More On Tax Planningfrom The Advisor's Professional Library
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
Because every client’s needs are unique, a canned approach to tax-efficient savings of Roth IRAs, traditional IRAs, 401(k), 403(b), NQ annuities, NQ accounts, etc., is not necessarily the most flexible or tax efficient option for every client. As advisors, we know that the words “tax-free” don’t always mean there’s no tax ever paid, just like the term “pre-tax” doesn’t mean there’s always more tax to be paid later.
The point I’m making is that tax law changes and client circumstances can change the landscape for what’s the most tax-efficient savings strategies today versus tomorrow. This is my second blog in a series on what I learned (or was reminded of) in the latest tax season; my first blog, Why I Don’t Like Roth IRAs: Tax Season Lesson, Part 1, garnered some praise and criticism from readers. In this blog, I present two current strategies that I believe might help many clients over the next few years.
Strategy 1: Tax Bracket Savings
Based on today’s tax laws, a family making a middle class living whose taxable income falls into the 15% tax bracket after deductions and exemptions is better off paying the 15% tax on their savings, rather than tax deferring it in an IRA or 401(k) for only a 15% benefit. However, if someone is employed by a company with a 401(k) plan offering a company match, they should contribute and take the free money. After saving the needed amount for the match, it may be better for the client to pay the tax and save money elsewhere in after-tax account structures.
So what type of client would this strategy work for?
A married couple filing joint returns with no kids could gross $94,100 while only paying 15% tax on after-tax savings. The 15% tax bracket threshold in 2014 is $73,800 + $12,400 standard deduction + $7,900 personal exemptions = $94,100.
The same family with four kids would be able to gross $109,900 ($73,800 + $12,400 + $23,700) and still fall into the 15% federal tax bracket on their income. This may even be beneficial at the 25% bracket for those who expect to be in the 28% or higher bracket for most of their future earnings periods.
Beyond the 25% bracket, it’s a case-by-case situation, but tax deferral at those stages becomes very beneficial for managing future retirement income, as most clients whose pre-retirement income is beyond the 25% bracket, rarely need income levels in retirement above 25%, assuming all debts are paid off prior to retirement, which builds in an indirect return of pre-tax savings versus post retirement withdraws.
Strategy2: Investing for Tax-Efficient Savings
So how should one invest those retirement savings if not in an IRA, 401(k) or Roth, but rather into a regular after-tax brokerage account? Based on the current tax code, anyone in the 15% federal tax bracket of income pays an effective tax rate on qualified dividends and long-term capital gains of zero! As in my examples listed above, it’s possible for each family to pay 15% tax one time on their saved income, and then invest it and never pay another dime of tax on their after-tax account dividends and growth. This is really no different than a Roth IRA structure, with a lot less restrictions/regulations—meaning more flexibility over their own money and future estate planning options.
Of course, tax laws can change just as the wind blows, so it’s important that strategies are updated as the tax laws dictate to maximize a client’s retirement savings potential for their best tax efficiency. Furthermore, if the long-term capital gains and qualified dividend rates remain at a 15% maximum rate for clients in the 25%, 28%, 33% and 35% marginal tax brackets, that’s still a very reasonable price on investment earnings if a client’s portfolio is invested properly for that benefit.
Hopefully, I’ve provided some food for thought when advising clients on how to save for the future more tax efficiently. The biggest thing we all need to remember is that one way forever is not the best advice for any client. Tax laws will change and improve the situation for some, while making it worse for others over the years.
Furthermore, some of our clients will never live as long as we project, while others will die many years after we planned. There are many other variables as well, including future medical expenses, disability needs, family hardships, etc. There will always be ongoing savings, planning, living, retiring, taxing and dying as a continuous, comprehensive planning struggle that we, as advisors, must take very seriously for our clients, while always being open to new ideas and strategies.
The one strategy that’s a constant, however, is the one that helps clients save tax efficiently as the tax laws change.
See the first blog in this series by Andrew Rice, Why I Don’t Like Roth IRAs: Tax Season Lesson, Part 1