Gain More from Your SabbaticalOctober 3, 2019
Over the last 24 months, many of our clients experienced successful exits through acquisition, secondary sale, or their company going public. This new liquidity set their financial trajectory on the fast-track, drastically changing what is possible for them.
In anticipation of liquidity, we had several brainstorming sessions with our clients. These discussions touched on an array of topics, but the common underlying sentiment was optionality. Although optionality is also the foundation of the Financial Independence / Retire Early (FI/RE) movement, these conversations were far from the stereotypes portrayed in the news.
Our experience collaborating with folks who are fortunate enough to navigate life-changing wealth early in their career is that they worked hard for the possibility. The attributes that put their financial trajectory years or even decades ahead of schedule don’t disappear overnight. But in many cases, these individuals do want to experience something different even if it’s for a short while.
Sabbatical, Enter Stage Right
Doing nothing for the next 30 years is much more intimidating than doing something else for a bit. The reason is that “something else” can be anything and “for a bit” can be as long as it makes sense for them. For our clients, these intrinsically motivated decisions created the space for travel, homeschooling kids, writing a book, volunteering full-time, starting a company, or unplugging and recharging before the next chapter of their lives.
Not only does proactively planning for liquidity allow clients to smoothly transition into this new chapter of life, it affords a new lever to gain more from their sabbatical.
Hidden Benefits of a Sabbatical
Aside from the perks to physical and mental well-being, there is an important lever we can consider for improving financial well-being during a sabbatical – harvesting gains inside an after-tax portfolio.
Given how much we talk about the benefits of harvesting losses, suggesting that you should harvest gains may sound like tax blasphemy. And it often is. However, years in which wage income is lower due to time off during a sabbatical, it could be beneficial to harvest gains.
When wage income drops in a year, fewer dollars are taxed at higher rates which drives down one’s effective tax rate (effective rate being the weighted average tax rate across all brackets). Although long-term capital gains are taxed at lower rates than wages, long-term capital gain income “stacks” on top of ordinary income from wages to determine taxable income. The total tax owed is then calculated based on the tax brackets outlined in the illustration below.
Consider an individual who normally has an Adjusted Gross Income (AGI) of $250,000 from salary, bonuses, and RSU vests. The ~$90,000 of income above $160,725 is taxed at 32% and any long-term capital gains realized during the year are taxed at 18.8%. The jump in capital gains rates at $200,000 for an individual and $250,000 for married couples is due to the 3.8% Medicare Surtax on investment income above those thresholds.
Now assume the individual took a sabbatical for half the year, limiting wage income to $125,000. Their top Ordinary Income Tax Rate is now 22% instead of 32%. Plus, up to $75,000 of capital gains are only taxed at 15% because they have not reached the $200,000 threshold for the additional 3.8% Surtax to kick in. This means they get to pay tax on $75,000 of capital gains at 15%, or voluntarily increase the tax bill by $11,250.
But why choose to pay tax when it isn’t necessary?
Harvesting Gains in a Portfolio
Voluntarily paying tax on portfolio holdings with embedded long-term gains has several benefits during years in which ordinary income is lower than normal.
1. Pay more tax to pay less tax.
Many people experiencing a liquidity event have shares of company stock that qualify for long-term capital gains treatment when sold. Diversifying out of the concentrated stock position means realizing gains and increasing the tax bill, which can be strategically aligned with taking time off. This may involve accelerating the liquidation strategy for a low-tax year because paying tax at lower rates is better than paying tax at higher rates when we know shares will be sold anyway. Then, when wage income rises once the sabbatical is over, there will be fewer capital gains taxes attributable to higher tax rates.
2. Increase portfolio cost basis to harvest losses when taxes are higher.
Assuming the stock market goes up over the long run, holdings should be worth more than when they were purchased. When gains are harvested from company stock and the proceeds are reinvested at current market prices, the new holdings have a higher cost basis. Within the assumption that markets go up over the long-term is the understanding that they will also occasionally go down. Opportunistically harvesting losses during market volatility is only possible if the current price of a holding drops below the price at which it was purchased.
Harvesting losses in a portfolio with refreshed cost basis can result in short-term losses. So, not only can one take advantage of lower capital gains rates during the sabbatical, once the sabbatical is over it is also possible offset any short-term capital gains associated with diversifying single stock risk with these short-term losses to minimize tax in higher income years.
3. You planned for this.
For clients with significant exposure to single stock risk and the tech sector from their equity compensation, we often advocate to keep 12 months of non-lifestyle spending needs in cash beyond their emergency fund. These non-lifestyle expenses are things like home updates, a new car, or a big anniversary trip. Having this cash helps prevent a drop in the price of their company stock from undermining their ability to live the life they want.
Now, imagine taking 3, 6, or 12 months off to explore life without being tied down at work. With the proper planning, not only is cash available to cover spending needs for the duration of the sabbatical, there is enough cash to pay the tax bill on any harvested gains.