Advisers Can Help With Effective Tax Planning

Tax planning is a key issue when folks are working, but it’s even more critical in retirement.
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While clients are working, tax planning is generally a key financial planning issue for them. Some people may be unaware of the need to continue these tax planning efforts into retirement. Financial advisers can provide key insight to long-term tax planning.

For some perspective, one premise behind tax-deferred retirement accounts was that taxable distributions would be made when account holders retired and were in a lower tax bracket. While this is still the case with some retirees, others may not see their tax rate drop once they retire. This might be due to several factors, including distributions from retirement accounts and changes in tax rates.

Types of income that might boost a client’s tax bill in retirement include:

  • Distributions from traditional retirement accounts, including required minimum distributions
  • Income from taxable investment accounts
  • Pension payments
  • Gains from the sale of a client’s home
  • Income from employment or self-employment

Here are some things that can be done to reduce taxes in retirement. Advisers also understand that taxes are a piece of the puzzle and reducing taxes is a strategy in your client’s overall wealth management rather than an objective unto itself. Sometimes clients eager to reduce their tax bills need to be reminded of this.

Read: from Robert Powell's Retirement Daily on TheStreet: Will Your Taxes Really Be Lower in Retirement?

Managing Tax Brackets

It’s a good practice to look at your client’s potential taxable income for the year. In years where their income might be lower than others it can make sense to accelerate some income items into that year to fill up their tax bracket so to speak. In other words, if they have room for additional income before their marginal tax rate bumps up to the next level it might make sense to take that income in the current year.

An example of this strategy might be to take additional taxable distributions from retirement accounts to fund their income needs for that year as opposed to using assets that wouldn’t be taxed.

Another example might be to do a Roth conversion in that calendar year.

Roth Conversions

Roth conversions are getting a lot of attention as a strategy to consider in 2020 due to the required minimum distribution (RMD) waivers in the CARES Act and our historically low tax rates in 2020. There may be merit for your clients this year or in the future. Roth conversions are a true trade-off; the client pays taxes on the converted amount in the year of the conversion. The benefit is lower required minimum distributions in subsequent years.

The keys in determining if this is a good strategy for your client surrounds that tax hit that they will take in the year of the conversion as compared to the tax savings they might realize in future years from potentially lower RMDs. Also, of course, it's critical to ensure that they have the cash outside of the traditional IRA to pay the taxes on the conversion, otherwise this becomes an expensive proposition.

Retirement Withdrawal Strategy

Tax planning should be a key component for the retirement withdrawal strategy that you devise for your clients. This will involve which accounts to tap and in which order. This strategy should include an annual review based on the managing tax brackets issue discussed above. The best course of action may change from year-to-year based on the client’s projected taxable income for that year.

Taxes should not be the sole consideration in deciding which accounts to tap but doing this level of analysis can help them save a considerable amount in taxes over time in many cases.

Qualified Charitable Distributions

Qualified charitable distributions (QCDs) are a way for those clients who are charitably inclined to direct some or all of their RMDs from IRA accounts towards a qualified charitable organization. Up to $100,000 of their RMD can be used as a QCD. The amount of the QCD will not be taxed, though there is no charitable deduction available for QCDs.

A quirk in the SECURE Act left the minimum age for QCDs at 70½ even though the age to commence RMDs was increased to 72.

Tax-Loss Harvesting

Tax-loss harvesting is a smart strategy for those with investments in taxable accounts at any stage of life. As part of the rebalancing process, look at any potential investment losses that can be realized to offset gains or other taxable income for that year. This should be done as part of your normal portfolio reviews for your clients and of course the investment merits should be the driving force, not the tax benefits.

Deferring RMDs on 401(k) Plans

For clients who are still working as of the age when RMDs commence, they may be able to defer RMDs on the money in their current employer’s 401(k) plan. To qualify, your client must hold a 5% or less ownership stake in their employer. Additionally, the employer must have elected this option as part of their plan’s rules.

A strategy around this exemption might be to do a reverse rollover of other retirement money into the employer’s 401(k) plan if they accept such rollovers. This might include an IRA account or an old 401(k) account. The benefit of doing this is that those funds would also qualify for the RMD deferral as well. It's imperative for you to review the employer’s plan to ensure that the investments offered and the plan’s expenses make this a good destination for your client’s retirement money.

This deferral does not impact RMDs from other retirement accounts, these RMDs must still be taken to avoid any penalties for missed RMDs.

Helping clients reduce their taxes in retirement is helpful on several fronts. Tax savings can help increase the amount of their nest egg available to them over the course of their retirement. Lowering their taxable income can also help keep them at a lower premium level for Medicare Part B.