Most clients are familiar with the idea of investment diversification, understand its benefits and have incorporated it, with the help of their advisor, into their planning. Fewer advisors, however, actively think about their clients’ tax diversification and include it in their discussions and planning.
What is tax diversification? The simplest explanation is having a number of different types of accounts that are taxed differently for federal and/or state income tax purposes. For instance, from a tax perspective, it might be wise to have some of your client’s money in a taxable account, like a regular brokerage account; some of it in a tax-free account, like a Roth IRA; and some of it in a tax-deferred account, like an IRA.
Diversification of this type has several advantages. One is that you can help reduce your client’s exposure to legislative risk: the possibility that the value of certain transactions, decisions or plans you make relying on the current rules is diminished in the future by a change to those rules.
For example, imagine your client is 69 years old and decides to convert a $300,000 IRA in 2014 to avoid future RMDs. Chances are, adding that much income to your client’s return will result in being subject to a higher tax bracket and a higher marginal tax rate.
While this is generally best to avoid, it might be worth it to avoid RMDs (that will soon be required at age 70 ½) and preserve more tax-favored retirement funds for heirs.
Now suppose that in three years, Congress enacts President Obama’s Roth IRA RMD proposal. If that were to occur (and no grandfather provision was adopted) your client would have to take RMDs anyway. And the price paid to get the money into the Roth IRA will almost certainly not have been worth it.
That’s legislative risk. Tax diversification can’t eliminate the risk, but it can help to reduce it.
Now is a great time to be talking to clients about legislative risk. Many of them are feeling its sting this tax season, perhaps for the first time. For instance, prior to 2013, the maximum tax rate on qualified dividends was 15 percent. For 2013, however, thanks to the combination of the American Taxpayer Relief Act’s (ATRA’s) new 20 percent top long-term capital gains rate and the 3.8 percent healthcare surtax that took effect, those same dividends might be taxed at 23.8 percent.
While we’ve known this would be the case for some time, sometimes “seeing is believing.” Well, when some clients see their dividend tax bill go up by more than 50 percent from one year to the next, you can bet they’ll believe that legislative risk is real and needs to be considered.
Another advantage of tax diversification is that whether your clients’ future tax rate is higher or lower, a portion of their savings will have benefited. For example, if their future tax rate is lower, their traditional IRA, 401(k) or similar plan will likely have given them a pretty good bang for their buck.
It will have reduced their taxable income in years when their marginal tax rate was higher and allow them to distribute the tax-deferred growth in later years, when their marginal rate is lower.
On the other hand, if your clients end up in a higher tax bracket later on in life — due to higher income, tax rates going up, or some combination of the two — their Roth IRA will have been the more valuable move.
A third key advantage of tax diversification is that it can help you manage your clients’ tax liabilities later in life. Sometimes advisors oversimplify the planning of retirement distributions.
For instance, many generalize that “Roth IRA money is the last money you should ever touch.” That’s a good rule of thumb, but it’s not an absolute. Another thing many advisors tell their clients is “Let tax-deferred accounts, like IRAs, grow for as long as possible.” This, again, is a good rule of thumb, but shouldn’t be an absolute.
Suppose your clients are retired and file a joint return. They receive Social Security benefits, have a pension, take periodic distributions from their IRA and have dividends, interest and capital gains from a taxable account. All together, their income is $230,000 — not too shabby. Now imagine that some significant expense comes up that you didn’t anticipate in your planning. You’re going to have to come up with the money from somewhere, but where?
You could follow “conventional wisdom,” leave your clients’ Roth IRA alone and take money out of their IRA first. That IRA distribution, however, could lead to significant tax consequences. Depending on how much you take, you could:
Push your client into a higher tax bracket
Cause some or all of their personal exemptions to be phased-out
Cause some (up to 80 percent) of their itemized deductions to be phased-out
Push your client over the married-joint health-care surtax threshold, subjecting some or all of their interest, dividends and capital gains income to the additional 3.8 percent surtax
Increase your client’s Medicare part B premiums in the future
Do you think any of those possibilities sound appealing to your client? I didn’t think so. A second option would be to sell additional stocks, bonds, mutual funds, etc., in your client’s taxable brokerage account, but that could lead to all of the same consequences as above.
(Note: Tax loss harvesting could be used to minimize or eliminate the tax impact of selling assets with a gain.)
Plus, if your clients hold on to the appreciated capital assets, their beneficiaries will get a step-up in basis upon their death.
Cue the third option: your clients’ Roth IRA. Although it goes against conventional wisdom, given the host of negative tax consequences that could befall them by adding more taxable income to the return — either in the form of IRA distributions or capital gains — it may be worth dipping into their Roth IRA.
There are other scenarios where the opposite approach may make the most sense, perhaps the most common of which is deciding whether to have your clients use more IRA money early in retirement to allow them to delay taking Social Security — a more tax-efficient and guaranteed source of income. Or perhaps your clients are in the 15 percent bracket or below and it pays to distribute IRA income before they have to in order to “fill up” the relatively low 15 percent bracket.
The common denominator in all these scenarios is that by having multiple types of accounts with different tax attributes — tax diversification — you can add flexibility to your clients’ retirement plan. Not to mention, as discussed above, tax diversification can help you minimize risk.
Hmmm… more flexibility? Less risk? Do these sound like things your clients want during retirement? Well then make sure tax diversification is part of your retirement conversation.