From the March 2008 issue of Boomer Market Advisor • Subscribe!

March 1, 2008

Lower tax means higher distributions

All else being equal, if you can lower your client's effective tax rate in retirement, you are increasing the client's distribution. While advisors spend a great deal of time managing investment strategies, the outcome in any given year is not very predictable. But taking the time to implement a more tax efficient investment strategy may yield immediate results for your retired clients.

The easiest way to lower the tax rate for income oriented investors is to effectively utilize our graduated income tax system. By properly allocating assets and managing distribution sources, advisors can take advantage of the lower income tax brackets to boost their clients' net distributions. The basic strategy consists of filling up the client's lower income tax brackets with distributions from their qualified accounts, and then shifting to their long term capital gains holdings for distributions that take them into the higher income tax brackets.

Let's take a look at a few examples that help illustrate the opportunities to lower your client's tax bill.

Assume we have a married, retired client who has assets in both his IRA and taxable accounts. For 2008, the client's joint federal income tax rate is 10% on the first $16,050 of income, and 15% on income between $16,050 and $65,100. Therefore, it generally makes sense to take distributions from the IRA until the client's taxable income for the year reaches the $65,100 threshold. Below that level of income, the client is only paying about 15% in federal income tax on those distributions.

Once the client's income for the year exceeds $65,100, the client's federal income tax rate jumps to 25 percent. To the extent possible, it makes sense to fund additional distribution needs from the client's taxable account. Distributions may be funded from dividend payments or the sale of long term capital gains assets. In either case, the client is again only paying 15 percent in taxes. By managing the source of the distributions between qualified and non-qualified accounts, you can take advantage of the lower income tax brackets and the favorable capital gains and dividend tax treatment.

Not only is it important to manage the source of the distributions, but you also want to consider which assets you allocate to each type of account. For instance, because most retired investors will own a reasonable amount of bonds, if often makes sense to allocate a higher percentage of the bonds to the IRA. If you can distribute a portion of the interest and only pay 15 percent in taxes, you will likely achieve a much higher after tax return than compared to using municipal bonds.

Conversely, to take advantage of the 15 percent dividend and long term capital gains rate, you would want to focus on holding your equity positions in the taxable account. If they are held in the IRA, you would end up converting the dividends and long term gains into ordinary income, which will likely result in a higher tax bill.

And don't forget about the effect of the IRA required minimum distribution rules. Because qualified accounts are ultimately subject to increasing RMDs, this is another reason to consider allocating the slower growing fixed income assets to the IRA. A smaller IRA account balance means smaller distributions throughout the client's retirement. By reducing the distribution, the client avoids having to give away more retirement assets in the form of taxes to Uncle Sam. Less taxes means the client is left with more capital to invest, which generally means more income later in life.

While every retired client's tax situation is unique, the point is you can help lower your client's tax rate by paying attention to the source of the distributions and the placement of the investment holdings. The nice thing about retirement income tax planning is that your hard work should have an immediate and positive impact on your clients' lives.

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