Windfall strategies

[socalrider]

Long time lurker here... what a great site - I have learned a ton here and at Bogleheads. 

Situation: I'm 48, wife is 50, 3 kids 10-15. 
Sole proprietor consultant $300-400k/yr income.  Wife works a bit, $25k/yr
I've been maxing out my SEP IRA for the last 10 years; that constitutes the bulk of our retirement accounts ($600k), with another $100k in a Roth & rollover IRA, and $100k in our emergency fund.  No debt other than a small mortgage which will be paid in 8 years.  I give 10%/yr to charity.  Retirement accounts are all in FZROX (Fidelity S&P500 index fund), emergency fund is in short term treasury fund. 

I'm about to enjoy the fruits of some profitable business decisions.  This year I expect to realize about $160k in long term capital gains, and an additional $1m in business income, followed by another $500k in 2024.  I *may* extend this streak for a few more years, but it's also possible that my income could revert back to its current level.  I'm in no particular hurry to retire; I enjoy my work & have plenty of time to travel & be with my family.  My goal is more "F__ you money" in case my situation changes. 

Question is how to manage the windfall.  I'm in CA, so I expect to get clobbered by taxes this year.  Here are the options I've looked at so far:

1. Donor Advised Fund to smooth out charitable giving.  This seems pretty easy/straightforward, unless I want to just give a ton more than usual for one or two years. 
2. Defined Benefit Plan.  This is more controversial - because I'm not sure how may years of excess income I'll have I could end up only contributing for a few years.  The DBP people I've talked to have said that I can always shut the plan down and roll it over to a 401(k), with the dramatic drop-off in income being a valid explanation for the IRS.  There are costs involved, but the tax savings are so large that it may be worthwhile even if I only contribute for a few years.  Looks like I could shelter $300k for the first year and maybe $250k for subsequent years.  If I do this I have to stop contributing to the SEP. 
3. MBD Roth?  I'm not quite clear on how this works with my SEP IRA.  It seems like the contribution limits are similar and I can't do both, so I'm not sure there's much of an advantage. 
4. I may also hire a financial advisor (fixed fee or hourly) to help with this & developing a more sophisticated asset allocation. 
5. Any other ideas?  Just suck it up, pay the taxes, and dump the remainder into a taxable brokerage account? 

Thanks for your thoughts!

[nereo]

This seems like an ideal case to talk to a CFP, as the complexities are huge and the potential tax burdens are going to run into the low six figures of done poorly. 
A couple thousand dollars spent with a professional will be well spent in this circumstance, IMO

Congrats on your success. You have truly “won the game”

[MustacheAndaHalf]

1. Donor Advised Fund to smooth out charitable giving.  This seems pretty easy/straightforward, unless I want to just give a ton more than usual for one or two years.

For the amounts involved, contributing six figures to a Donor Advised Fund (DAF) is surprisingly smooth.  You can also decide to reveal your full name and address, just your name, or remain anonymous.  For smaller donations to charities you don't want hassling (or knowing) you, I find anonymous donations helpful.

I view DAFs as IRS matching (32% at $400k/yr, 37% at $700k/yr).  Assuming you have more than your emergency fund outside retirement accounts ("F-you money"), I'd recommend donating shares you've held 366+ days directly to a DAF.  You do not sell the shares - so you don't pay tax on the sale.  And you take the full value of the shares as a donation.

I prefer DIY.  Setting up a DAF doesn't require a financial planner, in my view, and gives you the most control over how and when donations occur.  I'd strongly favor that route, and have taken it myself in similar circumstances.

[MDM]

SEP IRA & Solo 401K Questions - Bogleheads.org might be a good starting point for you.

For the dollar amounts in question, I would guess a solo 401k would be better for you than the SEP, but "get advice from someone very familiar with small business tax considerations" should be top of your to-do list.  Well done to get to where you are!

[socalrider]

Thanks all for the kind words and advice.  I'm still confused by everyone saying that the solo 401(k) allows for greater tax sheltering than the SEP-IRA.  Both seem to have max annual contributions of $66k/yr in 2023. 

Does the 401(k) allow for $66k pre-tax AND additional contributions which can be routed to a MBD Roth to shelter capital gains?  I'll keep studying up on this - thanks MDM for the Bogleheads link.

I'm definitely going to talk to a few CFP's. 

Any thoughts on the DBP?  Seems like the DAF is a no-brainer as thought.

What a lot of acronyms... :)

[SeattleCPA]

You probably want to use a pass-through entity and probably an S corporation. That might let you get a Section 199A deduction and avoid federal income taxes on last 20% of your income. (See here for info about how S corporations work: https://evergreensmallbusiness.com/tax-strategy-tuesday-one-person-s-corporation/).

BTW that S corporation would also let you take advantage of the pass-through entity tax (PTET) option. The "PTET" will save you $50K or more of federal income taxes. (A short blog post at our CPA firm website explains: https://nelson.cpa/pass-through-entity-tax-election-increases-salt-deduction/ )

I agree with the SEP vs 401(k) thing. Especially if you do an S corporation. But you may also want to look at employing spouse and that would change the calculus of SEP vs 401(k) maybe.

The other thing to consider is using real estate as a way to save WAY more pretax money. You need to use debt to really supercharge this. But you could (for example) use $600K of pre-tax money to buy a $2M building or rental (so that'd mean a $1.4M mortgage)... but then structured right, you'd be able to write off the $600K as a deduction.) You need to use one of the real estate loopholes to get big deductions onto your return. E.g., one way to do this would be via short-term rentals (discussed here: https://evergreensmallbusiness.com/tax-strategy-tuesday-vacation-rental-property/ ). Another way would be to use a self-rental for your business. Another way would be to talk your spouse into becoming a real estate professional (more info here: https://evergreensmallbusiness.com/tax-strategy-tuesday-real-estate-professional-tax-strategy/ )

You won't be able to use all the above stuff. Rather, you'd assemble a handful of the puzzle pieces to optimize.

Final comment: The tax stuff isn't something you get advice about from a CFP. Use a CPA who deals with this stuff every day.

[Sandi_k]

Between SEP-IRA and Solo 401(k), the reason you can save more with the 401(k) is it doesn't preclude you from a Backdoor Roth.

With the SEP, you have the pro-rata rule, which inhibits additional contributions.

[SeattleCPA]

Between SEP-IRA and Solo 401(k), the reason you can save more with the 401(k) is it doesn't preclude you from a Backdoor Roth.

With the SEP, you have the pro-rata rule, which inhibits additional contributions.

A SEP-IRA doesn't preclude you from backdoor Roth it just burdens you with the pro rata rules. Those may or may not be a big deal.

But that said, the 401(k) thing creates some other problems. First, as compared to a SEP, 401(k) doesn't play as well with an S corporation which @socalrider should consider. Second, if OP ever adds an employee, because of the permanence requirement and then the anti-discrimination rules, the 401(k) will probably be suboptimal as compared to a SEP at least for tax purposes.

[Sandi_k]

Between SEP-IRA and Solo 401(k), the reason you can save more with the 401(k) is it doesn't preclude you from a Backdoor Roth.

With the SEP, you have the pro-rata rule, which inhibits additional contributions.

A SEP-IRA doesn't preclude you from backdoor Roth it just burdens you with the pro rata rules. Those may or may not be a big deal.

But that said, the 401(k) thing creates some other problems. First, as compared to a SEP, 401(k) doesn't play as well with an S corporation which @socalrider should consider. Second, if OP ever adds an employee, because of the permanence requirement and then the anti-discrimination rules, the 401(k) will probably be suboptimal as compared to a SEP at least for tax purposes.

I didn't say that the SEP "precludes" backdoor Roths; I noted that it complicates it due to the pro rata rule.

Your point about employees and Solo 401(k)s is good additional info; thanks.

[Much Fishing to Do]

I had a S Corp where I generally made around $300k, but then had one huge year that put me well into the highest tax bracket.  Probably the best straight forward move I made (that was unique to me) was opening a DAF.  Instead of the cash I had made I actually funded it with my highest appreciated investments currently held, so not only did I save the 40% or whatever from the fed deduction but getting rid of those cap gains without being hit by a tax basically meant I saved more like half (or the way i thought of it was every $10k I put into the DAF was only really costing me $5k, pretty incredible).  Given once I retire (soon) charitable deductions will likely be worthless to me, my goal was to make this DAF a fund from which most of my giving in retirement will come from.  Its kinda nice to have it separated that way anyway form the investments I'll live off of, and I can then treat it like an endowment where I give away something like 6%/year until it expires or I do.

[socalrider]

I had a S Corp where I generally made around $300k, but then had one huge year that put me well into the highest tax bracket.  Probably the best straight forward move I made (that was unique to me) was opening a DAF.  Instead of the cash I had made I actually funded it with my highest appreciated investments currently held, so not only did I save the 40% or whatever from the fed deduction but getting rid of those cap gains without being hit by a tax basically meant I saved more like half (or the way i thought of it was every $10k I put into the DAF was only really costing me $5k, pretty incredible).  Given once I retire (soon) charitable deductions will likely be worthless to me, my goal was to make this DAF a fund from which most of my giving in retirement will come from.  Its kinda nice to have it separated that way anyway form the investments I'll live off of, and I can then treat it like an endowment where I give away something like 6%/year until it expires or I do.

Thanks for that.  I just opened up a DAF through Fidelity (took 5 minutes).  My CPA is running some scenarios this coming week to help figure out my options & how much I should contribute.  In retrospect, I missed an opportunity to move my shares into the DAF before they were sold to take advantage of the strategy you just outlined, but at the time those shares became valuable I did not know if I'd be receiving the other (much larger) windfall... bummer that a chunk of it will be going to the  gov't instead of charity. 

[Dicey]

I had a S Corp where I generally made around $300k, but then had one huge year that put me well into the highest tax bracket.  Probably the best straight forward move I made (that was unique to me) was opening a DAF.  Instead of the cash I had made I actually funded it with my highest appreciated investments currently held, so not only did I save the 40% or whatever from the fed deduction but getting rid of those cap gains without being hit by a tax basically meant I saved more like half (or the way i thought of it was every $10k I put into the DAF was only really costing me $5k, pretty incredible).  Given once I retire (soon) charitable deductions will likely be worthless to me, my goal was to make this DAF a fund from which most of my giving in retirement will come from.  Its kinda nice to have it separated that way anyway form the investments I'll live off of, and I can then treat it like an endowment where I give away something like 6%/year until it expires or I do.

From my parent's estate, I received some cash and an equivalent amount in an inherited IRA. I put the cash into a DAF and it's been a blast. The inherited IRA has grown quite a bit and now I'm doing RMD's. I wonder if there is a way to move the taxable IIRA over to the DAF without paying taxes on it? Do you know? If there is, I'd love to close out the IIRA and move it all to the DAF.

[Sandi_k]

@Dicey - my understanding is that if you want to use the IRA funds for charitable purposes, you need to set up a QCD after age 70.5

Prior to that age, any use of IRA funds for a DAF would be considered a distribution first.

In a quick Google search, I found an article to support that remembrance, but it is a little dated (late 2015). It says:

"IRA distributions meant to fund a donor-advised account are not considered qualified charitable distributions. (There is talk of changing the rule to include distributions to donor-advised fund accounts, but no such change is expected in the near future.)

The upshot is that even if you meet all the requirements to exclude a direct IRA distribution to charity from your taxable income, a direct IRA distribution to a donor-advised fund account is treated as a taxable withdrawal from your IRA under the provision. Most other 501(c)(3) public charities, such as those you support through your donor-advised fund, will qualify for a direct gift from your IRA.

https://www.donorstrust.org/tax-estate-planning/iras-and-dafs/

And from 2019, after the TCJRA:
https://www.donorstrust.org/donor-advised-funds/qualified-charitable-distributions-ira-daf/

Aha! Here's one, that says you CAN donate from the IRA, DIRECTLY to charity, skipping the DAF:

https://solvecfs.org/donate/ira-daf-distribution/

As of 2021, an IRS provision allows retirees age 72 years and older to donate up to $100,000 tax-free from their IRA each year to a qualified charity, such as Solve M.E.

Generally, when you take a distribution from your IRA, it is treated as taxable income. Under this provision, the assets are excluded from income if the distribution is made directly to charity.

The distribution is not included in your income so you avoid all the effects that a regular IRA withdrawal creates, including taxes on Social Security benefits.

The IRS Provision is here:

https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs

[GilesMM]

There is a Bogleheads page on managing a windfall.

[Dicey]

Wow, @Sandi_k , that's one fine rabbit hole you've prepared for me. Thank you ❤️!

[Sandi_k]

Wow, @Sandi_k , that's one fine rabbit hole you've prepared for me. Thank you ❤️!

You are welcome!

[socalrider]

Any thoughts on Defined Benefit Plans?  My CPA is recommending I consider this option. 

The benefit is that they allow pre-tax contributions much larger than the SEP IRA limit ($200-300k/yr), deferring taxes during a year or years where my marginal rate will be around 50%.

The drawbacks are relatively high administrative fees (First quote was $6k setup, $3750/yr; it'd probably get closed after 3 years & rolled into a regular IRA), and locking in the requirement to contribute for at least 3 years.  I think I can manage the second risk factor, and the fees are pretty low compared to potential tax savings.  Need to look into this more. 

[socalrider]

Update for posterity after consulting with a few other folks and our CPA:

Going ahead with a Donor Advised Fund (through Fidelity) and a Defined Benefit Plan (through Emparion) combined with a 401(k) to max out pre-tax contributions for the next 3 years at least.  The latter involves a $1780 setup fee, and $2480 annual fees.  If income drops substantially and the plan no longer makes sense it can be shut down - there are some details around this, so be careful out there. 

The only other piece was optimizing PTET payments (prepaying CA tax to get around double taxation at the Fed level). 

I read some interesting discussions around the pros and cons of the DBP.  In my case the expense and complexity is justified by the ability to shield 5x the income from taxes.  In general we live pretty frugal lives, so I'm confident the tax arbitrage will work out in our favor in retirement; and if we end up making a big pile and transforming into wealthy spendthrifts, well then we deserve to have the arbitrage shut down :)

Thanks for the help, all. 

[tj]

Update for posterity after consulting with a few other folks and our CPA:

Going ahead with a Donor Advised Fund (through Fidelity) and a Defined Benefit Plan (through Emparion) combined with a 401(k) to max out pre-tax contributions for the next 3 years at least.  The latter involves a $1780 setup fee, and $2480 annual fees.  If income drops substantially and the plan no longer makes sense it can be shut down - there are some details around this, so be careful out there. 

The only other piece was optimizing PTET payments (prepaying CA tax to get around double taxation at the Fed level). 

I read some interesting discussions around the pros and cons of the DBP.  In my case the expense and complexity is justified by the ability to shield 5x the income from taxes.  In general we live pretty frugal lives, so I'm confident the tax arbitrage will work out in our favor in retirement; and if we end up making a big pile and transforming into wealthy spendthrifts, well then we deserve to have the arbitrage shut down :)

Thanks for the help, all.

Can you roll over the DBP into an IRA if you ever do shut it down to maintain the tax deferred status? It seems like you should be able to but I am not familiar.

[socalrider]

Can you roll over the DBP into an IRA if you ever do shut it down to maintain the tax deferred status? It seems like you should be able to but I am not familiar.

Yes that's the idea.  Consult an expert obviously, as there are guidelines about what's reasonable and what's not (shutting it down and rolling over after one year, for example, would not be great). 

[LightStache]

A little late to the discussion, but I had a DBP from 2020 through 2022. I shut it down when I sold my business. And yes, after terminating the plan you roll the funds into an IRA or 401(k).

It's probably worth it for you. My plan admin charged $3K first year and $2K for annual admin. My accountant at the time was a nightmare and the DBP folks were gracious handling him pre-sale. After I signed the contract, the DB admin was a struggle to deal with and even filed Form-5500s late. The late penalty, which I think I'll avoid, is $ 2,586 per DAY for the DOL plus $25 per day for the IRS. Send me a PM if you want to know which company to avoid.

So I'd say go ahead and do it, just understand that you're going to have to manage your plan administrator and there will be additional reporting complexities.

[socalrider]

So I'd say go ahead and do it, just understand that you're going to have to manage your plan administrator and there will be additional reporting complexities.

Thanks!  Sent a PM - I've used my CPA for a decade now and he's been great, very responsive.  So far the setup with Emparion has been seamless but the proof will be in the pudding come filing time.  I'll be on the lookout; understood the greater complexity going in but worth it given the ability to defer such a large tax bill.