Tax and Estate Considerations of the Duke Method
In this installment of our series on the Duke Method, we look at two major components of your personal finances—taxes and estate planning. Keep in mind that these issues can be fairly technical and individualized, so we encourage you to consult with a financial professional who is well versed in both the Duke Method, as well as your unique situation.
Although the Duke Method can significantly reduce your tax bill, it’s important to remember that those benefits end after the first year. To evaluate the Duke Method properly, you need to consider how it will affect your long-term tax costs as well as your larger financial plan.
Understanding Tax Strategy and the Duke Method
Many people erroneously believe that the Duke Method is a “tax-free” strategy, but this doesn’t capture the whole picture. Although you may not be taxed on your initial distribution from your retirement plan, you will face other tax expenses down the road. For example, when you take distributions from your IRA, those will be taxed at ordinary rates. And, when you sell P&G shares from your brokerage account, those will be subject to capital gains taxes. Remember, the basis of the P&G shares held in your brokerage account is ZERO under the Duke Method, so the entire value of the shares is considered a taxable gain upon sale.
Capital Gains Taxes Depend on Income Level
You can reduce your capital gains tax rate to zero percent, but to do so, you must keep your taxable income under a certain threshold for the year: $80,000 for those married, filing jointly, and $40,000 for those single or filing separately. So, be forewarned: if you generate too much income in a given year, you could end up with a sizable tax bill.
To understand the implications of annual income, let’s look at two different couples, filing jointly:
The first couple’s total taxable income fell under the $94,050 threshold. Therefore, they would not owe any capital gains on the $50,000 in P&G stock they sold that year. In contrast, the second couple earned more than $94,050, so their $50,000 sale would be taxed at the 15% capital gains rate. And, if they had earned even more income, they could even face a 20% capital gains rate.
Lowering Your Capital Gains Bill
High capital gains costs might make you rethink the Duke Method. However, some strategies can help reduce your tax burden.
Spread Out Withdrawals to Lower Your Income
One approach is to extend the sales of your P&G stock over multiple years, making sure your annual income stays under the zero percent capital gains tax threshold. But this strategy requires a precise understanding of your cash flow, as well as disciplined budgeting and spending habits. Also, other income, such as pension and social security, can easily drive you over the income threshold. To put it simply, this approach can be difficult to execute.
In addition, holding onto P&G shares for years leaves you vulnerable to concentration risk—the problem of holding too much of one company’s stock. It will take many years of steady withdrawals to sell off all of your P&G shares while staying under the income threshold. During that time, you would be significantly exposed to any declines in the P&G stock price. This could significantly erode the gains you earned by pursuing the Duke Method.
On the other hand, if you try to eliminate concentration risk and sell large amounts of your P&G shares early in your retirement, you could incur significant capital gains tax costs, which could impact your overall financial plan. When it comes to the Duke Method, there is no one-size-fits-all approach. You need to assess how the strategy will affect the many facets of your financial life.
Donate Your Shares to Charity
You can also reduce capital gains taxes by donating shares to charity. This will earn you a charitable deduction for the fair market value of the donated shares. By doing so, you’ll not only receive a charitable deduction on the fair market value of the donated shares, you will also avoid paying capital gains taxes. When the shares you’re donating have a zero basis, like your P&G shares do under the Duke Method, you could enjoy significant tax savings. Plus, the charity won’t owe capital gains tax on the donation, either. It’s a win-win. Please note, we strongly encourage you to work with a CPA who has individual income tax expertise as transactions within one year of the QLSD may have other, seemingly unusual considerations.
However, it’s unlikely you will want to donate all of your P&G shares. Most people need at least some of their stock to cover their expenses, so don’t expect to use donations to entirely offset your tax bill. Also, remember that you can benefit from donating shares even if you don’t pursue the Duke Method.
The Duke Method and Audit Risk
The premise behind the Duke Method rests on cobbling together sections of the Internal Revenue Code, IRS Regulations, and two IRS private letter rulings (PLRs). PLRs pertain only to that case, and they explicitly do not establish precedence. That said, PLRs can provide insight into the IRS’s reasoning.
This is important because if you use the Duke Method and the IRS audits you, they could reject your approach and reverse your transactions. That could mean owing years of taxes, interest, and penalties—as well as considerable accounting costs to help you sort out the difficulty. As a result, the benefits you accrued from using the Duke Method could be entirely erased. To mitigate this risk, you can file additional disclosures with the IRS, which might protect you from accuracy-related penalties, but these filings won’t stop the assessment of underpaid tax and interest.
Estate Planning Opportunities with the Duke Method
Like tax considerations, estate planning issues are varied and personal. In fact, these two planning areas often overlap because estate issues often affect your and your beneficiaries’ tax burdens. So, it’s important to understand how the Duke Method can shape your estate planning decisions.
Creating a Trust for Greater Flexibility
In a dedicated retirement account—whether a company-sponsored plan or an IRA—your beneficiaries will almost always be your spouse, if you’re married, followed by your direct descendants. When you transfer your assets into a taxable brokerage account, as you do in the Duke Method, you have more choices for distributing your assets. A brokerage account also enables you to place your assets in a trust—an option not available with an IRA.
Asset Protection
Though a trust gives you more flexibility for estate planning, it can leave your assets at greater risk. That’s because assets held in qualified retirement accounts, such as company retirement plans, are protected under ERISA laws and are not subject to bankruptcy, creditors, or civil lawsuits like divorce; IRAs enjoy similar protections. A brokerage account, however, is not afforded these same protections—leaving your assets vulnerable to legal action. There are estate planning strategies, such as asset protection trusts, that can address these risks, but they involve losing some control over your assets. If you’re considering the Duke Method, consult with a qualified estate planning professional to make sure your—and your descendants’ assets—are sufficiently protected.
A Significant Limitation
Perhaps the single most misunderstood aspect of the qualified lump sum distribution pertains to the treatment of QLSD stock at death. An heir’s cost basis of most inherited assets becomes equal to the fair market value of those assets on the decedent’s date of death. This is called a ‘step up in basis.’ For example, if mom’s beach house is valued at $1 million on the day she died, her child’s cost basis in that house becomes $1 million, even if mom only paid $100,000 for the property. This means if the home is sold for $1 million by the heir, there will not be a taxable gain on the sale.
There are a number of exceptions to this ‘step up in basis’ rule; notably IRAs. There is no step up in basis for IRAs. Interestingly, the NUA of P&G stock received in a qualified lump sum distribution is also NOT stepped up in basis. This means that your heirs will always incur a long-term capital gains tax on the NUA, when selling their inherited QLSD P&G stock. In practice, this is tricky because a portion of the P&G stock is stepped up in basis. However, that portion is limited to the post-qualified lump sum distribution date subsequent appreciation.
For example, let’s assume Jim executes a qualified lump sum distribution in 2024 and does not implement the Duke Method. On the date of the qualified lump sum distribution, P&G stock was trading at $160. The per share cost basis of the stock he distributed was $6.82; all preferred stock. The NUA per share is equal to the difference, $153.18. If Jim dies when P&G is trading at $200 per share, his heirs will inherit stock as follows: Long Term Capital Gain Adjustment (NUA) $153.18. Cost Basis $200. If the stock is sold by the heir for $200, they will report a $153.18 long-term capital gain.
Because the Duke Method increases the NUA, the tax liability passed to the heirs is greater than instances when the Duke Method was not used. In the previous example, the NUA would have increased to $160. Therefore, if the same sale occurred in the above example, those heirs of NUA / Duke Method stock would report a $160/share long term capital gain.
The SECURE Act and the Duke Method
The Duke Method can also give your beneficiaries more time to withdraw their assets. The SECURE Acts, passed in 2020 and 2022, changed the way certain inherited assets can be distributed. Previously, beneficiaries had their entire lives to withdraw assets inherited from a retirement account. Now, most beneficiaries (except for surviving spouses) have only 10 years to withdraw such assets. This means, for example, that if you leave money for your children in an IRA, they will have 10 years to withdraw all of the funds.
The Duke Method helps diminish these concerns because a portion of your assets will be held in brokerage accounts, giving your beneficiaries unlimited time to withdraw their inheritance. Additionally, if you have placed your assets in certain types of trusts, your beneficiaries enjoy even greater benefits: these funds would be protected from creditors and civil lawsuits (including divorce) for the rest of the beneficiary’s life. In contrast, assets inherited through a retirement account must be withdrawn within 10 years, and once they’re withdrawn, they are no longer protected.
The Duke Method Requires a Coordinated Approach
The Duke Method offers a range of potential advantages, but it also has significant downsides—such as capital gains bills, concentration risk, and the threat of an audit—that can be hard for individuals to quantify or plan for. What’s more, many of these considerations are interdependent, so deciding whether to pursue the strategy requires a thorough understanding of your entire financial picture. That’s why your advisor needs to know more than just how to execute the strategy. They should be able to determine exactly how the Duke Method will help—or hinder—your long-term plans. At Truepoint, we have specialist teams devoted to every area of personal finance—tax, estate, investing, and financial planning—staffed by experienced professionals who work together to analyze your complete financial life. This enables them to determine exactly how the Duke Method will affect you—and whether it will, in fact, bring you closer to the retirement you dream of.
In our Frank Duke Method series:
