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  • Writer's pictureHannah Boundy, CFA®, CFP®

Three Tax Shortfalls That Could Impact Your Living Legacy

Updated: Jan 10, 2023

When it comes to investing for your financial goals, it's tempting to focus on investment returns at the expense of other vital inputs. Don't get me wrong, returns are necessary, and you must stress test your plan for various market outcomes. Still, it's essential not to ignore the implications of potentially costly tax decisions that can have just as large of an impact on your plan, if not more so. To help you better think through the consequences of those decisions, here are three tax shortfalls that could affect your living legacy and a few tips on how best to manage them.

Retiring Early

For many, the ability to retire early is the ultimate financial planning goal. Retiring early means finally quitting that stressful job that's burning you out. It means finally spending more time doing the things you love with the people you love. It may be tempting to dive into retirement for those who have successfully saved enough to retire early. However, it's essential to consider the implications of retiring early, mainly if you're doing so before attaining the golden retirement age of 59.5.

Retiring before turning 59.5 is no small feat. This is because distributions taken from qualified retirement plans such as an Individual Retirement Account are taxed with a 10% penalty when taken before the owner has turned 59.5. This penalty is a costly expense that can hamper the long-term viability of a financial plan. Fortunately, there are a few options for working around this rule.

The first option is simply to have cash available. This could come from downsizing, refinancing, or having cash saved in after-tax accounts like a checking/savings account or brokerage account. For those looking to access cash through equity in their home, it's essential to consider the long-term implications of that decision. There will be the added cost of interest if you choose to refinance (you are essentially financing your early retirement), and refinancing may not make sense in your overall financial plan. It's always a good idea to discuss any significant financial decisions with your financial advisor to ensure you're considering the entirety of your financial plan and how all of the pieces come together.

One other option is implementing a 72t, a tool based on the IRS rule that allows you to take funds from your IRA before turning 59.5 without incurring a 10% penalty. To execute on a 72t, you essentially annuitize a defined portion of your IRA and commit to taking equal distributions from that sum over a specified period of years (until you reach 59.5 or a minimum of 5 years). Using this option, you must pay regular income taxes on your draws. However, you can retire earlier without paying the tax penalty. While a 72t provides a unique planning opportunity, they are tricky to execute, and the implementation must be done accurately; otherwise, the entire amount becomes subject to the penalty tax. For this reason, we highly recommend working with a professional when exploring a 72t.

Selling a Large Asset

For those who plan on funding their living legacy through the sale of a large asset such as a business, investment property, or significant investment holding, it's essential to consider the tax implications of such a sale. For an asset that has been held for business purposes, the difference between the price the asset was purchased, also known as its cost basis, and the price the asset is sold will be subject to capital gains taxes. Capital gains taxes follow a progressive schedule, and the more you make, the more you will pay. These gains will be taxed at 20% for those making more than $445,850 (or $501,600 MFJ), which could result in a significant tax expense for you. To minimize this tax expense, you should consider a few options.

If the asset you're selling is a business, you might consider a phased buy-out. A buy-out will allow you to spread out the sale over time without recognizing all of the gains at once. This may look like selling 10% of your stake each year over a period of 10 years.

For those charitably minded, a case can easily be made to donate the asset directly or place the asset in a Donor Advised Fund before selling. This allows you to shelter the asset from capital gains taxes while also taking the deduction in the year you make the contribution. Donor-Advised Funds have many benefits for those who want generosity to be a part of their living legacy.

Finally, if you're looking to sell a rental property with significant capital gains, you may consider moving into the property full time. To claim a property as your primary residence, thereby allowing you to avoid paying capital gains taxes on a sale, you must live in the property for two years. It may not be the most convenient option, but if you can make it work, there are significant savings to be had from reclassifying a rental property as your primary residence prior to a sale.

Failing to Locate Assets Efficiently

When it comes to traditional investing, one commonly missed opportunity comes from efficiently locating assets in specific types of accounts based on their income profile. Logistically, this looks like placing your highest income-generating assets in tax-qualified accounts such as IRAs to defer that income and avoid paying taxes on it until it's distributed. Investments that generate less income should be placed in after-tax accounts where, when possible, tax-loss harvesting can be employed to offset gains.

While it can be tempting to consider your accounts individually and invest each one uniquely, this is a classic case of psychological misbehavior. Money is fungible – meaning it spends the same whether you keep it in your right pocket or your left. As such, it's better to consider your savings as a whole and invest your assets as a collective group. Doing so will allow you to simplify your investing approach in light of your financial goals, but it will also create tax savings opportunities such as those mentioned above.

For more information on how to make the most of your financial situation regarding tax planning, please don't hesitate to give us a call. We'd be happy to help you integrate thoughtful tax strategies into your living legacy plan.


Sherwood Financial Partners, LLC is a registered investment adviser. Sherwood Financial Partners, LLC may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. The information contained herein is not intended to convey or constitute legal or tax advice. Be sure to first consult with a qualified financial adviser, legal professional, and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Principal value and investment return will fluctuate. There are no implied guarantees or assurances that the target returns will be achieved or objectives will be met. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal.


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