Sadly, most people don’t thoughtfully consider their taxes when planning for retirement. Taxes are complex, but proper planning may reliably add tens or even hundreds of thousands of dollars to your family’s net worth over time.
I believe because of the complexity and a catch 22 I’ll describe, most default to another retirement rule gone awry – that you’ll be in a lower tax bracket once you retire. This is often false for a surprisingly wide range of retirees.
Here’s the catch: CPA’s generally do not perform proactive income tax planning for individuals unless you are a key client with a big business. Regardless, your CPA cannot advise on your investments, which are certainly related to your tax planning. They’re also not privy to your retirement goals nor the portfolio distributions required to meet those goals. Missing the longer-term view of things doesn’t allow a multi-year approach to your tax planning.
How about your average financial advisor? Well he doesn’t even fully understand your various marginal tax rates let alone how to execute tax planning strategies to save you money. Even if he was enlightened, his firm likely precludes him from providing any tax advice. Instead he’s instructed to say, “Consult your tax advisor.”
Either you never made aware of the tax planning opportunities you have, or if you are, around and around you go in trying to get help to capitalize on them … the dreaded catch 22.
A short story can illustrate a common scenario and planning opportunities.
The Successful Smiths
John and Jane Smith were a loving and hard-working couple that raised two well-adjusted children. John worked his way up the corporate ladder and achieved a senior level position. Jane was a school teacher for 25 years, taking a break for a few years when their kids were very young. They always saved but were able to save more as John climbed the ladder.
They worked into their early 60s and ended up accumulating more wealth than they dreamed possible — $2.5M in total with $1.75M in their IRAs and $750K in a trust account. Both had sizable pensions from their employers – John $6K and Jane $4K per month. John also had his Social Security benefit — $2K per month if he started today or about $3.5K per month, if he deferred to age 70.
The Smiths could see that the pensions alone would provide ~$120K pre-tax yearly and would cover what they needed to live their lifestyle – about $100K yearly plus $20K to cover their income tax liability. They figured that they would need to dip into their assets when they wanted to buy a car, take a special trip, make a gift larger than normal but that’s about it. Well, unless they do decide to buy that winter home in Florida.
The Smiths were happy with the financial security they had. But John said to their new advisor, “I know we’ve done well, but I feel like I’m missing something. I don’t feel like everything we have is tied into a coherent financial strategy. I’m concerned about what will happen tax-wise once we get into our 70s and must take those required minimum distributions – RMDs – from our IRAs. There’s also been years these mutual funds that send me a big 1099 tax bill for the trust account, but other years they don’t. This is why we hired you. To help make the most of what we have. Well that and I want to make sure someone I trust is there to take care of Jane, if I go first. What ideas do you have?”
The Smith’s advisor briefly explains there are several strategies that can applied to improve the overall efficiency of their planning and maximize their after-tax wealth.
Delay Social Security. “John, you are healthy and the pension income already covers your lifestyle expenses. Deferring Social Security to age 70 will allow additional room for tax planning throughout your 60s. The tax-planning benefits should lower the break-even age – the age how long you must live for deferral to pay off – a few years to your mid 70s. The longer you live, John, the more beneficial the strategy.
Asset location. “You’ve done a great job saving and a decent job investing too. One opportunity you seem to have missed is considering in what accounts or location to hold certain funds. While this gets complex, the key drivers of this strategy the following four items. The more of each, the greater the benefits. They are (1) time the assets will stay invested, (2) expected return, (3) tax rate, and (4) the tax efficiency of the investment itself. What we need to do is replace those funds in your trust account that generate those large 1099s. We’ll replace them with very tax-efficient funds.”
“Then in your IRA, we’ll put all the tax-inefficient and lower growth assets like bonds. The IRA shelters the income. And putting slower growth assets in the IRA will mitigate the associated tax bill come RMD time.”
Roth conversions. “While you’re firmly in the 25% tax bracket, once John’s Social Security and then RMD’s start, your income will be approaching $250K, accompanied by higher tax rates. What I’d suggest is immediately start utilizing Roth IRA conversions – choosing to pay tax on money in an IRA now and move it to a Roth IRA that will be tax-free forever – and continue to do so throughout your 60s. This way you pay tax at 25% and avoid higher RMDs and higher tax rates in the future. Even better, we can get creative and do multiple conversions each year. The IRS allows you to cherry-pick the best performer while undoing the rest. If a certain fund performs well after conversion, we’ll keep that one and all the growth is tax-free. If you look at the tax paid versus what the account has grown to, many of our clients have had a 25% tax rate lowered to 20% or even less.”
Their advisor suggests this is enough for today’s meeting. “Not too much to digest at once,” he said. “We’ll get into some other tax planning ideas I have next time. We need to explore some ways to improve the efficiency of your yearly charitable giving. Plus, let’s talk more about the winter home. There could be substantial tax savings in both these areas.”
“I’ll email you some of the supporting evidence for the strategies I’m describing. I realize you may not read it, but at least you’ll know that I have. To give a rough idea of the benefits, the Social Security strategy should make you about $70K better off today, if John is just average in life expectancy terms. And studies show the asset location benefits may range from zero to 0.75% yearly increase in net returns. So, with your $2.5M in assets and other traits, I think $10K yearly in increased wealth is a conservative figure. That’ll likely be more than $100K more over the next ten years. We’re off to a good start.”
Kevin Kroskey, CFP®, MBA is President & Sr. Wealth Advisor with True Wealth Design, an independent registered investment advisory and wealth management firm specializing in retirement, tax, and investment planning for successful familes at or near retirement.