic
04:45
Yeah, so the first thing that we looked at and analyzed were roth conversions. It makes sense to move some of the pre tax money over to Roth. We thought. Yes, it does, because right now, as you pointed out, she has more coming through the door than she needs to maintain her lifestyle. And that’s great because money is not a concern. But we’re being kind of inefficient as far as showing income that we don’t have to through those RMD’s because the RMD’s are above what she needs to support her lifestyle.

Chris Pavcic
05:17
So our thought process with this case is to take the one time tax it this year and over the next couple of years to flip some of that pre tax money to Roth, which in turn will minimize future RMD’s and get us to the right balance, where we’re only recognizing enough taxes, where that equates to the right after tax income for her.

Matt Blocki
05:38
Awesome. I see you have up to 191,950 is where the 24% federal tax bracket runs out. So if we look at her three income sources, right now. Plus, she doesn’t have dividends and interest. So we’ll just say she’s at, you know, after standard deduction, about 150 of income that she’s in the show. So that would give us about a 40, $40 to $41,000 Runway per year to do Roth conversions, and also get that done at a 24% bracket. But then also, if we look at the Medicare brackets as a single person, if you go, you know, over 193 total, you jump to from the fourth to the fifth tier of Medicare. So basically, we’re going to have a couple years of pain. As we get the Roth conversions out. Our Medicare premiums jump.

Matt Blocki
06:23
But then after that’s done, after the two year look back’s done, because Medicare looks back two years, then that’s going to fall off. And our target is to get her into the second or third bracket forever in Medicare once these Roth conversions are done. The other thing you mentioned is that she is charitably inclined. So one of the strategies here is, are we going to do a wait and see approach? Initially, she just had a will that had everything split between some family members and then charity. And you pointed out a couple things for tax efficiency. So walk us through, like, which accounts are going to be directed where now and then, what can she do while she’s living from a charitable perspective, and also save a lot more. More in taxes?

Chris Pavcic
07:07
Yeah, for sure. So there’s a lot to be done in this area, just given the charitable goals. So if we go back to her account, makeup on the balance sheet. So approximately a million was in retirement, million in the brokerage account, or, sorry, 2 million in each brokerage account. So with what we advised was to leave the qualified accounts to the charities, because they’re going to get those. They don’t have to pay any tax whenever they get those. If she wanted to go the route, like gift to charity at death through her estate plan. But then we also pointed out we could start doing stuff while she’s living to be way more tax efficient through a donor advised fund. And that’s where we looked at using some of this brokerage assets to donate now while she’s living.

Matt Blocki
08:02
So why a donor advised fund versus a QCD?

Chris Pavcic
08:06
Yeah. So the donor advised fund. So for her, it makes a ton of sense, because the one brokerage account that has about a million dollars in it was made up of just one concentrated holding that’s operating at a big gain. So out of the million dollars, about 500,000 is a gain, which is an awesome, really good problem. To have, she doubled her money. If she sells that while she’s living, she’ll incur capital gains tax, versus, if we move it to the donor advised fund, she gets a deduction that’s going to decrease what she’s showing on her tax return.

Matt Blocki
08:37
So we get an immediate deduction off of AGI.

Chris Pavcic
08:41
And then, second, she avoids the capital gains tax that she would otherwise recognize herself if she were to sell it. So there’s no capital gains if we do that.

Matt Blocki
08:50
And this works along with the Roth conversion, too, Chris, because by, if we do a Roth conversion, so the limit on a donor advised fund is 30% of AGI. So if her AGI is 150, right now, the most she could put into a donor advised fund is 45,000.

Chris Pavcic
09:05
Right?

Matt Blocki
09:05
30% of the 150. However, if we do, let’s just say, hypothetically, we do another 150 of a Roth conversion. Now, we have 300,000 of. Let’s just say enough with the standard deduction involved, just talking high level, we have 300,000 with 30% of that is 90,000. So if we do $150,000 roth conversion, that enables her to take 90,000 and contribute to the donor advice fund, which then knocks her income down to 209. So back within closer to that 24% bracket. So, basically, there’s an artwork here of saying we only want to convert money into Roth at a 24% bracket, but let’s get enough into the donor advise fund to inflate that income and then immediately erase. I’m sorry, enough, an orth conversion, inflate the income, and immediately erase a lot of that through the donor buys fund.

Matt Blocki
09:52
And as you pointed out, we’re not just getting a 24% deduction on that, we’re also getting. We’re avoiding that 20 or that 15% capital gain rate on that appreciation if we’re gifting an appreciated holding versus just cash. So, obviously, if you have a non qualified appreciated holding, you get the double tax benefit when you use that to fund the donor advice fund.

Chris Pavcic
10:11
And then the triple. I guess the third benefit for her specifically is that fund. It was an actively managed mutual fund, and it had high turnover, too. So as companies were getting swapped in and out, those capital gains trickled through to all, not just all the individual investors in this fund. So you don’t really have control over that. So there were years where there were big tax hits that could have been avoided.

Matt Blocki
10:36
So if we’re trying to do all this super detailed work of here’s what Medicare bracket we want to be, here’s what tax bracket we want to be. Here’s our district. A huge capital gain out of a big mutual fund could literally ruin all of the hard work that we put in all the analysis, because that’s not up to you. So ideally, as we unwind that, we want to direct index that. Where we can carry forward tax loss harvest is to then erase capital gains getting pushed on you without you knowing or wanting them. We can control how much capital gains you show or don’t show by offsetting the carry forwards against any gains in that year.

Chris Pavcic
11:10
For sure. Yeah. So a lot of efficiency. It’s cool because all of it’s possible, I guess, first and foremost, through our charitable goals, because we’re able to do all three of these things at once. We can convert funds to Roth, unwind that holding the big concentrated holding in the brokerage account. Then three still solve the charitable goal and give to charity while living. And then also, if you could gift from that donor advised fund at any point this year, in future years. Or you could just leave it and give the proceeds at death. So it’s very flexible.

Matt Blocki
11:46
Yes. Ideally at death, she’s going to want to have from a charity perspective while she’s living, obviously, using a highly appreciated stock, moving it into the daft is going to enable a lot of her goals. And then if there’s money left, which obviously, given our spending patterns versus our net worth, there’s going to be a lot left, unless she decides to spend more pre tax money to charity. And then the Roth money would be perfect to go to family members because they would receive that tax free. And then even the taxable account, there may be a step up in basis available there under current tax law, that obviously could change as well.

Matt Blocki
12:20
But with the direct indexing strategy, we can step basis up along the way without, you know, her paying the tax, again with the tax loss harvest and offsetting the gains, one for one. So let’s talk about portfolio. So, you know, she’s 77. What should our portfolio allocation be?

Chris Pavcic
12:42
Yeah. So if you google this, you’ll get a lot of different answers, kind of like cookie cutter answers. So I just did it while we’re sitting here. And the first thing that pops up if you google, how should my portfolio look if I’m 77, it brings up this 120 minus age rule. So it’s looking at, like, if you’re.

Matt Blocki
13:03
77, 43, that’s how much you wanted equities, 43%.

Chris Pavcic
13:08
Yeah. Which, based on her plan, we didn’t think makes a lot of sense. So the way that we, what we recommended ultimately was to be 80 20 overall. Just because she doesn’t, like, we talked about the income sources that she has is covering her expenses. So we don’t really, we want to protect her nest egg, but it’s not like we’re relying on the portfolio for income. But we still want to have a safe, you know, safe bucket to pull into so that 20% that’s in bonds we can reasonably expect isn’t going to be as high.

Matt Blocki
13:40
I mean, that’s $3 million. So 20% of $3 million is $600,000.

Chris Pavcic
13:45
Yeah.

Matt Blocki
13:46
And so that would like, based upon her current spending patterns, if she’s, you know, Social Security and pension is giving her everything she needs. If she were to spend up to capacity, I mean, that’s going to give her, you know, like a 20 year Runway of what she would need at a minimum, you know, like an extra 30,000 a year minimum. So I think that’s even too conservative. But that’s going to allow her to sleep at night very well. Even the 80 20, that’s a great point that you bring up. So out of that 20%, though, I think it’s really important to bring up the duration of those bonds. So we want to have some bonds that are available without interest rate fluctuation.

Matt Blocki
14:25
So if she needs money that year, they’re short term, and then the average within the portfolio will be a five year duration as well. See that last thing you want to do is sell a bond when the market’s down, for sure. Okay. Chris, anything to add on the portfolio?

Chris Pavcic
14:39
No, I don’t think so. I think it was a lot of back because like you said, it’s still, you could argue, still conserve. Give it. It sounds crazy. She’s, you know, 77 saying that 80 20 is too conservative. People might think that sounds a little nuts, but given her individual goals. Yeah. So there is a lot of. Because that’s what I was saying is we, like you’re, I think, comfortable in this position, this setup. But she, like, to your point about the sleeping at night, like, she just felt more comfortable with being more on the, I guess, conservative side of the.

Matt Blocki
15:12
So we ended up 80 20.

Chris Pavcic
15:13
Yeah.

Matt Blocki
15:14
Gotcha. So it’s like, realistically, she could have been 90 ten.

Chris Pavcic
15:17
Yeah.

Matt Blocki
15:19
Even as a 77 year old.

Chris Pavcic
15:20
Right.

Matt Blocki
15:21
But given that she’s not, the main goal of that is wealth preservation for the next generation or charity.

Chris Pavcic
15:26
Yeah.

Matt Blocki
15:27
So, okay, perfect. Well, then let’s talk about where do we hold the bonds? Where do we hold the stocks? What type of stocks do we hold in which account? Give us an overview of the asset location strategy we have in place for her.

Chris Pavcic
15:38
Yeah. So where we’re holding certain investments, you want to be mindful because each of these accounts has different tax treatment. So if we look at her brokerage accounts, those accounts receive capital gains tax treatment. So if we sell something at a gain, we have to pay 15%. But if we hold a stock that pays a dividend or a bond that pays interest, that’s going to be taxable as income even if you don’t use it. Yeah. So when were just talking about the 80 20, that 20% that’s in bonds, we wouldn’t want to hold those bonds in the brokerage account because bonds pay interest and that’s going to add to our tax bill.

Matt Blocki
16:13
What about municipal bonds, though? Because municipal bonds are tax exempt. Those still, and this is a trick of the trade, they’re tax free. Federally. They could be state. If you’re buying a municipal bond in the state you live, depending on the rules, but they still show up on something. Not agile, but yeah, it’s called magi.

Chris Pavcic
16:33
Or modified adjusted gross income.

Matt Blocki
16:36
So address that real quick. Why? Because we’re playing these Medicare brackets. So why is that magi so important for her? Because we could hold municipal bonds. The listeners could say why don’t you hold municipal bonds in the taxable account? What’s that going to do if we do that?

Chris Pavcic
16:50
You just mentioned it, the Medicare, specifically the part B and part D premiums are based on income. So we’re trying to do everything that we can to not basically on her tax return appear that she doesn’t have a couple million dollars saved.

Matt Blocki
17:04
So we do 600,000 in the taxable brokerage account and put it in municipal bonds or tax free. But let’s say they’re getting a 5% interest rate, 5% of 600, that’s 30,000 a year that’s tax free. But that 30,000 still shows up as part of her modified adjusted gross income, which is what Medicare takes into consideration. And then our Medicare premiums are going to continue to be very high. That’s why we want to hold them inside of the IRA, obviously.

Chris Pavcic
17:27
Yep. So any bonds, those are best suited for the iras because no matter what, it’s just whenever you take the distribution, that whole distribution is taxable as income. It doesn’t matter what happens between now and when you take the money out. If dividends are paid out or if interest is paid out, it doesn’t matter in an IRA. So tax inefficient investments should be held there, not brokerage account, no question.

Matt Blocki
17:52
Okay. And then what type of equity, so the Roth, the IRA is, you know, it looks like it’s with a million dollars, that’s going to be a 40 60 account, 40% equity, 60% bonds, because that 60% is going to be the bond allocation. So what does the Roth look like? And then what does the taxable account look like?

Chris Pavcic
18:10
Ideally, yeah, the Roth IRA. So that’s our most tax efficient long term planning account. So it’s all tax free growth, and the distributions are also tax free. So that’s where we want our highest appreciating investments. We want them in that Roth Ira. So we wouldn’t hold bonds there because we would naturally be limiting that growth. So the Roth, all equities, the bonds are going to be held in the traditional, the pre tax iras and then the brokerage account. We recommended to implement direct indexing, which I know we’ve talked about a lot on the podcast, but that’s going to hold individual equities that we’re tax loss harvesting over time.

Matt Blocki
18:51
Absolutely. And that’s super important to keep that agile down, keep that magi down. We can take up to 3000 even against income, but then really eliminate that capital gain line item on the balance sheet, that someone would have the mutual funds spinning out every year around the November December timeframe. Okay, perfect. And then, so why ultimately, from a distribution perspective, she was in some lifecycle funds with the 403 B and 457 plan. So the first, why was it important we move those versus just keep those in those funds, not pay an advisory fee to us? What is the major downside there as she distributes that money?

Chris Pavcic
19:34
Yeah, so as far as distributions, the concern is with the lifecycle funds, she’s in RMD years, she has to take required minimum distribution. So for this year, those RMD’s were about $40,000. So whenever we had to process those first before we rolled the funds to our IRA. And if you’re just in a lifecycle fund, it’s going to sell pro rata across large cap, mid cap, small cap international. And so each of those asset classes are going to be, they’re independent and some are going to be up, some are going to be down.

Chris Pavcic
20:09
But if you’re in a lifecycle fund, you just sell across the board versus if you hold a fund that covers large cap, a fund that covers mid cap, we can pick and choose where we’re selling from and be control over where we locking in a gain or a loss from a return standpoint, super important.

Matt Blocki
20:25
We actually did a podcast on that. They’ll be published soon. That breaks down. If you’re doing a pro ratted distribution versus have a actual strategy between equity and bonds, which equity and bond to pull from, it could be a couple hundred. If just talking about a million dollars distributing over 20 years at a 5% distribution rate, it can be a couple hundred thousand. Well, it could be like over a million dollars difference with how you do that, how we address the sequence of return risk.

Chris Pavcic
20:52
Secondly, I’d say, I know your question was about the portfolio, more like distribution wise with the lifecycle fund, but that is also where all of her pre tax money was. So it would be to coordinate the Roth conversion planning. Same thing. If it’s in the IRA. We can choose when to convert it. We can actually pick which funds we’re converting. So it gives even a step deeper than just the RMD’s, the Roth conversions. That was crucial too, to get those consolidated.

Matt Blocki
21:19

Awesome. Well, Chris, thanks for giving us a high level overview. A lot of considerations, you know. Think you’re retired? I’m set about $3 million. I can put my plan on autopilot. You know, were looking at the tax savings, the difference in plans. I mean, there’s over a million dollars in efficiency at play here if we do the right steps, you know, and stay disciplined year by year over the next 2030 years for this client. So thanks for breaking it down, and thanks for joining everybody. Look forward to catching you next week. Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible.

Matt Blocki
21:56
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