Do Capital Gains follow fund shares in an in-kind transfer?

[welkin]

Jurisdiction

New Jersey

I have been trying to get an answer to this question for a long time and have not been given a definitive answer after talking to my accountant, fund managers, and banks. So, I thought I would pose the question here. This has to do with in-kind transfers of mutual funds when taking a RMD in any colander year. I will try to be brief and make it simple.

I have many retirement accounts in two different financial institutions. I have set up accounts in each of these institutions where I have a retirement accounts and a personal accounts with very much the same investment in each. The vast majority of the funds are invested in the retirement accounts.

At the end of a preceding year, I calculate the value of all retirement accounts (Dec. 31) and calculate, based on IRS actuarily tables, what my RMD is for forthcoming year. Since I have the entire forthcoming year to make the transfer, I watch the market prices and decide when to make the transfer. My thinking is that the higher the fund price is at the time of transfer, the more shares will still remain in the retirement account, the less (in shares) I will be transferring out of the retirement account.

But I'm getting killed on capital gains because it appears that if I make the transfer before the last capital gains are paid (usually first 2 weeks of December and they are substantial), the capital gains are for all the shares that were transferred before the last gains were paid in the retirement account even though those gains were paid during the entire previous year while the shares were still in the retirement account. Is that about as clear as mud?

So, the question is, is it better to do a sell-buy for the distribution (out of retirement account into personal account) or do the in-kind transfer?

It looks to me that the capital gains follow the shares regardless of when they were paid. Do any of you know?

 

[Tax Counsel]

My thinking is that the higher the fund price is at the time of transfer, the more shares will still remain in the retirement account, the less (in shares) I will be transferring out of the retirement account.

And the more gain you'll have per share sold, too. The two go together. After all, one share worth $100 and ten shares that are each worth $10 will both get you $100 when you sell them (ignoring any fees). Thus selling when high you do preserve more shares, but also you get hit with more capital gains tax when you cash out to take the RMD under your approach. But to me, the number of shares isn't what I want to preserve. The number of shares is just how you divide up the total value, as in my example. My goal is selling the stocks/funds with the least gain in them for the most money I can get for them. That maximizes my return while still keep the tax lower than choosing some investment with a higher gain built into it.

What I'd normally do is find shares that are underperforming anyway and have little gain in them and sell those for the RMD. I'm then addressing two goals at once: getting rid of a poor performing stock/fund and minimizing capital gains. Whether a direct cash distribution or a distribution that is done by converting it into some other kind of investment, the capital gain will be the same, as you noted. Both are distributions, and are taxed the same. It's the timing and which shares/funds you select to sell that makes the difference in the gains, rather than how you take the distribution. The tax law is set up to ensure that the government will capture the gain you have regardless of the method you use to take that distribution.

So, I look at what gain is in my investments at the time I plan to sell to make the decision of what to sell to best meet those two goals: getting the most money from the investment and keep my capital gain as low as possible. Basically, I'm looking for what will get me the most money out of the investments I have after taking tax into account. It's the after tax amount that is most important as that's what I have to use, whether for the RMD or to buy something I need/want. If I had to make a distribution during the year but the timing is up to me (like an RMD requirement) then my choice is to first take distributions from the investments with the least gain in them, but I still want to get the most money from them, so I try to find when those low performers will have their best price. Yes, it'll increase the gain over waiting until it's at the lowest point in the year, but I'm also getting more out of each share sold, and assuming the same tax rate either way, selling when it's high will still net you more money after tax. If it would bump you into a different tax bracket, then the planning would be a bit different. So for me, it's the particular investment I choose to sell that's most important (lowest gains typically are preferred, all other things being equal), and then trying to pick when in the year I'll get the most out of that particular investment. But not all things are equal, complicating things. A new investment that I think will do very well will have a low gain because I've not had it long. That's why I use the term poor performers. I want to get rid of the worst in my investment portfolio anyway, so I use those for my RMD. Again, that may not result in the absolute minimum capital gains tax today, but over the long run will get me more in my pocket after tax.

It's always impossible to know if selling it a later date would be better or worse, so I just have make the best judgment on that as I can. As for how I choose to take the distribution, typically whichever will result in the least fees would be the route I'd take.

I'm not yet required to take RMDs, although I can withdraw from retirement accounts now without penalty. But if I want to make a distribution for some reason, the above is the method I use.

If I've misunderstood your question or something above is unclear let me know. It's a bit hard to distill what I do down to a paragraph or two. (I ultimately use spreadsheets to aid in analyzing what to sell). I don't know the details of your investments, obviously, and the mix of investments you have will affect the exact selection of what to sell to get your RMD. It also matters what goals you prioritize, too. Your goals may be different from mine.

 

[welkin]

If I've misunderstood your question or something above is unclear let me know. It's a bit hard to distill what I do down to a paragraph or two. (I ultimately use spreadsheets to aid in analyzing what to sell). I don't know the details of your investments, obviously, and the mix of investments you have will affect the exact selection of what to sell to get your RMD. It also matters what goals you prioritize, too. Your goals may be different from mine.

Thank you for the answer and I agree with everything you said. I have been very fortunate in my investments as a self-employed person over my working life. When I had very good years in business and had to pay high taxes, my accountant for more than 25 years (a very well experienced and respected account by the IRS) when asked, why so much income tax, self-employment tax, SEP contributions, and Medicare tax, he would say, the day will come when you thank me. We played by the rules, and I benefited greatly from it even though it did hurt to pay at the time.

But my question in this post is not about selling stock or funds that may be in a personal account with which all you said is true. The question relates to retirement accounts where dividends, short- and long-term capital gains are not taxed. The proceeds from those accounts are taxed as income when you take a distribution. If that is not the case, then please correct me.

So, if you take a distribution (in-kind: no sale and no buy) from a retirement account in mid-year, do you still have to pay capital gains tax on the shares for the remainder of the year when they are transferred to your personal account. My assumption is that you do but only for the gains paid while in the personal account for a partial year. But since the majority of gains are paid at the end of the year, it seems an unbalanced tax. That is the question I am looking for an answer to. If the answer would be yes, then waiting to the last capital gains distribution of the year before you do the in-kind transfer saves you capital gains tax because they were paid into the retirement account.

It's not small change I'm speaking about. I have tried to backtrack the math and the numbers don't make sense to me when I get the 1099's on my personal accounts.

 

[Tax Counsel]

The question relates to retirement accounts where dividends, short- and long-term capital gains are not taxed. The proceeds from those accounts are taxed as income when you take a distribution. If that is not the case, then please correct me.

Correct.

So, if you take a distribution (in-kind: no sale and no buy) from a retirement account in mid-year, do you still have to pay capital gains tax on the shares for the remainder of the year when they are transferred to your personal account. My assumption is that you do but only for the gains paid while in the personal account for a partial year. But since the majority of gains are paid at the end of the year, it seems an unbalanced tax. That is the question I am looking for an answer to. If the answer would be yes, then waiting to the last capital gains distribution of the year before you do the in-kind transfer saves you capital gains tax because they were paid into the retirement account.

In order for the exchange of a qualified retirement asset to qualify as a RMD distribution, the exchange would have to result in you receiving some non retirement plan asset. i.e. not a roll over distribution. It's got to be a taxable distribution, not something in which the tax is deferred.

Your question above alludes to that, and I agree that the capital gains in a qualified retirement plan are not generally taxed as long as you hold it. It's when you distribute the qualified plan asset that it becomes income, and for most common plans the entire distribution is treated as ordinary income. However, Roth IRAs and any retirement plan in which, for some reason you have a basis, the treatment is a bit different. Bear in mind that any retirement investment you made that was fully deductible on your income tax return in the year you bought it will have no basis. So, distributions from most traditional IRAs, § 401(k) plans, etc result in entirely ordinary income. For those, the capital gains really aren't relevant because that distribution is not treated as having any capital gain.

But there are other, less well known, retirement plans/assets. If you have one of those, then which one you have matters.

I see what you are getting at though. If the asset has a lot of gains paid out at the end of year and you are taxed only on the gain, then taking out a distribution after the fund does the rebalancing (or whatever else it does) that results in a lot of capital gains will increase your gain on that distribution over taking out the same amount from it before that distribution is declared or added to the account. But taking it out before the gain would also generally reduce the amount of capital gain you get in the fund at the end of the year because your assets in the fund at that time are less when the capital gains are computed.

That's why I'd look at what I'd have in my pocket after tax if I take the distribution both before the gains get added and after. Just looking at the amount in the account or what the capital gains tax will be only gives you half the picture. You need to take both into account pre and post capital gains earnings to figure out what gives you the most in your pocket in the end. There is a trade off involved and the exact numbers for your particular investments and your other income (and thus your tax rate) matter as to how that trade off comes out.

This very fact frustrates a lot of clients who want an easy rule of thumb to use. Such a rule may work out well most of the time, but not all the time. If you are willing to give up some potential money to get the simplicity then a simple rule may be just fine for you. If it works most of the time, the downside might not be a lot. But if you are the sort that wants to nail the best possible amount of cash in pocket at the end of every year, then a simple rule may not do that for you.

 

[welkin]

In order for the exchange of a qualified retirement asset to qualify as a RMD distribution, the exchange would have to result in you receiving some non retirement plan asset. i.e. not a roll over distribution. It's got to be a taxable distribution, not something in which the tax is deferred.

I agree. The asset, in the dollar amount of the RMD, must come from a non-taxable retirement plan and go into a personal account where it is taxed as income for the Calander year of the RMD before December 31 and marked (by the Plan) as the distribution for that year. The Plan then sends that information to the IRS as the RMD received for that year.

Your question above alludes to that, and I agree that the capital gains in a qualified retirement plan are not generally taxed as long as you hold it. It's when you distribute the qualified plan asset that it becomes income, and for most common plans the entire distribution is treated as ordinary income.

I also agree.

That's why I'd look at what I'd have in my pocket after tax if I take the distribution both before the gains get added and after.

And there is the rub. You don't know what the capital gains are going to be at any time during the year until they are paid. So, you can't really know if you will be better off taking the RMD at any point during the year based on share price until the final capital gains are paid for the year. That gives you a window of about 2 weeks to take the distribution. That is cutting it close to not taking the RMD (IMO) for that year and I understand that there are substantial penalties if you don't take it.

There is a trade off involved and the exact numbers for your particular investments and your other income (and thus your tax rate) matter as to how that trade off comes out.

I have 6 retirement plans in two institutions. I do not take RMD's from each. I calculate the value of all as a total on December 31 of the preceding year and take an RMD for the total from one of the plans. I find that to be simpler than taking 6 RMD's for bookkeeping and tracking of the investments.

I think you have confirmed that it is best to wait for all capital gains to be paid to the plans before taking the RMD and not be so concerned with share price during the year.

Thank you.




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[Tax Counsel]

And there is the rub. You don't know what the capital gains are going to be at any time during the year until they are paid. So, you can't really know if you will be better off taking the RMD at any point during the year based on share price until the final capital gains are paid for the year.

Yep, that's exactly the problem: forecasting out to the end of the year is difficult at best.

Thank you.

You're welcome. I'm glad there was something useful in my somewhat rambling posts on the subject.