Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.
If your clients have done virtually all of their investing in tax-deferred plans, spend-down strategies may be relatively simple. Find a sustainable withdrawal rate for retired clients and help them stick to it, recognizing required minimum distribution (RMD) rules after age 70 ½.
However, many clients have multiple sources for cash in retirement, including nonqualified investments in taxable accounts. Retirees also may have after-tax Roth accounts that can provide tax-free distributions after age 59 ½ and five-year holding period hurdles are cleared. A deeper look at the tax implications of the client’s various assets and how they interact may reveal some unique hidden opportunities to add additional value to the financial plan.
Many advisors have a default method to plan for multiple streams of cash flow:
First: Tap taxable accounts to maximize tax deferral in retirement plans.
Second: Start accessing pretax plans after age 70 ½, to comply with RMD rules.
Third: Keep money in Roth accounts as long as possible, for eventual tax-free payouts to clients or their beneficiaries.
This sequence has merit, but putting this plan on autopilot can lead to paying more tax than necessary. One key drawback is channeling compound growth into pretax accounts. The larger they grow, the larger the eventual RMDs, which could move the client into a higher future tax bracket.
Moreover, tax-free Roth withdrawals may be justified in some situations. If a client needs cash, but using taxable or tax-deferred accounts could trigger severe tax consequences, qualified Roth distributions might be a better source. For instance, clients might face a situation in which more taxable income would raise taxes on Social Security benefits or long-term capital gains or generate higher Medicare premiums; Roth payouts could come to the rescue!
For overall tax savings, one approach is to advise clients to take some money from their pretax accounts when they’re in their 60s: older than 59 ½, so the 10% early withdrawal penalty won’t apply, and younger than 70 ½, at which point RMDs greatly reduce the flexibility in your withdrawal approach. Closely monitoring such distributions can keep clients in today’s 12% , 22% and 24% tax brackets, which are low by recent standards, and reduce future RMDs.
Money that 60-somethings take from pretax accounts may be used for living expenses, if needed. This arrangement could help clients defer starting Social Security until age 70, for the largest monthly payout, partially untaxed — and possibly a larger lifelong payout for a surviving spouse.
Another option would include conversions to a Roth IRA, where there are no lifetime RMDs and future distributions are tax-free. Current tax law prohibits recharacterization of a Roth IRA conversion, so money shifted to the Roth side generates an indelible tax bill. It’s often best to wait for a Roth IRA conversion until late in the year, when taxable income might be estimated accurately — and also to rely upon a sophisticated software program (like the one I developed) to calibrate how much to convert without creating unexpected tax bills.
Clients may have other sources of cash flow to consider in retirement planning. Some will have health savings accounts (HSAs), which combine upfront deductions with tax-free compounding. Distributions from HSAs also will be tax-free, if they are used for qualified medical expenses.
Loans also may provide liquidity without delivering tax bills. A home equity line of credit might be tapped — and the interest may be tax deductible if the money is used to buy, build or substantially improve the home that secures the loan. A reverse mortgage might be an option for tax-efficient liquidity. In addition, clients who have permanent life insurance policies could borrow from the cash value, if a smaller death benefit is acceptable.
However you feel about deferred annuities, you may have some clients who hold these contracts when they retire. Are the guarantees greater than the actual value, inviting a drawdown that exercises their rider? Are there profits that should be realized? Should cash be accessed via taxable withdrawals or a partially tax-free annuitization? By reading the annuities’ terms carefully, you can decide when and how to best squeeze money from them.
A comfortable retirement is a prime goal for many clients. Look beyond your default method to plan for multiple streams of cash flow and add value by creating tax-efficient plans to keep cash flowing.
— Related on ThinkAdvisor:
- Roth IRA Conversions: How Much Is Too Much?
- Think You Know the Capital Gains Tax Rate? Think Again.
- Beware the Social Security ‘Tax Torpedo’
Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn’t find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.
In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly impact cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model “what-if” scenarios with account positions and align a client’s risk tolerance with their portfolio risk.