So far in this series on the Frank Duke Method, we have explored the history and goals of the method and explained how to implement the strategy. In this installment, we will provide guidelines that can help you determine if the Duke Method is the best approach for your retirement assets. In our experience working with P&G retirees, the appropriateness of the Duke Method depends heavily on your unique situation, so we strongly encourage you to meet with a financial advisor, preferably one who does not simply recommend or reject the Duke Method for every client.
Evaluate Your Concentration Risk and Tax Situation
As a reminder, the Duke Method seeks to lower the tax bills for those retiring from P&G. Specifically, it involves moving assets from your P&G retirement plan into two different accounts—a taxable investment account and a traditional IRA. After this initial rollover, you then make an additional transfer, moving assets from the taxable account into the IRA in such a way that you can avoid paying ordinary income tax on the cost basis of your distributed P&G stock.
The possibility of paying zero income tax on the distribution of your retirement assets is very appealing, and many P&G employees and financial advisors assert, based solely on this, that it is the preferred distribution approach. At Truepoint, we take a more individualized approach and analyze each client’s specific situation to determine whether the Duke Method is the best approach for them.
When considering the Duke Method, it is important to understand two issues:
(1) Concentration risk: Concentration risk is the danger of having too much of your assets in one security. For those retiring from P&G, your concentration risk comes from the amount of P&G exposure you have relative to your other assets and income sources. One of the main investing related benefits of retiring from P&G is the ability to diversify your P&G stock. However, the utilization of the Duke Method, coupled with strategic tax planning, may extend your concentration risk. Why? In the Duke Method, the cost basis of your P&G stock becomes zero. The net unrealized appreciation (the NUA discussed in earlier pieces) becomes equal to the per share market value of the distributed stock. This means you will incur more capital gains tax when the stock is sold. Because of a graduated capital gains tax rate structure, which will be addressed in a subsequent piece, spreading the PG stock sales over multiple years may result in less capital gains tax. Therefore, it is critical to confirm that your financial projection indicates that you can withstand the prolonged concentration risk.
(2) Your specific tax situation: Tax rates and tax burdens vary significantly by individual. Insisting that the Duke Method is the right approach for everyone overlooks this reality. In truth, a tax strategy that benefits one person might increase another’s tax burden. You need to have a solid understanding of your current tax obligations as well as your likely future tax rates to assess if the Duke Method will likely benefit you.
To Thine Own Self Be True: Know The Answers!
To help you evaluate whether the Duke Method is the best approach for you, ask yourself:
(1) Are you likely to withdraw little from your investment accounts over the first few years of retirement? If so, the Duke Method may be a good choice. Having other sources of income besides your investment portfolio will give you more flexibility when it comes to selling your P&G shares. You will likely be able to sell your shares over a longer period of time, which can reduce the capital gains tax costs that come with the Duke Method. Keep in mind, though, that additional sources of income may also put you in a higher tax bracket, which can erode some of the gains you made by choosing the Duke Method.
(2) Can you follow a strict, by-the-numbers investment plan, or do your emotions sometimes take over? The benefit of the Duke Method is that it allows you to avoid paying income tax on your P&G shares when you retire. However, you will owe long-term capital gains tax on the NUA of those shares when sold. This looming tax bill can cause some people to put off selling their shares, even when the time is right, because they don’t want to face the additional taxes. Emotional decisions like these detract from the Duke Method. It’s important to remember that following the Duke Method involves more than executing a series of steps when you retire. You must continue to make prudent choices with those shares year after year.
(3) Could your income tax rate increase in the future? If so, you could end up paying more in taxes by using the Duke Method. Remember, by rolling the cost basis back into your IRA you are effectively deferring (not eliminating) ordinary income tax. You will still need to pay ordinary income tax on these dollars when you ultimately withdraw them from your IRA. Also, be aware that your total tax burden depends on many factors. Even if your income tax rate drops in the future, the Duke Method might still increase your total tax bill. It’s always best to check with your accountant or a tax specialist—even better if this professional has a thorough knowledge of your investment plan.
Charitable Giving: An Alternative to the Duke Method?
It is important to remember that there are other strategies to help manage your retirement tax burden. What’s more, they can provide an advantage over the Duke Method—they are much less likely to face an audit risk or challenge from the IRS.
If you are charitably inclined, there are a number of opportunities you can use to reduce the tax. An effective, IRS-approved method for reducing and potentially offsetting the ordinary income tax cost on the distributed stock involves accelerating charitable donations into the current tax year. How? Through the use of a donor-advised fund. A donation of the PG stock results in a charitable deduction for the market value of the stock, which is well above the cost basis of those shares. For example, if the trustees’ cost of your stock is $6.82 and PG is trading at $135 on the date you make your donation, you are entitled to a $135/share deduction. The entire gain is not only untaxed, it is DEDUCTED. Charitable strategies do more than reduce the income tax you owe on your P&G shares. They also can preserve the cost basis for those shares in your taxable brokerage account. That will reduce your capital gains burden, compared to the Duke Method. Finally, this strategy also helps model for your children and other family members the importance you place on charitable giving.
Seeing the Big Picture
The Duke Method is a compelling strategy, potentially offering tax savings. But it is not a one-size-fits-all approach. To put it another way, just because you can do it, doesn’t mean you should. To determine whether it is the best approach for you requires an in-depth understanding of several moving parts—your tax burden, your investment plan, and your future income and expenses. Meeting with a financial professional can help give you a more complete picture of your situation and help you anticipate issues that you may not expect. This is why at Truepoint Wealth Counsel we take a holistic approach to financial planning. We bring together a comprehensive team of professionals—financial and estate planners, investment experts, and tax specialists—who can help you see the whole picture and assess the best strategy for your retirement assets.
In our next piece, we will dive a little deeper into some additional, nuanced income and estate tax consequences of the Duke Method such as the “12-month penalty box”.