By: Amy Herrick | June 11, 2009 | Annuities, Bad Financial Advice
Lump sum investments can be the easiest and the hardest placements to make wisely.
If you have a lump sum to invest you may think to keep the transaction easy that it makes sense to “keep it all together” in a single account or holding. Later on for tax reasons or restrictions on a holding this could be a big mistake in what is then perfect hindsight.
Often one just assumes it should all be invested together and it does make less paperwork for everyone all around. This thinking could cost you money later when withdrawals are desired.
For an example in real life, take a $200,000 windfall from an inheritance. The money is all tax free and you want to invest it for later. Sounds pretty simple, right?
The examples here do not make any investment illustrated good or bad choices. The right product for the right application for the right client is always the best choice.
Fast Forward to “later” age 60 and our investor is still in the workforce and paying taxes.
Investor one invested all $200,000 of it in a single location for our example. Then most years some dividends or capital gains were declared and they were reinvested. Investor one would then pay current income taxes on those distributions. The underlying purchase had some appreciation too over the years. The investment grew to $500,000 with a $250,000 cost basis. He needed to take out $100,000 for something special. Rough math tells us that about 50 cents on every dollar he takes is appreciation, so I would expect $50,000 of his $100,000 withdrawal to be included in his income for the tax year of the withdrawal.
Investor two invested all $200,000 of it in eight different $25,000 increments. Then most years some dividends or capital gains were declared and they were reinvested. Investor one would then pay current income taxes on those distributions. The underlying shares had some appreciation too over the years. The account grew once again to $500,000 with a $250,000 cost basis. He needed to take out $100,000 for something special. Rough math tells us that about 50 cents on every dollar he takes is appreciation, so I would expect $50,000 of his $100,000 withdrawal to be included in his taxable income for the tax year of the withdrawal. Wrong! He chose to liquidate part of three lower averaging performance holdings that resulted in only $33,000 in taxable income to report.
Investor three invested all $200,000 of it one place too. He chose a tax deferred vehicle, so no taxes were paid on the growth every year. Withdrawals in this example are taxed as earnings first and principal last and do not have any favorable capital gains treatment at this writing. The investment grew to the same $500,000 with a $200,000 cost basis. He needed to take out $100,000 for something special. Because earnings are taxed first in this instrument, all $100,000 of this withdrawal would be reported as taxable income here. Total shock at this revelation ensued.
Investor four invested all $200,000 of it in four $50,000 increments in deferred taxation instruments. Appreciation is tax deferred, so no taxes were paid on the growth every year. Withdrawals are taxed as earnings first and principal last and do not have any favorable capital gains treatment at this writing. The investments collectively grew to the same $500,000 with a $200,000 total cost basis. He needed to take out $100,000 for something special. If you looked at the last example for the answer you may think all $100,000 is again taxable and the results could be pretty similar. Wrong! Investor two chose to liquidate two investments on a partial basis to obtain his $100,000. His taxable income to report was only $30,000 in this situation, but will be taxed at regular rates.
Often a little foresight and vision on what the future consequences of an investment will be at eventual liquidation will work wonders for your checkbook later when it is too late for hindsight to do you any good at all.
It is only money…YOURS!
Notice on the same $100,000 figure four investors withdrew, they included in income four different amounts respectively: $50,000, $33,000, $100,000 and $30,000. The tax liabilities generated were quite different too. In many cases that extra liability will be taken form the portfolio again the following year to cover the tax liability created at the time of the withdrawal. Which triggers a new taxable event, and new taxes due and so on and so on…
Disclosures;Amy Rose Herrick, ChFC, Investment Adviser Representative is a Registered Representative of and offers Securities and Investment Advisory Services through Woodbury Financial Services, Inc., Member FINRA, SIPC and Registered Investment Adviser branch office 4536 SE 37th Street Topeka, KS 66605-9141 785-379-0586
Neither Woodbury Financial Services, Inc., nor its registered representatives or employees, provide tax advice or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.
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